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Trump's growth nirvana

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Andrea Iannelli
Andrea Iannelli

- The document discusses the potential economic impact of President-elect Donald Trump's proposed fiscal plans, including tax cuts and increased spending. - It finds that tax cuts would provide a larger short-term boost to growth than increased spending, but that spending measures have higher fiscal multipliers. Tax cuts are also more likely to push up Treasury yields and pose risks for bond investors. - The size and permanence of the tax cuts will determine their impact, with temporary cuts having lower multipliers than permanent ones. Spending is generally more efficient at boosting growth. - Trump's tax cut proposals are larger than Republican plans but may be less effective at boosting growth due to focusing more on high-income

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  PERSPECTIVES NOVEMBER 2016 This is for investment professionals only and should not be relied upon by private investors Trump’s growth nirvana Not all fiscal plans are created equal What should we make of Republican policy makers’ and President-Elect Donald Trump’s plans for higher spending and various tax cuts? There is currently no visibility on the implementation of these plans, which we expect to change materially in the coming months. But we can assess how effective individual measures are likely to be, by analysing their fiscal multipliers. At face value, a sizeable tax reform would add significantly to US growth in the short term - if financed by extra debt. While multipliers for tax cuts are low, the sheer size of the suggested cuts means they would have a significant impact on nominal GDP. The expenditure promises made during the election campaign are fairly modest in comparison, even when accounting for their better multipliers. Excessive tax cuts pose a larger risk for bond investors than the incoming team’s spending proposals, as the suggested tax cuts are more likely to push up US Treasury yields. The importance of fiscal multipliers Fiscal multipliers give an idea of how successful tax cuts or spending proposals are in promoting overall economic growth. If multipliers are high, such measures could be highly successful, boosting demand not only directly but also indirectly, as employment and incomes rise and corporate revenues improve. Higher bond yields and tighter monetary policy would reduce fiscal multipliers, and, therefore, the boost to the economy. This means that the new administration will have to carefully assess its fiscal headroom and support central bank credibility to keep term premia low. It is true that bond yields and term premia have risen substantially post- election in anticipation of fiscal easing, but they remain exceptionally low by historical standards (Chart 1). Chart 1: Reassessing the future? Post-election yield sell-off Source: Bloomberg, November 2016. DIERK BRANDENBURG joined Fidelity International as a senior credit analyst in 2003. After leading the financial team in the fixed income division for six years, Dierk took responsibility of developed market sovereigns & strategy in 2014. Prior to joining Fidelity, Dierk was Deputy Head of Credit at the Bank for International Settlements and also worked at Deutsche Bank. Dierk holds a PhD in Economics and degrees from Freiburg University and the London School of Economics. ANDREA IANNELLI is an Investment Director at Fidelity. Andrea joined Fidelity in 2015, and represents the Fidelity fixed income investment team to institutional and wholesale clients in Southern Europe and Latin America. 1M1Y 2Y3Y 5Y 7Y 10Y 30Y 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 US Treasuries Curve - 18 November US Treasuries Curve - 7 November
  PERSPECTIVES | Trump’s growth nirvana 2 What will determine Trump’s multipliers? The size of fiscal multipliers depends crucially on whether one assumes there will be a recession in the US next year or not. Fiscal multipliers are higher in a recession and lower or negative when approaching full employment, due to import drag (as foreign companies meet the demand the full-capacity domestic market struggles to meet), rising interest rates and potential crowding-out effects. Monetary policy also affects fiscal multipliers. Policy commentators will argue that there are synergies between expansive monetary and fiscal policy as the monetary funding of fiscal spending can amplify the stimulus. But with US inflation set to rise and protectionism potentially driving up import prices, there will be little appetite for such a combined approach. Tighter monetary policy looks more likely, and this would mean lower fiscal multipliers for any given fiscal policy measure. Bond yields play a key role, too. If yields rise in anticipation of yet more debt, then government deficit spending risks crowding out interest-sensitive private sector spending. For now, however, one can rule out higher yields as a headwind to fiscal multipliers. This is because the term premium – the excess yield that investors require to commit to holding a long-term bond instead of a series of shorter-term bonds - is close to zero, even after the recent sell-off (Chart 2). This is the key argument that multipliers could be higher than usual, as there will be crowding in of private investment at these rates, once the government creates the demand. Chart 2: US term premium remains ultra-low Source: Fidelity International, Haver, 15 November 2016. Based on NY Fed ACM Model.   