2017 Article IV Consultation-Press Release; Staff Report

Abstract

2017 Article IV Consultation-Press Release; Staff Report

An Economy that is at Full Employment

1. The U.S. economy is in its third longest expansion since 1850. Real GDP is now 12 percent higher than its pre-recession peak, and job growth has been persistently strong. The first quarter was weighed down by what appears to be a transitory slowdown in consumer demand. However, business and consumer confidence indicators are strong, and the labor market is healthy, making it likely that both investment and consumption will grow steadily in the coming quarters (Figure 1).

Key Macroeconomic Aggregates

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Contribution to GDP growth

2. Given the significant policy uncertainty, staff’s macroeconomic forecast uses a baseline assumption of unchanged policies. The forecast neither builds in the effect of tax reform nor the expenditure reductions proposed in the administration’s budget. Under this forecast, growth is expected to rise modestly above 2 percent this year and next, driven by continued consumption growth and a cyclical rebound in private investment. Growth is forecast to subsequently converge to the underlying potential growth rate.

3. Financial conditions remain very supportive of growth. Term premia are negative (around the same levels as 12 months ago), the dollar is moderately stronger, corporate bond spreads have compressed, and equity markets have registered significant gains with a very low pricing of volatility. Survey indicators suggest that there is a relatively abundant supply of credit to both households and corporates.

4. While there are measurement uncertainties, the U.S. economy appears to be back at full employment. The unemployment rate has been at, or below, 5 percent for the past 18 months. The tightening labor market is drawing detached workers back into the labor market and starting to put upward pressure on wages (particularly for those that are switching jobs). Labor force participation has improved modestly, and measures of capacity utilization have returned to pre-crisis levels. Although there are sizable measurement uncertainties, it appears that economic slack has been virtually exhausted, and GDP is expected to rise above potential in 2017Q3.

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Labor Market Slack 1/

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Sources: Haver Analytics; and IMF staff calculations1/ Closer to the center signifies less labor market slack
Figure 1.
Figure 1.

Recent Developments

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Sources: Autodata; BEA; Census; Conference Board; FRB; ISM; NFIB; Haver Analytics; and IMF staff calculations.

5. Inflation is gradually heading toward the Federal Reserve’s medium-term objective. However, sizable negative shocks to core inflation occurred over the past few months—linked to cell phone prices and prescription drugs—which may be transitory but still give rise to downside risks to the inflation outlook. Survey expectations of medium-term inflation are reasonably well anchored but market-based measures of inflation expectations have drifted down. Under staff’s baseline, core inflation is expected to rise modestly above 2 percent in 2019 and subsequently approach the Fed’s medium-term target from above.

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Wage Growth

(percent, y/y)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Sources: BLS; FRB; and Haver Analytics
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Inflation and Output Gap

(percent, y/y)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Sources: BEA; Haver Analytics; and IMF staff estimates

6. The financial system appears generally healthy but there are rising vulnerabilities in some areas. The capital position of U.S. banks is strong, and bank asset quality continues to be good as evidenced by the results of the Federal Reserve’s most recent Comprehensive Capital Analysis and Review. Over the past year, money market fund reform—that required institutional funds to have a floating net asset value and allowed them to impose liquidity fees and redemption gates—led investors to smoothly rotate more than US$1 trillion out of prime funds (holding commercial paper) and into government bond funds. Strains in the energy sector from lower oil prices have been absorbed (despite defaults on around US$50 billion in energy debt in 2016) although deleveraging and reorganization in the sector is still ongoing. However, there are areas of concern:

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U.S. MMFs’ Investment

(US$ trillions)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Sources: SEC, OFR.
  • Corporate credit. Leverage is rising in parts of the non-energy corporate sector, and there is some evidence of a steady erosion of underwriting standards in the corporate bond market (Figure 2). In addition, structural shifts in bricks-and-mortar retail are leaving some companies struggling to adjust, with knock-on implications for parts of retail real estate.

  • Household credit. Potential risks that warrant increased attention include those embedded in the rapid growth in auto lending (particularly to higher risk borrowers) and in student loans.

  • Equity markets. Equity valuations remain high, and the price-earnings ratio is well above its long-term average. A significant equity price decline would feed through balance sheets and have significant wealth effects.

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Equity Market Valuation

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Sources: FRED, Robert Shiller

7. While progress has been made in some areas, a number of the shortcomings in financial stability oversight that were highlighted in the 2015 FSAP remain unaddressed (see Annex III). These include data blind spots (especially for nonbanks) that preclude a full understanding of the nature of financial system risks, residual vulnerabilities in repo markets and money market funds, the absence of harmonized national standards or consolidated supervision for insurance companies, the complex institutional structure for financial regulation, a housing finance system that remains in limbo with little progress in reforming the government sponsored enterprises, and an incomplete picture of financial interlinkages and interconnections within the financial system. There is also a continuing need to remove impediments to data sharing among regulatory agencies.

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International Imbalances

(Percent of GDP)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Source: IMF staff estimates.
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Effective Exchange Rates

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

8. The U.S. external position is moderately weaker than implied by medium-term fundamentals and desirable policies (see Annex I). The current account deficit has narrowed from its pre-crisis levels owing to higher private saving and lower investment in the aftermath of the financial crisis and is expected to remain close to 3 percent of GDP over the medium term. The international investment position shows a growing net liability that currently amounts to 43 percent of GDP, reflecting sustained current account deficits and valuation differentials between U.S. and overseas assets (including those linked to the recent appreciation of the U.S. dollar). The real effective exchange rate has appreciated 4 percent over the past 12 months but is up by around 20 percent since end-2013. This leaves the U.S. dollar moderately overvalued, by around 10–20 percent.

Figure 2.
Figure 2.

Corporate Leverage

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Sources: Federal Reserve Board, Moody’s KMV, GFSR, BAML, Haver.

A Wide Range of Risks Around the Baseline

9. Significant policy uncertainties imply larger-than-usual, two-sided risks to near-term growth. On the one hand, a medium-term path of fiscal consolidation, such as the expenditure based consolidation proposed in the budget, would address medium-term fiscal imbalances but result in a growth rate that is below staff’s baseline. Such an adjustment is likely to also have negative implications for the income distribution. On the other hand, spending reductions could be less ambitious, and tax reforms could lower federal revenues, provide stimulus to the economy, and raise near-term growth (and possibly potential growth). However, the latter policy mix would have negative implications for debt sustainability, worsen the overvaluation of the U.S. dollar, and increase current account and NIIP imbalances (see Risk Assessment Matrix).

10. Over the medium-term, a broader retreat from cross-border integration represents an important downside risk to trade, sentiment, and growth. Such an evolution of policy may manifest itself in a more contentious or inward-looking approach to trade and investment. Alternatively, restraining inward immigration could exacerbate labor force constraints implied by an aging demographic. There is also a risk that a very divided political system may stall the administration’s agenda and/or create increased policy uncertainty, impeding progress on the policy changes needed to strengthen productivity, labor force participation, and investment.

