Federal Reserve Suggests Tempering Expectations for Tax Cuts

Chris Gaetano
Published Date:
Jul 11, 2018
Federal_Reserve_Bank_of_SanFrancisco (1)

While the Tax Cuts and Jobs Act signed late last year was done to boost economic growth, the Federal Reserve Bank of San Francisco suggested that we should keep our expectations in check, saying that forecasts could be overly optimistic.

The main issue is timing. An economic stimulus, like that which might be produced by a tax cut, act as a fiscal multiplier, defined as "the response of GDP to a policy change affecting government spending or tax revenue." Previous research, mostly focused on state-level economies, has found that fiscal multipliers have more of an impact during bad economic times than good ones. While these studies have tended to focus not on tax policy changes but government spending, the Fed believes the same general principles apply due to what's called "marginal propensities to consume, (MPC)," which is basically how much people spend versus save new income. 

The Fed said that there have been numerous microeconomics studies showing that cash-strapped individuals have a higher MPC than those in more comfortable positions. Basically, when you don't have a lot of money, there's a lot of things you want (or need) to buy but can't, and so when you get money you are likely to buy those things. When you already have money, and then get more, you're more likely to save the extra income. 

Extrapolating this out to the population as a whole suggests that the average MPC should fall during times of economic expansion, as would the impact of a fiscal multiplier, because more people have more money. The Fed noted that average MPC was 20 to 30 percent higher during the recession compared with other years, and so given the standard theoretical link between MPC and fiscal multipliers, "this finding implies that the tax multiplier in recessions is at least 20-30% higher than in expansions." 

The U.S. economy, the Fed noted, has been expanding for eight years in a row, which is one of the longest expansions since World War II, "with resource utilization considered tight by nearly every measure." 

Given all this, the Fed believes that speculation about the benefits of the new tax law is likely a little too optimistic. While forecasters have expected the measure to boost 2018 GDP by around a percentage points, "the literature... suggests the true boost is more likely to be well below that, as small as zero according to some studies." 

Beyond economic impacts, the Fed also warned that the timing of the tax cuts might make the country less able to respond to crisis situations in the future. Historically, said the Fed, deficits tend to be highly counter-cyclical, which means they generally rise during economic bad times, as governments pass policies to mitigate the impact, and lower in economic good times, as the tax revenues increase with economic growth. The only time this did not happen was during the Vietnam War due to sharply increased military spending. However the Fed said the U.S. will likely see a return to this "highly unusual" pattern because "while the cyclical component of the deficit is expected to fall in the next few years, the actual deficit is projected to rise" due to the tax cuts. 

"The projected procyclical policy over the next few years may raise concerns regarding the nation’s fiscal capacity to respond to future downturns and its ability to manage the growing federal debt," said the Fed. 

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