The recently passed tax changes will undoubtedly boost economic activity this year and next. But there is no such thing as a free tax cut and stronger growth could create significant risks to the economy.
Coming into 2017, the economy already was accelerating, expanding at a 3% pace for the final three quarters of the year. The tax cuts should solidify that pace, as businesses will be incented to invest and households will have more money to spend.
On the corporate side, the beneficiaries vary sharply by the type and size of business. Larger businesses will generally see the largest tax reductions. But what they will do with the funds is unclear. Some will increase capital spending and some will pay bonuses or raise wages. This will boost growth. Others, however, will buy back stock and raise dividends, which may benefit investors, but not add much to economic activity.
Because many of the large corporations already had ample profits to invest, it is uncertain there will be significant new spending on plant, equipment or technology. That said, given the huge amount of tax cuts for these companies, even a modest diversion into capital spending would hype growth.
On the other end of the size spectrum, small business owners benefit modestly. It doesn’t appear they will be spending a lot more.
The sweet spot is the mid-sized, “growth” companies who need capital and have the market to expand. The lower tax rates, and especially the expensing of investment spending, could boost activity significantly.
As for households, there is a similar diversity of impact. The vast majority of tax cuts go to upper income households. They tend to invest, not spend, so the impact on consumption could be modest.
However, most lower and middle-income households also will see their taxes reduced. The added take home pay may not be enough to buy a lot of goods, but it should be enough to expand spending.
The expansion in consumption may be limited, as households have reduced their savings sharply. The only period over the past sixty years where the savings rate has been this low was during the housing bubble, when households went deeply into debt. Some of the added take home pay may go to stabilizing balance sheets.
Unfortunately, no good deed goes unpunished. Expansionary fiscal policy normally is employed when the economy needs a boost, especially after a recession.
The current tax cuts come when the economy already is in good shape and the unemployment rate is near historic lows. To find the labor needed to expand, firms may have to bid-up wages.
If labor compensation accelerates, prices could rise. And that is the rub. Higher inflation would force the Federal Reserve to increase rates, possibly faster and greater than expected.
The tax cuts will boost growth, but that could wind up being too much of a good thing. An overheated labor market could create significant problems for businesses and the Federal Reserve. Those issues, however, are at least a year away.