However, higher nominal yields are a headwind worth considering given the size of the national debt. The refinancing of this debt could become an issue for a variety of reasons. For example, will foreigners remain happy to hold US dollars and Treasuries at current rates? Any changes to the Fed’s board or its statutes which undermine its independence would also be negative for bonds. Which works best – tax cuts or spending? The basic rule is that spending multipliers are higher than tax multipliers because part of any tax cuts will be saved. Indeed, the Republican preference for lower taxes over higher government spending is likely to lead to an inefficient (costlier) expansion with relatively low multipliers. -10 -5 0 5 10 15 20 1968 1973 1978 1983 1988 1993 1998 2003 2008 2013 Fed Funds Rate 10y Term Spread 10y Term Premium (ACM) Greenspan conundrum Taper Tantrum
  PERSPECTIVES | Trump’s growth nirvana 3 In fact, because tax payers will adjust their expectations of future taxation, it’s hard to see how tax multipliers can ever be efficient (i.e. larger than 1, boosting GDP by more than taxes are cut) when compared to spending multipliers. Only when tax cuts are strictly temporary and target liquidity- constrained households and companies can they beat spending increases for efficiency. In all other situations, the permanent income hypothesis applies - people will be looking through the new measures, adjusting their saving and borrowing to account for future tax increases. For example, the recent oil price decline (essentially a tax cut) had zero effect on US consumption in 2015/16. Even at the height of the 2009 recession, multipliers for temporary tax cuts were never greater than 1, and for permanent tax cuts they were below 0.5 (Chart 3). Chart 3: Spending stimulus more efficient than tax cuts in 2009 and 2015 Source: Fidelity International, Blinder/Zandi, 2015. How do Trump’s tax plans compare to Reagan’s cuts? The history of US tax legislation bears this out: there is no magic formula where tax cuts pay for themselves. Trump’s ideas echo President Ronald Reagan’s ground-breaking, broad-based tax cuts. Reagan faced different constraints; he benefited from lower debt levels but had to deal with much higher bond yields. His first tax cut cost the Treasury cumulative revenues equivalent to a massive 12% of GDP between 1981-1984. That did boost the economy in the short- term, but did not help the budget (Chart 4). Chart 4: Reagan’s tax cuts boosted growth, but also the deficit Source: Congressional Budget Office, Office of Tax Analysis, BEA, 2016 - 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80 Temporary tax cuts Permanent tax cuts Spending Changes 2009 Q1 2015 Q1 -12.0 -10.0 -8.0 -6.0 -4.0 -2.0 0.0 2.0 4.0 6.0 8.0 -3.0 -2.5 -2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 GDP growth, federal deficit, % GDP Tax cuts, % GDP (4y avg) Tax legislation Deficit % GDP Real GDP yoy% Reagan Bush Jr Obama Clinton Bush Sr
  PERSPECTIVES | Trump’s growth nirvana 4 As a consequence, Congress spent most of its time in the 1980s reversing Reagan's measures, even introducing a tax increase under George H. W. Bush at the height of the late 1980s recession. President Bill Clinton pushed through another tax hike at the beginning of his first term, but then rode the budget all the way into surplus, helped by soaring productivity and a strong labour market. Georg W. Bush and Congress rediscovered tax cuts as a stimulus tool in the 2003 recession, and President Barack Obama pursued them in the 2008 recession. How aggressive are Trump’s proposed tax cuts? Trump’s own tax cut proposals are significantly larger than the Republican party’s (GOP) plans, but would probably ultimately be less effective (Table 1). What compromise on the tax cuts the House of Representatives and Trump reach next year will therefore matter a lot. The latest GOP proposal is estimated to cost $2.4 trillion over 10 years (about 1.3% of baseline GDP per year on average) while the Trump plan could be anywhere between $4-6 trillion (about 2.2%-3.3%), including taxes of $200 billion on deferred foreign income that is repatriated. Table 1: Impact of GOP and Trump tax proposals GOP 2016 Trump 2016 Assuming 33% income tax rate Assuming 15% rate income tax rate Static cost analysis (2016-2025) $bn Individual income taxes 981 2,192 3,730 Corporate income taxes 1,197 1,936 1,936 Other taxes 240 240 240 Total 2016-2025 2,418 4,368 5,906 Dynamic Simulation (2016-2025) CBO GDP base case (2016-2025) 20% GDP vs base 9% 7% 8% Capital stock vs base 28% 20% 24% Wages vs base 8% 5% 6% Jobs vs base 1,687 1,807 2,155 Total cost of tax reform ($bn) 191 2,640 3,932 Source: Fidelity International. Tax Foundation 2016. CBO: Central Budget Office. Viewed dynamically, i.e.by simulating growth and employment effects, the various plans could add between 7% and 9% to baseline GDP over the next 10 years according to the Tax Foundation. This reduces the net cost of the tax cuts, as tax revenues would rise, especially under the GOP proposal that foresees a significant broadening of the tax base. Despite its much larger stimulus, the Trump proposal would have a lower impact on GDP than the GOP plans because it is less targeted on fostering investment and tax cuts are more focused on the higher income brackets, where saving rates are higher.
