Republican prospects for 2018 have been described as “dismal” and “hopeless.” But can the positive effects of tax cuts, namely higher GDP growth, save Republicans from the coming “blue wave?” As we wrote in November, delays in tax cuts negatively affect GDP growth. But what about when they go into effect?
Note for all charts: the black dotted line represents the average GDP growth from 1947 to 2017, not the average for the data range of the chart.
The year of 1965 is the best example in the Kennedy period(above) of the immediate beneficial effects of tax cuts. For that year, growth was consistently higher than the average since 1947. But thereafter the spike subsides, perhaps indicating that the arrival of a highly anticipated tax cut leads to a frenzy of economic activity initially, which wears off. 1965 started and ended with a quarterly GDP growth rate of 10%, unheard of for the modern era. But then for most of 1966 and 1967, growth was weak. As we determined in our last piece on growth and tax reform, when investors anticipate tax cuts, they tend to put off investment until the tax cut goes into effect. This leads to lower GDP growth in the lead up to a tax cut.
The delay in growth until the second tax cut (growth does not seem to have been significantly affected by the first tax cut in 1963) is likely a result of the expectation investors and businesses had that another, larger tax cut would be coming in less than a year.
The example of the Reagan tax cuts(above) is complex, as there was a significant negative externality at the time that was suppressing growth. Inflation had been persistently high for over a year, peaking at nearly 15% in March of 1980. The Federal Reserve under chairman Paul Volcker dramatically raised interest rates, taking the Fed Funds rate from 9.03 to 18.9 in less than half a year, as you can see below.
Another factor in the delay of growth was that the first Reagan tax cut was for personal income, not corporations. As with the Kennedy tax cut, this seems to indicate that decreasing the corporate tax rate drives growth more than decreasing the income tax rate. As you can see in 1986, the cut in both the corporate and individual rate had more immediate positive growth effects.
The Bush tax cut(above) supports the thesis. Growth in this period is muted, as is the case generally in modern developed economies, but we can still see the overall effect: low growth leading up to a tax cut, high growth immediately after the tax cut, then a return to moderate-low growth. For quarters 2, 3, and 4 of 2003, growth was well above the average of about 3%. Q1 of 2004, by contrast, was below average.
So what does this mean for Republican prospects in 2018? The tax bill has already gone into effect for the most part, though parts of it, generally dealing with individual deductions, will have to wait until 2019. According to prediction markets, whether Republicans will win in 2018 is something of a toss-up: As of this writing, the political prediction algorithm PredictIt gives Democrats a 65% chance of taking the House and a 37% chance of taking the Senate.
However, the election will be in November, meaning we will have had 3 quarters of economic data to examine. If past trends are an indication, we will likely have at least 2 quarters of growth positively affected by the tax bill. Republicans and those who share their optimistic rhetoric about 2018 have presented the argument that working families will “feel” the effects of tax reform before they vote in the mid-term election. “Feel” is a dubious word, so I’ll put it like this: based on previous cuts, GDP will likely have registered positive effects of tax reform by November 2018. That is, if we don’t enter a situation akin to the early 1980s. Whether or not that will ultimately save Republicans from the “blue wave” is dependent on too many uncertainties to predict this early.
There are two likely scenarios in 2018: the first is something like what happened during the Reagan tax cuts. High inflation leading to a sudden, steep hike in rates, delaying positive growth for several quarters. In this scenario, Republicans would be in quite serious electoral trouble. It will be very difficult to lay out the claim that the tax cuts were positive for growth when the economy is contracting due to Fed attempts to stop runaway inflation. I don’t know how likely this scenario is, but inflation has been increasing. The average inflation rate in 2015 was 0.1%, 1.3% in 2016, and 2.1% in 2017. If we have high inflation in 2018, the new Fed chair may elect to raise rates dramatically, which could lead to a recession or otherwise suppressed growth, which will put Republicans on the backfoot when it comes to tax reform.
The other scenario is that inflation stays in the normal range and there is no need for dramatic rate hikes. Growth will then likely conform to the historical trend. Under this scenario, Republicans, including the President, will be able to make a credible argument that the tax bill has had a meaningful positive impact on economic growth - especially considering the exaggerated Democratic rhetoric about the bill.
However, they should be wary of what follows: growth effects from tax cuts seem to deteriorate within a year. The growth outlook might not be so positive for 2020, when Trump, should he choose to run, will be up for re-election. That being said, Republicans probably won’t be playing defense this November. In the high growth scenario, that is. If stagflation sets in instead of promised growth, Republicans will face difficult electoral odds.