|GDP Outlook in 2011 After the Tax Deal|
The Guardian Unlimited, December 21, 2010
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The enthusiasm of the U.S. business press for the compromise tax package worked out by President Obama and Republicans in Congress led to a mini euphoria of upbeat economic projections for 2011. While the economy will do better with this tax package than if no deal were forthcoming, much of the discussion has exaggerated the potential stimulus to the economy.
First, it is important to remember that although the total package is scored as costing almost $900 billion over two years, almost everything in this package simply leaves in place current tax rates and spending. The biggest portion of the tax cut continues the tax rates put in place by President Bush in 2001. The continuation of these tax cuts, including a lower estate tax rate, accounts for almost $400 billion of the $900 billion.
Adding in the cost of a technical fix to the Alternative Minimum Tax, which is done every year, and the continuation of a series of smaller tax breaks brings the total to $670 billion. This portion of the package buys exactly zero stimulus since it simply amounts to continuing tax policies already in place. Had these tax breaks not continued it would have been a drag on growth, but their continuation does not provide any additional momentum to the economy. The $60 billion cost of extending unemployment insurance for another year can also be put in this category.
The only net stimulus in this package comes from replacing the $60 billion Making Work Pay tax credit in 2011 with a $110 billion reduction in the payroll tax and the allowance of full expensing of new investment. The latter is projected to cost $55 billion a year for the next two years. The full expensing in this deal replaces a provision of the 2009 stimulus package that provided for 50 percent expensing, which means that the net boost to the economy is half this size.
In sum, the net stimulus for the economy from this package in 2011 will be in the range of $70 billion or about 0.5 percent of GDP. This is not likely to provide a substantial boost to growth.
While the tax deal will be a net positive to growth for 2011, there are many other factors that are pushing in the opposite direction. First, much of the spending in the original stimulus package will be coming to an end in the first two quarters of 2011. This includes both infrastructure spending for projects that will be nearing completion and also assistance to state governments that allowed them to better weather difficult fiscal times.
State and local governments continue to face large budget shortfalls. They are finding it increasingly difficult to paper over their budgetary gaps (most state and local governments are required to run balanced budgets) and will have to resort to further cutbacks and tax increases in the year ahead.
House prices are once again falling, with the most recent data showing an 8.5 percent annual rate of decline. This pace is likely to accelerate in the months ahead. The housing market had been supported through the first half of 2010 by a first-time buyers’ tax credit. This had the effect of pulling many purchases forward from the second half of the year or 2011. As a result, sales have fallen by almost one-third. As inventories build up again, many homeowners will be forced to make substantial price cuts to sell their houses.
Declining house prices will be another blow to consumption as homeowners recognize that they have lost even more wealth than they had previously believed. The current pace of decline implies a loss of more than $1 trillion in wealth over the course of a year. The actual loss of wealth could easily be twice as large if the rate of price decline accelerates.
Another factor depressing consumption is the recent bump in interest rates. While interest rates are still extremely low in both real and nominal terms, the current 10-year Treasury rate is close to a full percentage point above the lows hit in the late summer. This rise in interest rates will bring to an end the wave of mortgage refinancing that had helped to free up tens of billions of dollars for consumption. Relatively few homeowners will see much gain in refinancing at current mortgage rates.
It is also important to recognize just how slow the underlying rate of growth in the economy actually is. Most analysts have highlighted the overall GDP growth figure. However, this number has been inflated over the last year by a rapid build-up of inventories.
Over the last four quarters GDP growth averaged 3.2 percent. However, final demand growth averaged just 1.3 percent over this period. In the most recent quarter, inventories were accumulating at almost the fastest rate on record. It is unlikely that the rate of inventory accumulation will accelerate further. Rather, the rate is likely to slow, meaning that inventories will be a net drag on growth in coming quarters.
In sum, there is every reason to expect that 2011 will be another year of weak growth with little, if any, decline in the unemployment rate. The economy will be somewhat stronger as a result of this tax package being put in place compared to a scenario in which nothing was done, but this is very far from the fabled second stimulus that some are acclaiming.