Tuesday, December 5, 2017

Tax reform is priced in, but not a stronger economy

The S&P 500 keeps setting new record highs, we're on the cusp of a major tax reform, and the economy is showing signs of perking up. Pessimists fret that we're in another bubble that could pop at any moment, while optimists believe the economy has lots of upside potential. I'm still in the latter camp, though I do acknowledge that it's tough to find much that is cheap these days. In any event, what the market seems to be ignoring is that the kind of tax cuts we're about to experience—which are unprecedented in their focus on businesses—are very likely to lead to a business investment boom, and that in turn is likely to result in more jobs, more productivity, and higher wages and salaries in the years to come.

The S&P 500 is up about 24% since the week before Trump won last year's election. Half of that gain is due to increased earnings on continuing operations, while the other half is due to a rise in the multiple the market is willing to pay for a dollar's worth of those earnings (i.e., PE ratios). Over that same period,  5-yr Treasury yields have jumped by about 80 bps (from 1.3% to 2.4%), and real yields on 5-yr TIPS have jumped 65 bps (from -0.33% to +0.33%), implying a meaningful increase in real growth expectations but only a modest rise in inflation expectations.

Both the bond and the stock market have thus undergone some significant price adjustments that are consistent with an improved economic outlook. Investors expect more growth (as seen in rising real yields) and rising after-tax profits (as evidenced by higher PE ratios). So: is the market now pricing in an economic boom because of the likely passage of Trump's tax reform? Or is the market just pricing in the boost to future after-tax earnings that would result from a sizeable reduction in corporate income taxes (from 35% to 20%)? The way I read the market tea leaves, the market has little doubt that tax reform will pass, and that it will in turn boost after-tax corporate profits. But as yet I see no convincing evidence that the market is pricing in a substantial increase in economic growth rates—almost certainly not of the magnitude which the Republicans are touting (i.e., 3% or more). So we're faced with a mixed bag of market expectations: good news for profits and equity investors, but not much reason to cheer for the man on the street. That's missing the forest for the trees.

Outside of the Republican booster community and supply-side economists, I see very few who expect real GDP growth to rise significantly in coming years. Left-leaning commentators argue that the tax reform being pushed is very unlikely to do anything outside of lining the pockets of big business and the wealthy. A recent Bloomberg article, "Supply-Siders Still Push What Doesn't Work" argues that what has really been holding growth back is not high taxes and heavy regulatory burdens, it's an aging population that is still nursing the wounds to confidence it suffered in the Great Recession of 2008-09. It's not hard to deploy statistics in a way that bolsters your argument, as the Bloomberg article does, but there are some facts in the historical record which should be incontestable: the tax cuts that occurred during the Reagan and Clinton eras boosted economic growth considerably, while the massive fiscal spending "stimulus" of the Obama years failed miserably. (see charts below)

As I argued a year ago, the only good thing about the American Recovery and Reinvestment Act of 2009 was that it served as a laboratory experiment to test the value of the government spending multiplier. ARRA boosters argued that it would kick-start the recovery and deliver strong growth for years to come. Unfortunately, the results were the exact opposite of what was expected by the Keynesians. Why? Because the ARRA was all about income redistribution. It did nothing to change the incentives to work and invest:

Fully 63% of the "stimulus" spending was income redistribution in disguise (i.e., tax benefits and entitlements). And if you reclassify things such as education, housing assistance, and health as transfer payments, then over 75% of the $840 billion allocated to "stimulus" was essentially income redistribution. Only 8%—$65.5 billion—went for transportation and infrastructure (i.e., the "shovel-ready" projects that would put American back to work). Not a dime went to increase anyone's incentive to work harder or invest more.
The ARRA was a laboratory experiment in the power of the government spending multiplier to grow the economy by "stimulating demand." It ended up proving that the multiplier is way less than one. American taxpayers borrowed $840 billion only to learn that the payoff was only a small fraction of the additional debt incurred. We wasted almost a trillion dollars of the economy's scarce resources, and that's a big reason why the recovery has been so disappointing. If we had instead "spent" the money on lowering tax rates for everyone (e.g., we could have eliminated corporate taxes for three years with the ARRA money spent) in order to give them a greater incentive to work and invest, the results could have been dramatically better. The tax cuts might even have paid for themselves in the form of a stronger recovery over time.