11. There are negative risks to the inflation outlook. To date, progress toward the Fed’s medium-term inflation goal has been slow, with previous upswings in core inflation having stalled. Further, bottom-up estimates of core inflation (see Abdih et al. 2016) suggest it will be a challenge to break inflation out of its post-crisis range. Finally, changing dynamics in the U.S. labor market and in technology, that are at this point not fully understood, may mean that the expected pick-up in nominal wages and prices could prove elusive. Recent inflation outturns raise the risk that there may be a more-than-transitory headwind to the upward path of core inflation. There is a risk that there are nonlinearities in the Phillips curve that could push inflation higher if unemployment falls further below the natural rate. However, there is, at best, weak empirical evidence of nonlinearities in either aggregate or disaggregated versions of the wage or price Phillips curve.

12. Cyber risks to the financial system are on the rise and potentially systemic. Risks to financial stability from cyber-crimes are a growing concern and have been flagged several times in the annual reports of the Financial Stability Oversight Council (FSOC). Market solutions to limit risks are hampered by information asymmetries and externalities (Box 1). The U.S. is steadily improving its regulatory framework to strengthen the resilience of the financial system. Nevertheless, the lack of a comprehensive picture and the fast-evolving nature of these vulnerabilities make any assessment of the size of systemic risks and their potential economic costs highly uncertain.

13. Authorities’ views. There are significant upside risks to the outlook driven by the planned changes in policies. Sustainably increasing growth to 3 percent is a challenging but feasible objective and will help draw in more workers to quality employment who have been left detached from the labor market. The right combination of tax reform, deregulation, and a fairer global trading system would encourage business investment, job creation, and allow the U.S. to remain a world leader in technology and productivity. Further, a significant reduction in federal non-defense spending would allow the burden of a high and rising public debt to be lifted off the economy. Valuations in financial markets are at high levels, the market pricing of volatility is low, and the term premium remains compressed. Nonetheless, financial stability risks are manageable, a reflection of the stronger regulation and supervisory structure that had been built in the past several years. Cyber risks constitute one of the largest and most pervasive risks facing the U.S. Efforts will be increased to protect federal networks and critical infrastructure as well as strengthen public private partnerships to enhance resiliency through the promotion of information sharing, best practices, and effective response and recovery efforts. The administration is also working on an international engagement strategy for cybersecurity to enhance coordination with partners in protecting against malicious actors, promoting a secure and resilient financial system, and safeguarding an open and secure global internet.

Cyber Risks to Financial Stability1

In the U.S., the finance industry has seen by far the most cyber incidents with confirmed data losses. In 2016 alone, cyber incidents have disrupted the provision of financial services (e.g., DarkSeoul malware), resulted in significant loss of assets (e.g. Bangladesh Bank), and damaged the integrity of financial data (e.g., Corkow malware). Financial market infrastructure (e.g. payments systems and clearing platforms) tend to have little redundancy and concentrate risk, potentially causing attacks to transmit quickly across large parts of the financial system. Increased digitalization and network interconnectivity mean that cyber-attacks are likely to occur with greater frequency and sophistication.

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Incidents with Confirmed Data Loss, Per Industry

(2016)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Source: Verizon, IMF staff illustration.

Cyber risk is potentially systemic but difficult to assess and quantify. Cyber risk exposures are common across firms and are highly correlated under stress. However, the rarity of large cyber events, unknown patterns of shock transmission, the lack of data about events, complex risk aggregation, and the uncertainties around the long-term effects of cyber events all hamper the measurement, modeling, and pricing of cyber risk.

The popularity of cyber liability insurance has grown rapidly as financial institutions view it as a convenient way to transfer cyber risk. However, actuarial modeling techniques are underdeveloped making it difficult to price risk, leaving insurance markets incomplete and with large gaps in coverage. There have also been concerns that risk exposures in the insurance market are concentrated, and a large cyberattack could exceed providers’ ability to withstand such correlated losses.

The U.S. financial oversight framework has increased supervisory intensity and enhanced regulatory requirements related to cyber vulnerabilities. Regulators are developing and enforcing standards for cyber risk-related vulnerabilities. Standards are tiered by size and risk, processes for information sharing are being enhanced, and regulators are undertaking thematic examinations of cybersecurity preparedness. There are efforts also to define the scope of critical financial sector infrastructure and institutions.

Nevertheless, further policy action is needed. The largely sectoral approach to cyber has created gaps in the framework and a lack of consistency. Action is needed to build resilience including:

  • Reducing information asymmetries through data and information sharing. Systematic collection and sharing of cyber data, including on the costs of cyber events, would help improve the understanding of the size and nature of the risk and facilitate better risk management and modeling (by both the public and private sector).

  • Undertaking forward-looking scenario analysis and simulations. Such “war gaming” exercises can help improve thinking about future risks in a structured manner: how they might materialize, how much they could cost, and how they could be contained. This information would help improve financial and contingency planning both at a firm level and for the system as a whole.

  • Pursuing public-private partnerships between industry, governments, and academia. This could help improve systemic risk management by combining policymaking on the one hand and technical and subject matter expertise on the other hand.

  • Refining the regulatory architecture. To encourage cyber-resilient financial systems, high level regulatory principles should be complemented with more specific guidance at the firm level.

1 Emanuel Kopp, Lincoln Kaffenberger, and Christopher Wilson, 2017, “Cyber Risk, Market Failures, and Financial Stability,” IMF Working Paper, forthcoming (Washington: International Monetary Fund).

Risk Assessment Matrix

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An Economy that is Failing to Raise Living Standards

14. The U.S. economy is delivering better living standards for only the few. The recent national election demonstrated a broad dissatisfaction with economic outcomes and prospects. For some time now there has been a general sense that household incomes are stagnating for a large share of the population, job opportunities are deteriorating, prospects for upward mobility are waning, and economic gains are increasingly accruing to those that1 are already wealthy. This sense is generally borne out by economic data and when comparing the U.S. with other advanced economies.

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Living Standards Indicators

(U.S. ranking out of a sample of 24 OECD countries. Lower rank denotes worse outcome)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Sources: OECD, World Bank. Sample is the 24 OECD countries for which wage data is available in 1995. For healthcare coverage the “1995” observation is for 1997. PISA scores are for 2003 and current. Average annual wages are in 2015 US$ at market exchange rates. Due to data limitatons, secondary school graduation rates rankings as well as poverty rate rankings for 2005 are for a 16 country subsample.

15. Weak productivity is a significant headwind to better living standards. Throughout the current expansion, there has been little meaningful sign of a pick-up in productivity. While evidence is mixed, there are various candidate explanations: low business investment, declining dynamism in the labor market, lower churn in business formation and destruction, and an aging population (see Box 2). Regardless of the cause, low productivity has been associated with a stagnation in household incomes for a large share of the population. Indeed, in inflation-adjusted terms, more than half of the U.S. population has lower incomes today than they did in 2000.

