Will The Trump Tax Cut Really Worsen The Trade Deficit?

In a piece by Prof. Jeffrey Frankel recently, he has argued that the Trump administration’s corporate tax cut will fuel the worsening of the current account deficit. The arguments he makes might make sense under normal circumstances, but I would argue that these are not normal circumstances. The trade deficit could indeed worsen, but the mechanism for that is likely to be quite different.

The purported logic for a widening trade deficit is as follows. A tax cut would leave a larger amount of cash in the hands of companies to spend - either in the form of dividends or higher pay for management. Part of this money in turn would be spent on imports thus widening the trade deficit. This is naturally rather simplistic. Money that was invested in a financial asset is more likely to be reinvested than being spent.

Alternatively, a tax cut would widen the budget deficit. The assumption is that the widening budget deficit will largely be financed by foreigners. In turn, the foreigners will finance the purchase of dollars by selling more to Americans - widening the trade deficit. However the assumption that the deficit will be financed by foreigners is suspect.

The massive balance sheet expansion by the US Fed has not translated into a corresponding increase in the broader money supply. Since the first quarter of 2008, while the Fed’s balance sheet swelled 5.5 times from $800B to $4.4T, the M2 money stock only doubled from $7.5T to $14T. This is a strong sign that the money has been fed into financial assets domestically or has fled the country in search of yield. The record high earnings multiple on the S&P 500 are a reasonable hint that this could be true. If the Fed simultaneously hikes rates, the money to finance the deficit could come from a withdrawal from the equity markets. The money could also be obtained through a sell-off of foreign assets by Americans themselves.

Alternatively, one could consider the scenario as posited by Nomura’s Chief Economist, Richard Koo. According to his theory of balance sheet recessions, corporates in most of the developed world today are in the process of repairing their balance sheets. This means that they are not borrowing money even at the record low rates. In fact, they are in the process of paying down debt or increasing assets to strengthen their balance sheets. If this is true, then the excess cash available to corporations due to the tax cuts would not end up being spent. Instead it will be used to pay down debt more quickly or be invested in Government debt - thus financing the deficit. This will have the double benefit of hastening the return to normalcy for businesses and still keep inflation and the trade deficit in check.

Finally, a tax cut could trigger a repatriation of the profits, at least on the margins, that American businesses have famously kept parked abroad for so long. This money could also become available to finance the deficit.

In all the above scenarios, the trade deficit would not be affected, just as the Trump administration wants. Of course, if there is a large scale repatriation of funds to the US, we could see a strengthening of the dollar. This would hurt US competitiveness and eventually the trade deficit. Can’t have your cake and eat it too.

Featured Image credit Gage Skidmore