Fiscal Policy

Irish tax distortions have a material impact on aggregate eurozone economic data.

Will there be a mismatch between what the U.S. wants to sell (Treasuries) and what the world wants to buy?

It looks like a combination of tax cuts and spending increases will raise the U.S. fiscal deficit by about 2 percentage points of GDP (that’s the number Krugman used; Goldman’s US economics team puts the increase in the fiscal deficit between fiscal 2017 and fiscal 2019 at 1.7 percent of GDP). The IMF’s standard coefficient relating changes in the fiscal balance to changes in the external balance would imply that the U.S. current account deficit will increase by about a percentage point of GDP—so rise to around 4 percent of GDP. There are a few reasons to think that this might be a bit high. The U.S. is globally speaking, a relatively closed economy. Imports have increased at about a quarter of the pace of domestic demand over the course of the recovery from the global (or north Atlantic) crisis. So the external spillovers from a U.S. fiscal stimulus might be smaller than the global norm. * A high portion of the tax cut will go toward buybacks, special dividend payments, and the like, and a high portion of those payments may be saved not spent. This isn’t a fiscal stimulus designed for maximum impact on demand. And, well, the IMF’s coefficients have a whole lot of implicit assumptions baked into them—assumptions that may not hold this time. In most cases a fiscal loosening changes the stance of monetary policy, and those changes in the stance of monetary policy in turn drive some change in the exchange rate. But, if the Fed doesn’t end up tightening more, or if the dollar doesn’t in fact appreciate as the Fed tightens, the impact of the fiscal expansion on the trade deficit may be smaller than the simple application of the IMF’s model would predict. But there are a couple of factors that could work the other way too. The closer the economy is to operating at capacity, the more the demand created by the stimulus may bleed out to the rest of the world. That is arguably what happened in q4 of 2017. Domestic demand growth accelerated, with the contribution from demand to GDP growth rising from around 2.5 percent to above 3.5 percent. But an unusually big chunk of that was spent on imports—over 50 percent. ** If that pattern continues, The U.S. would get stuck with the debt while the United States’ big trading partners would get the stimulus. A poorly timed fiscal expansion thus could end up making China, Korea, Japan, Germany, and the other big exporting economies great. Aside from trade there is an “income” channel. Or more specifically, a “higher interest rate on a big stock of external debt” channel. The U.S. now has a large stock of external debt, so a higher nominal interest rate in the U.S. mechanically leads to higher interest payments on that external debt (interest payments are big part of the income balance in the current account, along with the dividend income on foreign direct investment). The United States’ external debt has quietly increased to about 50 percent of GDP, so a 1 percentage point increase in the nominal interest rate translates into half a percentage point of GDP increase in the amount of interest the U.S. will need to pay to the world. *** This swing is easy to forecast even if the change will come slowly: effectively, the central banks of the world’s biggest (former?) currency manipulators stand to gain over time as they rollover their maturing treasuries into higher-yielding bonds, raising the cash return on their excess reserves. There are many ironies here of course. But the most important, perhaps, is that Trump’s trade goals will likely be set back by his biggest policy success: the tax bill. Had Congress been unable to agree on a large tax cut—or had the Trump administration insisted on a budget-neutral tax plan—there is a strong argument that the trade deficit would now be set to fall. European demand growth is (finally!) strong and the Eurozone’s output gap is falling. With the market looking forward to the end of the ECB’s asset purchases and speculating about the beginning of a tightening cycle, the euro is rising. The combination of China’s stimulus in 2016, the controls