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Total Factor Productivity Growth

(Percent y/y)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Source: OECD. Averages over the given periods shown

Understanding the U.S. Labor Productivity Decline: A State-Level Perspective1

Labor productivity growth in the United States has slowed down markedly since the mid-2000s. The slowdown has been visible at the state level with a decline in the entire distribution of productivity outcomes across states. This state-level variation in labor productivity can help shed some light on the potential drivers of falling productivity. A panel regression was estimated across states that examined the variables that may help explain the decline in productivity during the most recent economic expansions. The analysis finds that:

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Real GDP Per Worker

(annual growth, percent)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Sources: BEA, IMF staff calculations.
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Real GDP per Worker by State

(annual growth, percent)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Sources: Bureau of Economic Analysis and IMF staff calculations.Note: whiskers show highest (lower) value excluding outliers; boxes show lower and upper quantiles, 25th and 75th respectively; horizontal line shows the median.
  • Capital investment. States with a higher initial capital stock per worker have higher productivity growth. This is a robust feature of all the past episodes of economic expansion. Encouraging an increase in investment appears critical to fostering higher productivity at the national level.

  • Taxation. The level of state income taxation (as a share of state-level GDP) is negatively correlated with productivity both during the current expansion and in the 2000s. This is in contrast with previous expansions where labor productivity growth was not associated with cross-state differences in the tax regime.

  • Demographics. A rising dependency ratio is found to put downward pressure on output per worker. At the national level, an aging population is likely to continue to compress productivity outturns.

  • Dynamism. There is no evidence from state level data that the rate of churn either in the creation/destruction of establishments or in the labor market is correlated with labor productivity. This is true both for the recent expansion and in the 2000s.

  • Manufacturing. State-level differences in the size of the manufacturing sector also do not appear to be correlated with productivity outturns.

The state-level regressions point to various policy areas that could help raise productivity: a reduction in distortions in the tax system and a lowering of marginal rates; regulatory changes to incentivize private investment; infrastructure investment; and skills-based immigration reform that improves the dependency ratio.

1 Authored by Ali Alichi, Ravi Balakrishnan, and Rodrigo Mariscal.

16. Labor force growth has been on a structural decline. Labor force participation peaked in 2000 at 67 percent and has fallen to below 63 percent today. This has been a result of an aging population and the partial reversal of the post-war gains made in female participation. The aggregate figures, though, hide a concerning decline in prime-age male labor force participation, a trend that has been especially acute for those without college education. Further, over one-third of prime-age men that are not in the labor force are now living in poverty. Beyond demographics, studies link falling U.S. labor force participation to institutional factors (limited subsidies for childcare and the lack of paid family leave) and to declining work opportunities (particularly for the low-skilled). Together, weak productivity and a slower growth of the labor force account for three-quarters of the decline in potential growth since 2000.

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Rapidly shifting demographics

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Source: Haver Analytics, U.S. Census Bureau
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Labor Force Participation Rates

(percent)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Sources: BLS, Have Analytics.
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Prime Age Male Labor Force Participation Rate

(percent of population)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Sources: BLS Current Population Survey, and IMF staff calculations.

17. The slowdown in potential growth has been associated with several secular dimensions of the deterioration in living standards:

  • A decline of the labor share of income. Since 2000, the U.S. labor share has fallen by 3.5 percent. The decline in the labor share has been a common pattern across states and within most industries. There are multiple factors at work but at the core is an increase in competitive pressures facing U.S. workers including from an erosion of unionization, greater concentration among employers, and higher substitutability between labor and capital arising from technological change and routinization (see Box 3). This declining labor share in intimately linked to an increase in income polarization.

  • Rising income polarization. Real median household income increased by more than 5 percent in 2015 but is still 1½ percent below its pre-crisis level. Post-crisis gains in real per capita GDP have accrued almost exclusively to higher income groups. Perhaps more disconcerting, “hollowing out” has meant a shrinking share of the population is taking home earnings that are close to this stagnant median income. Since 2000, around 3½ percent of the population has left the middle-income group. The bulk have moved into that segment of the population earning less than one-half of the median income (see Box 4).

  • High rates of poverty. Poverty has been falling slowly since 2012 but, despite this, one in seven Americans is currently living in poverty. The problem is persistent. One half of those that were in the lowest quintile of the income distribution 20 years ago are still in the lowest quintile today. In addition, the children of poor households are more likely to have significantly lower earnings as adults (compared to those who did not grow up in poverty).

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U.S. Labor Share and Income Inequality

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Sources: BEA, US Census Bureau, and Haver Analytics
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Poverty Rates

(Percent of total population)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Sources: Census Bureau; Haver Analytics; and IMF staff calculations1/ Takes account of government programs designed to assist low income families

18. These adverse developments are feeding back into growth outturns. For example, income polarization is suppressing consumption (see Alichi et al., 2016), weighing on labor supply and reducing the ability of households to adapt to shocks. High levels of poverty are creating disparities in the education system, hampering human capital formation and eating into future productivity. While many of these symptoms are interconnected, the diagnostics of the nature and size of the connections, and the feedback loops between the various forces are difficult to disentangle.

Explaining the Declining Labor Share of Income in the U.S.1

The Facts. Since the early 2000s, the labor share of income has fallen by 3.5 percent. Breaking the data down by state and industry shows the decline is broad based although with significant variation in the pace across states and industries. 90 percent of the aggregate decline has been driven by a fall in the labor share within industries and states. Thus, the falling labor share does not appear to be the result of compositional changes either in industrial structure (e.g., the decline in manufacturing) or the regional distribution of production.

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Labor Share by State: Change 2001-2014

(in percentage points)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Sources: BEA and Haver Analytics

The Drivers. Exploiting cross state variation of the labor share data at the industry level, and matching that with new data on the task characteristics of occupations, reveals that the decline in labor share was highest for those industries that:

  • Had a high initial intensity of “routinizable” occupations;2

  • Experienced the steepest declines in unionization;

  • Faced the greatest increase in competition from imports; and

  • Had the highest intensity of foreign input usage.

  • The exposure to task offshoring or the intensity of labor market regulations appears not to have had a significant impact on the labor share.

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Labor Share by Industry: Median Change Over 2001-x14

(in percentage points; x-axis values are industry codes)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Source: BEA, Haver Analytics, IMF staff calculations
uA01fig20

Drivers of Labor Share Decline: 2001-14

(in percentage points)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Sources: IMF staff estimates.

Bottom line. The results suggest that technological change, exposure to trade, and the changing structure of labor institutions all contributed to the fall in the U.S. labor share of income. Since 2000, the bulk of the effect appears to come from changes in technology linked to the routinization of tasks, followed by trade globalization.

