Why Trump's Fiscal Plans Might Not Blow Up the Budget

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Donald Trump's election victory has triggered an apparent regime change for markets, driving up projections for U.S. growth, inflation, and global bond yields amid expectations the president-elect will ramp up government spending and tax cuts. His fiscal ambitions — hopes of an infrastructure boom and 4 percent annual growth — have elicited a slew of cheers, as well as fears, including the risk they crowd out private spending and vex the Fed's bid to smooth the business cycle.

Time to take a breather. U.S. economists at Deutsche Bank AG argue that Trump's budget plan will likely yield only a modest impact on government finances, despite a flurry of headline-grabbing tax cuts.

They project the U.S. budget deficit, as a share of GDP, may rise from a Bloomberg median estimate of 3.2 percent in 2016 to just 3.5 percent in the first few years of a Trump administration, representing an annual revenue loss of a modest $100 billion.

"What we can say is that the proposed tax cuts may not have as large of an impact on the government's finances as some analysts project," U.S. economists at the German bank, led by Joseph LaVorgna, wrote in a report on Tuesday.

Their projections focus on the short-term costs of Trump's tax plan — a reduction in marginal rates on capital gains, as well as personal and corporate income — without factoring in significant net increases in defense or infrastructure spending. (The finalized budget will be subject to horse-trading between the executive and legislature, with House Speaker Paul Ryan seen as a fiscal conservative.)

Instead, the authors focus on historic precedents, when marginal taxes staged a notable decline under a Republican presidency. They find after the tax cuts enacted during the Ronald Reagan and George W. Bush administrations, federal receipts remained close to their historic average share of GDP. 

The precedents are fitting: In the 2016 fiscal year, federal revenues as a share of GDP were 17.5 percent (down from 18 percent at the end of 2015) close to the 2003 level. Using that historical basis, they figure that number may fall to around 17 percent in the coming years, which would be slightly higher than the four-year average from 2004 to 2007, the years following the 2003 introduction of Bush's cuts in marginal rates. When Reagan signed a flurry of tax cuts into law between 1981 and 1985, federal revenues averaged 17.8 percent.

If nominal GDP expands 5 percent next year — 3 percent after inflation — and federal revenues as a proportion of national output decline to their roughly Bush-era average, the Treasury would face an extra $100 billion shortfall, the economists calculate.

There's no suggestion that federal revenues are mean-reverting during bouts of Republican tax breaks, but their analysis serves to illustrate the point that tax policy may not increase deficits as much as some market participants assume, citing the aftermath of the Bush and Reagan cuts. 

This pushback against the narrative of a fiscal boom echoes projections from JPMorgan & Co. from last month that concluded Trump's agenda will likely yield little impact on U.S. employment and inflation in the next two years, while tax cuts will boost growth by a modest 0.4 percentage points by the end of 2018.

To be sure, Deutsche Bank's projections focus on the impact of the tax plan specifically — and don't factor in the potential multipliers, including spending behaviors on the back of lower marginal rates, and the extent to which animal spirits will be unleashed thanks to shifting regulations.

On the latter point, the analysts draw attention to one over-looked Trump proposal that could turbo-charge corporate spending. Under Trump's business plan, manufacturing companies would be permitted to immediately expense their capital investments, while the deductibility of interest expenses on future loans would be eliminated.

LaVorgna and team conclude this move would significantly increase the net present value of a given investment project, and, as such, may encourage companies to ramp up spending, possibly at the expense of stock buybacks  — another reason why the fiscal landscape in the coming years is hard to sketch out.

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