Research Insights, November 21, 2016

Will 1600 Pennsylvania Avenue Return to Economic Relevance, Or Is It Merely Rhetoric?

With the Chicago Cubs winning the World Series for the first time since 1908, the city of Cleveland winning its first professional sports championship since 1964, England voting to leave the European Union, and Donald Trump winning the U.S. Presidential election, it seems anything is possible – even government policy returning to economic relevance.  But will we see government policy play a decisive role in the direction of the economy in the near term?  

Will Campaign Rhetoric Become Policy Reality?

In the days following the surprising election results, equity and fixed income markets were betting that President-elect Trump’s proposals favorable to economic growth such as infrastructure spending and tax cuts would be implemented while discounting the likelihood of campaign rhetoric surrounding trade.  In spite of these views, they are not a certainty and significant questions remain. How will government policies related to the economy be managed?  How much will military spending increase?  What will be the magnitude of new infrastructure spending and will it be privately or government funded?  And where will personal and corporate tax rates be adjusted?  Last, will substantial new protectionist trade policies be implemented?  Deficit hawks in Congress will need to be convinced to support the new President’s spending increases and tax cuts, but, if not, will enough Democrats acquiesce to those tax cuts in return for the infrastructure spending they have been trying to pass the last eight years?  Even if markets are correct and we see significant infrastructure spending and tax cuts, the U.S. economy has pursued similar policies before, with two very different economic outcomes. 

Reagan Redux or Party Like It’s 1999?

With an emphasis on increased government expenditures and proposed reduction in tax rates, the President-elect’s fiscal and tax policies are being associated with former President Reagan’s policies.  However, former President George W. Bush also increased government spending and reduced tax rates with a very different economic result.  As a result, whether his policies and economic outcomes more closely resemble Reagan’s or Bush’s may have significant implications for commercial real estate.  

While government expenditures increased under both administrations, they increased significantly more during the Reagan years, with annual government expenditures being 30% higher in his final year in office as compared to levels in place the year before he took office. Comparatively, while still a significant increase, government expenditures increased 20% during the Bush administration, a meaningful difference.  

Budget deficits increased materially under both but ballooned as a percentage of GDP far more during Reagan’s presidency in line with the greater government expenditures we saw previously.  During Reagan’s term, government deficits as a percentage of GDP averaged 4.0%, while deficits averaged 1.9% during Bush’s presidency. While part of the difference is due to the fiscal surpluses in the first two years under Bush, even excluding those years, the average annual deficit was 2.4%, well below the Reagan average.

As a result, government expenditures were a greater contributor to economic growth during the Reagan administration than Bush’s administration with government expenditures adding 0.7% to economic growth under Reagan  and only 0.43% under Bush. 

Examination of tax rates also reveals significant differences.  During Reagan’s tenure, average corporate taxes paid as a percentage of corporate profits actually increased from 29.9% in 1979 to 36.5% in his last year in office.  Conversely, corporate taxes as a percentage of corporate profits declined significantly during Bush’s time in office, going from 33.8% in 1999 to 22.4% in his last year in office.  While corporate taxes as a percentage of profits increased under Reagan, they declined significantly under Bush. The graph below depicts the change in corporate tax rates as a percentage of corporate profits and the corporate tax rates as a percentage of corporate profits at the beginning and end of each president’s term.

The change in the top personal income tax rate from the beginning of their terms to the end of their presidencies also varies significantly.  During Reagan’s term, the top personal income tax rate declined from 70% in 1979 to 28% in his final year, while the personal income tax rate under Bush only declined from 39.6% the year before he took office to 35% in the last year of his second term. The graph below depicts the change in the top personal tax rate at the beginning and end of the two administrations.

What were the economic impacts of these differences?  GDP growth was substantially different with annual GDP levels growing 31% from 1979 to 1988 during Reagan’s presidency on an inflation adjusted basis and 18% from 1999 to Bush’s last year in office.  Personal consumption expenditure growth was also materially different, with annual personal consumption expenditure levels increasing 35% from the beginning of Reagan’s presidency to the end while increasing only 22% from the beginning of the Bush presidency to the end.  Business investment growth was also significantly different with annual business investment increasing more than 39% from 1979 to 1988 as compared to a total increase of 1% from 1999 to 2008. Even if we use the peak of business investment during Bush’s term as opposed to 2008 when the Great Financial Crisis significantly reduced business investment, business investment only increased 14.9%.  As a result, business investment on average contributed 0.8% to GDP under Reagan and only 0.17% on average to GDP during Bush’s presidency.