Thursday, May 10, 2018

Laffer Curve strikes again: lower tax rates produced more revenue

The results of last year's Trump tax cut are starting to roll in, and they should not be surprising to students of the Laffer Curve or readers of this blog. As I noted last October, not cutting taxes rates is boosting the deficit:
Since early last year (February 2016, to be exact), when talk of tax cuts began to spread and politicians on both sides of the aisle began to agree that our corporate tax rate—the highest in the developing world—should be cut, revenues from corporate and individual income taxes have flatlined, despite the fact that personal incomes have increased by almost 5%, trailing earnings per share have increased 8%, and the stock market has jumped some 30%.
Indeed, there was zero growth in federal revenues beginning in February 2016 through the end of last year. Further, as I predicted back then, "if the tax code is reformed, and marginal tax rates on incomes, capital gains, and corporate profits are reduced, Treasury will see an almost immediate surge in revenue." And it is happening.

Today's April Treasury report showed that April tax receipts not only set an all-time record, but were fully 12% higher than last April's receipts. People and corporations had been postponing income and accelerating deductions for the 22 months leading up to last December's landmark tax reform, and now they are beginning to realize that income and stop postponing deductions. Tax receipts are once again growing, and there is every reason to expect more of this for the foreseeable future.

Chart #1

As Chart #1 shows, individual income tax receipts have jumped this year, led by very strong receipts in April. Corporate income tax receipts are still soft, but that's not too surprising considering the huge reduction in the corporate tax rate. In any event, individual income tax receipts account for the lion's share of federal income, and they have once again turned up in decisive fashion. 

Chart #2

As Chart #2 shows, spending has been rising at a fairly constant rate (about 4% per year) since 2015. On a rolling 12-mo. basis, federal revenue has risen at a 3.4% rate over what it was a year ago, and it could easily be recording 5-6% rates of growth going forward. With just the tiniest bit of spending restraint, we could see the budget deficit hold steady or decline between now and year end.

Chart #3

As Chart #3 shows, the federal government's finances are very dependent on the health of the economy. They always deteriorate during and after recessions, and they almost always improve during periods of growth. The recent increase in the budget deficit is anomalous in that regard. But when seen through the lens of the Laffer Curve, it is understandable and thus likely temporary.

The Laffer Curve can be summed up as follows: people respond to incentives, especially changes in tax rates. When there is talk of a future reduction in tax rates, it is reasonable to expect tax revenues to decline in anticipation, then subsequently rise once the rates have been cut. Business investment was weak in anticipation of a reduced business tax rate, and now it should be stronger, with the result being more jobs, more income, more profits, and more revenues to Treasury.

The one thing to worry about is the spending side. Spending discipline unfortunately is lacking in today's Congress, and the unchecked growth of entitlements promises to wreak havoc with federal finances in coming years.

Tuesday, May 8, 2018

Jobs nirvana

The economy isn't booming, but labor market fundamentals have never been so good.

Chart #1

The BLS today reported that April job openings were the highest ever recorded (see Chart #1). The current business cycle expansion has added 10 million net new private sector jobs to the economy since late 2007, yet businesses are looking to hire another 6.55 million. Impressive.

Chart #2

The unemployment rate has fallen to a mere 3.9%, and there are only 6.4 million people actively looking for work, according to the BLS. If there is a problem it is the apparent inability of those looking for work to qualify for or accept the jobs being offered. (see Chart #2) Geographical mismatches are one overlooked but likely culprit: the WSJ noted the other day that a growing number of cities around the country are paying people to relocate there because they have a shortage of able-bodied workers. And with businesses enjoying peak earnings these days, it would not be surprising for many to sweeten their salary offerings in order to fill jobs. What's not to like?

Chart #3

As a percent of the workforce, layoffs are now down to their lowest level ever, as shown in Chart #3. Never before has job security been so solid.

Chart #4

Small businesses are where by far the most new jobs are created, and the owners of those businesses have rarely been so optimistic about the future, as Chart #4 shows.

Chart #5

As Chart #5 shows, real disposable personal income per capita is at an all-time high of $39.5K. That is up 10% from the end of 2007 (i.e., just before the Great Recession hit), and it is just about double what it was 38 years ago, in 1980. Granted, the pace of gains in the past decade has been only about 1% per annum, which is disappointing compared to the 2.1% per annum gains of the 1980-2007 period. But we are making progress and the future looks bright.

Capital today is relatively abundant, thanks to years of growth, rising profits, and lower corporate income taxes. An abundance of capital is an unqualified boon for labor, because when capital is abundant labor sooner or later becomes scarce. This means that the price of labor is bound to rise further, and that should take the form of higher real wages and salaries, plus more job opportunities as businesses seek to ramp up investment. 