put on in 2017, and the euro’s rise against the dollar has led China’s currency to strengthen against the dollar. While Korea continues to resist calls to expand its system of social insurance and bring its fiscal surplus down [PDF], the won—and many other Asian currencies—are now facing pressure to appreciate. With a bit of U.S. pressure on key countries to limit their intervention (both through the front door and through the back door), currencies like the Korean won, the new Taiwan dollar, and the Thai baht could all rise—supporting global adjustment. Canada’s dollar is rising, and the U.S. trades a lot with Canada. A deal on NAFTA would likely lead the Mexican peso to rise too. Basically, many of the conditions were in place for some of the deterioration in the non-petrol balance that occurred after the dollar rose in 2014 to reverse. But that would have required patience on the part of the Trump Administration—and refraining from policies that juice U.S. demand just as the rest of the world is starting to look better.   Very wonky endnote: I wanted to do the very rough math needed to plug the demand stimulus into a standard partial equilibrium model for the U.S. trade balance (something akin to the Fed’s international transactions model). Such models have their critics (they don’t model savings and investment, they are partial equilibrium not general equilibrium models, etc.) but I have generally found them a useful guide for thinking about the trade balance. Let’s stipulate that U.S. demand growth would be expected to contribute about 2.5 percentage points of GDP to U.S. growth in the absence of a major shift in fiscal policy in the next couple of years (that’s the average pace of increase in the last 12 quarters of data, though it arguably is a bit stronger than what the U.S. should be able to generate over the long-term. And let’s stipulate that growth in U.S. trading partners will be between 3 and 3.5 percent (roughly, the IMF’s forecast for global growth). The Fed puts the income elasticity of U.S. imports at around 2—so 2.5 percent demand growth should translate into a 5 percent increase in import volumes. And the income elasticity of U.S. exports is more like 1.5, so 3 percent growth abroad translates into a 4.5 percent increase in export volumes. Exports are a bit smaller than imports as a share of GDP (17 versus 20 percent of GDP or so), so all things equal the expected differential in volume growth would lead the real trade deficit to widen a bit. Now throw in the stimulus. Krugman estimates that a 2 percentage point of GDP fiscal impulse over the next two years would boost growth by about half that (or 1 percentage point). Technically, I should turn that into an estimated demand impulse—as U.S. demand growth, not overall U.S. growth, is what drives imports. So to be overly precise, let’s assume that the impetus to domestic demand is more like 1.25 percentage points of GDP over two years. If all that came in a single year, import volume would be expected to grow by 7.5 percent. In practice, the impulse is likely to be spread over the next two years. No matter: absent an acceleration in global growth, the additional impulse to U.S. demand would clearly be expected to raise the U.S. trade deficit (very roughly, an additional 2.5 percentage points of import growth over two years versus baseline means about 50 basis points of GDP in extra imports over that period). Now for the part I find much harder: the impact of the dollar. The Fed’s model implied that a 10 percent increase (decrease) in the dollar reduces (raises) U.S. exports by close to 7 percent over 3 years. And a 10 percent increase in the dollar raises imports by about 4 percent over two years. Seems straightforward. But remember the lags—the model implies that the impact of a dollar rise in the second year after the change (quarters 5 through 8) is almost as big as the effect in the first year. For 2018 exports, the three year lag implies changes in the dollar in 2016, and 2017 matter as well as changes in the first quarter of 2018. And for imports, moves in late 2016 and 2017 still matter. A plot of the lagged dollar shows this well—if you look at the trailing three year sum (an imperfect measure of the exchange rate impulse for