  PERSPECTIVES | Trump’s growth nirvana 5 Will tax cuts boost productivity longer term? Cutting corporate taxes could have supply side effects, but these are notoriously difficult to measure and only play out over long time horizons. For example, Reagan's supply side policies did very little to raise productivity growth during his tenure; most of the growth came from rising labour market participation. Productivity only improved significantly in the late 1990s and it is hard to link this to any tax policies of the 1980s. Chart 5: Low productivity has fuelled a secular stagnation TFP: total factor productivity. Source: Fidelity International, Bureau of labour statistics (BLS), Bureau of Economic Affairs (BEA), Federal Reserve Bank of San Francisco, 2016. Having said that, a lack of capital deepening and low total factor productivity are at the root of the thesis of secular stagnation (Chart 5). In the model analysis by the Tax Foundation, the country’s capital stock could grow by about 20%-30% over the next 10 years under Trump’s plans. This could address a key weakness in the US growth story even if total factor productivity remains low, by supporting labour market participation and trend growth (Charts 6 and 7). Chart 6: Capital deepening has slowed post crisis Source: Fidelity International, Haver, BEA 2015. Chart 7: Falling participation weighs on productivity Source: Fidelity International, Haver, BLS March 2016. How effective will Trump’s spending plans be? Compared to tax cuts, an increase in government expenditure is expected to have a higher multiplier, and therefore a larger impact on GDP. Infrastructure and defence spending multipliers are well above 1x in a recession, but drop sharply when at full employment. While the US is technically close to full 2.11% 0.51% 2.01% 0.44% 0.42% 2.4% 1.8% 2.4% 1.6% 0.5% -1% 0% 1% 2% 3% 4% 5% 1948-1973 1973-1995 1996-2003 2004-2007 2008- TFP (Ut adj) Capacity Utilization Labor input Capital Input GDP per capita 60,000 80,000 100,000 120,000 140,000 160,000 180,000 -5% 0% 5% 10% 15% 20% 1950 1960 1970 1980 1990 2000 2010 capital stock p/ worker, $ y/y % y/y % Capital Stock/Labour Force 60 61 62 63 64 65 66 67 68 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Participation rate (5y avg) Productivity growth (5y avg) Republican President Democrat President
  PERSPECTIVES | Trump’s growth nirvana 6 employment, the low labour participation rate suggests there are still under- utilized resources, so if the new administration can lift growth through spending, then that may support the multiplier (Table 2). Table 2: Spending multipliers of 2009 fiscal package As of Q1 2009 As of Q1 2015 Spending changes 1.53 0.89 Temporary increase in SNAP (formerly food stamps) 1.74 1.22 Temporary federal financing of work-share programs 1.69 1.13 Extension of unemployment insurance benefits 1.61 1.01 Increase in defence spending 1.53 0.87 Increase in infrastructure spending 1.57 0.86 General aid to state governments 1.41 0.58 Low Income Energy Assistance Programme 1.13 0.55 Source: Fidelity International, Blinder 2016. Based on Moody’s Analytics model of the US economy. The Obama administration already approved $300 billion of infrastructure investments over five years in 2015, but Trump has bigger things in mind. The president-elect plans to spend $1 trillion over 10 years to rebuild US infrastructure. Assuming an average multiplier for government spending of 1.4x, the Trump plan would add 0.8% per year to U.S. GDP growth, or 0.3% more than the current administration's plan (Table 3). However, multipliers can differ considerably depending on monetary policy and long-term yields. In the analysis in the table below, they range from 0.7x to 1.9x depending on debt constraints and the monetary policy regime. Table 3: Trump’s spending plan would boost growth more than Obama’s Impact on GDP Multiplier Obama $300bn 2015-20 Trump $500bn 2017-22 Difference Debt constraint - hawkish Fed 0.7 0.24% 0.40% 0.16% Median outcome 1.4 0.48% 0.80% 0.32% No debt constraint - dovish Fed 1.9 0.65% 1.09% 0.43% Source: Fidelity International. Expenditure multipliers from Leeper/Traum/Walker 2015, OMB, Trump, FIL calculations, November 2016. Our analysis is a static pro-forma scenario relative to the Central Budget Office’s base case for US GDP that ignores crowding in effects or productivity gains. But the effects of Trump’s plans may take time to come through. Current progress in US infrastructure spend is slow. For example, typically only 25% will get spent in the first year for projects such as highways. As most of the spending authority sits with the individual states, the federal government will need to create strong incentives to see the budgeted money spent quickly. The macro impact of infrastructure spending will be lower still if it is financed through public-private partnerships without engaging in direct deficit financing. For example, the EU’s 500 billion ‘Junker Plan’ is hardly visible at the macro level two years after launch. Concern over the deficit will limit fiscal headroom All multipliers discussed above assume that the tax cuts and expenditure programmes are financed by additional debt. Yet the fiscal deficit is on a rising path and will remain so for the foreseeable future, according the Central Budget Office, unless the government cuts entitlements (Chart 8).