1 See Y. Abdih and S. Danninger, “What Explains the Decline of the U.S. Labor Share of Income?”, IMF working paper WP/17/167. World Economic Outlook (2017) provides an international perspective on the same issue.2 The study relies on characterizing the tasks of different occupations at the 3-digit level along two dimensions: routinization and offshorabilty. These characterizations draw on the Occupational Information Network of the Department of Labor that uses survey-based occupation features to measure, among other things, the repeated nature of job tasks, the ability to perform a job off-site, and the need for person-to-person interactions.

Drivers of U.S. Income Polarization—Evidence from the States1

The Facts. For the past 45 years, the U.S. has faced a secular increase in income polarization. Since 2000, about 3½ percent of total households have moved out of the middle-income group (that earns between 50–150 percent of the median income), with most of those households ending up in the low-income group (earning less than 50 percent of the median).

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Income distribution 1/

(change in percent of total households)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Source: Current Population Survey.1/ Income is adjusted for household size using OECD’s equivalence scale. Middle income (class) consists of households falling within 50-150 percent of median income.

State-Level Patterns. The degree of “hollowing out” is variable across the U.S. states. To give a sense of variation, since 2000, the increase in income polarization was among the largest in Kentucky and North Dakota. In Kentucky, more than 7 percent of households moved from the middle- to low-income ranks. In North Dakota, largely due to the oil boom, more than 10 percent of households moved from the middle- to the higher-income group. Idaho and Oregon, on the other hand, experienced very little change in income polarization during this period.

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Income Polarization by Sector, 2000-15

(contributions to the change in percent of total households)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Source: Current Population Survey; and IMF staff calculations.

Sectoral Moves. Alongside this increase in polarization, there has been a secular shift in the structure of U.S. production. Since 2000, most of the workers moving out of the middle-income group have lost jobs in manufacturing and construction. Around 1 percent of those households have moved into service sector jobs earning more than 150 percent of the median, but 2½ percent of households have moved into low skilled service jobs that earn less than 50 percent of the median income.

Regression analysis. Using state-level data, we find that the bulk of move from the middle- to low-income group can be explained by a structural shift in industrial composition (i.e., the decline in manufacturing and rise of services), an increase in the share of (low income) immigrant households, and an aging of the workforce. Increases in education attainment have been a countervailing force.

uA01fig23

Contributions to the Change in “Downward” Income Polarization, 2000-2015

(percent of total households)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Source: Current Population Survey; and IMF staff calculations.
1 See A. Alichi, R. Mariscal, and D. Muhaj, “Hollowing Out: The Channels of Income Polarization in the United States”, IMF working paper (forthcoming).

The Right Macroeconomic Policy Mix

With the economy at full employment, it is important that the U.S. puts in place the right policy mix for this stage in the cycle. That would involve gradually removing both fiscal and monetary support and refocusing efforts on expanding potential growth, raising competitiveness, and strengthening the supply side. Doing so will lower the current account deficit and improve the net international investment position, reduce the overvaluation of the U.S. dollar, and have positive spillovers to other countries. There are two parts to this policy shift:

A. A Sustained and Balanced Medium-Term Fiscal Consolidation

19. Under unchanged policies, demographic trends and rising interest rates will lead to a steady increase in fiscal deficits and public debt over the medium term. To prevent this, the U.S. should put in place a plan for fiscal consolidation that raises the federal primary surplus by 2½ percent of GDP over the next several years (to around 1 percent of GDP or a general government primary surplus of around ¾ percent of GDP). This adjustment can be phased in gradually but ought to begin in 2018 to ensure that the federal debt-GDP ratio falls over the medium term.

uA01fig24

Government Debt

(percent of GDP)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Source: IMF staff estimates

20. The administration’s budget proposes an expenditure-based medium-term fiscal consolidation. Under the authorities’ budget, the federal primary balance is forecast to go from a 1.9 percent of GDP deficit to a 2.1 percent of GDP surplus over the next 10 years. This includes:

  • A reduction in both non-defense spending and defense outlays as a share of GDP. The non-defense spending reductions are concentrated in two broad areas: a downsizing of line agencies (outside of defense and security) and reductions in spending on safety net programs (including funding for Medicaid and food stamps as well as tightening eligibility for earned income and child tax credits and disability insurance).

  • A tax reform that is designed to improve efficiency, lower marginal rates, and broaden the base while leaving the federal revenue-GDP ratio broadly unchanged.

  • An extremely optimistic real GDP growth assumption, that rises to 3 percent by 2021 and remains at that level over the medium term.

21. Even with an ideal constellation of pro-growth policies, the potential growth dividend is likely to be less than that projected in the budget and will take longer to materialize. The U.S. is effectively at full employment. For policy changes to be successful in achieving sustained, higher growth, they would need to raise the U.S. potential growth path. The international experience and U.S. history would suggest that a sustained acceleration in annual growth of more than 1 percentage point is unlikely. Indeed, since the 1980s, there are only a few identified cases among the advanced economies where this has happened. These episodes mostly took place in the mid to late 1990s against a backdrop of strong global demand, and many of them were associated with recoveries from recessions. The U.S. itself experienced one comparable growth acceleration as it recovered from the deep recession of the early 1980s. However, this event occurred during a period of favorable demographics, rising labor force participation, a significant expansion of the federal fiscal deficit, and an acceleration in trading partner growth. These tailwinds are unlikely to recur today.

uA01fig25

Growth Accelerations in Advanced Economies

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Sources: CBO, OECD, and IMF staff calculations*Denotes countries coming from recession and explains large growth acceleration.Chart shows those years in which the growth in potential GDP per working-age adult increased on average by one percent for at least 5 years.

22. The U.S. has some fiscal space but an expansionary fiscal policy would be counterproductive at this stage of the cycle. The U.S faces low financing costs and benefits from strong demand for high quality liquid assets and the U.S. dollar’s status as a reserve currency. Over a longer horizon, if the fiscal costs associated with an aging demographic remain unaddressed, the debt-GDP ratio will continue to rise which may call into question the creditworthiness of the federal government. However, with the economy so close to full employment any fiscal impulse at this juncture is unadvisable and will almost certainly lead to a steepening of an already-unsustainable federal debt-GDP path (see Annex II), an even more overvalued U.S. dollar, a more accelerated path of monetary policy normalization, and growing global current account imbalances.

23. Instead, a gradual fiscal consolidation should be pursued. As currently framed, the budget implies significant cuts to discretionary spending that places a disproportionate share of the adjustment burden on low- and middle-income households. This would appear counter to the budget’s goals of promoting safety and prosperity for all Americans. Instead, a different composition of adjustment—with higher revenues and expenditures—could be put in place based on:

  • A tax reform that simplifies the tax system, improves efficiency, supports low- and middle-income households and, importantly, increases the federal revenue-GDP ratio (see below).

  • More balanced expenditure restraint that strengthens the effectiveness and efficiency of the safety net and reprioritizes appropriations, increasing spending on those programs that encourage labor force participation, improve infrastructure, and raise productivity and human capital.