exports) the dollar is rising not falling. In other words, don’t count on a boost to exports from the dollar’s recent weakening right now. In fact, the average level of the dollar in 2016 was significantly above its average level in 2015—and the dollar’s average level in 2017 was about at its 2016 level. The dollar’s impulse to exports would only really be expected to be positive in 2019. If the dollar stays at its current level the roughly 5 percent depreciation in the broad real dollar from its 2017 average should push up the pace of export growth by about 3.5 percentage points relative to a baseline over 2018, 2019 and 2020 and also do a bit to hold down the pace of import growth. But remember that the baseline includes some lagged impact from the dollar’s strength in late 2016, and thus the depreciation baseline would show a slowdown in export growth. My ballpark math thus suggests that the exchange rate won’t do much to offset the projected widening of the real trade deficit in 2018, but could help stabilize the real trade balance in 2019. Note that this is just the forecast for the real trade balance. The price of oil matters too (still). And the U.S. interest bill is likely to rise along with U.S. interest rates, pushing the current account up even if the trade deficit is constant. Now for a few even wonkier caveats. The Fed’s trade model is based on historical relationships, and those may not hold perfectly. For example, the dollar’s 2003 to 2008 depreciation boosted exports by a bit less than would have been expected based on the models used at the time, while the dollar’s 2014-2016 rise has had more or less the expected negative impact on exports. I personally worry that the positive effect of dollar depreciation on exports is not quite as strong as the negative effect of dollar appreciation. And, well, the dollar’s 2014 to 2016 rise does not seem to have led to the expected increase in imports—which is a bit of a puzzle (an inventory adjustment in 2015 clearly played a role). That creates a bit of risk too: if there is a bit of catchup to forecast, imports might rise by even more than the basic model would suggest. Even with the dollar’s recent depreciation, it is still substantially stronger than it was from 2008 to 2013. Finally, the estimated historical income elasticity is also subject to challenge—there is some evidence that income elasticities have fallen recently. But this still rough math convinced me of two things: 1) The dollar’s current weakening won’t have an impact for a while; 2) The Trump administration should hope that the income elasticity of imports has fallen and the rise in the trade deficit that accompanied the acceleration of demand growth in the fourth quarter is a one-off and not a sign of things to come. * The average spillover to the rest of the world from imports since the end of 2009 has been a little over 20 percent of the increase in U.S. demand. Until the dollar’s 2014 appreciation, that was typically offset by the spillover of growth in the rest of the world to the U.S. ** I am curious how others react to this graph. I added exports to demand—but also plotted the increase of imports against domestic demand. This is an effort to try to capture the different ways trade can impact growth. Ideally, export demand would rise as domestic demand falls. That though clearly wasn’t the case in 2015—hence the slowdown in overall U.S. growth. Conversely, in the fourth quarter of 2017—unlike in q2 or q3—the bulk of the increase in U.S. demand ended up supporting global rather than U.S. output. That’s why overall growth slowed even as demand growth accelerated. *** Tim Duy, among others, has noted that higher rates now have the advantage of giving the U.S. more scope to cut should growth falter in the future. No disagreement from me. I only would note that, for the U.S., the advantages a higher nominal rate path provides for monetary policy have to be balanced against the disadvantages higher rates always pose to a net debtor. The stock of U.S. external debt, measured relative to U.S. GDP, has essentially doubled since the last Fed rate hiking cycle. A return to a world of 4 percent nominal/2 percent real rates thus has a larger mechanical cost to the U.S. than in the past.