  PERSPECTIVES | Trump’s growth nirvana 7 Chart 8: Rising federal deficits *The blue bars above the line indicate deficits, the ones below indicate surpluses. Source: Fidelity International. Haver, Congressional Budget Office, 2016. This means that a lot will depend on how the administration deals with the Affordable Care Act (‘Obamacare’) and other social programmes. Cuts in these areas and the associated lower transfer payments will offset some of the expansionary effects of tax cuts and infrastructure spending. Conclusion US President-elect Donald Trump wowed voters during his campaign with grand promises to raise spending and cut taxes; in his victory speech, he announced he would double economic growth. But will he really? Compromises and delays are the reality of Washington politics, so it is anyone’s guess to what extent Trump will be able to implement his plans. Still, it’s worth crunching the numbers to assess the overall impact of individual proposals, their efficiency and the costs involved. Our analysis shows that Trump’s plans would indeed boost growth – quite significantly. However, it also shows that Trump’s preference for tax cuts over spending is economically inefficient, reviving the economy by less than similar amounts of spending would. On very optimistic estimates, Trump’s suggested tax cuts could add 7%-8% to GDP over the next 10 years, while his spending proposals could add between 0.4% and 1.1% to GDP annually. Although they are less efficient, Trump’s suggested tax cuts are of such a scale that they could, in the short term, have a larger impact than his spending plans, which pale a little in comparison. Quite how much growth his proposals would create crucially depends on monetary conditions. If his plans trigger higher yields or a tightening of monetary policy, their efficiency would suffer, potentially more than halving the impact on GDP. The new administration will therefore need to assess its fiscal headroom and tread carefully not to undermine the Fed’s credibility.       -3 0 3 6 9 12 15 18 21 24 27 30 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 Federal deficit % GDP* Federal Outlays % GDP Republican President Democrat President CBO Forecast
  PERSPECTIVES | Trump’s growth nirvana 8   Important Information This document is for Investment Professionals only and should not be relied on by private investors. This document is provided for information purposes only and is intended only for the person or entity to which it is sent. It must not be reproduced or circulated to any other party without prior permission of Fidelity. This document does not constitute a distribution, an offer or solicitation to engage the investment management services of Fidelity, or an offer to buy or sell or the solicitation of any offer to buy or sell any securities in any jurisdiction or country where such distribution or offer is not authorised or would be contrary to local laws or regulations. Fidelity makes no representations that the contents are appropriate for use in all locations or that the transactions or services discussed are available or appropriate for sale or use in all jurisdictions or countries or by all investors or counterparties. This communication is not directed at, and must not be acted on by persons inside the United States and is otherwise only directed at persons residing in jurisdictions where the relevant funds are authorised for distribution or where no such authorisation is required. Fidelity is not authorised to manage or distribute investment funds or products in, or to provide investment management or advisory services to persons resident in, mainland China. All persons and entities accessing the information do so on their own initiative and are responsible for compliance with applicable local laws and regulations and should consult their professional advisers. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities, but is included for the purposes of illustration only. Investors should also note that the views expressed may no longer be current and may have already been acted upon by Fidelity. The research and analysis used in this documentation is gathered by Fidelity for its use as an investment manager and may have already been acted upon for its own purposes. This material was created by Fidelity International. Past performance is not a reliable indicator of future results. This document may contain materials from third-parties which are supplied by companies that are not affiliated with any Fidelity entity (Third-Party Content). Fidelity has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. Fidelity International refers to the group of companies which form the global investment management organization that provides products and services in designated jurisdictions outside of North America Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. Fidelity only offers information on products and services and does not provide investment advice based on individual circumstances. Issued in Europe: Issued by FIL Investments International (FCA registered number 122170) a firm authorised and regulated by the Financial Conduct Authority, FIL (Luxembourg) S.A., authorised and supervised by the CSSF (Commission de Surveillance du Secteur Financier) and FIL Investment Switzerland AG, authorised and supervised by the Swiss Financial Market Supervisory Authority FINMA. For German wholesale clients issued by FIL Investment Services