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Tax Reform Is No ‘Sugar High’

Despite unprecedented monetary tightening, the 2017 law breathed new life into the U.S. economy.

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Washington, March 27, 2019 | comments
Wall Street Journal
By Kevin Brady and Lawrence B. Lindsey


The current mantra from opponents of the 2017 Tax Cuts and Jobs Act is that the strong economic growth that followed is the result of a “sugar high.” Many now wrongly argue the U.S. is headed for a sharp economic slowdown, possibly even recession. These arguments reflect political and ideological wishful thinking, not a substantive analysis of what is happening in the economy.

The nonpartisan Joint Committee on Taxation expected the benefits of the tax cuts to peter out after a year. It argued that the tax law would stoke inflation and force the Federal Reserve to raise rates, counterbalancing the pro-growth effects of the tax cut.

This prediction proved half right. The Fed did act—aggressively. From December 2017 to 2018, it raised its target for the federal-funds rate by 1%, the biggest hike in any calendar year since 2005. In addition the Fed shrank its monetary base by nearly $400 billion during 2018. That is the fastest calendar-year drop in history.

But there was no inflation for the Fed to contain. The 12-month inflation rate was 1.75% at the end of 2018, calculated with the Fed’s preferred measure, the personal consumption expenditure price index. That was down from 2% at the end of the third quarter and 2.25% at the end of the second. At year’s end, inflation was below the Fed’s target and falling. The decline in inflation throughout the year is proof the tax law didn’t create a “sugar high”: Its supply-side benefits offset any increase in demand.

But the Fed raised interest rates anyway. The market indicated that the Fed was moving too quickly. In the weeks before the December rate hike, the market’s inflation expectations dropped by 0.4%. The futures market predicted that if the Fed raised rates, it would be the last hike for the foreseeable future and the next move would likely be a decrease.

In his March press conference Fed Chairman Jerome Powell acknowledged the problem, noting that “financial conditions tightened considerably over the fourth quarter.” This was an understatement. The St. Louis Fed’s measure of financial stress had its sharpest quarterly rise since the onset of the Great Recession during the fourth quarter.

Thanks to the tax cuts and deregulation, the economy boomed in 2018 despite monetary tightening. The old tax code disincentivized American companies from growing in the U.S. and forced jobs, production and intellectual property offshore. U.S. companies now can invest in the U.S. without a competitive disadvantage. For the first time in memory, more foreign direct investment is coming into the U.S. than going out. Jobs, research and production are returning from overseas.

As a result, in 2018 the U.S. enjoyed its fastest rate of growth since 2005, and unemployment is at record lows. Wages are finally starting to increase after a long stagnation. The after-tax user cost of capital, or a business’s cost of making additional investments, fell 10%. Contrary to official forecasts, the labor-force participation rate rose, reversing years of decline.

Moreover, many of the tax-code changes will take time to manifest fully. For example, businesses can fully and immediately write off expenses. This is a tax-free incentive to invest in worker productivity, driving long-term growth and higher wages.

There is no reason to expect the American growth machine to sputter out soon as long as sound tax and regulatory policies continue. Personal income grew 4.5% in 2018 but at an annual rate of 5.7% in the last half of the year. With one million more job openings than there are people looking for jobs, personal income is likely to grow even faster in 2019. With inflation low, that higher income should translate into consumption growth of roughly 3%; consumption makes up 70% of the economy.

On the supply side, labor productivity increased 1.8% in 2018 compared with 1.1% in 2017 and an average of only 0.5% from 2012-16. The productivity surge is the key reason the rise in wages hasn’t led to inflation.

Consumer and business confidence remain high and show every sign of recovering from the financial-conditions swoon at the end of last year. The University of Michigan’s consumer-confidence index fell from 98.3 to 91.2 in January but has since almost fully recovered to 97.8.

The Business Roundtable’s survey of future business expectations dropped in the first quarter of 2019 from its record high 2018 levels, likely reflecting the tightening of financial conditions. But even at the new level it is 15 points higher than the 2012-16 average. The best two years for growth in that period were 2013 and 2014, at 2.6% and 2.7%. And future business expectations are 9.2 points higher than in those years, suggesting growth will exceed the mid-2% level.

The economy’s critics point to a global economic slowdown. But the U.S. has by far the fastest growth rate among Group of 7 countries. A likely explanation is that the tax changes made the U.S. the best place in the developed world to invest in new plant and equipment. The tax bill cannot be blamed for the inability of other countries to make structural changes in their economies. But American growth is likely to remain strong despite global weakness. The U.S. economy is about 12% exports, so even a 2% decline in growth overseas would only take about a quarter of a percentage point off domestic growth.

Some naysayers seem almost to be cheering for a slowdown so as to vindicate their economic program of higher taxes and more regulation. They know their agenda cannot be sold to the American people when our current economic success is so clear for all to see.

Mr. Brady, a Republican, represents Texas’ Eighth Congressional District and is ranking member of the Ways and Means Committee. Mr. Lindsey, a former Fed governor and assistant to President George W. Bush for economic policy, is president and CEO of the Lindsey Group.

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