  • Measures to reform the social security system, including raising the income ceiling for social security contributions, indexing benefits to chained CPI or PCE inflation, increasing the retirement age, and instituting greater progressivity in the benefit structure. This could reduce the imbalances in the social security system by around 0.5 percent of GDP per year.

  • Policy action to contain healthcare cost inflation, including through technological solutions that increase efficiency, encourage greater cost sharing with beneficiaries, and shift incentives toward remunerating providers for health outcomes (rather than per procedure).

  • Avoiding self-inflicted wounds from political brinkmanship over appropriations and the debt ceiling. As has been argued in past consultations, consideration could be given to replacing the debt ceiling with a clear, simple medium-term fiscal objective or automatically adjusting the debt ceiling in a way that is consistent with whatever agreement is struck on the broader budget parameters.

Such a policy approach would lower the public debt-GDP ratio over time and would do so with better distributional outcomes. Supporting low- and middle-income households and promoting investments in human and physical capital formation, would feed back into better growth and lead to more broad-based improvements in living standards over the medium-term.

24. Authorities’ views. The administration is committed to increasing defense, infrastructure and security spending in the upcoming fiscal year and to lower most other spending items, outside of social security and Medicare. There is scope to reduce or eliminate programs with limited effect on outcomes since there is significant inefficiency and duplication in existing federal spending. As part of this re-examination of spending, efforts were being made to devolve responsibilities and provide states with greater flexibility in a range of areas (including Medicaid, social assistance programs, and infrastructure provision). This would allow states to innovate, find more efficient solutions, and ultimately yield better outcomes at a lower cost. The proposed reductions in federal spending will encourage a return to productive work and, as a result, have positive implications for the income distribution.

B. A Gradual and Well Communicated Monetary Normalization

25. With the Federal Reserve on track to achieving its dual mandate of price stability and maximum employment, policy rates should continue to rise. The pace of rate increases can be gradual, especially when compared with previous tightening cycles, and should certainly be data dependent. Given the downside risks to inflation and the asymmetries posed by the effective lower bound, the Federal Reserve should be ready to accept some modest, temporary overshooting of its inflation goal that allows inflation to approach the 2 percent medium-term target from above. Doing so would provide valuable insurance against the risks of disinflation and having to bring the federal funds rate back down to zero. Presuming fiscal policy and other developments evolve in line with staff’s forecasts, to ensure that inflation rises only modestly above 2 percent will require an increase in the federal funds rate of a further 25 basis points in 2017 and 75 basis points in 2018. Policy rates should level off at the neutral rate by end-2019 (which is judged to be in the 2.5–3 percent range). As in the past, futures markets are pricing in a much flatter path for the federal funds rate in 2017–19 (although it is worth noting this measure does not represent the modal forecast of the market).

uA01fig26

Policy Rate Expectations

(percent)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Sources: Federal Reserve; Bloomberg; and IMF staff estimates

26. Alongside the ongoing normalization in policy rates, it is appropriate that the Federal Reserve looks to unwind the post-crisis increase in its holdings of treasury and mortgage-backed securities. Given the risk of triggering an unexpected steepening of the yield curve or a rise in MBS spreads, plans for the Fed’s balance sheet should be well-telegraphed at an early stage. The recent addendum to the policy normalization principles and plans provides market participants with a clear path for changes in reinvestment policy that will help avoid undue volatility in fixed-income markets. Specifically, the addendum indicates:

  • There will be a gradual reduction in the Federal Reserve’s securities holdings as reinvestments of maturing issues are scaled back over time. Initially, only maturing principal above US$6 billion per month for treasuries and US$4 billion per month for MBS would be reinvested. These caps would be gradually raised to US$30 billion and US$20 billion per month, respectively, during the first year that reinvestments are being reduced.

  • The US$30 and US$20 billion caps would remain in place over the medium term allowing for a gradual decline in the balance sheet.

  • The FOMC would be prepared to resume reinvestment of principal payments if there were a material deterioration in the economic outlook that warrants a sizable reduction in the target for the federal funds rate.

uA01fig27

Balance Sheet

(US$ trillions)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Sources: FRB; and IMF staff estimates

The expectation of FOMC members is that this plan would begin to be implemented later this year.

27. The monetary policy effects of balance sheet roll-off are expected to be small. Under the announced plan, if normalization were to begin at end-2017, the balance sheet would decline by US$318 billion in 2018 and by US$409 billion in 2019. Such a reduction could have a monetary policy impact equivalent to a 22 basis point increase in the federal funds rate over the next two years (based on Davig and Smith, 2017). Even this relatively small effect may, though, be overstated since market pricing already incorporates an expectation of balance sheet reduction over the medium-term. This seems to be borne out by the modest market impact from the publication of the addendum to the policy normalization principles and plans. Given the small monetary effects, unless the U.S. economy is hit by a significant negative shock, it is appropriate that the normalization of the balance sheet proceeds independently of changes in the federal funds rate and in inflation and employment outcomes. Decisions on the balance sheet should, instead, be geared toward minimizing market volatility.

28. As balance sheet normalization proceeds, the FOMC could provide a broad indication of what the eventual monetary policy operating framework may look like over a longer horizon. Further, given the long duration of the Fed’s holdings of MBS securities, consideration could be given to either selling or swapping MBS for treasuries to ensure that, over the longer run, the balance sheet is only made up of treasury securities. Continued clear communication of such prospective changes will maintain the Federal Reserve’s estimable track record of smoothly normalizing U.S. monetary policy.

29. Authorities’ views. Recent declines in inflation are viewed as likely to be transitory and idiosyncratic. It was expected that inflation would remain somewhat below 2 percent in the near term but would rise to the 2 percent objective over the medium term. However, the FOMC is conscious of the potential downside risks to inflation following recent data outturns and would be watching incoming data carefully for signs that there may be more sustained headwinds that would prevent the Fed from reaching its medium-term inflation goals. Fed holdings of securities are expected to decline in a gradual and predictable manner and the federal funds rate would be the primary means for adjusting the stance of monetary policy. A material reduction in the economic outlook that warranted a sizable reduction in the federal funds rate could be accompanied by a resumption of reinvestment of principal payments. However, under the baseline outlook, the intention is for changes to the balance sheet to be quietly operating in the background over the next several years with minimal effects on financial conditions. The future level of reserves in the banking system would be appreciably below that seen in recent years but larger than before the financial crisis. Details about the longer-term operating framework would be decided and communicated to the public in due course.

Strengthening the Foundations for Growth and Resilience

As was highlighted in the 2016 Article IV, the U.S. faces serious constraints on its medium-term growth prospects. These include weak productivity, falling labor force participation, an increasingly polarized income distribution, an aging population, and high levels of poverty. These pernicious secular trends have led to a labor share of income that is around 5 percent lower today than it was 15 years ago, a middle class that is smaller today than at any point in the last 30 years, and—aside from the immediate aftermath of the financial crisis—the lowest potential growth rate since the 1940s. Finding solutions to alleviate these long-running supply-side issues and mitigate the associated unfavorable trends in the income distribution will be key to the health of both the U.S. and the global economy. It will require action in multiple areas—tax, infrastructure, trade, regulation, education, healthcare, immigration, and support for low-and middle income households—which should be front-loaded as much as is possible.