GmbH, Kastanienhöhe 1, 61476 Kronberg im Taunus. For German institutional clients issued by FIL Investments International – Niederlassung Frankfurt on behalf of FIL Pension Management, Oakhill House, 130 Tonbridge Road, Hildenborough, Tonbridge, Kent TN11 9DZ. In Hong Kong, this document is issued by FIL Investment Management (Hong Kong) Limited and it has not been reviewed by the Securities and Future Commission. FIL Investment Management (Singapore) Limited (Co. Reg. No: 199006300E) is the legal representative of Fidelity International in Singapore. FIL Asset Management (Korea) Limited is the legal representative of Fidelity International in Korea. In Taiwan, Independently operated by FIL Securities (Taiwan ) Limited 15F, 207 Tun Hwa South Road, Section 2, Taipei 106, Taiwan, R.O.C. Customer Service Number: 0800-00-9911#2 IC16-119

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Trump's growth nirvana

  • 1.   PERSPECTIVES NOVEMBER 2016 This is for investment professionals only and should not be relied upon by private investors Trump’s growth nirvana Not all fiscal plans are created equal What should we make of Republican policy makers’ and President-Elect Donald Trump’s plans for higher spending and various tax cuts? There is currently no visibility on the implementation of these plans, which we expect to change materially in the coming months. But we can assess how effective individual measures are likely to be, by analysing their fiscal multipliers. At face value, a sizeable tax reform would add significantly to US growth in the short term - if financed by extra debt. While multipliers for tax cuts are low, the sheer size of the suggested cuts means they would have a significant impact on nominal GDP. The expenditure promises made during the election campaign are fairly modest in comparison, even when accounting for their better multipliers. Excessive tax cuts pose a larger risk for bond investors than the incoming team’s spending proposals, as the suggested tax cuts are more likely to push up US Treasury yields. The importance of fiscal multipliers Fiscal multipliers give an idea of how successful tax cuts or spending proposals are in promoting overall economic growth. If multipliers are high, such measures could be highly successful, boosting demand not only directly but also indirectly, as employment and incomes rise and corporate revenues improve. Higher bond yields and tighter monetary policy would reduce fiscal multipliers, and, therefore, the boost to the economy. This means that the new administration will have to carefully assess its fiscal headroom and support central bank credibility to keep term premia low. It is true that bond yields and term premia have risen substantially post- election in anticipation of fiscal easing, but they remain exceptionally low by historical standards (Chart 1). Chart 1: Reassessing the future? Post-election yield sell-off Source: Bloomberg, November 2016. DIERK BRANDENBURG joined Fidelity International as a senior credit analyst in 2003. After leading the financial team in the fixed income division for six years, Dierk took responsibility of developed market sovereigns & strategy in 2014. Prior to joining Fidelity, Dierk was Deputy Head of Credit at the Bank for International Settlements and also worked at Deutsche Bank. Dierk holds a PhD in Economics and degrees from Freiburg University and the London School of Economics. ANDREA IANNELLI is an Investment Director at Fidelity. Andrea joined Fidelity in 2015, and represents the Fidelity fixed income investment team to institutional and wholesale clients in Southern Europe and Latin America. 1M1Y 2Y3Y 5Y 7Y 10Y 30Y 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 US Treasuries Curve - 18 November US Treasuries Curve - 7 November
  • 2.   PERSPECTIVES | Trump’s growth nirvana 2 What will determine Trump’s multipliers? The size of fiscal multipliers depends crucially on whether one assumes there will be a recession in the US next year or not. Fiscal multipliers are higher in a recession and lower or negative when approaching full employment, due to import drag (as foreign companies meet the demand the full-capacity domestic market struggles to meet), rising interest rates and potential crowding-out effects. Monetary policy also affects fiscal multipliers. Policy commentators will argue that there are synergies between expansive monetary and fiscal policy as the monetary funding of fiscal spending can amplify the stimulus. But with US inflation set to rise and protectionism potentially driving up import prices, there will be little appetite for such a combined approach. Tighter monetary policy looks more likely, and this would mean lower fiscal multipliers for any given fiscal policy measure. Bond yields play a key role, too. If yields rise in anticipation of yet more debt, then government deficit spending risks crowding out interest-sensitive private sector spending. For now, however, one can rule out higher yields as a headwind to fiscal multipliers. This is because the term premium – the excess yield that investors require to commit to holding a long-term bond instead of a series of shorter-term bonds - is close to zero, even after the recent sell-off (Chart 2). This is the key argument that multipliers could be higher than usual, as there will be crowding in of private investment at these rates, once the government creates the demand. Chart 2: US term premium remains ultra-low Source: Fidelity International, Haver, 15 November 2016. Based on NY Fed ACM Model.   