Well that de-escalated quickly...
Following yesterday's breathless rip higher in small cap stocks (which are down today) and 'high-tax' stock outperformance (which is collapsing today), it appears 'sell the news' is more today's meme as many on Wall Street question the chances of getting a bill through... and what its effect would be.
As UBS' Seth Carpenter wrote overnight: "We don't believe that tax reform or even sizable tax cuts will happen. Even if a tax cut of 1 percent of GDP somehow happens, it is not a game changer."
Larger tax cuts than we anticipate are likely the single, most-easily identifiable upside risk to our forecast. Our baseline forecast incorporates no fiscal stimulus in 2017. For 2018, we have incorporated only modest corporate and personal tax cuts. Even with the new tax proposal from the Administration, our outlook remains unchanged. We are sceptical that a large fiscal stimulus package that increases the deficit will occur. There has not been substantial legislation passed so far this year, despite control of the Congress and the White House by a single party. Moreover, the fiscally conservative wing of the Congress will have to confront another vote to raise the debt limit next year in the context of any decision made about fiscal policy.
We could, of course, be wrong. While we do not expect the passage of a substantial tax reform package, there will be strong motivation to pass something. There is clear, long-running desire for tax reform. Moreover, 2018 is a mid-term election year, and without major legislative achievements to date, there is a clear incentive for the governing party to demonstrate an ability to produce results. The Administration released an outline of a tax reform proposal, but the Congress will dictate the finalform of any legislation. Put differently, a proposal from an Administration is non-binding.
Tax reform has historically been extremely difficult, in part because there are many different views on what sectors should receive preferential treatment. Even for the Senate to reach 50 votes in order to pass a reform package, in our view, the Administration's proposal would have to be pared back. The debt ceiling was recently suspended until December. Given the Treasury Secretary's ability to use what are referred to as "extraordinary measures" to finance the government into 2018, a new vote on the debt limit will be necessary next year.
For fiscal conservatives, voting for a substantial increase in the debt limit while also voting for a tax package that will substantially increase the deficit will likely prove an uncomfortable set of votes, particularly because 2018 is a mid-term election year.
The estimates of the budgetary impact of the Administration's proposal range widely. We do not think it is useful to wade into that debate, as the Congress will craft any legislation that arises. A plausible—though still to our minds, extremely unlikely—scenario would be tax cuts that amount to roughly 1 percent of GDP. Tax cuts of this size would justifiably be seen as large and would probably achieve political goals. But in our view, even a tax package of this size would change our forecast by a matter of degree, not of kind.
Fiscal multipliers, which tell us how much each dollar of fiscal stimulus is worth for overall output, are notoriously difficult to estimate precisely. Most estimates find that multipliers from tax cuts are smaller than multipliers from spending. Moreover, if taxes are reduced for agents with a relatively low marginal propensity to spend, the multiplier will be lower still. ad fiscal stimulus been enactedwhen the economy was far from full employment and the Fed was trying to be as accommodative as possible, the effects would likely have been larger. But with the unemployment rate at historically low levels and with the Fed already embarking on a path of policy tightening, fiscal stimulus will in part likely lead to further policy rate hikes to prevent an overheating in the economy.
The table below presents a range of estimates on fiscal multipliers from a survey published by the Congressional Budget Officeand the CBO's own work. We present the 25th and 75thpercentile of the distribution of the estimates.
Corporate tax cuts are generally found to have relatively low multipliers as do tax cuts for the upper-end of the income spectrum. Tax cuts for lower and middle class families tend to have higher multipliers, as these households tend to spend a larger fraction of additional disposable income. In transforming the dollar amount of a tax cut into stimulus, however, because of the progressive nature of the tax system, across-the-board tax cuts will tend to cut taxes substantially more for upper income households.
Taking all of these multipliers together, we believe a reasonable assumption is that a compromise tax cut that would come out of the Congress would have a multiplier of about 0.5 or less. That is, each dollar cut in taxes translates to 50 cents on output. In the case of a tax cut that amounts to 1 percent of GDP, then, we would expect to see something like a one-half percentage point increase in GDP. The specifics of the tax plan will matter greatly: whether the tax cut is permanent or temporary will matter, how much focus is paid to business versus individual taxes, and other considerations. Regardless, a tax cut of roughly this size would push our forecast for 2018 up to no more than 2¾ percent if the tax cut is rapidly enacted. That type of growth would clearly be an acceleration compared to recent growth rates, and the unemployment rate would fall further than our current projection of 4.0 percent. We currently envision two rate hikes from the Fed in 2018, one in June and one in December. That outlook is less aggressive than the FOMC currently projects, because we think inflation will rise less rapidly than the Fed does. With a substantial tax cut, inflation could rise as rapidly as the Fed envisions, and the downside uncertainty to inflation would be meaningfully reduced. As a result, the Fed would likely hike three times next year under such a scenario. A fourth hike would be possible if the tax package is implemented this year and the data show a sharper-than-anticipated decline in the unemployment rate right away.
The takeaway for us is to be wary. We see little likelihood of a meaningful tax cut. But even if taxes were cut substantially, the size of the package would likely be of a size that would lead to only a modest revision to our outlook.
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So back to the de-hoping cycle...