I sat down with the FT's Matt Klein for an Alphachat podcast on the international provisions in the December tax reform.

“Thanks to the Tax Cuts And Jobs Act, Walmart—America’s largest employer—is raising wages,” tweeted House Speaker Paul Ryan on January 11. Walmart CEO Doug McMillon was only too happy to embrace the narrative. “[T]he President and Congress have approved a lower business tax rate,” he told employees. “So, we’re pleased to tell you that we’re raising our starting wage to $11 an hour.” As economists, we are admittedly prone to being cynical. But when a CEO whose compensation depends on happy shareholders says he’s giving more of their profits to employees just because those profits are about to get bigger, we go beyond cynicism. We go for the data. As shown in the graphic above, this is the third wage hike that Walmart has announced in the past two years. Each one was preceded by a period of accelerating private retail wage growth—which is precisely what a cynical economist would expect. Firms raise wages when they need to attract and retain workers. But that makes for crummy PR. Much better to share credit for rising wages with lawmakers who cut your taxes. Gives them motivation to keep the goodies coming. It also helps bury the bigger story, which emerged by leak a few hours after the wage announcement: Walmart would be closing 63 Sam’s Club stores, affecting an estimated 9,400 employees. Don’t you just hate cynical economists?

In Foreign Affairs online last month, we used our own implied earnings growth (IEG) estimates from stock prices around the world to evaluate President Trump’s impact on the U.S. market. We found that it was virtually nil until at least September 2017, when GOP congressional leaders announced their tax-reform initiative. Laying aside the question of the president’s role in the reform, U.S. IEG has outperformed its developed-market peers by 0.3 percent since then—as shown in the inset graphic above. An important item of sharp recent debate is what effect the tax reform will have on U.S. GDP growth, which will determine—among other things—the extent of the additional debt burden. The Trump Treasury forecasts a 0.7 percent increase in GDP growth on average per year over the next decade, primarily as a result of corporate tax cuts. The Treasury analysis has been scathingly challenged by Jason Furman and Larry Summers, among others. One way to estimate the tax reform’s growth effects is to look at the historical relationship between corporate earnings and GDP. From 1990-2015, U.S. corporate earnings grew with GDP at a ratio of almost 3:2, although after 2007 the ratio fell to 1:1. If either of these trends were to persist, our implied earnings growth estimate from stock prices suggests an average annual GDP growth boost of 0.20-0.30 percent, as shown in our main graphic. This estimate is slightly higher than that produced with a very different methodology by the Tax Foundation, although it is only about a third of what Treasury is forecasting. In short, even upbeat stock market investors appear to be projecting far less growth from tax reform than the Trump Administration.  

Warning: long, wonky, and not for the fainthearted. I try to assess how the international reforms will impact where firms book profits and thus the measured trade and income balance, not just the mechanical impact of a higher fiscal deficit.

The eurozone member-states may never be able to run a fiscal policy that is optimal for the eurozone taken as a whole.

Abe's consumption tax hike stalled what until then had been a demand led recovery, leading to a three year period with no growth in domestic demand. 