However, higher nominal yields are a headwind worth considering given the size of the national debt. The refinancing of this debt could become an issue for a variety of reasons. For example, will foreigners remain happy to hold US dollars and Treasuries at current rates? Any changes to the Fed’s board or its statutes which undermine its independence would also be negative for bonds. Which works best – tax cuts or spending? The basic rule is that spending multipliers are higher than tax multipliers because part of any tax cuts will be saved. Indeed, the Republican preference for lower taxes over higher government spending is likely to lead to an inefficient (costlier) expansion with relatively low multipliers. -10 -5 0 5 10 15 20 1968 1973 1978 1983 1988 1993 1998 2003 2008 2013 Fed Funds Rate 10y Term Spread 10y Term Premium (ACM) Greenspan conundrum Taper Tantrum
  • 3.   PERSPECTIVES | Trump’s growth nirvana 3 In fact, because tax payers will adjust their expectations of future taxation, it’s hard to see how tax multipliers can ever be efficient (i.e. larger than 1, boosting GDP by more than taxes are cut) when compared to spending multipliers. Only when tax cuts are strictly temporary and target liquidity- constrained households and companies can they beat spending increases for efficiency. In all other situations, the permanent income hypothesis applies - people will be looking through the new measures, adjusting their saving and borrowing to account for future tax increases. For example, the recent oil price decline (essentially a tax cut) had zero effect on US consumption in 2015/16. Even at the height of the 2009 recession, multipliers for temporary tax cuts were never greater than 1, and for permanent tax cuts they were below 0.5 (Chart 3). Chart 3: Spending stimulus more efficient than tax cuts in 2009 and 2015 Source: Fidelity International, Blinder/Zandi, 2015. How do Trump’s tax plans compare to Reagan’s cuts? The history of US tax legislation bears this out: there is no magic formula where tax cuts pay for themselves. Trump’s ideas echo President Ronald Reagan’s ground-breaking, broad-based tax cuts. Reagan faced different constraints; he benefited from lower debt levels but had to deal with much higher bond yields. His first tax cut cost the Treasury cumulative revenues equivalent to a massive 12% of GDP between 1981-1984. That did boost the economy in the short- term, but did not help the budget (Chart 4). Chart 4: Reagan’s tax cuts boosted growth, but also the deficit Source: Congressional Budget Office, Office of Tax Analysis, BEA, 2016 - 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80 Temporary tax cuts Permanent tax cuts Spending Changes 2009 Q1 2015 Q1 -12.0 -10.0 -8.0 -6.0 -4.0 -2.0 0.0 2.0 4.0 6.0 8.0 -3.0 -2.5 -2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 GDP growth, federal deficit, % GDP Tax cuts, % GDP (4y avg) Tax legislation Deficit % GDP Real GDP yoy% Reagan Bush Jr Obama Clinton Bush Sr
  • 4.   PERSPECTIVES | Trump’s growth nirvana 4 As a consequence, Congress spent most of its time in the 1980s reversing Reagan's measures, even introducing a tax increase under George H. W. Bush at the height of the late 1980s recession. President Bill Clinton pushed through another tax hike at the beginning of his first term, but then rode the budget all the way into surplus, helped by soaring productivity and a strong labour market. Georg W. Bush and Congress rediscovered tax cuts as a stimulus tool in the 2003 recession, and President Barack Obama pursued them in the 2008 recession. How aggressive are Trump’s proposed tax cuts? Trump’s own tax cut proposals are significantly larger than the Republican party’s (GOP) plans, but would probably ultimately be less effective (Table 1). What compromise on the tax cuts the House of Representatives and Trump reach next year will therefore matter a lot. The latest GOP proposal is estimated to cost $2.4 trillion over 10 years (about 1.3% of baseline GDP per year on average) while the Trump plan could be anywhere between $4-6 trillion (about 2.2%-3.3%), including taxes of $200 billion on deferred foreign income that is repatriated. Table 1: Impact of GOP and Trump tax proposals GOP 2016 Trump 2016 Assuming 33% income tax rate Assuming 15% rate income tax rate Static cost analysis (2016-2025) $bn Individual income taxes 981 2,192 3,730 Corporate income taxes 1,197 1,936 1,936 Other taxes 240 240 240 Total 2016-2025 2,418 4,368 5,906 Dynamic Simulation (2016-2025) CBO GDP base case (2016-2025) 20% GDP vs base 9% 7% 8% Capital stock vs base 28% 20% 24% Wages vs base 8% 5% 6% Jobs vs base 1,687 1,807 2,155 Total cost of tax reform ($bn) 191 2,640 3,932 Source: Fidelity International. Tax Foundation 2016. CBO: Central Budget Office. Viewed dynamically, i.e.by simulating growth and employment effects, the various plans could add between 7% and 9% to baseline GDP over the next 10 years according to the Tax Foundation. This reduces the net cost of the tax cuts, as tax revenues would rise, especially under the GOP proposal that foresees a significant broadening of the tax base. Despite its much larger stimulus, the Trump proposal would have a lower impact on GDP than the GOP plans because it is less targeted on fostering investment and tax cuts are more focused on the higher income brackets, where saving rates are higher.
