In December, I wrote that the GOP tax bill could end up backfiring, not because of its effects on the structure of taxes, many of which were constructive, but because of bad timing. The fact that the bill cut total tax revenue just as the economy was approaching full employment made it highly procyclical. Standard principles of countercyclical fiscal policy call for tax cuts or spending increases as the economy moves into recession and tax increases or spending cuts as it moves toward full employment—a pattern that largely prevailed from the 1990s through 2014.
Fiscal policy since then has been procyclical, and the spending deal now before Congress will make it even more so. The following chart updates one I posted in December. Its projections for 2018 are modified in two ways.
First, the CBO has revised its projection of the output gap for 2018 from -0.2 percent to +0.1 percent. The output gap measures the amount by which GDP exceeds or falls short of the level that the economy is able to sustain in the long run without excessive inflation.
Second, to reflect the impact of the new budget deal, I have changed the 2018 estimate for the structural deficit of the federal budget from -2.5 percent to -3.7 percent. The structural balance is the surplus or deficit that would prevail if the output gap were zero. When the economy slips into recession, the actual balance moves toward deficit because tax revenues automatically tend to fall and spending on unemployment benefits and other items tends to increase. The structural balance removes the effects of these “automatic stabilizers.”
If the budget deal becomes law, the degree of fiscal stimulus, as measured by the difference between the output gap and the structural balance, will be the greatest since 1973, when the rate of inflation was 6.25 percent, rising to 11 percent in 1974 and followed by a recession. Optimists say there is less risk in “running the economy hot” now than in the 1970s because of hidden labor reserves that don’t show up in the official unemployment numbers and a productivity boom they expect because of cuts to taxes and regulations. Let’s hope they are right.