Rabobank issued a review on President Trump intends to give the economy a boost through an increase in infrastructure spending, a reduction of tax rates, and by cutting excessive regulation that is hampering business activity. However, bills on government spending and taxation are written by Congress and can only be signed or vetoed by the President. This means that Trump will have to work with Republicans in the Senate and the House of Representatives to implement his fiscal policy plans.
Trump’s tax proposals would reduce taxes for all income groups, but the higher incomes would benefit the most. This is ironic since his rise to the Republican nomination has been attributed to a revolt by blue collar voters. On balance, Trump’s tax proposals would lower tax revenue. The bulk of the loss would come from reduced business taxes. This would give the economy a fiscal impulse which would be amplified by his proposals for government spending on infrastructure and defense. However, because of the large tax cuts his proposals would probably have a substantial upward impact on the budget deficit and the public debt.
The budget hawks in Congress may have some problems with that. Note that House Speaker Paul Ryan used to be one of them. Therefore, the size of the fiscal stimulus may be smaller than Trump would prefer. For example, the $1 trillion infrastructure spending spree that he proposed during his campaign may be a bit too much for the budget hawks. What’s more, the Republicans may try to squeeze in some spending cuts elsewhere to mitigate the expansionary impact of the fiscal policy package on the budget deficit.
High debt ratio set to increase further
The US public debt ratio is already high (108% of GDP in 2016, IMF) and poised to grow further due to unfunded liabilities in social security and healthcare programs, an ageing population and rising interest rates as the Fed continues its policy normalization in the coming years. For example, the IMF estimates unfunded pension liabilities at about 20 percentage points of GDP (IMF, 2016). Other estimates of Social Security and Medicare liabilities go as far as multiple magnitudes of the reported government debt levels (Powell and Smith, 2016). Trump’s tax plan is estimated to add another 28 percentage-points to federal government debt by 2025 (The Committee for a Responsible Federal Budget (CRFB, 2016). This would imply a rise in the general government debt to at least 136% in 2025.
Figure 3: The economy doesn’t appear to need any stimulus…
The CRFB does not take into account possible positive economic growth effects, but we expect those effects to be limited and temporary, as the positive impact of Trump’s fiscal policy is likely to be weakened by his trade policy. What’s more, given the current state of the US economy, public stimulus could lead to higher inflation and interest rates, which would hurt private consumption and investment. This results from the fact that the US will expectedly close the output gap (i.e. the discrepancy between actual and potential output) in 2017, with unemployment already under the natural rate (Figure 3).
Public debt challenges
To interpret the challenges posed by the size of US public debt it is important to look at the affordability of the debt and the capacity of the US to finance it. Public debt is said to be affordable if current and future debt payment obligations can be met without introducing measures that substantially harm growth, welfare or quality of ongoing public services.
Rating agencies suggest that debt is affordable when interest payments constitute less than 10% of total government revenue. In the US, the ratio was about 10% in 2016, despite historically low interest rates. With interest rates set to increase as the Fed continues its policy normalization in the coming years, the weight of interest payments on the budget will already increase under current policies. If we add to that the debt increasing and revenue decreasing effect of Trump’s fiscal plans, and debt affordability is clearly at stake.
In order to keep fulfilling debt obligations in the future, President Trump will either have to cut other expenditures or further raise budget deficits and thus debt – if Congress will allow him. The first option would harm domestic households and/or firms, while the second option would create a negative feedback loop of rising interest payments, rising debt and rising interest rates.
Eventually, the question is if debt can be refinanced. Generally, the larger the debt, the lower the demand for newly issued bonds and the higher the interest rate to be paid. Ghosh et al. (2013) have calculated debt limits for a panel of developed countries by combining the historic primary balance reaction function with interest rate data. Depending on different ways of calculations, they argue that the US debt limit, beyond which refinancing would become problematic, lies between 160% and 180% of GDP. Remember that Trump’s tax plan is estimated to raise public debt to 136% of GDP by 2025. That said, Ghosh et al. (2013) do not take into account the ‘exorbitant privilege’ that the US has, by providing the global principal reserve currency.
All in all, Trump should worry about the affordability of the public debt, yet may have some leeway as regards his administration’s capacity to refinance the debt.