What will be the impact of Trump’s tax cut?

The cut in corporate income tax passed by the US House of Representatives on 16 November could positively affect the US economy. And therefore the rest of the world economy as well.

The tax reform plan passed by the US House of Representatives involves a cut in corporate income tax from 35 to 20 per cent. But the plan is not yet a fact. The bill now goes to the Senate, where it will probably encounter more resistance and where the Republicans have only a very small majority. Meanwhile, the Republicans in the Senate are working on their own tax cuts plan. Before this actually becomes law, the Republicans will thus have to agree on a plan that is supported in both houses of Congress. There is already consensus in the Republican party on one element of the tax plan: the reduction of corporate income tax from 35 to 20 per cent. This is therefore the subject of this provisional analysis.
We use the National Institute’s Global Econometric Model (NiGEM) to calculate the effect of a cut in corporate income tax on interest rates, inflation, GDP growth and government debt. Our analysis is based on two scenarios: immediate implementation of the tax cut in the first quarter of 2018, as preferred by the House of Representatives. Or later implementation in the first quarter of 2019, as the Senate proposes.

Instant reaction in the financial markets

In both scenarios - implementation in 2018Q1 or 2019Q1 - the reaction in the financial markets will be immediate. This instant reaction will be triggered by the expectation that the Fed will raise interest rates if GDP increases and therefore inflation as well. Bond yields will also increase by 50 to 90 basis points. This same expectation will also initially make the dollar more attractive. The exchange rate will rise initially by 3 to 5 per cent.
In the long term, both the exchange rate and long term interest rates will stay at a higher level than the baseline (a scenario with no tax cut). If implementation is delayed for a year as proposed by the Senate, this will not affect the timing of the reaction in the financial markets. But later implementation will have different effects in the short term than would be the case if the tax cut coincides with the reaction in the markets.

"Later implementation will push up bond yields and investment will be more difficult"

GDP growth will get a two-year boost

The alacrity of the financial markets will lead to a perverse effect if the tax cut is delayed for a year. The markets will react to something positive, although the economy will suffer in the short term. Bond yields will rise and this will slow economic growth, without any benefit to GDP from the tax cut. This will make it more difficult to invest. This effect will not occur if the tax is implemented immediately in the first quarter of 2018. In this case, GDP will increase straight away. GDP growth will peak in the course of 2018 at 4.5 per cent, and then slowly subside to the baseline level. The boost to GDP growth will last two years.
In the delayed implementation scenario, GDP will not start to increase until 2019. GDP growth will actually subside in 2018, but as soon as businesses start to feel the tax benefits it will shoot up and peak at 6 per cent in 2019. The effect of the tax cut on GDP growth will be over in 2021. In both scenarios, GDP growth will get a two-year boost, after which it will fall back to the baseline.

Attractiveness of the dollar will lead to a dip in inflation

If the tax cut is implemented immediately, there will be conflicting factors affecting inflation: the growth of GDP will push inflation up, while the stronger dollar will reduce inflation. In the NiGEM model, inflation will initially fall to below 0 per cent. Inflation will be positive again in 2019 and rises to a level between 2.5 and 3.5 per cent in 2021-2022. After this inflation will decline, but will stabilise at a higher level than in the base scenario (with no tax cut) at slightly above 2 per cent. Inflation will also be reduced by the stronger dollar if the tax cut is delayed. This will change when the tax measure becomes law and GDP picks up.
The notable point is that – regardless of when the tax measure takes effect – the attractiveness of the dollar in both scenarios will lead to a similar dip in inflation. In the case of later implementation, it will take longer before inflation rises, since the GDP growth will also begin later.

Interest rates to rise

How the Fed responds to these developments depends on when the tax plans come into effect. If it happens immediately, the Fed will maintain its current policy of incremental increases in 2018. Declining inflation would normally make the Fed more cautious with respect to incremental increases in interest rates. This decline in inflation will now however be offset by the growth spurt of GDP. Inflation will gradually begin to rise again, pushed higher by lower corporate income tax. In 2019 the Fed will therefore move to a higher trajectory and increase the frequency of its rate hikes to rein in inflation.
If the measure does not take effect until 2019, rising interest rates will initially slow economic growth. In this case, the Fed will not hike interest rates in 2018. The Fed will not resume its strategy of incremental hikes until 2019 to rein in inflation, and interest rates will reach the level assumed in the baseline in 2021. In the longer term, yield curves will flatten in both scenarios and reach the same level. Interest rates will ultimately stabilise at a higher level than in a scenario with no tax cut.

Further rise in government debt in the long term

What is the effect on GDP and government debt in the long term? GDP will grow to a higher level. The economy will therefore benefit, but the same cannot be said with respect to government debt. Proponents of the measure claim that the effect of lower corporate income tax will be offset by economic growth, which will in turn boost the public finances. In reality, government debt is increasing faster than GDP. Without a tax cut, the ratio of government debt to GDP will grow to 91 per cent in 2027. With the tax cut, this ratio will rise to 110 per cent. A further increase in government debt is the most important other side of the coin in the long term. Apparently this point is not a priority for the Republican party at this time.

The tax cut presents opportunities for those doing business in the US in the short term

Opportunities for entrepreneurs

In the short term, when it takes effect the measure will present opportunities for anyone doing business or investing in the US. Exporters to the US will benefit from the cheaper euro. An increase in GDP will directly affect order books for entrepreneurs doing business in the US. US consumers are still an important driving force for the global economy. And we will grow with them.

Read the full report here.