The election of Donald Trump in November 2016 was not just a public referendum on American social values, but on fiscal policy as well. The Obama-era stimulus package consisted primarily of increased deficit spending without much divergence from what is considered normal tax policy when attempting to propel the economy out of recession. The result was one of the most sluggish, albeit longest, expansions in U.S. history. The slow expansion of the Obama administration became a key pillar to then Republican presidential candidate Donald Trump’s campaign, as he promised to deliver record economic growth through a series of aggressive personal and corporate income tax cuts. In December 2017, Trump fulfilled his promise to lower taxes as Congress passed the Tax Cuts and Jobs Act less than one year after he took office.
The total outstanding public debt was already $19.8 trillion when Donald Trump became the 45th President of the United States. Since then, it grew to $21.2 trillion, according to Federal Reserve Economic Data (FRED) published by the Federal Reserve Bank of St Louis. Although U.S. debt continues to grow, it grew at a quarterly average of 1.3 percent, a 35 percent decrease when compared to the U.S. historical average. At the same time, U.S. GDP also grew at a quarterly rate of 1.3 percent. That means that the U.S. debt to GDP ratio has remained constant so far during the Trump presidency.
This is in sharp contrast to the post-recession Obama presidency, which saw large increases in the U.S. debt to GDP ratio. During that time, GDP grew at a quarterly rate of 0.9 percent, but debt levels rose at twice that rate. The Obama-era stimulus was justified as a means to help the economy bounce back from the worst downturn since the Great recession. By 2012, the idea of secular stagnation as first introduced by economist Alvin Hansen was re-introduced by Lawrence Summers prompting more government stimulus. Secular stagnation is the idea that the private economy is prone to sluggish growth caused by insufficient demand, unless stimulated by extraordinary public actions via monetary and fiscal policies.
But, did it work?
Despite these extraordinary public actions –record deficit spending and the Federal Reserve unprecedented decision to keep short-term nominal interest rates at the zero lower bound for a prolonged period after the recession – economic growth remained low by historical standards (some readers will argue that the unusually large deficits worked because growth could have been lower).
It is obvious to most economists that structural factors have contributed to an increase in the propensity to save relative to investment demand resulting in lower real interest rates and lower economic growth. Most experts argue that some government deficits can lift aggregate demand and therefore boost a sluggish economy. However, fewer experts consider that although deficit spending can work to stimulate growth in the short-run, prolonged deficit spending leads to debt accumulation, which impairs growth.
This is because too much debt lifts expectations of a government debt crisis. Consistent with Japan’s experience, new research1 suggests that the fear of a public debt crisis lowers economic growth. As public debt accumulates, the growth rate of output declines persistently, while the yield on government bonds decreases. This is because a debt crisis raises expectations of a large-scale capital levy. Attempts to stimulate economic growth via larger deficits can result in declining economic growth and long-term interest rates.
In economies plagued by low growth, attempts to stimulate growth with large increases in government borrowing can result in higher debt to GDP ratios, which in turn will harm economic growth. These facts leave policymakers with an increasingly challenging task.
Why persistently higher deficits are a terrible idea
Besides the fact that politicians, like most of us, may find it hard to “live within their means,” economists have long believed that running a deficit could be a powerful tool, at least in the short run, because higher government spending raises aggregate demand to boost economic activity.
The initial popularity of using deficit spending to increase output was based on the belief that the market economy is unable to sustain aggregate demand at a level consistent with full-employment output.
Standard Keynesian theory has argued that an increase in government spending has a multiplier effect. The multiplier effect refers to the increase in income arising from any new injection of spending. As for the size of the multiplier, the experts are divided. Some experts2 argue that the multiplier is around 0.8 while others3 estimate the multiplier to be closer to 1.5.
Most experts also seem to agree that the multiplier effect can be substantially larger than one when the zero lower bound on the nominal interest rate binds. The key reason is that a persistent increase in government spending raises labor demand, this translates into higher expected inflation, hence into a negative real interest rate (given a zero nominal interest rate), inducing a substitution from future consumption into current consumption to raise the level of output4.
