The Phaserl


Markets Are Priced for Perfection

by Jim Rickards, DailyReckoning:

Trump unveiled his tax plan yesterday. Part of his agenda calls for a reduction of the corporate tax rate from 35% to 15%.

It’s unclear at this moment what the final result will be after all the negotiations and political horse trading that will inevitably take place.

It’s very likely Trump planned to enter negotiations at 15%, fully expecting a compromise bill resulting in a demonstrably higher rate.

It’s the art of the deal.

But it doesn’t seem particularly well thought out.

It’s difficult to project the impact the tax cuts will have on the economy, of course. But without offsetting spending reductions or making up the revenue somewhere else, a tax cut could balloon the deficit.

Estimates vary, but a 15% tax rate without offsets could cost the government trillions of dollars in lost tax revenues over the next decade.

But Trump advisors believe they can avoid a debt crisis through higher than average growth. This is mathematically possible but extremely unlikely.

The Trump team hopes for nominal deficits of about 3% of gross domestic product (GDP) and nominal GDP growth of about 6%, consisting of 4% real growth and 2% inflation. If that happens, the debt-to-GDP ratio will decline and a crisis might be averted.

Again, this outcome is extremely unlikely. Deficits are already over 3% of GDP and are projected by the Congressional Budget Office (CBO) to go higher.

CBO estimates that both inflation and real GDP will each grow at about 2% per year in the coming ten years. This means that nominal GDP, which is the sum of real GDP plus inflation, will grow at about 4% per year, not the 6% the Trump team envisions.

The debt-to-GDP ratio is projected to soar even under the Trump team’s rosy scenarios.

CBO projections show that deficits will increase to 5% of GDP in the years ahead, substantially higher than the hoped for 3% in the Trump team formula.

Since debt is incurred and paid in nominal terms, nominal GDP growth is the critical measure of the sustainability of U.S. debt.

Why is that important?

Because retiring Baby Boomers will soon be making large demands on social security, Medicare, Medicaid, Disability payments, Veterans benefits and other programs that will drive deficits higher.

But there are numerous problems even with the CBO projections.

They make no allowance for a recession in the next ten years. That is highly unrealistic considering that the current expansion is already one of the longest in history. A recession will demolish the growth projections and blow-up the deficits at the same time.

CBO also makes no allowance for substantially higher interest rates. With $20 trillion in debt, most of it short-term, a 2% increase in interest rates would quickly add $400 billion per year to the deficit in the form of increased interest expense in addition to any currently project spending.

Finally, CBO fails to consider the ground-breaking research of Kenneth Rogoff and Carmen Reinhart on the impact of debt on growth. I have discussed the 60% debt ratio danger threshold before. But there is an even more dangerous threshold of 90% debt-to-GDP revealed in the Rogoff-Reinhart research.

At that 90% level, debt itself causes reduced confidence in growth prospects — partly due to fear of higher taxes or inflation — which results in a material decline in growth relative to long-term trends.

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