UPDATE (5/10/18): First-time claims for unemployment continue to decline. No one ever would have predicted such low levels. The last time they were this low was in 1969, when the total number of jobs was less than half of what it is today:

Chart #6

Monday, May 7, 2018

Argentina just got a $5 billion lesson in the Laffer Curve

Recently, and in the short span of 4 trading days, Argentina's peso suffered a 10% drop, leaving it down 30% vis a vis the dollar over the past year. The Central Bank spent some $5.5 billion of its reserves trying to stem the latest decline, which was arrested only after the central bank hiked short-term rates to a punishing 40% and the government promised to cut spending.

The catalyst for the latest peso decline appears to have been a new 5% income tax on non-residents' holdings of central bank debt (Lebac). This tax, which was part of a comprehensive—and mostly positive—tax reform passed late last year, took effect on April 25th, the very same day that the central bank suddenly was faced with significant outflows of foreign capital. It would seem that foreigners were unhappy paying a tax of 5% of their 30% Lebac coupons. In effect, some $5.5 billion of Lebac was unloaded by foreign investors, converted—thanks to the central bank's sales of its foreign reserves—to dollars, and then shipped out of the country. This was equivalent to the exodus of almost 10% of Argentina's precious foreign reserves. And all because of a 5% tax that might have generated, in the best of cases, about $0.5 billion per year. Ouch. As Art Laffer tells it, "when you tax something more, you should expect to get less of it." Less, in this case, being foreign capital, which Argentina desperately needs to jump-start its economy.

Most observers blame Argentina's ongoing problems on its inability to reign in government spending and tame its 25-30% inflation rate. I think the problem is simpler. As I noted 18 months ago, Argentina has been addicted to money-printing for a long time. Its monetary base has been growing about 30% per year for the past 9 years. Money printing has been and continues to be a major source of financing for the government's deficits. In the U.S., federal deficits are financed almost entirely by the sale of government debt. In Argentina, however, if the government can't finance its deficit by selling debt, then it simply resorts to asking the central bank for money, in exchange for an IOU. The U.S. spends money it borrows from the market, but the Argentine government spends money created out of thin air by its central bank.

Argentina has two ways to proceed if it wants to get things under control. One, reign in government spending in order to reduce the deficit (no more taxes, please!). Two, establish enough credibility with foreign investors so that government deficits can be financed with debt sales. Nothing wrong with doing both, of course, while at the same time eschewing money-printing.

Chart #1

Chart #1 documents Argentina's primary problem: massive money printing. For the past 9 years, the central bank has allowed a 30% annual expansion of the monetary base (two-thirds of which is currency in circulation). Not surprisingly, inflation has been running around 25-30% per year. Inflation, as Milton Friedman famously noted, is a monetary phenomenon. Inflation happens when the supply of money exceeds the demand for it. And in this case, a ten-fold increase in the money supply over 9 years clearly and by far outpaced money demand, so the value of the peso plunged and prices in turn soared.

Chart #2

Another problem that has plagued the country off and on over the years is the government's attempts to manage the peso's exchange rate. If the peso's decline can be slowed, as government bureaucrats typically argue, then that will reduce inflation pressures (thus conveniently shifting the blame from money printing to the foreign exchange market). Notably, the Macri administration, which began in late 2015, wisely abandoned the "official" rate and allowed the peso to float freely (this is shown in Chart #2 where the red and blue lines converged). That restored confidence, and the peso slowed its decline for the next year or so even though money printing continued apace, because demand for pesos improved with improved confidence.

Chart #3

But they have reverted to type of late, by selling $5.5 billion of their forex reserves in order to keep the peso from plunging, as seen in Chart #3. Since that didn't work, their only choice was to jack up short-term interest rates in order to bolster demand for the central bank's debt. Higher interest rates can work in the absence of a decline in money printing (note the similarity to the Fed's use of IOER to bolster banks' demand for bank reserves in the presence of an abundance of excess reserves), but that's not a lasting solution nor will it inspire long-term confidence.

In the end, the math is compelling: since mid-2009, the monetary base has expanded ten-fold, and the peso has lost 83% of its value. The culprit is money printing, and it has got to stop. Any other "fixes" will only prove temporary. Short-term interest rates on Lebac are only effective if they offer investors after-tax compensation for the expected depreciation of the peso. With money printing running at 30% and the peso down 30% in the past year, the after-tax coupon on Lebac needs to be well above 30% to avoid further capital outflows. (Thus it's no surprise that with Lebac rates today at 40%, the peso appears to have stabilized.)

Argentine President Mauricio Macri is, like Donald Trump, a successful businessman who has pledged to restore prosperity to his country. Macri has done a lot of good to date, but this recent peso problem is an unfortunate blemish on his record. I'd like to think that he will take the appropriate steps to get things back on track. So far he's made serious inroads on government corruption and red tape, and the economy's fundamentals have improved measurably (in dollar terms, the Argentine stock market is up 33% since Macri took over). It would be a crime if he didn't set a better course for monetary and fiscal policy. Please, Mr. Macri: cut government spending, pledge to honor Argentina's commitments, get rid of unnecessary taxes, and instruct the central bank to reign in the growth of the money supply.