Income redistribution does nothing to change the long-term growth path of the economy. It takes investment, risk-taking, and working harder and more effectively to boost growth. Incurring debt to finance spending is a waste of the economy's resources, but incurring debt to finance productive investment can lead to a real payoff. Indeed, that was the lesson we learned from the ARRA: excessive spending financed by debt can weaken the economy.

The principle virtue of the Tax Cuts and Jobs Act about to be passed by Congress is that it significantly increases the after-tax rewards to business investment by slashing corporate income tax rates and by allowing immediate expensing of capital investments. This automatically lowers the hurdle rate for all investment projects, and thus it should lead to a significant increase in investment, jobs, and incomes over time. The TCJA  has its faults, unfortunately, and these center on measures which produce only one-time gains in after-tax income (e.g., increases in the standard deduction and the child credit which do nothing to reward new investment, harder work, or risk-taking). But on balance it is very pro-growth.

The TCJA differs importantly from the Reagan tax cuts in the early 1980s, since the latter focused almost exclusively on lowering individual income tax rates. Reagan gambled that cutting tax rates on individuals would eventually lead to a stronger economy since everyone would have an incentive to work harder and invest more. But by focusing directly on the investment side of the economy, the TCJA could prove even more effective than the Reagan tax cuts.

The charts that follow illustrate the various ways in which the economy is already perking up, and they also illustrate why I think the market has yet to price in a stronger economy as a result of the passage of the TCJA.

Chart #1

 Chart #2

Charts #1 and #2 illustrate the substantial recent upturn in US industrial & manufacturing production, and how that has been accompanied by a significant pickup in Eurozone industrial production. We're seeing a coordinated acceleration in global manufacturing and output, which is a nice tailwind to enjoy.

Chart #3

Chart #3 suggests that housing starts have lots of upside potential, especially considering the strong levels of builder sentiment. By eliminating or limiting the mortgage interest deduction (which subsidizes housing and thus makes housing more expensive than otherwise), the TCJA could make housing more affordable for the middle class and thus stimulate more housing supply. A dramatic increase in the standard deduction would render the loss of the mortgage deduction moot for a whole swath of the population.

Chart #4

As Chart #4 suggests, the ISM manufacturing report is consistent with GDP growth exceeding 3% in the third quarter. The Atlanta Fed's GDPNow index currently predicts fourth quarter real growth of 3.2%. That would put real growth for the year at over 2.7%, which is comfortably above the 2.2% annualized growth rate of the current business cycle expansion. This is very encouraging.

Chart #5
Chart #6

Chart #5 shows a substantial recent slowdown in the growth of Commercial & Industrial Loans (a proxy for bank lending to small and medium-sized businesses). Ordinarily, this would be disturbing since it could be the result of a severe tightening in lending standards. But as Chart #6 shows, banks have little reason to tighten lending standards since delinquency rates on all loans and leases are at record lows. This suggests that the slowdown in lending reflects caution on the part of business borrowers, and that is not necessarily a bad thing. Relative to GDP, C&I Loans are about as high as they have ever been.

Chart #7

Chart #8

Chart #7 illustrates the incredible and lasting strength of corporate profits over the past decade. Chart #8 uses this measure of profits (derived from income tax data supplied by businesses to the IRS and compiled into the National Income and Product Accounts) to show that current PE ratios are not excessive by historical standards. Yes, PE ratios are above average, but profits have been way above average for a long time, so the market is not necessarily in bubble territory. I wrote more extensively on this issue here.

Chart #9

Chart #10

Chart #9 looks at the 2-yr annualized growth rate of GDP since 1970. I use this measure in order to smooth out the typically volatile nature of this series on a quarterly and annual basis. It should be easy to see how strong growth was during the mid- to late-1980s, following the Reagan tax cuts. It also illustrates the impressive strength of the economy in the late 1990s, during which time the capital gains tax rate was cut. Chart #10 illustrates how sensitive capital gains tax collections are to changes in the capital gains tax rate. Capgains realizations surged in advance of the big hike in the capgains rate in late 1986, and surged again as the rate was cut during the late 1990s. Lower tax rates can indeed boost tax revenues, while the threat of higher rates can crush tax revenues.

