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Politics & Policy

The State of the Union: A Few Thoughts

I am no fan of the State of the Union address. It’s a show I wish we would do away with, from the clapping and standing ovations to the talking points to please the base and the ones to please the Washington insiders. Most of the new policies introduced during a State of the Union never see the light of day (which is often a good thing), so it seems to be more about signaling than anything else. And, yet, here we are again.

We are told that the speech will be about unity rather than division. Here are some issues that I expect President Trump will cover.

Tax Reform: The president is expected to take a victory lap about the passage of the tax reform. In fact, I think he should spend most of his time tonight selling his tax cuts. If he doesn’t, he will have wasted an important opportunity, because the level of misinformation about the tax cuts is still high. This would be a perfect opportunity to learn from President Reagan’s way of communicating and explaining misunderstood policy ideas.

Explaining how tax reform impacts the economy and wage growth is important, where it is correct. President Reagan was a master of this form. However, I worry that, instead, President Trump will explain how the tax cuts are good for the economy because they put money in people’s pockets, money that Americans can then spend on U.S. goods, which get a new lease on life and grow the economy. That’s a Keynesian explanation, and it’s not how it works. Consumption follows economic growth, not the reverse.

We are also going to hear a lot about those bonuses and pay increases. I think those are great but I don’t think they are as much the product of the tax reform as much as they are the result of a tighter labor market. It’s not a bad thing, and we should cheer them no matter what.

However, I hope the president will take some time to explain how lowering marginal tax rates on investment gives companies an incentive to earn more taxable income leading them to invest in other businesses and the expansion of their factories. This in turn raises workers’ productivity, and ultimately leads to higher wages. In other words, he should talk about how that there is more growth wage coming. He can point to the increase in capital expenditures as evidence that things are happening.

Low corporate rates make American companies more competitive. We know this not only from theory, but also because other countries have complained that they fear losing capital to the U.S. now.

Regulations: The president has delivered on his promise to tackle deregulation. He deserves real credit for this and I assume he will talk about what he has done and what else he wants to do. For instance, the end of net neutrality and the move undertaken by the FDA to lighten up its approval process will boost investments for sure. The president has effectively slowed down the growth of the regulatory state, which is great. However, more needs to be done to truly deregulate.

Infrastructure: Based on a Trump infrastructure plan leaked a few days ago, we can expect more calls for state and local government involvement in infrastructure — that’s good — but also an addition $200 billion over ten years for its infrastructure plan. The hope is that this spending will in turn unleash billions of dollars in private infrastructure spending. This part of the speech will be a crowd pleaser, I suspect.

Now, $200 billion in new spending is better than $400 billion or $1 trillion. However, as I have written before, the call for more federal investment in infrastructure is a bad idea. In that I agree with Chris Edwards at Cato:

The proposals generally move in the wrong direction. New federal subsidies are not needed. Any state wanting to improve its infrastructure can do so with its own funding. States have huge revenue-raising power through income, sales, property, and gas taxes. They can issue debt for infrastructure, and charge user fees. They can also privatize infrastructure — such as airports and seaports — and end subsidies.

Federal infrastructure spending is often counter-productive. Last year, the CBO reported that a 1 percent increase in “public physical capital” — such as highways or airports — leads to 0.06 percent economic growth. If the leaked plan is our guide, that’s where most of the money will go. However, there are reasons to believe that this number overstates the returns on federal spending on infrastructure. Indeed, there is a large body of research showing how federal investment in transportation is often misallocated because of political pressure, is used inefficiently because the supply and demand are not guided by market prices, and suffers from costly systemic overruns. These problems, in addition to the fact that federal investments often give priority to union labor and follow inefficient requirements, mean that federal investments often have a negative return, not just a lower return.

The most productive infrastructure spending is done by the private sector to fund projects that are actually needed. That often means spending money where the economy is growing as opposed to spending it in low-growth areas in hopes of jump-starting the economy. A lack of jobs, not a lack of roads is the problem in such places.