  • 5.   PERSPECTIVES | Trump’s growth nirvana 5 Will tax cuts boost productivity longer term? Cutting corporate taxes could have supply side effects, but these are notoriously difficult to measure and only play out over long time horizons. For example, Reagan's supply side policies did very little to raise productivity growth during his tenure; most of the growth came from rising labour market participation. Productivity only improved significantly in the late 1990s and it is hard to link this to any tax policies of the 1980s. Chart 5: Low productivity has fuelled a secular stagnation TFP: total factor productivity. Source: Fidelity International, Bureau of labour statistics (BLS), Bureau of Economic Affairs (BEA), Federal Reserve Bank of San Francisco, 2016. Having said that, a lack of capital deepening and low total factor productivity are at the root of the thesis of secular stagnation (Chart 5). In the model analysis by the Tax Foundation, the country’s capital stock could grow by about 20%-30% over the next 10 years under Trump’s plans. This could address a key weakness in the US growth story even if total factor productivity remains low, by supporting labour market participation and trend growth (Charts 6 and 7). Chart 6: Capital deepening has slowed post crisis Source: Fidelity International, Haver, BEA 2015. Chart 7: Falling participation weighs on productivity Source: Fidelity International, Haver, BLS March 2016. How effective will Trump’s spending plans be? Compared to tax cuts, an increase in government expenditure is expected to have a higher multiplier, and therefore a larger impact on GDP. Infrastructure and defence spending multipliers are well above 1x in a recession, but drop sharply when at full employment. While the US is technically close to full 2.11% 0.51% 2.01% 0.44% 0.42% 2.4% 1.8% 2.4% 1.6% 0.5% -1% 0% 1% 2% 3% 4% 5% 1948-1973 1973-1995 1996-2003 2004-2007 2008- TFP (Ut adj) Capacity Utilization Labor input Capital Input GDP per capita 60,000 80,000 100,000 120,000 140,000 160,000 180,000 -5% 0% 5% 10% 15% 20% 1950 1960 1970 1980 1990 2000 2010 capital stock p/ worker, $ y/y % y/y % Capital Stock/Labour Force 60 61 62 63 64 65 66 67 68 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Participation rate (5y avg) Productivity growth (5y avg) Republican President Democrat President
  • 6.   PERSPECTIVES | Trump’s growth nirvana 6 employment, the low labour participation rate suggests there are still under- utilized resources, so if the new administration can lift growth through spending, then that may support the multiplier (Table 2). Table 2: Spending multipliers of 2009 fiscal package As of Q1 2009 As of Q1 2015 Spending changes 1.53 0.89 Temporary increase in SNAP (formerly food stamps) 1.74 1.22 Temporary federal financing of work-share programs 1.69 1.13 Extension of unemployment insurance benefits 1.61 1.01 Increase in defence spending 1.53 0.87 Increase in infrastructure spending 1.57 0.86 General aid to state governments 1.41 0.58 Low Income Energy Assistance Programme 1.13 0.55 Source: Fidelity International, Blinder 2016. Based on Moody’s Analytics model of the US economy. The Obama administration already approved $300 billion of infrastructure investments over five years in 2015, but Trump has bigger things in mind. The president-elect plans to spend $1 trillion over 10 years to rebuild US infrastructure. Assuming an average multiplier for government spending of 1.4x, the Trump plan would add 0.8% per year to U.S. GDP growth, or 0.3% more than the current administration's plan (Table 3). However, multipliers can differ considerably depending on monetary policy and long-term yields. In the analysis in the table below, they range from 0.7x to 1.9x depending on debt constraints and the monetary policy regime. Table 3: Trump’s spending plan would boost growth more than Obama’s Impact on GDP Multiplier Obama $300bn 2015-20 Trump $500bn 2017-22 Difference Debt constraint - hawkish Fed 0.7 0.24% 0.40% 0.16% Median outcome 1.4 0.48% 0.80% 0.32% No debt constraint - dovish Fed 1.9 0.65% 1.09% 0.43% Source: Fidelity International. Expenditure multipliers from Leeper/Traum/Walker 2015, OMB, Trump, FIL calculations, November 2016. Our analysis is a static pro-forma scenario relative to the Central Budget Office’s base case for US GDP that ignores crowding in effects or productivity gains. But the effects of Trump’s plans may take time to come through. Current progress in US infrastructure spend is slow. For example, typically only 25% will get spent in the first year for projects such as highways. As most of the spending authority sits with the individual states, the federal government will need to create strong incentives to see the budgeted money spent quickly. The macro impact of infrastructure spending will be lower still if it is financed through public-private partnerships without engaging in direct deficit financing. For example, the EU’s 500 billion ‘Junker Plan’ is hardly visible at the macro level two years after launch. Concern over the deficit will limit fiscal headroom All multipliers discussed above assume that the tax cuts and expenditure programmes are financed by additional debt. Yet the fiscal deficit is on a rising path and will remain so for the foreseeable future, according the Central Budget Office, unless the government cuts entitlements (Chart 8).