A. Tax Policy

30. There is broad agreement on the objectives of tax reform. These include simplifying the system and scaling back the extensive network of tax preferences; lowering marginal rates; incentivizing labor force participation, business investment, and productivity-enhancing innovation; mitigating income polarization; and supporting low- and middle-income households.

31. However, the consultation revealed differences of views on the policies to achieve these objectives. The limited details that are available on the administration’s tax reform suggest it is likely to generate a fall in the revenue-GDP ratio over the medium-term and that tax relief is likely to disproportionately benefit the wealthy. In staff’s view, to provide resources for fiscal outlays that would strengthen potential growth and to contribute to the needed reduction in the public debt, the tax reform should be designed to be revenue enhancing over the medium-term. Such a reform could include:

  • Business tax. The U.S. corporate income tax could move to a rent tax (either a cashflow tax or an allowance for corporate capital tax) with a somewhat lower marginal rate. This would incentivize business investment and lessen the existing bias toward debt finance. Such a reform could be combined with an elimination of the various corporate tax preferences that currently complicate the system, making the tax code more equitable and efficient. Naturally, such a change would have important domestic effects (on activity and investment) and sizable international spillovers (including effects on both international investment location and changing incentives for profit shifting).

  • Taxing offshore profits. Transitioning to a territorial system, as has been proposed by the administration, merits consideration but ought to be combined with a minimum tax for profits earned in low tax jurisdictions to limit the scope of profit-shifting. The administration’s proposal to enact a one-time tax on the stock of unrepatriated profits of multinationals deserves support as part of a comprehensive tax reform package. Such profits could be taxed at a rate that is modestly lower than the current corporate tax rate. Providing only moderate tax relief would be efficient (since it is a tax on past profits) particularly given that the existing system of tax deferral has already conveyed significant benefits to those taxpayers that have chosen not to repatriate profits. Such a policy would generate a temporary, front-loaded uplift in fiscal revenues, which can help fund near-term expenditure needs (e.g. infrastructure, paid family leave, healthcare) before the full tax reform is in effect. Payment of the resulting tax liability could be spread over several years to address liquidity concerns of affected corporations.

  • Individual income tax. Providing tax relief for low- and middle-income groups, as has been proposed by the administration, would help alleviate income polarization and encourage labor force participation. The bulk of itemized deductions can be eliminated alongside an increase in the standard deduction. Any remaining deductions (e.g., for mortgage interest and charitable contributions) should be capped. Consideration could also be given to limiting the tax preference that is given to employer-provided health insurance plans. The authorities should expand eligibility and increase the generosity of the earned income tax credit (EITC) to support lower-income households and incentivize work. To lessen the risk that an expanded EITC leads to a decline in pre-tax wages at the bottom of the income distribution, the EITC expansion ought to be combined with an increase in the federal minimum wage.

  • Pass-through entities. Any tax rate reductions for pass-throughs need to take revenue implications into account. Setting the effective rate on pass-throughs below the effective rate on distributed corporate profits and/or the top marginal personal income tax rate creates important incentives for some firms to become pass-throughs and for high income employees to become independent contractors in order to lessen their tax burden. Putting in place anti-avoidance provisions could help limit such a recharacterization of income but would add significantly to administration burdens with uncertain implications for revenues.

  • Consumption taxes. To ensure the overall tax reform is revenue-gaining, the U.S. has the scope to rely more on other revenue sources, including a federal level consumption tax, a broad-based carbon tax, and a higher federal gas tax. To give a sense of what is feasible, a broad-based, 5 percent consumption tax would generate around 1½ percent of GDP per year in revenues, a carbon tax of around US$45 per ton of CO2 would generate 0.5 percent of GDP per year, and each 50 cents increase in the gas tax would raise revenues by around 0.3 percent of GDP per year. Such a move from direct to indirect taxes is likely to be positive for long-run growth. If the reductions in personal income tax are designed to be progressive and targeted toward low- and middle-income households, they will also help lessen income polarization (Box 5).

32. Authorities views. The administration continues to work to craft a tax reform that reduces distortions and provides tax relief for middle-income families, consulting with both Congress and the public. The administration is committed to lowering individual income tax rates, eliminating a range of exemptions and deductions, expanding the standard deduction and providing help for child and dependent care expenses. The intention is to eliminate the alternative minimum tax, the 3.8 percent surcharge on capital gains and dividends, and the estate tax. On the business side, the goal would be to lower the corporate tax rate to 15 percent (including for pass-throughs), eliminate most tax expenditures and special regimes, and transition to a territorial system with a one-time repatriation tax on already accumulated overseas income. The dynamic effect of this combination of reforms is expected to maintain the federal revenue-GDP ratio at close to current levels. The proposal to put in place either a carbon tax or consumption tax is not politically feasible at this time.

B. Improving Infrastructure

33. Underinvestment in infrastructure has become a growing constraint on private sector productivity and long-term growth and job creation. Investment in public infrastructure has declined significantly in the post-recession period. A permanent increase in federal, state, and local infrastructure spending of at least 0.5 percent of GDP per year is needed (based on the American Society of Civil Engineers estimates of the U.S. infrastructure gap). This should be achieved by an increase in federal, state, local and private funding of infrastructure projects. Priorities include improving the quality and reliability of surface transportation and upgrading infrastructure technologies (e.g., in high speed rail, ports, and telecommunications). It will be important to ensure the right mix is achieved between the public funding of maintenance and repair versus new projects. The US$200 billion appropriation in the budget aimed at catalyzing US$1 trillion in private and public infrastructure investment would, if realized, support long-term growth.

uA01fig28

Public Investment, Structures

(percent of GDP)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Sources: BEA; Haver Analytics; and IMF staff calculations

34. Authorities’ views. U.S. infrastructure needs to be rebuilt and modernized to create jobs, maintain economic competitiveness, and connect communities and people to opportunities. The administration is targeting an increase of US$1 trillion in infrastructure investment through a combination of new federal spending and incentives for greater private, state and local funding. The federal government is prepared to offer loans, loan guarantees, and lines of credit to support infrastructure projects with federal outlays concentrated on only the most transformative projects (priorities include motorways, roads, aviation, airports, and air traffic control systems). Efforts will be made, where feasible, to transfer responsibilities to state and local governments. The private provision of infrastructure will be leveraged to achieve better procurement methods, more market discipline, and a long-term focus on maintaining assets. The environmental review and permitting process is fragmented, inefficient, and unpredictable making the delivery of infrastructure more costly and time-consuming while offering little environmental protection. The intent is to significantly streamline these processes, reducing the time taken to approve pending projects and increasing both the certainty of project completion and the return on investment.