That’s not to say that there is nothing the federal government can do when it comes to infrastructure. For instance, policymakers should reduce hurdles to private investment in infrastructure — for example, airports. The Trump administration has made noise about that and it should follow through with bolder initiatives. The capital-expensing change to the tax plan should help increase returns for infrastructure investment but more can be done. I think that we should end federal subsidies to state governments for infrastructure to spur state privatization rather than jack it up. Anything to cut federal regulations that raise costs for building state infrastructure, such as the Davis-Bacon labor rules, is a must-do as well as reductions to regulations that restrict state privatization. The plan talks about the elimination of federal restrictions on interstate tolling, that’s good but more is needed to make a real difference. Finally, the tax exemption on municipal-bond interest stacks the deck against private investment, and should be repealed.

Spending and Debt: I worry that the administration will continue to be silent about the need to reduce the debt by reducing spending. We know what the drivers of our future debt are: Social Security, Medicare, and Medicaid. Any lawmakers serious about our debt should talk about the imperative of reforming these programs.

As a reminder, debt and deficit means higher debt payments. Here are some CBO numbers for you. In the next ten years, our deficit will increase by $900 billion, to $1.5 trillion. That’s in time of prosperity and peace. I wrote a few weeks ago:

In 2018, the cost of interest on our debt will grow from $307 billion, or 7 percent of total spending, to $818 billion, or 12 percent of spending, by 2027. That’s more than the government will spend on all its “investments,” such as research and development, education, training, and infrastructure.

The long run looks even worse, with interest payments consuming 21 percent of all spending in 2047. That’s $1 of every $5 the federal government spends going toward interest on our debt. Considering the underlying growth in entitlement spending – from 55 percent of today’s budget to 70 percent by 2047 – you don’t have to think too hard to imagine what it means for other parts of the budget, such as education and infrastructure.

What does it look like if interest rates go up? I wrote:

In December 2015, the Committee for a Responsible Federal Budget estimated that an increase of a half-point above the projections would add $850 billion to the deficit over 10 years, while a 1-point increase would add $1.7 trillion. A return to the average rates during the 1980s would add $6 trillion to the deficit. Having more deficit and more debt means less ability to respond to recessions, foreign attacks and other emergencies if needed, not to mention higher taxes in the future.

Add to this tax cuts that weren’t paid for with spending cuts and all the new spending coming our way. The economy will grow, but there is only so much that growth can do to stomach all that extra debt. This is really scary.

Trade: I assume the president will renew his threat to withdraw from or rewrite NATFA significantly. It would be a mistake and would undo many of the gains from tax reform and deregulation. The Wall Street Journal has a good article on this today that notes that “withdrawing from Nafta would be a $50-billion-a-year mistake for the U.S.” The author, Matthew J. Slaughter, writes:

In a new report canvassing dozens of academic and policy studies, I find that the U.S. gross domestic product is now 0.2% to 0.3% larger than it would be without Nafta, a yearly boost of about $50 billion.

When U.S.-based multinational companies expand in Mexico and Canada, the result is often more jobs and higher wages back home. These “foreign” investments tend to complement, not replace, U.S. operations. A 2014 Peterson Institute study found that a 10% increase in employment at a U.S. multinational’s Mexican affiliate leads to a 1.3% increase in employment, a 1.7% increase in exports, and a 4.1% increase in research spending in the stateside parent company.

Nafta has helped America’s small businesses, too. In 2014, more than 125,000 small businesses exported $136 billion to Canada or Mexico. That is 25% of all U.S. small-business exports. Not only has Nafta increased the size of American workers’ paychecks, it has helped them stretch those paychecks further. American consumers have saved $10.5 billion a year from lower tariffs under Nafta, with most of the benefits going to households with annual incomes below $70,000.

The whole thing is worth reading. I sadly expect Trump to spend a lot of time on this misguided agenda since it seems to be the one issue where he has been the most consistent about over the years. We will see.

I am curious about how the president will navigate the immigration issue. He has shown signs that he is willing to grant a path to citizenship to some, which is great, but he’s got to know that his base isn’t happy. I expect a lot of rough rhetoric about immigration but hope it will be just that, rough rhetoric. Immigration is an important aspect of our future growth whether some like it or not.

To be continued . . . 

Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.

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