This post is authored by Peter Erickson, a staff scientist at the Stockholm Environment Institute and a co-author of a new paper in Nature Energy that studies how much of U.S. oil reserves are economical to extract as a result of government subsidies that benefit the oil industry. This post is a response to a previous post, by Varun Sivaram, arguing that federal tax breaks for the oil industry do not, in fact, cause a globally significant increase in greenhouse gas emissions, citing a recent CFR paper authored by Dr. Gilbert Metcalf at Tufts University. Dr. Sivaram’s short response to Mr. Erickson’s rebuttal is included at the bottom of the post. As Congress moves towards tax reform, there is one industry that hasn’t yet come up: oil. While subsidies for renewable energy are often in the cross-hairs of tax discussions, the billions in federal tax subsidies for the oil industry rarely are; indeed, some subsidies are nearing their 100th birthday. And yet, removing oil subsidies would be good not only for taxpayers, but for the climate as well. The lack of attention on petroleum subsidies is not for lack of analysis. Congress’ own Joint Committee on Taxation values the subsidies at more than $2 billion annually.  (Other researchers have put the total much higher.) Just in the last year, two major studies have assessed in detail how these subsidies affect investment returns in the US oil industry. The two analyses—one published by the Council on Foreign Relations (CFR) and the other in Nature Energy (which I coauthored)—both show the majority of subsidy value goes directly to profits, not to new investment.   That inefficiency—both studies argue—is reason enough for Congress to end the subsidies to the oil industry. But oil subsidies also have another strike against them: oil is a major contributor to climate change. The burning of gasoline, diesel, and other petroleum products is responsible for one-third of global CO2 emissions. That climate impact is one of the reasons the Obama Administration had committed, with other nations in the G7, to end these subsidies by 2025. Both the CFR and Nature Energy analyses arrive at a similar figure as to the net climate impact. As CFR fellow Varun Sivaram notes in a previous post on this blog comparing the two studies, the CFR study finds that subsidy removal would reduce global oil consumption by about half a percent. Our analysis for the Nature Energy study also finds a reduction in global oil consumption of about half a percent. (You won’t find this result in our paper, but it is what our oil market model, described in the online Supplementary Information, implies.) The most critical place where the studies—or rather, authors—differ is how they put this amount of oil in context. (Our study also addresses many more subsidies, and in much more detail, than the CFR study, but that is not the point I wish to address here.) Sivaram refers to the half-percent decrease in global oil consumption as “measly…washed out by the ordinary volatility of oil prices and resulting changes in consumption…the nearly-undetectable change in global oil consumption means that the climate effects of U.S. tax breaks are negligible.” I would argue that this assertion confuses the effect of subsidies on oil consumption with our ability to measure the change. But before I get into it further, let me first describe how much oil and CO2 we are talking about. By the CFR paper’s estimates, removal of US oil subsidies would lead to a drop in global oil consumption of 300,000 to 500,000 barrels per day (corresponding to 0.3% to 0.5% of the global oil market). The sequential effects in their model are shown in the chart below, which I made based on their results. It shows their lower-end case, in which global oil consumption drops by 300,000 barrels per day (bpd). (This case is described in their paper as using EIA’s reference case oil price forecast and an upward-sloping OPEC supply curve.)  In their model, a drop of over 600,000 bpd in US supply from subsidy removal is partially replaced by other sources of U.S., OPEC, and other rest-of-world supply, yielding a net reduction in global consumption of roughly half as much (300,000 bpd, shown in the right column). (This ratio itself is also interesting and important. For each barrel of oil not developed because of subsidies, this case shows a drop in global oil consumption of 0.45 barrels. The CFR study’s other three cases show a drop of 0.51, 0.63, and 0.82 barrels of global consumption for each US barrel left undeveloped.) Each barrel of oil yields, conservatively, about 400 kg of CO2 once burned, per IPCC figures. So, the range of impacts on oil consumption in the CFR study (again, reductions of 300-500k bpd or 110 million to 200 million bbl annually) implies a drop in global CO2 emissions of about 40-70 million tons of CO annually. (The actual emissions decrease from subsidy removal could well be greater, because this estimate doesn’t count other gases released in the course of extracting a barrel of oil, such as methane or other CO2 from energy used on-site). From a policy perspective, 40 to 70 million tons of CO2 is not a trivial (measly) amount. Rather, it is comparable in scale to other U.S. government efforts to reduce greenhouse gas emissions. For example, President Obama’s Climate Action Plan contained a host of high-profile measures that, individually, would have reduced annual (domestic) greenhouse gas emissions by 5 million tons (limits on methane from oil and gas extraction on federal land), 60 million tons (efficiency standards for big trucks), and 200 million tons (efficiency standards for cars). The CFR authors don’t quantify their findings in CO2 terms, however, and Sivaram refers to oil market volatility as a way to discount CFR’s findings on reduced oil consumption, concluding that the effects are “undetectable” and “negligible.” The argument is essentially that because other changes in the oil market are bigger, and can mask the independent effect of subsidy removal, that subsidy removal has no effect on climate change. This line of argument conflates causality, scale and likelihood of impact (which in this case are either all known, or can be estimated) with ability to monitor, detect and attribute changes (which is rarely possible in any case, even for more traditional policies focused on oil consumption). By this logic, almost any climate policy could also be discounted as immaterial, because it is rare to be able to directly observe with confidence both the intended result of a policy and the counterfactual – what would have happened otherwise.  