Interest rates are likely to increase following enactment of the recent taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. reform bill (Tax Cuts and Jobs Act). Rising interest rates stemming directly from the growth provisions of the tax reform bill would be a positive sign that the tax cut is working to encourage capital formation, and should not be cause for alarm. However, the Federal Reserve may choose to increase interest rates even more out of unwarranted fear that growth, per se, is inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. ary. That would have a negative effect on the economy, and would offset some of the growth that would be expected from the tax bill.
Growth provisions work mainly by raising returns to investment and saving, including interest rates
The biggest pro-growth provisions in the bill are the corporate rate cut to 21 percent and the immediate expensing (depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. write-off) of equipment, which will encourage additional capital formation. Other growth-related provisions are the deduction of some pass-through businessA pass-through business is a sole proprietorship, partnership, or S corporation that is not subject to the corporate income tax; instead, this business reports its income on the individual income tax returns of the owners and is taxed at individual income tax rates. income, and the modest reduction in income tax rates on wages, salaries, and interest on savings. These will encourage some additional investment, work, and saving.
The expansion begins as the tax reductions raise the after-tax returns on physical investment in equipment, buildings, and other structures. Higher returns on plant and equipment lead to rising investment to expand factories, mines, farms, commercial real estate, and rental housing. The amount of productive physical capital in the economy grows. As it does so, returns are eventually driven back to pretax-cut levels, and the capital stock settles at a new, higher equilibrium level.
During this period, interest rates on bonds and other forms of lending tend to rise in line with the returns on the physical investments. While returns on business assets are high, investors in those assets are willing to pay more to lenders to attract the saving needed to buy the additional machines, buildings, or other assets. Savers can buy bonds, lending to businesses that are adding capacity. Savers can buy stock, helping companies to raise money for expansion through new share issues. Savers may also invest directly in noncorporate businesses of their own, or through partnerships and venture capital funds. These financial and physical assets are competing avenues for saving, and their returns must rise and fall apace.
Deficit concerns are real, but need perspective as to cause and effect
Some observers may fear that the larger federal budget deficit and federal borrowing stemming from the tax reductions might raise interest rates by absorbing national saving, thereby “crowding out” private borrowing for capital formation and retarding the expansion. This is unlikely for two reasons.
- First, the business tax reductions in the tax plan will contribute directly to higher business saving, in the form of higher corporate-retained earnings and depreciation set-asides, and corresponding higher cash flow for pass-through business. There will be a modest increase in labor force participation and hours worked due to the modest reduction in income tax rate on wages and salaries. Personal saving will increase as well due to the incentive of higher returns and higher after-tax incomes. State and local government revenues will rise, their deficits fall.
- Second, the United States is part of a large, open, global financial market. World saving will shift toward the United States as U.S. residents and businesses lend more at home and less abroad, and as foreign investors send money to the United States to participate in the U.S. expansion. U.S. government bonds will not exhibit any increase in the risk of default due to the modest expansion of federal debt forecast over the period. Attracting the required capital inflow to aid in the financing of the budget deficits should require no more than a few basis points in higher interest rates, as, for example, a Treasury bond rate of 2.7 percent rising to 3.0 percent.
This is not to say that deficits are without cost. The ability of Congress to spend without imposing taxes results in more government spending than the public would support if it saw the full cost of government every year. Higher borrowing also raises interest payments, which crowd out other government spending priorities. It is also crucial to distinguish between deficits that arise from policies that promote growth and output, and deficits that arise from additional government consumption.
Reaction of the Federal Reserve may be important
The Federal Reserve might instigate a further increase in interest rates in reaction to the tax bill. It may do so out of concern that economic growth or higher federal deficits alone would cause inflation. However, this is not a valid concern. A tax cut that lowers production costs and expands the capital stock and labor force participation does not cause inflation. It expands production of goods and services. More goods chasing the same money supply tends to reduce prices along with the cost of production.
The Federal Reserve’s economic model includes the old concept of a trade-off between low unemployment and rising inflation, called the “Phillips curve.” In this model, the tax cut could cause inflation by reducing unemployment and putting upward pressure on wages, which would put upward pressure on prices. The Federal Reserve treats this as a source of inflation.
This view is mistaken. A reduction in the supply of unemployed labor might raise the level of wages once, but not repeatedly. Systemic inflation – continual, repeated, ongoing increases in the general price level – can only occur if the Federal Reserve continually overexpands the money supply (as was done by central banks in interwar Germany, recent Zimbabwe, or contemporary Venezuela).
The apparent connection among unemployment, wages, and inflation is a misreading of history. Sometimes, if the Federal Reserve triggers unexpected inflation, it can induce people to work and produce more for what appears to be a rising real wage or price, leading to a short burst of growth. But in this case, the growth is caused by the inflation, not the inflation by the growth.
Recent comments by Randal Quarles, vice chair for supervision at the Federal Reserve, suggest that the Fed is more open than in the past to the possibility that the tax reduction could expand economic capacity, and raise supply along with demand. He allowed that a capacity-increasing expansion might not put as much upward pressure on prices as a demand-driven expansion. If that is the case, we may avoid an unnecessary and harmful clampdown by the central bank on the growth of credit. However, Quarles also said it is premature to write off the Phillips curve. If that is the case, then we must keep a watchful eye on the Federal Reserve, lest it prematurely choke off the growth promised by the tax reform.[1]
[1] See Vice Chair Quarles’ speech, “An Assessment of the U.S. Economy,” delivered Feb. 26, 2018, at the 34th Annual NABE Economic Policy Conference, Washington, D.C., available at https://www.federalreserve.gov/newsevents/speech/quarles20180226a.htm. Selected highlights include:
Share“What would be the likely consequences if growth were to shift up on a sustained basis? Here I think … it matters whether growth is embodied in a sustained increase in the productive capacity of the economy or, instead, is primarily the product of a boost to aggregate demand.
“Real expenditures on capital equipment increased at a double-digit pace in the second half of last year, providing early hope that the investment drought that has weighed on growth in recent years might finally be breaking.
“That inflation has remained low even as activity has picked up and the labor market has tightened has led a number of commentators to question the relevance of the Phillips curve analytical framework that ties inflation to the strength of the economy.
“In my view, it is premature to write off the Phillips curve. Indeed, I think it is likely that tightness in labor markets will eventually show up in wages and prices.
“Fiscal policy is likely to impart considerable momentum to growth over the next couple of years not only by increasing demand, but also by boosting, to some degree, the potential capacity of the economy.
“It might seem reasonable to assume that faster growth would lead to firmer inflation. However, I think a lot remains to be seen. … A demand-led increase can be expected to have a greater positive effect on prices than a step-up in the pace of potential growth. Growth led by an increase in the economy’s productive capacity, either through increased labor force participation or higher productivity growth, is likely to impart less upward pressure on prices.”