Image Source: Bloomberg.
The damage to Americans’ pockets from inflation in the last few years seems to have been one of the main factors explaining the American voters’ discontent with Joe Biden’s administration. Kamala Harris could not disassociate herself from this legacy and was unable to explain that this inflationary phenomenon was global, caused by the breakdown of global production chains and labor shortages resulting from the lockdowns. The contribution of the Biden administration’s COVID-19 bailout program explains less than half of the 2021-2022 inflation, according to several studies. The Democrats’ campaign failed to communicate that, in fact, the U.S. recovery since the pandemic has been the fastest and most widespread among advanced countries and that inflation, which is primarily the Federal Reserve Board’s (the Fed) responsibility, is close to pre-pandemic levels and the long-term Fed’s target.
The paradoxical thing about Trump’s victory is that though Republicans likely won because of the importance of the economy and voters’ perception of the Democrats’ mishandling of it, Trump’s agenda based on lower taxes, higher tariffs and migrant deportations threatens to derail the recovery.
1. Tax Policy
Trump has proposed reducing the corporate tax rate from 21 percent to 15 percent, the extension of the tax cuts for individuals implemented in 2017 and expiring in 2025, and the elimination of taxes on tips and social security payments. These measures are expansionary and may very likely result in increased consumption and investment in the next couple of years. Trump has said that these cuts will be offset by additional revenue from higher tariffs on imports from China and other countries, and by further growth in the tax base. However, the tax bases for these items are very different. To offset the reduction in revenue from tax rate reductions, Trump would have to raise tariffs by at least 20 percent on all $3.8 trillion of U.S. imports. Moreover, there is a contradiction with respect to tariffs: if the goal of import substitution with “Made in the USA” products is achieved, tariff revenue will be reduced. The implicit expectation that lower tax rates will lead to more growth and higher revenues is based on the Laffer Curve, a theoretical construction with inconclusive empirical results in the U.S. and elsewhere. Finally, Trump has recruited Elon Musk and Vivek Ramaswamy to head the new “Department of Government Efficiency” to attack the other way to “finance” tax cuts, which is to reduce government spending. However, entitlements and mandatory spending (including debt service) account for 60 percent of federal spending. If we add 13.3 percent defense spending, total “untouchable” spending represents 73 percent of total federal spending, or 16 percent of GDP. The remaining discretionary spending is 27 percent of spending, or 6 percent of GDP. Given that the expected fiscal deficit for 2024 is 6.7 percent, a reduction of the deficit to 4 percent of the deficit would imply draconian cuts of 50 percent to discretionary spending (excluding defense). It should be noted that every item in this discretionary portion will have strong advocates from both parties. Think of items such as education, basic infrastructure, R&D, etc. Elon Musk may be a genius entrepreneur, but he is no magician. A study by the Committee for a Responsible Federal Budget estimates that under Trump’s economic program the U.S. federal debt will increase by 17 points of GDP by 2030. The Tax Foundation has estimated that the net impact of $7.8 trillion in tax cuts and $4.7 trillion of revenue offsets promised in the campaign would increase the deficit by $3 trillion. If Trump does not reduce the deficit or increases it, which is most likely, long-term interest rates could rise, limiting growth. If against all expectations Trump can lower the deficit, he will have to renege on much of his campaign promises on taxes. Trump’s fiscal policy is expansionary in the short term but given the narrow current economic gap relative to the economy’s potential GDP, the incremental dynamism is likely to be reflected in rising inflation expectations.
2. Massive Deportations
In his campaign, Trump promised to deport all illegal migrants. There are an estimated 10 million undocumented workers, of which 4 million are Mexican. With unemployment at a rate of 4.3 percent, these workers are most likely employed. Removing even a fraction of these workers from the economy would impact both economic activity and prices, especially in agriculture and services such as restaurants, construction, and others. To achieve his campaign promises Trump has appointed Tom Homan, former director of ICE (Immigration and Customs Enforcement). Although Homan is considered “tough,” in his first statements he has said that he will initially prioritize the deportation of immigrants who have violated other laws. JD Vance has proposed funding this effort through a 10 percent tax on remittances (which can be returned to legal workers by reporting their income to the IRS at the end of the year). Arguably, this measure would also hit organized crime money laundering through remittances. It remains to be seen how much of these deportation promises will translate into action, but at any rate their effect will be negative for U.S. inflation and growth, and potentially very negative for Mexico from both a financial and humanitarian standpoint.