Chart #11

It is noteworthy that the current equity risk premium, illustrated in Chart #11, has remained relatively high in recent years. This suggests investors have been very reluctant to price in a stronger economy. Risk premiums were much lower in the boom years of the 80s and 90s.

Chart #12

Chart #12 shows how weak business investment has been in the past decade, despite the extraordinary level of corporate profits shown in Chart #7. A dearth of business investment has been at the root of the economys sluggish performance over the past decade. That is why the TCJA, which boosts incentives for business investment, could be so important—it directly addresses the problem that has plagued the economy for years. And by lowering business income tax rates here relative to other countries, it could act as a magnet for international capital flows.

Chart #13

Chart #13 shows the 5-yr annualized growth in productivity, highlighted by presidential terms. The Bloomberg article cited above showed the annual growth in output per hour on a year over year basis. This measure of productivity is naturally volatile, so measuring it over longer periods makes it easier to see the big trends. Output per hour isn't the same total labor productivity, however, which is shown in Chart #13, and in any event changes in productivity are one thing while growth in the overall economy (which includes productivity and the number and hours of people working) is another. Regardless, the very weak growth of GDP and productivity in the Obama years is pretty good proof that the policies pursued during the Obama years were not conducive to growth or prosperity. The second half of the Clinton years, in contrast, rank right up there with the Reagan years, all of which featured tax rate reductions.

Chart #14

Chart #14 shows nominal and real rates on 5-yr Treasuries, plus the difference between the two, which is the market's expectation for consumer price inflation over the subsequent five years. Inflation expectations haven't changed much in the past few decades, and currently average about 1.8% per year for the foreseeable future, which is very much in line with what inflation has averaged in recent decades.

Chart #15

Chart #15 compares the real yield on 5-yr TIPS (red line) with the real Fed funds rate (the Fed's target for overnight rates minus the rate of inflation as measured by the PCE Core deflator). Think of the red line as the market's expectation for what the blue line will average over the next 5 years. Note that the real yield curve inverted (i.e., the blue line exceeded the red line) prior to each of the past two recessions. That happens when the Fed becomes so tight that the economy begins to weaken and the market begins to assume that the Fed will be cutting rates in the future. Currently, the real yield curve is still positively sloped. If anything stands out here, it is the market's belief that the Fed is going raise rates only a few more times in the years to come. If the economy picks up steam, however, the Fed is going to be raising rates by a lot more than that.

Chart #16

As Chart #16 shows, the level of real yields on TIPS (blue line) tends to track the economy's real rate of growth over time. That's only logical, since very high real yields can hardly be generated by a weakly-growing economy, whereas a strongly-growing economy, such as we had in the late 1990s, can produce very positive real yields on a variety of asset classes. The current level of real yields in the bond market is consistent with real economic growth rates that are roughly 2%, which is what we've seen over the recent business cycle expansion. If real growth rates were to ratchet up to 3% or more per year, I would bet lots of money that real yields on TIPS would rise to at least 1-2%. With stable inflation expectations, that would imply 5-yr Treasury yields of almost 3-4%, substantially higher than the current 2.2% rate on 5-yr Treasuries. Bond investors need to brace for sharply higher yields if I'm right about the impact of the TCJA.

Chart #17

Chart #17 suggests that nominal yields on 5-yr Treasuries are unusually low given the current level of core inflation. This reinforces the fact that stronger real economic growth would necessarily lead to substantially higher nominal Treasury yields.

As should be obvious from the last two charts, Treasury yields are quite low compared to where they would probably trade if the economy were to prove much stronger than currently expected as a result of tax reform. 

To sum up: the rally in equity prices is evidence that the market is pricing in the passage of tax reform. But the continued low level of real and nominal Treasury yields is evidence that the market has yet to price in the stronger economic growth that is likely to result from tax reform.

UPDATE: I'm adding my chart of GDP growth vs its long-term trend in order to give some broader context to this discussion, and to add to some discussion of the subject of "potential" GDP in the comments section.


Al said...

Great post. That ism man graph is crazy eh. Super high.

Thanks Scott.