  • 7.   PERSPECTIVES | Trump’s growth nirvana 7 Chart 8: Rising federal deficits *The blue bars above the line indicate deficits, the ones below indicate surpluses. Source: Fidelity International. Haver, Congressional Budget Office, 2016. This means that a lot will depend on how the administration deals with the Affordable Care Act (‘Obamacare’) and other social programmes. Cuts in these areas and the associated lower transfer payments will offset some of the expansionary effects of tax cuts and infrastructure spending. Conclusion US President-elect Donald Trump wowed voters during his campaign with grand promises to raise spending and cut taxes; in his victory speech, he announced he would double economic growth. But will he really? Compromises and delays are the reality of Washington politics, so it is anyone’s guess to what extent Trump will be able to implement his plans. Still, it’s worth crunching the numbers to assess the overall impact of individual proposals, their efficiency and the costs involved. Our analysis shows that Trump’s plans would indeed boost growth – quite significantly. However, it also shows that Trump’s preference for tax cuts over spending is economically inefficient, reviving the economy by less than similar amounts of spending would. On very optimistic estimates, Trump’s suggested tax cuts could add 7%-8% to GDP over the next 10 years, while his spending proposals could add between 0.4% and 1.1% to GDP annually. Although they are less efficient, Trump’s suggested tax cuts are of such a scale that they could, in the short term, have a larger impact than his spending plans, which pale a little in comparison. Quite how much growth his proposals would create crucially depends on monetary conditions. If his plans trigger higher yields or a tightening of monetary policy, their efficiency would suffer, potentially more than halving the impact on GDP. The new administration will therefore need to assess its fiscal headroom and tread carefully not to undermine the Fed’s credibility.       -3 0 3 6 9 12 15 18 21 24 27 30 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 Federal deficit % GDP* Federal Outlays % GDP Republican President Democrat President CBO Forecast
  • 8.   PERSPECTIVES | Trump’s growth nirvana 8   Important Information This document is for Investment Professionals only and should not be relied on by private investors. This document is provided for information purposes only and is intended only for the person or entity to which it is sent. It must not be reproduced or circulated to any other party without prior permission of Fidelity. This document does not constitute a distribution, an offer or solicitation to engage the investment management services of Fidelity, or an offer to buy or sell or the solicitation of any offer to buy or sell any securities in any jurisdiction or country where such distribution or offer is not authorised or would be contrary to local laws or regulations. Fidelity makes no representations that the contents are appropriate for use in all locations or that the transactions or services discussed are available or appropriate for sale or use in all jurisdictions or countries or by all investors or counterparties. This communication is not directed at, and must not be acted on by persons inside the United States and is otherwise only directed at persons residing in jurisdictions where the relevant funds are authorised for distribution or where no such authorisation is required. Fidelity is not authorised to manage or distribute investment funds or products in, or to provide investment management or advisory services to persons resident in, mainland China. All persons and entities accessing the information do so on their own initiative and are responsible for compliance with applicable local laws and regulations and should consult their professional advisers. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities, but is included for the purposes of illustration only. Investors should also note that the views expressed may no longer be current and may have already been acted upon by Fidelity. The research and analysis used in this documentation is gathered by Fidelity for its use as an investment manager and may have already been acted upon for its own purposes. This material was created by Fidelity International. Past performance is not a reliable indicator of future results. This document may contain materials from third-parties which are supplied by companies that are not affiliated with any Fidelity entity (Third-Party Content). Fidelity has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. Fidelity International refers to the group of companies which form the global investment management organization that provides products and services in designated jurisdictions outside of North America Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. Fidelity only offers information on products and services and does not provide investment advice based on individual circumstances. Issued in Europe: Issued by FIL Investments International (FCA registered number 122170) a firm authorised and regulated by the Financial Conduct Authority, FIL (Luxembourg) S.A., authorised and supervised by the CSSF (Commission de Surveillance du Secteur Financier) and FIL Investment Switzerland AG, authorised and supervised by the Swiss Financial Market Supervisory Authority FINMA. For German wholesale clients issued by FIL Investment Services GmbH, Kastanienhöhe 1, 61476 Kronberg im Taunus. For German institutional clients issued by FIL Investments International – Niederlassung Frankfurt on behalf of FIL Pension Management, Oakhill House, 130 Tonbridge Road, Hildenborough, Tonbridge, Kent TN11 9DZ. In Hong Kong, this document is issued by FIL Investment Management (Hong Kong) Limited and it has not been reviewed by the Securities and Future Commission. FIL Investment Management (Singapore) Limited (Co. Reg. No: 199006300E) is the legal representative of Fidelity International in Singapore. FIL Asset Management (Korea) Limited is the legal representative of Fidelity International in Korea. In Taiwan, Independently operated by FIL Securities (Taiwan ) Limited 15F, 207 Tun Hwa South Road, Section 2, Taipei 106, Taiwan, R.O.C. Customer Service Number: 0800-00-9911#2 IC16-119