U.S.: Whatever the Final Figure, Stimulus Is Still Vital
The strength of the economy in the coming year may well be in the hands of just 100 people. With the Easter recess over, the Senate will take up President George W. Bush's tax plan: $350 billion in cuts or $550 billion? Increase the child credit or abolish the dividend tax? However it plays out, Washington pump-priming will have to go a long way to offset the drags from a weak labor market, an iffy global economy spooked by the severe acute respiratory syndrome epidemic, and tax hikes on the state and local level.
Whether you agree with the wisdom of long-run deficits or not, it's important to keep in mind that fiscal stimulus has been used to pump up the private sector since the Great Depression. The coming tax plan may contain an extension or increase of the depreciation allowance. That could help capital spending, one sector mostly missing in this recovery. Reducing the dividend tax rate may not necessarily boost the stock market. A boost will depend on how big the final cut is. Nonetheless, the federal budget's biggest lift to economic growth will come from its effect on consumers, who remain crucial to the strength of this economy.
Their importance was evident in the first quarter, when real personal spending rose at an annual rate of only 1.4% -- the slowest pace in 1 1/2 years -- and real gross domestic product increased a paltry 1.6%. War jitters, higher energy costs, and bad weather caused much of the slowdown, and the reversal of these factors should boost growth in the second quarter. But ratcheting up real GDP growth in the second half will depend on consumers and businesses having the money as well as the confidence to spend at a faster pace than they have in the past year.
THAT'S WHERE THE TAX PLAN comes in. Tax relief has been a key engine for domestic demand because past cuts have pushed the average tax burden on consumers back to 1994 levels (chart). Real aftertax income grew by 4.3% in 2002. The gain was triple the rise in real before-tax income, and it helped real consumer spending to advance 3.1%, accounting for 90% of real GDP growth last year. The gap between the two measures of income narrowed last quarter, although take-home earnings still rose a bit faster than pretax income.
Although the final plan is still weeks away, tax relief for individuals is expected to total about $150 billion over the next 17 months. That means by the end of the next fiscal year in September, 2004, disposable income would be about 2% higher than it would be without the tax cuts. That should go a long way toward increasing spending, especially if the cuts are front-loaded into 2003.
Fiscal stimulus will have to play a central role in the second half because the economy is facing other drags. The SARS epidemic is a potential threat to trade, especially with Southeast Asia. The Federal Reserve's Apr. 23 Beige Book report on regional economies noted a falloff in Asian tourists visiting the West Coast, expected cuts in aircraft orders, and at least one supply delay because of a SARS-related plant shutdown in Asia.
And don't expect job growth to turn around soon. Productivity, not labor input, has generated all the growth in output since the recession began in early 2001. So companies have little need to hire workers.
THE GOOD NEWS is that increased output per hour worked is slowing the growth in unit labor costs. Consequently, even in a time of weak revenue growth, such as the first quarter, companies were able to make more money. And they used that money to boost their profits as well as to increase pay. Compensation for private workers rose 1.4% in the first quarter, vs. the fourth quarter, and 3.8% from a year ago.
Because of an increase in health-care insurance and pension payments, benefits jumped 2.4% in the quarter, or 6.1% from year-earlier levels. Yet despite the cost squeeze from bennies, companies still increased wages and salaries by 1%, double the gain of the fourth quarter. Compared with a year ago, wages and salaries are up 3%, equal to the recent energy-boosted inflation rate.
Pay should keep advancing in coming quarters, even if the unemployment rate pops up above 6%. First, productivity shows no signs of slowing, which means companies can continue to raise the pay of their workforce. Second, falling oil prices mean inflation is coming down from its 3% yearly pace in March. Cheaper gas and fuel will give households more money to spend on other items.
The latest readings on consumer confidence and weekly reports on store sales suggest consumers are already in a mood to spend. The Conference Board's index of consumer confidence surged in April, to 81, from 61.4 in March. The end of the Iraq war lifted both consumers' view of the current economic conditions and their outlook for six months from now (chart).
With war jitters easing, consumers went shopping. Store sales in April are running well ahead of March figures, and the return of zero-percent financing probably pushed vehicle sales last month above their March annual rate of 16.1 million. As a result, consumer spending began the second quarter with a good head of steam. That should pump up the overall real GDP numbers, generating stronger momentum heading into the second half, when the federal tax cuts should kick in.
CONSUMERS, HOWEVER, won't be able to spend all that extra money at their local malls and car dealers. They will face a bigger tax bite from their state and local governments, which will dampen growth. For most of the 1990s, state and local government receipts followed the same growth trend as the federal government. But because most state constitutions require balanced budgets, the trends split in late 2001 when the recession caused a steep fall in tax payments at the same time demand for unemployment benefits and other safety-net programs ballooned (chart). By the first quarter of 2003, personal payments to state and local governments were up $14 billion from a year ago, while federal taxes were still falling, at a rate of $42.6 billion.
The gap will worsen in coming months. According to the National Conference of State Legislatures, states have a cumulative budget deficit of about $21 billion for the current fiscal year that ends on June 30, plus a total gap of $78 billion for fiscal 2004. The states' coming fiscal drag from higher taxes or spending cuts will offset about two-thirds of the stimulus expected from Washington.
But as the first quarter's GDP data show, the economy is not growing at a pace that makes this recovery feel like the real thing or that brings down the unemployment rate by any significant degree. This economy needs whatever help it will get from Washington. And one-third of a loaf is better than none.
By James C. Cooper & Kathleen Madigan