2017 Policy Moves Will Spur Economic Growth in 2018 and Budget Battles
This year saw important changes in both fiscal and monetary policy. The tax reform initiative will have a major impact on federal spending and federal budget deficit management for years to come. Both the House of Representatives and the Senate have passed versions of tax reform. The committee process to reconcile the two bills is being launched this week. A reconciled bill must still be approved by final votes in the House and Senate before being signed into law by the President. We expect that to happen before the end of this year. Even under dynamic scoring, which allows feedback loops in the scoring models to increase tax revenues over time, both the House and the Senate versions of the tax bill will tend to increase the federal budget deficit according to various scoring models. This in turn may reduce maneuvering room on any spending initiatives that the Trump Administration may propose in 2018, including infrastructure spending and spending on the proposed border wall with Mexico. Next year, the Trump Administration may push for entitlement reform before it pushes for new legislation on infrastructure spending because entitlement reform has the potential to free up some funding for infrastructure.
In both the House and Senate bills, the largest economic benefits from a new federal tax code will accrue to corporations, less so to households. U.S. corporations will benefit from tax reform as effective tax rates are lowered and overseas profits are more easily repatriated. This will be a support to corporate profits coming at a critical time when corporate profit margins are being squeezed by higher operating costs in a late-cycle economy. Equity prices may also be supported by share buybacks funded with repatriated dollars. We expect most households to see a small-to-moderate reduction in their federal tax bills once the final legislation is passed. However, that may be countered by the loss of the state and local tax deduction, especially for residents of high tax states such as California and New Jersey. We expect that the net short-term effects on the U.S. economy from a new tax code will be moderately positive, resulting in increased business investment and consumer spending. However, if there is too much pressure on the federal budget deficit from reduced tax revenues, then there is at least some potential for increased federal taxes later on. Also, if states and local governments feel less support from federal revenue sharing, then there is potential for the tax burden to shift downhill to state and local governments, requiring them to raise taxes later.
Federal Reserve monetary policy also changed significantly this year. In October, the Federal Reserve began to reduce the amount of maturing assets that it is reinvesting. A decrease in the amount of assets being reinvested will gradually reduce the size of the Federal Reserve’s $4.5 trillion balance sheet. The Fed has not issued a final target for the size of its balance sheet. That may be in the range of $2 to $3 trillion. The shift away from reinvesting maturing assets will gradually reduce the demand for Treasury bonds, putting a small amount of upward pressure on Treasury bond yields. Also, we expect the Fed to increase the fed funds rate range for the third time this year at the conclusion of the Federal Open Market Committee meeting on Wednesday, December 13. As the Fed puts upward pressure on interest rates, there is potential for higher interest rates to increase the borrowing costs of the federal government, adding to the federal budget deficit already under pressure from tax reform.
For a PDF version of this report click here: US_Economic_Outlook_1217.
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