The Dynamic Distributional Effects of Tax Reform: A Heterogenous Agent Model1

The U.S. authorities plan to reduce personal income tax rates and to simplify the existing system (by eliminating deductions and consolidating the marginal rate structure). To jointly assess the dynamic effects on income distribution and the macroeconomy of lowering effective personal income tax rates, a multi-sector, general equilibrium, heterogenous agent model, calibrated to the U.S., was deployed.

A middle-class tax cut. A simple reform was simulated that reduces the effective tax rates for those earning between 0.5 to 4 times the median income, paid for by a cut in (wasteful) government spending.

  • There is a positive effect on output from an increase in the labor supply and higher savings (which in turn lowers the cost of capital). Higher after-tax incomes stimulate consumption, raising the demand for both capital and labor. The supply side effects are not large enough, however, to prevent the tax cuts from being revenue losing.

  • The tax cut results in a loss of revenues of 0.8 percent of GDP but raises steady state GDP by just under 1 percent. This implies a personal income tax multiplier of 1.1. 2

  • Both middle- and low-income households profit from the cut. Even though the lowest quintile does not receive a tax cut, the increased demand for non-tradable services by middle income households raises the demand for—and the wages of—low-skilled labor helping to support their income and consumption.

uA01fig29

Macro Effects of Middle-Class Tax Cut

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

uA01fig30

Consumption, by quintile

(percent change in steady state)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Adding in a consumption tax and an EITC expansion. To ensure the reform is revenue neutral, consumption taxes are increased. To mitigate the regressive effects of the consumption tax on the poor, the EITC is expanded for households earning less than one-half of the median income.

  • As expected, the shift from direct to indirect tax has a small but positive impact on growth.

  • The tax cuts and EITC expansion leave the bottom 60 percent of the income distribution better off. However, the increased after-tax cost of non-tradables makes highest earners worse off in terms of steady state consumption.

uA01fig31

Macro Effects of Middle Class Tax Cut, Consumption Tax and EITC

(percent change)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

uA01fig32

Consumption, by quintile

(percent change in steady state)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

The impact of tax cuts for higher income groups. Instead of targeting tax cuts at the middle class, the same experiment was run (with consumption tax and EITC expansion) but with the tax reductions accruing, instead, to those in the top quintile.

  • Relative to the middle-class tax cut, there are larger growth effects when the tax cut is incident on the higher income groups. The top quintile responds to lower taxes by saving more3 and supplying more high-skilled labor. This feeds through into a bigger growth effect. The increased after-tax income of higher income households translates into higher demand for non-tradables which, in turn, are produced by low- and middle-income groups.

  • Despite the larger growth impact, there is an important trade-off with the effects of such a reform on the income distribution. Even with the EITC expansion and a higher demand for those services that are produced by low- and middle-income groups, the share of total consumption that goes to low and middle- income households would fall under such a policy. Not surprisingly, the tax cut for the wealthy significantly worsens the polarization of income and the model’s embedded “trickle-down” effects are insufficient to raise welfare for the bulk of the population.

uA01fig33

Middle Class vs High Income Tax Cuts

(% change)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

uA01fig34

Consumption, by quintile

(percent change in steady state)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

1 See S. Lizarazo, A. Peralta-Alva, and D. Puy, “Do Tax Cuts Trickle Down: A Heterogenous Agent Model Approach for the U.S.”, IMF Working Paper (forthcoming).2 Magnitudes all correspond to the % change from the baseline steady state. The new steady state is reached after 5 years.3 For the same model in an open economy setting, increased saving by higher income groups would lower the current account deficit but not increase investment. This would diminish the growth effect (by around half) but would still leave tax cuts for the top quintile having a larger GDP impact than if the tax cuts were targeted at the middle-class.

C. Financial Regulation

35. Important gains have been made in strengthening the financial oversight structure since the global financial crisis (see the 2015 Financial Sector Assessment Program). Over the past several years a series of decisive measures was put in place to lessen the potential for financial stability risks, including enhanced capital and liquidity requirements, better underwriting standards in the housing sector, greater transparency to mitigate counterparty risks, and limits on proprietary trading. The Dodd-Frank Act requirements have stimulated supervisory intensity, with increased emphasis on banks’ capital planning, stress testing, and corporate governance. While it has raised compliance costs for financial institutions, the Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR) process has proven to be particularly valuable. Further important regulatory measures have been, or are being, implemented including liquidity risk requirements for money market and mutual funds; standardization of derivatives products and markets; measures that reduce banks’ medium-term asset-liability mismatch (through the net stable funding ratio); and a framework for bank recovery and resolution (i.e., rules on “living wills” and bail-in-able debt).

36. The Treasury has proposed a range of reforms to the financial oversight of depository institutions. These include:

Refocusing existing standards

  • Changes to regulatory thresholds. The total asset threshold (currently at US$50 billion) above which banks are subject to Fed stress testing would be increased and the set of bank holding companies subject to enhanced supervision and prudential standards would become smaller.

  • Liquidity Coverage Ratio (LCR). The LCR would only apply to GSIBs and a lower liquidity standard would be applied to non-GSIBs that are internationally active. Non-internationally active banks would not face a LCR requirement. The definition of High Quality Liquid Assets (HQLA) in calculating the LCR would be expanded to include high-grade municipal bonds. In addition, a less conservative calculation would be used in determining future net cash outflows (the denominator of the LCR).

  • Supplemental Leverage Ratio (SLR). The calculation of the ratio would be made less binding by allowing for deductions in the denominator (for cash, Treasury securities, and margin held for centrally cleared derivatives).

  • Risk-based capital surcharges. The application of international standards for the enhanced SLR, and the calculation of Total Loss Absorbing Capacity for GSIBs would be revisited. There would also be a delay in the implementation of trading book capital rules and the Net Stable Funding Ratio to give time to reexamine these proposed rules.

  • Volcker Rule. Banks with less than US$10 billion in assets would be exempt from the Volcker rule. The definition of what constitutes proprietary trading would be narrowed, and banks would be given more leeway to maintain a market-making inventory of assets.

  • Residential Mortgages. Some of the regulations would be relaxed, including loosening the minimum requirements for loans to be eligible for securitization by the government sponsored entities, revising limits on fees for mortgage lending, scaling back the mortgage risk retention rules, and simplifying reporting requirements.

Procedural and organizational changes

  • Comprehensive Capital Analysis and Review (CCAR). In order to lessen the regulatory burden, the Treasury report proposes moving the Fed’s stress testing process to a two-year frequency; requiring publication of the Fed’s stress testing models; giving banks more leeway in using their internal models; and limiting the stress tests to a more narrowly defined and less conservative set of scenarios. In addition, qualitative considerations (e.g., on a bank’s risk management systems and capital planning process) would no longer be the sole basis in objecting to capital plans for banks subject to stress testing. The existing countercyclical capital buffer would be eliminated, and countercyclical tools would be implemented, if needed, as part of the Fed’s stress testing exercise.