Rather, I would argue that if we are to meet the challenge of global climate change, we’ll need these 40 to 70 million tons of avoided CO2, and many more, even if there is uncertainty about exactly how big the impact will be. Concluding an action represents a small fraction of the climate problem is less a statement about that action than it is about the massive scale of the climate challenge. Indeed, as the Obama White House Council on Environmental Quality stated, such a comparison is “not an appropriate method for characterizing the potential impacts associated with a proposed action… because…[it] does not reveal anything beyond the nature of the climate change challenge itself.” So, I argue that subsidy removal is indeed material for the climate, even by the CFR report’s own math. And as Sivaram also notes, the CO2 emission reductions would multiply as other countries also phase out their subsidies. Lastly, I need to disagree with Sivaram’s statement that our study is “written in a misleading way”. He asserts this because in the Nature Energy article we focus on the entire CO2 emissions from each barrel, rather than apply an oil market economic model as described above that counts only the net, or incremental, global CO2. But the incremental analysis method above is not the only way to describe CO2 emissions. Indeed, comparing the possible CO2 emissions from a particular source to the global remaining carbon budget is a simple and established way to gauge magnitudes, and nicely complements the incremental analysis enabled by oil market models.   As another noted subsidy expert—Ron Steenblik of the OECD—commented separately in Nature Energy, our analytical approach provides an important advance because it enables “researchers to look at the combined effect of many individual subsidies flowing to specific projects and to use project-specific data to gauge eligibility and uptake.” Similar assessments of other countries, and other fossil fuels, would provide an important window on the distortionary impacts of these subsidies and their perverse impacts on global efforts to contain climate change. Sivaram Response to Erickson Rebuttal First of all, I am grateful to Peter Erickson for responding in this way to a blog post I wrote that was critical of his conclusions. His response was graceful and sophisticated—I think I largely agree with it, and he’s pointed out some holes in my post that I want to acknowledge. However, I do still stand by my headline, “No, Tax Breaks for U.S. Oil and Gas Companies Probably Don’t Materially Affect Climate Change.” In fact, I think the Erickson rebuttal above reinforces just that point. Tackling the overall thesis first: in his rebuttal, Erickson is willing to accept that a reasonable estimate for the carbon impact of U.S. tax breaks for oil and gas companies is 40–70 million tons of carbon dioxide emissions annually (there may be other greenhouse gas emissions, such as methane, that increase the climate impact). Erickson even compares the magnitude of this negative climate impact with the positive impact of President Obama’s efficiency standards for big trucks. I am absolutely willing to accept that removing U.S. tax breaks for oil companies would be about as big a deal, in terms of direct emissions reduction, as setting domestic efficiency standards for big trucks. Importantly, this direct impact is trivial on a global scale, which is the point that I made in my original post, reinforcing Dr. Metcalf’s conclusion in his CFR paper. I am, however, sympathetic to Erickson’s argument that the world needs a rollback of tax breaks, efficiency standards for big trucks, and a whole suite of other policies in the United States and other major economies to combat climate change. And there is certainly symbolic value to the United States rolling back its oil industry tax breaks, possibly making it easier to persuade other countries to follow suit. I also want to concede that Erickson very rightly called me out on unclearly discussing the relationship between oil price volatility and the effect on oil prices of removing tax breaks. We definitely know which direction removing subsidies would move prices (up) and global consumption (down). I should have been clearer that my comparison of the frequent swings in oil prices to the tiny price impact of removing subsidies was merely to provide a sense of magnitude, NOT to imply that measurement error washes out our ability to forecast the magnitude of tax reform’s price impact, ceteris paribus. Finally, Erickson took issue to my characterization of his paper as “misleading.” Indeed, I never meant to imply that he and his co-authors intended to mislead anybody. I still, however, stand by what I meant: that the paper might lead a casual reader to take away an erroneous conclusion by relegating the global oil market model to an appendix and only citing the increase in U.S. emissions in the main body. In my opinion, readers need to know that industry tax breaks have a very small effect on global greenhouse gas emissions, but there are other very important reasons to remove them. And yes, the United States absolutely should remove its tax breaks, as should other countries remove their fossil fuel subsidies. On that count, Erickson and I are in complete agreement.

Goods made in China flow through Ireland before returning to China, and the many other ways tax influences the balance of payments.