What If The Tax Bill Turns Out To Be A Policy Error?

What If The Tax Bill Turns Out To Be A Policy Error?

A common question asked lately is “What will cause the next recession?” Although no single answer is obvious at this point, what history has taught us is that business cycles do not end from old age; they end due to some type of policy error (monetary or fiscal).

As confidence builds that Congress will pass a tax bill, it seems a good time to ask the question that seems contrary to what everyone is hoping from the bill. The question is: what if the tax bill ends up being a policy error that leads us down the path to a recession? The question arises from a basic supply and demand concept: too much demand and not enough supply.

What if the tax bill stimulates demand from consumers but does not stimulate businesses to increase supply? If this happened we would face the classic economic situation where demand outstrips supply and businesses gain power to raise prices. How this could lead us down the path towards a recession is if prices rise faster than anticipated, and the Federal Reserve becomes more aggressive in raising interest rates. Many recessions have started once interest rates rose to the point where they had a negative impact on consumers’ or corporations’ ability to spend, because more of their income had to be dedicated to interest payments for the portion of their debt that was adjustable or variable. Higher interest rates could also hurt spending if consumers are funding their spending with debt and can no longer afford to borrow due to higher interest rates.

Supply:

We are seeing more and more evidence from the employment data and business surveys that businesses have job openings but cannot find sufficient qualified help to fill the positions. This creates the risk that businesses are not able to increase supply of their product because they do not have the staffing needed and cannot or will not improve productivity to increase supply.

There are two factors that could cause businesses to hold back on investing in plant and equipment to improve productivity and increase supply:

  1. The current Senate version of the tax bill delays corporate tax cuts until 2019. This would run the risk that any spending that corporations may have planned would be delayed until 2019.
  2. Potential caution from businesses over fear that Democrats will retake the House and Senate at the 2018 mid-term elections and reverse current trends that have been viewed as business friendly.

Demand:

History shows that tax cuts do stimulate demand from consumers as more of their take home pay remains in their wallet (physical or virtual). Note that a tax cut is different from a one-time check being sent to consumers. If the consumer believes that the increased income is a long-term event versus a one-time event, they are more willing to spend the extra income. This occurred with both the Reagan and the Bush tax cuts.

Interest Rates:

The Federal Reserve has been slowly raising interest rates because of its concern that a tight labor market will start to cause rapid wage increases, which could ultimately lead inflation to accelerate. Fed officials are proceeding slowly and cautiously at this point because inflation remains subdued (as measured by the official inflation numbers). If the tax bill stimulates demand and causes inflation to begin rising faster than projected, the Federal Reserve may well respond by increasing the pace or the size of its interest rate increases in order to control inflation.

As of this writing the tax bill appears to be in the final stages as the House and Senate are now meeting to reconcile the differences between the two versions. Until a final version is passed, I have to give you the response that people probably hate the most: “It’s too early to tell”.

The key to the pending tax bill will be to watch the reaction from the business community. Do they view the legislation as being sufficient to give them confidence to make long-term investments in their businesses? Or do they continue to hold higher levels of cash, pay out more in dividends or buy back more shares? None of the last three choices increases the supply of goods or services.

About The Author

Steve Scranton is the Chief Investment Officer and Economist for Washington Trust Bank and is a CFA charter holder with over 30 years of investment experience with equities, tax-exempt and taxable fixed income securities. Steve actively participates on committees within the bank to help design strategies and policies related to client and bank owned investments. Steve also serves as the economist for the Bank and has been a featured speaker for both client and professional organization events throughout the Northwest.