3. Import Tariffs
Trump has proposed to increase import tariffs on Chinese goods to 60 percent, and to place a uniform tariff of 10 percent to 20 percent on all U.S. imports. China’s tariff increase would cause price pressures on items such as iPhones, home appliances, solar energy equipment, and batteries, among many others. It is possible that China would respond with its own tariffs on U.S. products and additional restrictions on the participation of U.S. companies in that country causing a tariff war that would result in lower production and higher prices, even if in the long run these policies attract investment to the U.S. market. The same can be said with respect to tariffs on the rest of the world. Proponents of Trump’s protectionist policies argue that Trump will use tariffs as a bargaining chip, and that in practice he will be much more selective and strategic in their use. But even if tariffs are selective, it is doubtful that the government will be able to optimize resources and comparative advantages among nations better than the market. The Congressional Budget Office (CBO) estimates that contrary to what Trump argued in his campaign, the tariffs Trump imposed in 2018 reduced potential U.S. GDP by 0.3 percent in 2020. It is important to stress the interdependence and inconsistencies of Trump’s economic program: if indeed tariffs are selective and bargaining tools, then the expected tax collection targets for this item will be lower and the fiscal deficit higher.
4. Trump Complicates the Fed’s Job
Trump’s economic package puts the Fed in a tough spot. The difficult balancing act of bringing U.S. inflation back to the target of 2 percent without tilting the economy into a recession, which the Fed seems to be achieving, is in jeopardy. The economic impact of deregulation in sectors such as banking and energy, coupled with a lower tax burden for both businesses and individuals, is likely to cause a re-acceleration of the economy at the margin. Given the strength of its current pace and low rate of unemployment, the additional stimulus created by Trump’s economic policies may increase long-term inflationary expectations and force the Fed to reconsider the cadence of the current monetary policy easing cycle. The increase in long-term rates (which has already begun after the election) stemming from market concerns about both inflation and the fiscal deficit going forward would result in a tightening of liquidity conditions in the economy. Trump is likely to pressure the Fed to lower rates to offset the contractionary effect of rising long rates on the housing and construction sector. This would potentially lead to a showdown between President Trump and Fed Chairman Jerome Powell. With control of the Senate and the House of Representatives, the debate over Fed independence is no longer a theoretical curiosity.
In Conclusion
With Trump winning the presidency and the Republicans taking control of Congress, financial markets have reacted as expected: the stock market rose due to expected higher profitability caused by tax cuts and deregulation of various sectors, but long-term bonds fell due to concerns about deficits and inflation, resulting in a stronger dollar. Once the initial euphoria has passed, it appears that the likelihood of a period of caution and risk aversion has increased. The market is looking for clues to untangle the desirable, from the possible, and the probable in Trump’s economic package. The elephant in the room is the fiscal deficit and the fact that Trump has not made a credible case that anything will be done, let alone to fix it, but merely to contain it. His protectionist platform on labor and international trade, coupled with his tax policy may lead to a re-acceleration of the economy in the short term with negative consequences for inflation and growth in the medium and long term. The economy in the end may prove to be President Trump’s demise.
Jorge Mariscal is a member of Global Americans’ International Advisory Council and a lecturer at the School of International and Public Affairs of Columbia University.
Global Americans takes pride in serving as a platform that offers in-depth analyses on various political, economic, environmental, and foreign affairs issues in the Western Hemisphere. The views and opinions expressed in this article are solely those of the author and do not necessarily reflect the views of Global Americans or anyone associated with it, and publication by Global Americans does not constitute an endorsement of all or any part of the views expressed.
