Trade and Capital Flow Consequences of Tax Reform: A Means to a Faster Expansion of U.S. Capital Formation and Employment
December 21, 2017
H.R.1 – originally named “The Tax Cuts and Jobs Act of 2017” and subsequently retitled to conform to Senate Budget rules as “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018” – has passed the Congress and awaits the President’s signature.
We estimate that the Act will boost investment, employment, and incomes in the United States. That is good news. However, another outcome of the bill may cause concern in some circles, and might be given a bad-news “spin.” To wit: the bill will temporarily increase the U.S. current account (or trade) deficit. This should not alarm anyone but instead be viewed as a positive sign that the world wants to invest in America. It will not harm the U.S. economy. On the contrary, it will facilitate the expansion of the U.S. capital stock, our productive capacity, and our ability to compete in the world.
Looking only at the permanent reduction in the corporate tax rate to 21 percent, we expect long-run GDP to be 1.7 percent higher after all economic adjustments. This would imply an increase of roughly $1.8 trillion in the quantities of plant, equipment, and commercial and residential structures in the economy, boosting productivity, wages, and employment.
If the rest of the tax bill is extended on a permanent basis, particularly the expensing provision and the reduced income tax rates, including the reduced rates on business income, the increase in GDP would be nearer 4.7 percent, and the stock of capital would be close to $5 trillion higher than under current law.
These potential additions to the U.S. capital stock must be funded through additional saving. Some of that added saving will be done by Americans. The higher returns on capital will cause people to save more, to buy more American stocks and bonds, and to pump more money into their small businesses. The corporate and individual tax reductions on business income, and the faster depreciation permitted by expensing, will boost businesses’ saving directly by raising after-tax cash flow. A portion of the tax cuts on wages and salaries will be saved. However, these increases in domestic saving may not be large enough to cover the capital stock expansion and the increased federal borrowing to fund the deficit. For the remainder, we must look to international capital flows.
The World Bank projects global saving over the next decade of about a quarter of a quadrillion dollars. That’s $250,000,000,000,000. An infinitesimally small portion of that projected world saving may be redirected toward the United States, by several means. U.S. businesses may repatriate cash held abroad. U.S. banks and mutual funds may lend more at home and less abroad. Foreign banks, mutual funds, and individuals may lend more or invest more in the United States and less at home. Foreign businesses may expand their U.S. subsidiaries.
Any increase in the capital inflow coming to the United States will be matched by an equal increase in the U.S. current account deficit. This is an accounting truism. Increased capital-flows toward the United States provide an inpouring of foreign exchange seeking dollars. The dollar will rise, until there is a corresponding increase in U.S. purchases of foreign goods and services to balance the capital inflow. The increased spending will be in part for investment goods to expand U.S. factories, and in part for consumption goods. These increased outlays will be over and above the rising levels of production in the United States, not a substitute or diversion away from U.S. production.
It is only normal, and historically true, that when a nation begins to grow more rapidly than its trading partners, its purchases of foreign goods grows more rapidly than its sales to foreign buyers. When a trade deficit is the result of increased growth, rather than a drop in buying by foreign customers, it is not a drag on the domestic economy.
The capital inflow to assist in the additions to the capital stock will be temporary. There will be only a finite amount of additional capital to be built here. Once that capital has been funded, the capital inflow for that purpose will be complete, and international saving-flows will return to normal, as will the level of the dollar and the current account (trade) balance. In the short run, the capital inflow will boost the dollar and the current account deficit. In the medium run, foreigners will receive an increased stream of dividends and interest on their added U.S. assets, which will assist in reversing the capital-flow, the rise in the dollar, and the current account increase. In the long run, U.S. savers will be earning more interest and dividends too, and the effects on the capital-flow will fade.
The temporary nature of the capital-flows can be best understood by noting that the new plant, equipment, and other structures must be paid for only once. After that, the added capital will pay its own way, earning enough to cover its maintenance or replacement. (If it were not expected to do that, no one would buy it in the first place!)
Also note that, as the added capital is put in place, American wages and employment will rise, and the total amount of saving done by Americans will rise. Over time, Americans will fund more of the expansion. As Americans add to their assets, some of the government bonds that foreigners may have initially bought may be refinanced by Americans. Americans will increase their holdings of domestic or foreign stocks and bonds. In the long run, the holdings of domestic savers versus foreign investors will return to normal shares of the (larger) total stock of productive capital in the United States.
Several things are clear. The tax bill will boost investment and incomes in the United States, and make the country a better place to locate production and hiring. There will be a transitory rise in the trade deficit, but in the context of a stronger, faster-growing economy. The associated capital-inflow will speed the expansion of U.S. industry and employment. Finally, there is no reason to interpret the temporary trade swings as detrimental, or providing an excuse for restraint of trade or abandonment of trade expansion agreements.