Next request. Market liquidity update. Spreads, etc. This are always my favorite graphs.

Benjamin Cole said...

What a wonderful post and I am still in euphoria over the numbered charts.

I think raising the standard deduction does increase rewards for working and thus is pro-growth.

We will see if the Fed allows real GDP growth above recent rates...

The regulation-socialist induced housing shortages on the West Coast will suffocate growth too...and cause inflation, scaring the already timid Fed...everyone is pink in their own neighborhood...

Still things look mostly good...

Scott Grannis said...

Alain: thanks. I’ll get around to your request soon I hope, but for the moment everything (liquidity, spreads) looks about as good as could be expected.

WealthMony said...

Another great post by Scott Grannis. I agree with Benj, things look mostly good. Here's how I see this situation playing out, but I hope I am wrong. We have a Fed that apparently is content with European-like 2% GDP growth. It fears inflation. After tax law changes, the economy picks up, perhaps to as high as 4%. The Fed quickly raises interest rates. The yield curve inverts and maybe by 2019 or 2020 the U.S. is again in a recession and horrendous bear market for stocks.

Scott Grannis said...

We can hope the Fed won't make that mistake again (they made the mistake of overly tightening in the late 1990s and early 2000s because the economy was so strong). However, I would note that even if the Fed raises rates at a faster pace in response to a strengthening economy, it won't necessarily be bad for the equity market or for the economy. (Of course it WILL be bad for the bond market!) It all depends on how things evolve and how much and how fast the Fed tightens. But they will need to tighten, if only to raise real rates to a level commensurate with stronger growth.

It's quite possible that rising money market and bond yields could serve to depress PE ratios even as earnings pick up. So it's conceivable that even with a much stronger economy the stock market might not deliver above-average returns in the years to come.

In any event, I think we have at least a few years before it becomes time to worry about Fed tightening enough to produce a recession.

bt1138 said...










We have seen this movie before.

WealthMony said...

Scott Grannis, has the GDP gap been closed as a chart from the Washington Post would indicate? There's no way two quarters of 3% annualized growth can make up for 8 years of 2.1% growth, which is a full % below long-term trend.

I do not know how to copy and past the WP chart, but what it shows is a GDP @ $15 trillion just before the Great Recession, with that level being on the long-term trend line. It shows the trend line extended to today at $17 trillion and the current GDP @ $17 trillion plus, which closes the gap between actual and long-term trend.

That does not agree with your excellent long-term GDP trend/actual chart where we are still about $3T deficient.

I would really welcome any attempt at possible explanation on your part. I know you do not have the time to deal with every question readers pose, and without my providing the WP chart you can only imagine it. Thank you.

steve said...

UNKNOWN or more specifically UNNAMED (wimpy), what a negative and cynical perspective.

Great work Scott, you do THE best work of any economist and are RETIRED!

What is absolutely amazing to me is the level of bond yields. As I've said repeatedly, I've been trading bonds for over 20 years now but have NEVER seen the ostensible disconnect from yields to reality.

Question is does the bond market know something we don't OR is this simply a matter of supply Vs demand? I believe the latter. Simply put, there is so much $ chasing so much yield (or just plain any asset) that yields are trading much lower than one would expect.
I will not try to prognosticate yields. I have in the past and have been burned. That said, there is a "pause" in yields at the very least and I begrudgingly will say the I "expect" yields to rise but wouldn't bet much on that right now.

WealthMony said...

Sorry to take up space, Scott, but here's the address for the graph I referenced from the Washington Post:


Frozen in the North said...

As the saying goes: Good luck with that!

Not entirely sure how you get higher growth. The US economy is at or near full employment, 60% of GDP is consumption (in one form or another). I see this as a great vehicle for Wall Street with massive asset acquisitions in the near future and massive share buyback -- I don't see massive growth in Capex -- and as for housing...well since you've got to hit the 100k threshold to get benefits from tax cuts, I don't see who exactly is going to be buying housing, especially since health insurance is about to get a lot more expensive with the removal of the individual mandates.

