President Trump has announced two initiatives in recent weeks, which will have major implications for the Australian economy.
I will come back to his proposals to introduce tariffs on imported steel and aluminum soon. But for this blog I’ll focus on his landmark tax reforms, which, on their own, are a game-changer.
KPMG Economics’ global macroeconomic modelling suggests Australian GDP will be permanently reduced by 0.3 percent in the medium term as a direct consequence of the U.S. tax reforms. This equates to A$5bn and 25,000 jobs lost.
It is important to note that these are likely to be conservative estimates. Depending on how aggressively global firms, in particular U.S. companies respond, given the incentives contained in the legislated tax reforms, there is a definite risk that our modelling has under-estimated the amount of capital which would otherwise have come to Australia but will now get allocated to economic opportunities elsewhere.
For the U.S. itself, the Congress of the United States Joint Committee on Taxation (JCT) has estimated the Trump tax reforms will reduce tax revenues over the next decade by nearly US$1.5 trillion. But the upside, according to various US economists, is that U.S. GDP will rise from between 0.4 percent to 2.8 percent by the end of 2027.
U.S. capital stock is expected to be between 1 percent and 5 percent higher primarily because of the lower corporate tax rate, bonus depreciation, and the deductibility of certain pass-through business income. Domestic business investment would also be boosted, since the after-tax cost of capital in the U.S. will decline because of the lower corporate tax rate.
However, this business investment activity could be even further boosted if the huge amounts of untaxed profits sitting as offshore cash reserves are brought onshore after the introduction of deemed repatriation provisions. This could amount to at least US$1.25 trillion of extraordinary investment funds available to finance new capital and businesses within the U.S.
Further, employment is expected to rise by between 0.3 percent and 0.6 percent, driven by new investment activity and the reallocation by labour of work over leisure time (as a consequence of lower marginal tax rates). Higher aggregate employment and increased wages result in greater consumption activity; anticipated to be about 0.7 percent higher than the base case.
So much for the U.S. domestic scene – the question from an Australian perspective is whether the tax reforms help raise the global tide such that all countries lift with it; or do they help the U.S. to the detriment of other countries?
One of the key impacts of the Trump tax reforms is an increase in the level of U.S. government debt which causes short and long bond rate yields to increase – making U.S. government securities relatively more attractive to global investors, which results in the demand for U.S. dollars rising and the U.S. currency appreciating.
These financial market effects act as a mechanism by which the U.S. tax reforms are transmitted through to other countries. The corollary of the appreciation in the U.S. dollar is a corresponding depreciation in the Australian dollar (A$). This makes the cost of imported goods and services relatively higher in Australia.
The depreciation in the exchange rate lifts demand for Australian exports after an initial period of adjustment. However, over the medium term U.S. import demand falls as foreign goods and services are substituted by domestically produced goods and services that have expanded as a result of the new investment activity that was stimulated as a direct consequence of the tax reforms.
Australia’s export activity follows that of the rest of the world and eventually dips below the base case levels and stays there into the medium term.
Lower investment activity and reduced medium term export activity puts downward pressure on wages growth, and while still nominally positive, the ‘imported’ inflation (from higher prices of foreign goods and services) has the effect of reducing the real wage in Australia. Declining real wages and higher import prices cause consumers to reduce their spending, which further weakens economic activity in Australia.
The net effect of these impacts is a reduction in Australia’s GDP by about 0.3 percent in the medium term after experiencing a slightly stimulatory effect in earlier years owing to higher export demand.
While 0.3 percent may not seem earth-shattering, let’s put that figure in context. The National Institute of Economic and Social Research (NIESR) in London has recently analysed the potential impact of a scenario where the European Central Bank (ECB) looks to halve the entire debt built up from its €2 trillion post-GFC program of quantitative easing.
On the basis that the ECB reduces its balance sheet by half – equating to €1 trillion – NIESR has estimated GDP for the Euro Area would be reduced by the same 0.3 percent figure as our modelling predicts the trump tax reforms will have on Australia. It is a significant impact.
For Australia the biggest impact will not be the exchange rate adjustment, or the interest rate effect, or even the impact on exports. Rather, the biggest impact is likely to come from whether the company and international tax changes in the U.S. will choke off foreign direct investment into Australia from U.S. investors; or even potentially from non-U.S. foreign investors who may now divert their capital to the U.S. that otherwise might have come to Australia.
Australia has relied on the U.S. as a source of debt and equity for decades. The U.S. is the single largest foreign investor in Australia; investing about one and a half times more than investors from the UK, and nearly 10 times more than investors from China. As a small, open economy that relies on the world to supplement our own savings for investment, if global capital decides Australia is no longer as attractive as the U.S. as an investment destination, solely because of more competitive company and international tax regimes, then the negative economic impacts modelled above are likely to be understated.
As KPMG has said before, and this analysis reinforces it, company tax matters. It influences whether a company – particularly a foreign company – invests in one country or another; which in turn creates jobs and grows wages for our workforce and generates additional tax revenues for the government. Our analysis has shown that, in the global economy where every country is chasing a finite amount of new investment dollars, the margin matters.
While Australia has been arguing about the merits or otherwise about tax reform, the U.S. has implemented its own. And quickly. And the global business environment has now changed dramatically as a result.