However, household expectations over the central bank actions also matter. Government stimulus tends to raise the inflation rate. The size of the government multiplier will depend on consumers’ expectations over monetary policy. If the nominal interest rate is at its lower bound, a rise in inflation rate lowers the real interest rate, and consumers have an incentive to consume and invest. On the other hand, if the central bank were expected to react to a rise in the inflation rate in a manner that results in a higher real interest rate, then consumers would reduce their expenditures and save. This latter scenario would reduce the size of the government multiplier5.
Regardless of the size of the multiplier, new research6 finds that large increases in government spending – wasteful or not – are not welfare enhancing. Using data from the U.S. Great Recession, the authors find that the optimal increase in (useful) spending is around 1.5 percent of GDP. Any larger spending stimulus decreases welfare. Any government waste is welfare-detrimental even with a large output or employment gap.
The Trump administration deficit-financed tax cut experiment
That brings us to the current administration, seemingly not aware of recent massive debt accumulation or simply choosing to ignore it to focus on campaign promises. The Trump tax cuts were met with a lot of resistance. For one, the tax cuts would raise government debt and higher government debt can impair growth. Another reason experts gave for opposing the tax cuts is the fact that for individuals, a share of the increase in disposable income resulting from tax cuts could end up saved thus resulting in a lesser bang for each buck.
However, Post World War II U.S. data suggest that personal income tax cuts lead to a fall in tax revenues while corporate income tax cuts have little impact on tax revenues. This is because although personal income tax cuts have a small positive impact on consumption, investment and employment, it is cuts to the corporate income tax that lead to large increases in investment resulting in a substantially larger growth effects7.
Finally, other economic research8 also shows that deficit-financed tax cuts outperform deficit spending – deficits resulting from spending increases without tax cuts – in improving GDP. Deficit-financed tax cuts deliver up to five dollars of additional GDP per one dollar of decline in government revenue caused by the tax cuts. Deficit-financed tax cuts stimulate investment and output significantly, with the effect peaking three to five years after the policy change.
Although private consumption does not change significantly in response to tax cuts private investment does9. Tax cuts, especially corporate tax cuts have the potential to grow the economy, but their benefit depends on how they are structured. For tax changes to promote growth, changes should encourage new economic activity (rather than providing a windfall for previous investments) and reduce economic distortions.
Rightly so, deficit hawks feared that if deficit-financed tax cuts failed to raise growth, low growth would lead to more debt and a higher debt to GDP ratio. So far, growth has kept up with debt, thus holding the debt to GDP ratio constant. Only time will tell if President Trump’s tax cuts were the “shot in the arm” that the U.S. economy needed. One thing is certain: the current administration’s new experiment will greatly inform the policy debate.
Orphe P Divounguy is the chief economist at the Illinois Policy Institute. He also heads the Quantitative Policy Group.
1 Keiichiro Kobayashi & Kozo Ueda, 2017. “Secular Stagnation and Low Interest Rates under the Fear of a Government Debt Crisis,” CIGS Working Paper Series 17-012E, The Canon Institute for Global Studies.
2 Barro, R.J., 1981. Output effects of government purchases. J. Polit. Econ. 89 (6), 1086–1121.
3 Ramey, V.A., 2011. Identifying government spending shocks: It’s all in the timing. Quart. J. Econ. 126 (1), 51–102.
4 Christiano, L., Eichenbaum, M., Rebelo, S., 2011. When is the government spending multiplier large? J. Polit. Econ. 119 (1), 78–121.
5 Yangyang Ji, Wei Xiao. 2016. “Government spending multipliers and the zero lower bound” Journal of Macroeconomics, 48, 87-100
6 Florin Bilbiie, Tommaso Monacelli, Roberto Perotti. 2017. “Is Government spending at the Zero Lower Bound desirable”. Forthcoming, American Economic Journal: Macroeconomics
online version: http://www.nber.org/papers/w20687.pdf
7 Mertens, Karel, and Morten O. Ravn. 2013. “The Dynamic Effects of Personal and Corporate Income Tax Changes in the United States.” American Economic Review, 103 (4): 1212-47.
8 Mountford, A. and Uhlig, H. (2009). “What are the effects of fiscal policy shocks?” Journal of Applied Econometrics, 24: 960–992. doi:10.1002/jae.1079
9 Blanchard O and Perotti R. 2002. “An empirical characterization of the dynamic effects of changes in government spending and taxes on output.” Quarterly Journal of Economics. 117(4): 1329–1368