The explosion of the deficit (one solution is to restrict/eliminate Social security, Medicaid and medicare. (50% of the Fed's budget)) is the only solution. My guess is that all three programs should be halved to reduce the deficit. If you believe in the tax cuts then you have to believe that the 1 trillion additional debt has to be addressed immediately. Seriously, cut cut cut. Until the 1 trillion figure is fully addressed

As for me, perfectly happy with the new and improve flow through position. My taxes just went massively down, and I am very happy. My tax advisor tells me that the new drafts for flowthrough are very very promising in reducing my tax burden.

As for Joe six-pack...really I don't care. He voted for Trump, he must hvae understood what he wanted to do.

Scott Grannis said...

WealthMony: Re potential GDP. The WP chart you link to shows one of many possible ways of calculating how much the economy is able to grow over time without getting "overextended." The gray line which purports to represent the economy's "potential" growth path works out to an annualized increase of about 1.4%. Since the middle of 2009 the economy has actually been growing at about 2.2% per year. The chart I'm fond of showing shows a long-term trend growth rate of 3.1% per year beginning in 1966. No one really knows what the economy's actual "potential" growth rate is. The one I use is just an extrapolation of what we have seen over the previous 40 years. 1.4% might be right for today's world, and so might 2.2%, and so might 3.1%. We can't really know until well after the fact.

Personally, I think a potential growth rate of 1.4% per year is ridiculously low. But that is what the "new normal" crowd would have us believe is the "new" potential growth rate. They are the same ones who don't think we need tax cuts, because there is no way for the economy to grow faster. They believe that businesses always operate at maximum efficiency, even when burdened with thousands of regulations and shackled by the highest corporate tax rate in the developed world. Profits, like money, just grow on trees and can be harvested at the whim of politicians and put to a higher purpose. You get my drift.

An interesting aside: the economy's growth rate can be thought of as the combination of the growth rate of the labor force and the rise in the productivity of the labor force. The long-term trend of productivity in the post-war years is roughly 1.8% per year, and the long-term trend in jobs growth over that same period is about 1.6% per year. Add the two and you get close to 3.1%, which is what I'm using for "potential." To say that potential growth is now only 1.4% is to say that the labor force is likely to grow by less than 1% a year (it's been growing a little less than 2% per year for the past decade) and productivity is only going to be maybe 0.5% per year (which is less than what it has averaged since 2009). Both those figures seem awfully low and dismal to me.

But clearly the Washington Post has bought into this way of thinking in a big way with their decision to run with this chart. I'm shocked, shocked, to see that they have deployed "facts" that support the Democrats who are resolutely opposing the Republican's tax plan.

I'm going to add my GDP chart to the post for reference. As you will see, there is still a huge gap (about $3 trillion) between where the economy is today and where it might be if growth had continued at the pace of the previous 40+ years.

Benjamin Cole said...

Do federal deficits matter?

"December Legislation Could Bring Back Trillion-Dollar Deficits"---The Committee For a Responsible Federal Budget

They say trillion-dollar red ink by fiscal 2019.

I realize I sound like a fat lady who says, "I am 50 pounds overweight. So what does another 10 pounds matter?" but one has to wonder what a couple trillion more in debt matters when you owe $20 trillion already.

Some notes:

The Fed seems to be able to buy back debt without inflationary impact. The Bank of Japan has bought back 45% of Japan's nation debt, and they have a problem with deflation (they also allow development in Tokyo, which has a powerful deflationary impact on living costs and property values).

Back in the US, five years of 4% inflation would cut more than $4 trillion off the effective federal debt load. If the US runs moderate inflation, we could run moderate federal deficits in perpetuity, and total federal debt would not grow in relation to GDP.

And remember: There are no deficit hawks in DC (when your party is in power!).

Johnny Bee Dawg said...

Good Lord, this post is packed with great data points.
Outstanding observations and commentary once again, SG!!

Rob said...

Agreed, outstanding work Scott.

Unknown said...

I am not sure this tax plan survives the light of day. Did any of you notice that in their haste to get this passed the senate left in the corporate AMT.


An excerpt:
Robert Murray, C.E.O. of Murray Energy Corp., angrily estimated that his company’s tax bill would increase by $60 million. “What the Senate did, in their befuddled mess, is drove me out of business and then bragged about the fact that they got some tax reform passed,” Mr. Murray said in an interview. “This is not job creation. This is not stimulating income. This is driving a whole sector of our community into nonexistence.”

