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Written by: Matthew F. Beaudry , Senior Investment Director | Putnam Investments
President Trump’s election campaign called for new fiscal policies with the intent of accelerating economic growth to approximately 3.5%, according to an economic policy speech he gave in September (Source: Time.com). The changes included a mix of lower income-tax rates, a relaxation of many business regulations, and greater support for energy infrastructure development. With his party in control of both the Senate and the House of Representatives, there is a strong probability that many of these change could be enacted.
New presidents typically arrive in office with an economic agenda. In the case of Trump, the nature of his proposals has invited comparison with a variety of changes made under the first term of President Ronald Reagan in the 1980s.
The Reagan policy prescription
President Reagan is well known for the first major legislation of his administration, The Economic Recovery Tax Act of 1981, which resulted in one of the largest tax cuts in history. Individual income tax rates came down substantially. The top tax rate on individuals went from approximately 70% to 50% (it was reduced even more in subsequent legislation). The tax burden on businesses also became lighter. Companies received a new incentive to make capital investments in plant and equipment because the new Accelerated Cost Recovery System allowed them to write off depreciation at a faster pace.
Like Reagan, Trump also favors reducing income-tax rates for individual taxpayers and lightening the tax burdens on estates and capital gains. Trump’s tax plan differs in one regard, as it looks to reduce the overall tax rate on corporations while simplifying the tax code to eliminate a variety of corporate deductions and exclusions that are currently permitted.
Highlights of Trump’s economic proposals
Spending proposals
Reagan also sought to stimulate the economy with a major defense buildup in the 1980s. Defense spending approximately doubled under Reagan in dollar terms (Source: Congressional Budget Office).
The details on the Trump proposals are yet to be determined, but he has discussed both an infrastructure building program and a likely increase in defense spending. Currently, defense spending accounts for a little over three percent of GDP, close to a postwar low (Source: The World Bank). In terms of overall U.S. GDP, defense spending in early 2017 is only about half as big as its share in 1981.
The Reagan administration is well remembered for the deregulation of the air traffic controllers, but regulation reform encompassed many industries including finance, energy, health care, railroads, and trucking. The Trump administration has already begun to address regulatory reform in the health-care and financial sectors, and announced measures that take a new direction in the energy sector.
Different economic starting points
Presidents can share an economic philosophy, but they operate in unique economic and political contexts. In the 1980 election year, high inflation was a great concern, and aggressive rate increases by the Fed, led by Chair Paul Volcker, pushed the economy into recession. While growth had returned by the time Reagan took office in January 1981, the economy slipped back into recession even as he signed the stimulus bill later that year.
Today the economy is in different circumstances. Inflation is low. The current recovery has lasted almost eight years, and growth appears to be solidifying. Unemployment is below 5%. While the Fed is again in tightening mode, the pace is very gradual and the fed funds rate is below 1%, not above 10%.
The expansion of the Reagan years
In the course of the 1981–82 recession, both monetary and fiscal policy made progress. Inflation began to subside, and the fed funds rate began to ease. The Congress and President Reagan agreed to measures to gain control of the rising federal deficit. In late 1982, they enacted The Tax Equity and Fiscal Responsibility Act, which rescinded a portion of the previous year’s tax cuts.
While the 1981–82 recession was difficult, the expansion that ensued was impressive. Real GDP growth accelerated to a vigorous pace greater than 4%. The jobless rate fell to 5% from over 10% in 1982, inflation dropped from 11% to 4%, and both the fed funds rate and 10–year Treasury yields declined. The annual federal budget deficit, after widening, was narrowing by the time Reagan left office, although debt had increased by $1.7 trillion. (Source: fred.stlouis.org)
The policy outlook today
The stock market’s strong surge following the election seems to indicate enthusiasm that Trump’s proposals can accelerate economic growth from a reasonable growth rate to a more robust level. Low inflation and interest rates provide a more favorable starting point than was the case in 1981, creating a better likelihood of success.
The risk in Trump’s proposals is that the economy, with unemployment at 4.8%, does not have a lot of slack. A fiscal stimulus near the levels of the Reagan initiatives is unusual to attempt with the economy so near to conventional definitions of full employment. A surge in growth that creates greater demand for labor could cause labor market imbalances. While the labor force participation rate has been historically low and could rise, it is not clear that the supply of skilled labor would meet business demand. History tells us that conditions such as these can lead to faster wage growth and higher inflation. With the Fed already poised to raise interest rates, a change to fiscal policy that appears likely to stoke inflation might draw a more aggressive monetary policy stance from the central bank. This would be a risk for markets to consider.
For now, looking at the 1980s for clues about the course of the economy in the next few years remains an academic exercise. The new administration still needs to formulate actual fiscal policy proposals for investors to form a clearer picture. The most important questions are likely to be the order of priorities set by the administration. Then it remains to be seen how many of these priorities Congress enacts, and what changes are made along the way. Both the magnitude of the policies and the timing of their implementation can influence the ultimate impact because the economy remains a dynamic system.
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Source: Time.com. Donald Trump’s Speech on Jobs and the Economy, September 15, 2016.