Tax cuts the perfect remedy for what ails the US economy
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Wage gains and productivity growth are interconnected, and both economic variables have performed poorly in the current business cycle. Well-designed tax cuts could immediately help rectify this situation.

Start with the recent employment report and what it implies for nominal personal income, which is determined by the number of people who have a job, how many hours they work and what they are being paid.   

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The data show that income growth rebounded sharply when the recession ended in June 2009, but it has essentially been range-bound at a modest pace for much of the time since then.

 

More recently, the pace of personal income growth is showing signs of losing momentum — its growth rate is now expanding at the bottom end of its 3.5-5.5 percent band.

On the surface, this is surprising given the fact the unemployment rate is below 5 percent. Normally, at this point in the business cycle, wages would be accelerating much faster than they are at present.

This would give an added boost to personal income, thereby further lifting consumption and hence the overall economy relative to its prevailing trend, which has also been weak during this business cycle. This is not happening, however; at least not yet. Amazingly, there is still little evidence of meaningful upward wage pressures.

Just look at the trends in average hourly earnings, compensation per hour and the employment costs index. They are all expanding modestly in line with their underlying trends and do not point to an imminent pickup in underlying inflation.

Why? The lack of wage pressure could be due to both demand-side and supply-side factors. For example, the economy may just not have grown fast enough and long enough to absorb the remaining slack in the labor market.

In this case, stronger demand is needed. But, the lack of wage growth could also be due to the aforementioned weakness in productivity growth. For example, the economy is coming off one of its weakest five-year periods of growth in output per worker on record.

We know that, over long periods of time, wage gains are almost entirely the result of productivity growth. What can be done to fix the economy's current dilemma? Cut taxes for both households and corporations.

Lower taxes on labor will immediately lift after-tax disposable income. The upshot of greater after-tax disposable income would be faster consumption.

This, in turn, will cause firms to meet increased demand by hiring more workers and extending the hours worked of their existing employees. Then, as the unemployment rate falls further, workers' wages should rise because firms will have to bid up increasingly scarce labor resources.

To be sure, this is purely a demand-side phenomenon. Ultimately, supply-side considerations matter more for the economy's long-term potential growth.

In order to lift productivity growth, companies need to invest more in capital. Indeed, the lack of meaningful capital investment is the main reason why improvements in productivity have been so weak for the past decade-and-a-half.

If the labor market tightens substantially further in response to household tax cuts, companies may have no choice but to make productivity-enhancing investments to offset increasingly expensive labor inputs. However, corporate tax policy can be revised to boost firms' incentives to invest.

Reducing corporate tax rates to make them competitive with the rest of the world, while simultaneously allowing firms to fully expense their capital outlays in the year of purchase, would dramatically increase the after-tax return on capital.

In turn, greater capital deepening would help reverse the recent downtrend in productivity growth. Furthermore, if the tax system were altered so that debt financing was not preferential to equity financing, there may be less incentive for firms to issue debt to buy back stock.

Thus, supply-side focused tax policies that encourage greater capital investment will, over time, increase the country's capital stock, which has been growing at an abysmal rate relative to prior economic cycles.

This would have the added benefit of increasing the potential growth rate of the economy. Substantial tax cuts that are likely to be implemented sometime in the coming months underlie our expectation of a more robust economy.

This momentum should carry into 2018 and thereby extend the current business cycle a good deal longer.

 

Joseph LaVorgna is the chief U.S. economist and a managing director for Deutsche Bank Securities. He is a regular guest on CNBC programming. 


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