To fix this, conferees will have to find the same amount of revenue from other sources. So, other taxes are going to go up – a lot. Or the AMT for companies will have to disappear. And given the very tight timeline to get this done, and the intransigence of the “freedom caucus”, and the furor over many other provisions, the longer this thing is in the public’s eye, the less chance it has of becoming law.

Scott Grannis said...

Re the corporate AMT: Yes, keeping it in was surely a mistake. But getting rid of it shouldn't be that hard. Recall that total corporate income tax revenues to Treasury are only about $300 billion/year. How much of that comes from the corporate AMT? 10 or 20%? The solution is to allow the CBO-scored deficit for the whole package to increase by a tiny amount. Best solution of course would be to just forget about pay-go and do the right thing, which is to lower top marginal rates as much as possible, and/or use dynamic scoring. Currently the CBO is estimating that the huge drop in corporate tax rates to 20% would result in only a tiny increase in taxes coming from repatriated profits. In reality it's likely to be much, much higher. $1 trillion might come back in two years, why not? That alone would generate $200 billion in revenues! That would easily "pay for" the elimination of the corporate AMT.

The Cliff Claven of Finance said...

US economy production is best measured by GDP changes over at least one year,
avoiding seasonal adjustments.

3Q 2016 to 3Q 2017 growth was almost the same as the
average GDP growth rate since the last recession ended.

Claims of an economic boom are grossly overstated.

3Q 2017 GDP (2nd revision) was up +4.2% over 3Q 2016, including inflation.

3Q GDP price index was up +1.8% over 3Q 2016

Therefore 3Q 2017 Real GDP was up only +2.4% over 3Q 2016 Real GDP
(+4.2% minus +1.8%).

2.4% growth, year-over-year, compares to the average growth rate of 2.2%
since the last recession ended, something Republicans still complain about.

The difference between a +2.4% annual growth rate,
and +2.2% annual growth rate
is barely worth mentioning.

3Q 2016 GDP = $18.729 trillion annual rate
3Q 2017 GDP = $19.509 trillion annual rate (second revision)

3Q 2016 GDP Price Index = 111.64
3Q 2017 GDP Price Index = 113.64 (second revision)

The Cliff Claven of Finance said...

Mr Grannis wrote the following sentences
in an earlier comment here.

"My Reply" will explain why I believe he is unreasonably bullish,
possibly biased by an expanding investment portfolio,
rather than relying on unbiased economic and demographic data.

Potential Real GDP growth rate based on past 5 years = +1%
Potential Real GDP growth rate based on past 16 years = +2%
Potential Real GDP growth rate based on past 50 years = +3%
Potential Real GDP growth rate based on Trump speech = +4%

1% = an estimate based only on past five years
2% = my guess, assuming Republicans do okay in 2018 elections
3% = Mr. Grannis' wishful thinking
4% = Mr. Trump's master salesman BS

"The long-term trend of productivity in the post-war years is roughly 1.8% per year, and the long-term trend in jobs growth over that same period is about 1.6% per year. Add the two and you get close to 3.1%, which is what I'm using for "potential."

My reply:
First of all, 1.8% + 1.6% don't equal +3.1%,
not that the +3.1% matters anyway,
when compared with the recent growth,
about +2% annual Real GDP growth since 2000.

In economics, where we are now,
and where we are going in the next decade,
should not be based on,
pre-2000 economic data,
especially data from the 'good old days',
of the 1960's and 1970's.

Slow US population growth, and our aging population,
will subtract at least one percentage point,
from the potential Real GDP growth rate,
versus the +3.1% long term average.

The Cliff Claven of Finance said...

Part 2

" ... the Washington Post has bought into this way of thinking in a big way with their decision to run with this chart. I'm shocked, shocked, to see that they have deployed "facts" that support the Democrats who are resolutely opposing the Republican's tax plan."

My reply:
The Washington Post is a left-wing biased newspaper,
fine for lining the floor of bird cages,
when The New York Times is sold out!

But their +1.4% potential GDP growth rate,
is reasonable -- actually overstated,
based on trends in the past five years.

I am a libertarian, and I oppose Trump tax reductions,
because any nation that takes in $3 for every $4 spent,
as the US government does,
is under taxed, not over taxed.

Also, the $1.41 trillion of lost tax revenues
in the Senate bill (first version),
was almost entirely due,
to $1.33 trillion of lost tax revenues,
from cutting the corporate tax rate,
from 35% to 20%.

The tax cuts are almost entirely
business tax cuts,
for the "Top 10%"

"To say that potential growth is now only 1.4% is to say that the labor force is likely to grow by less than 1% a year (it's been growing a little less than 2% per year for the past decade) and productivity is only going to be maybe 0.5% per year (which is less than what it has averaged since 2009). Both those figures seem awfully low and dismal to me."

My reply:
The potential growth figures ARE dismal.
I know you like to ignore bad news,
but you should not.

Potential growth is really less than 1%, not 1.4%.
based on BLS estimates,
of future labor force growth,
which is fairly easy to estimate,
based on demographics,
and the current low unemployment rate.

The BLS predicts near zero
labor force growth through 2024.

Past periods of rapid economic growth,
begin during periods of steep unemployment,
unlike today at 4.1%,
because a declining unemployment rate,
causes a lot of labor force growth.

Future productivity growth,
is only a rough estimate,
based on growth in recent years (+0.6%),
and the long-term trend (down)

Over the past decade, productivity growth
declined from a post-war average of +2% growth,
to a growth rate of about +1% annually,
and just +0.6% annually in the past five years.

US productivity growth in the past,
has been driven by,
domestic investment growth,
particularly net of depreciation.

But ... the 10-year average rate,
of US domestic investment,
(net of depreciation),
as a share of GDP,
has declined from over 11% of GDP,
in the late 1960s,
to about 4.5% of GDP, in 2016.

The BLS projects the US labor force
will reach 163.8 million in 2024.

As of September 2017,
the US labor force was 161.1 million.

That means the growth rate,
of the US labor force,
is projected to average only +0.2% annually,
over the coming 7 years.

The “labor force” contribution to GDP growth,
peaked in the 1970s and early 1980s,
and has been in a downtrend since then.

Demographics and productivity growth,
in the 'good old days'
should not be used,
to predict the future economy.

Scott Grannis said...

Cliff: the one thing I think you are missing is that current productivity and labor force growth trends are not fixed nor immutable. Changes in taxes can almost certainly result in powerful dynamics that ripple throughout the economy. People and businesses definitely respond to incentives and changes in incentives.

Cutting corporate tax rates significantly would almost certainly result in more investment, more jobs, and higher wages and salaries. More investment would very likely result in higher productivity. Higher wages and salaries would very likely result in faster labor force growth (those who are sitting on the sidelines would be tempted to bet back in).

BLS projections of the labor force and productivity are meaningless, since they take no account of changes in tax rates. Demographics can change as well.

The Cliff Claven of Finance said...

Mr. Grannis:

As the eternal optimist,
you prefer to ignore recent actuals (past five years)
and the long term down trends,
of BOTH productivity growth rates,
and labor force growth rates.

That is a lot of recent real data to ignore.

You say BLS projections of labor force growth are "meaningless".
That claim is ridiculous.

Demographics of the working age population are easy to estimate.
They limit labor force growth in the next five years.

The current unemployment rate is low.
That also limits labor force growth in the next five years,
unless the unemployment rate is even lower in five years.

You must be dreaming of the good old days,
prior to 2000, and ignoring the actuals after 2000,
with an average Real GDP growth rate of about 2%.

To me, Republicans always favoring tax cuts,
even without corresponding spending cuts,
are like Democrats always favoring much high minimum wages,

Both are like cheerleaders, with nota care about
what actually happened after prior tax cuts,
and large minimum wage hikes, in the past.

The Reagan tax cuts were followed by a long-term decline
of the Real GDP growth rate (three year average)
and a long term decline of the productivity growth rate.

That's reality, unless you live in an alternate universe.

The least an economist should do,
is report accurately what happened in the past,
and not cheerlead every tax cut as the first step
leading to some long-time growth explosion,
that is just wishful thinking,
not based on economic history

Scott Grannis said...

Cliff: let me respond briefly to your points.

I am an optimist when there is reason to be optimistic. I think you're trying to argue that since economic performance has been poor (to be sure, productivity and labor force growth have been miserable), then one should be pessimistic. I'm optimistic because I think things can improve.

Productivity has lots of room to increase, if business investment picks up. Labor force growth can improve dramatically if the labor force participation rate picks up (i.e., if people are enticed back into the labor force).

The low unemployment rate can increase if enough people rejoin the labor force. The economy could of course continue to grow even if the unemployment rate increased.

I favor tax cuts when I see that tax rates are so high that they are distorting economic decisions (e.g., the $3 trillion of overseas profits that haven't been repatriated).

I think I have been very careful to show how weak the current recovery has been, and why and how I think it can improve. That is not blind optimism, nor is it wishful thinking.

The Cliff Claven of Finance said...

You are a very optimistic person,
who hopes for great times ahead.

I am a realist who observes history,
especially the past 10-20 years.

I think you are overlooking demographics
of the US working age population that has
already shaved about one percentage point
off potential GDP growth.

Meanwhile, it is getting too close to Christmas
and New Years, for me to oppose your optimism.

I'm going to wild guess you are so optimistic,
because you are retired,
wealthy from owning Apple stock for a long time,
and show us a picture of yourself with a beautiful woman,
who is either your wife, or a professional model,
so I understand your eternal optimism!

I would be glad to be wrong,
and see long-term growth increase to 3% or 4%,
but what you are seeing seems to be
that a mere 5% cut in government revenues,
(about $3 trillion revenue, minus $150 billion a year from the tax cut)
will increase long term economic growth
by 50% (from 2% to 3%)
or even by 100% (from 2% to 4%),
but I see that as wishful thinking,
with no economic history,
supporting that level of improvement.

If you are saying "it's different this time"
then please recall that many people
also said that in 2000,
and in 2007 too !

Keep your fingers crossed
that the attacks on Trump,
do not succeed
-- everyone is against him,
except Fox News,
and it is painful to watch.

Merry Christmas,
and Happy New Year to
you, and all readers here.

Scott Grannis said...

Thank you, Cliff. You show it's possible to disagree without becoming obnoxious, and I appreciate that. We should all, of course, hope for the best. And even those who despise Trump should hope he is successful.

Unknown said...

Interesting blog. A couple counterpoints to consider:

1) Whether or not these tax policies "work", I'd imagine, is very time and situation dependent. Right now I’d think that with unemployment near historic lows and consumer confidence very high that this tax policy is a little late to the game, and any additional benefits it brings to the economy at this point will likely be marginal.

2) I think the assumption that lower taxes will incentivize businesses to hire, which puts more people to work and further stimulates growth through consumer spending, is not likely to transpire right now. Businesses (now more so than ever) are concerned with making profits for their investors, not with employing people. Capitalism is not a charity project, so businesses will certainly higher people to the extent that it helps their bottom line, but if it doesn’t then they’re going to either take the tax cuts as a direct benefit to their bottom line or re-invest the money they save on tax breaks in something that has a return in excess of their cost of capital. I agree that the latter action will likely stimulate the economy, but I question 1) how many CEO’s will resist the temptation to take the short term benefit of a higher stock price and instead use the tax savings to invest in their businesses for the long term and 2) how large that impact will actually be. Corporate hurdle rates for investment projects (i.e. their cost of capital) have been coming down for years as more company capital structures have shifted to being more debt financed as rates have come down. This hasn't translated to higher levels of investment, as you pointed out. Now we give them some excess cash and some accounting incentives and expect that to change? Furthermore, lower interest rates have made the Net Present Value of capital projects more attractive today than say, 15 years ago. This, too, has not helped capital spending.

I agree these tax cuts will likely have some positive impact on growth, but I doubt the benefit will be high enough to justify the "pay for themselves" argument. Any short term benefit will likely contribute to longer term pain in the form of higher debt burdens. What no one seems to be talking about are the high debt burdens our government (think Social Security and Medicare) and companies have incurred, not to mentioned the dire state of our public pension obligations, and how this is going to impact our economic future. Sure, we can squeeze out some short term gain, but ultimately we're just kicking the can down the road and adding to the pain that we'll inevitably have to face.

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