  • Financial Sector Oversight Council (FSOC) powers. The FSOC would be allowed to assign a lead regulator in cases where multiple regulators have jurisdiction. A separate report will be released in the coming months examining the process by which the FSOC can designate financial institutions as systemic and subject them to enhanced supervision.

  • Resolution. The living wills submission schedule would move to a two-year frequency and the FDIC would be removed from the process (with the Fed being the sole authority). Greater clarity would be given on the assessment framework which would be subject to public comment. Further recommendations on orderly liquidation authority will be released in the coming months in a separate report.

  • Institutional changes to the Office of Financial Research (OFR) and the Consumer Financial Protection Bureau. It would be possible to remove the directors of these agencies at will, and their budgets would be subject to annual appropriations (with the OFR budget under the control of Treasury).

  • A simplification of the regulatory regime. The report recommends action to reduce fragmentation, overlap, and duplication in the U.S. regulatory structure, including by consolidating regulators and more clearly defining regulatory mandates.

  • A regulatory off-ramp. The Treasury proposal recommends allowing institutions that maintain a 10 percent leverage ratio to be exempt from risk-based capital, liquidity, and stress testing requirements as well as not to be bound by the Volcker rule.

37. There is broad-based support for simplifying the regulatory structure and fine-tuning various regulatory requirements for smaller, non-systemic institutions. The 2015 FSAP found significant scope to reduce regulatory overlaps and consolidate regulatory agencies to encourage better coordination and reduce duplication. There is also a case to put in place a simpler regime for small and community banks, that is backed by risk-based supervision. Finally, there is a need to revisit the thresholds for institutions to be subject to stress tests or to be considered systemic.

38. Nevertheless, the thrust of the current approach to regulation, supervision and resolution should be preserved. The FSOC should be supported in its efforts to identify risks and respond to emerging threats to financial stability. There is scope and need to extend the analytical work of the OFR. The Fed should continue to refine and strengthen its CCAR exercise and maintain the rigorous requirements currently in place for passing the stress testing exercise. The current designation framework could be improved to be more expeditious, transparent, and accountable. The exemption of Treasury securities from the calculated leverage ratio is problematic and could lead to efforts to exempt other low-risk weighted assets from the calculation (which would erode its effectiveness as a supplemental tool). Finally, efforts to dilute liquidity and counterparty risk requirements should be avoided, especially if doing so creates inconsistencies with the minimum standards determined by international regulatory bodies.

39. The U.S. ought to maintain its special resolution regime for systemic financial entities as a backstop to resolution under the bankruptcy code. This would help facilitate orderly resolution and prevent any contagion that could put system-wide stability at risk (see 2015 FSAP). A court-based bankruptcy regime may prove insufficiently nimble, lack the authority to provide needed temporary public financial support, lead to a dilution of regulators’ powers, and give rise to stability and contagion risks. To ensure adequate preparation for potential resolution cases, the FDIC should remain responsible, jointly with the Fed, for the adequacy and review of “living wills”.

40. The current risk-based capital framework should not be replaced with a simple leverage ratio. On a system-wide basis, the incremental capital needed to meet a 10 percent leverage ratio is estimated to be close to US$200 billion (see Chami et al, 2017). While this may be unduly costly for many banks, the existence of such an “off ramp” may give banks counterproductive incentives to increase capital but place more capital into risky activities. It would be particularly problematic to allow banks to self-select into a less demanding regulatory and supervisory regime, regardless of the underlying systemic risk of their operations.

uA01fig35

Incremental Tier-1 Capital Needed to Meet A 10 percent U.S. Leverage Ratio

(US$ billions)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Sources: SNL data; and IMF staff calculations. U.S. leverage ratio defined as tier 1 capital / banks total assets excluding off-balance sheet assets.

41. The maintenance of a robust financial regulatory regime in the U.S. has positive spillovers to other economies. These have manifested both through reducing financial stability risks in the U.S. and the knock-on effects from encouraging progress to strengthen the global regulatory framework. As such, the U.S. should remain engaged in the international discussions and reaffirm its commitment to agreed international standards. Delayed implementation of trading book capital rules, the Net Stable Funding Ratio, and Total Loss Absorbing Capital rules runs the risk of eroding efforts to complete this and other areas of the international reform agenda.

42. Authorities’ views. The administration is committed to the core principles of preventing taxpayer-funded bailouts; focusing regulations to address systemic risk and market failures; making financial regulation efficient, effective, and appropriately tailored to the size of the institutions; and strengthening the public accountability of financial regulatory agencies. The Secretary of the Treasury has published the findings and recommendations following a thorough review of existing laws and financial regulations insofar as they relate to depository institutions. The proposed changes are driven by a desire to more carefully customize and tailor the regulatory regime to the size and risk of the depository institutions and to reduce regulatory burdens. A broader use of cost-benefit analysis by financial regulators should be required, regulators should face stronger transparency and accountability requirements, and there is a need to provide regulatory relief for small and community based financial institutions. The U.S. Treasury Department will continue to participate in the full range of international meetings on financial regulations and will continue to advocate for a level playing field for U.S. financial institutions. The institutional changes proposed for the CFPB and OFR are geared toward making the agencies more accountable with a more focused mandate.

D. Trade

43. Open international trade has long supported U.S. growth and job creation with positive spillovers for other countries. A slower pace of global trade reform since the early 2000s has left in place trade barriers, subsidies, and other trade-distorting measures. There is a need, therefore, to revitalize the process for further trade integration. The promotion of a level playing field in international trade, particularly in growth areas such as services, would offer important gains to the U.S. (in terms of productivity, competitiveness and economic growth, markets for exports, and job creation) while also promoting global economic growth. In this regard, the administration’s commitment to free, fair and mutually beneficial trade and investment and to improving the rules-based international trading system is welcome.

44. Several trade policy reviews are underway. The administration has initiated several policy reviews that are expected to conclude with specific recommendations. These include examining the forces underlying bilateral goods trade deficits, whether steel or aluminum imports should be restricted on national security grounds, analyzing the effect that free trade arrangements have had on the U.S. economy, and reviewing government procurement practices (linked to existing “Buy American” provisions). As these reviews proceed, the U.S. has reiterated publicly that it intends to keep its markets open and fight protectionism, while standing firm against all unfair trade practices. In its deployment of Section 232 of the Trade Expansion Act of 1962, the U.S should be judicious in its use of import restrictions on national security grounds.

45. The administration is focused on reshaping existing U.S. trade agreements. The administration has withdrawn from the Trans-Pacific Partnership and notified Congress of its intent to renegotiate NAFTA. Pursuing new and updated trade agreements could provide the administration an opportunity to address existing trade barriers while unlocking new sources of growth. There are important gains to be had for all negotiating parties in securing more ambitious agreements with trading partners, in areas such as transparency, e-commerce, services, as well as labor, environmental and safety standards. The U.S. would benefit by remaining open as it pursues new or amended trade agreements and should avoid new import restrictions.

46. Authorities’ views. Free, fair and reciprocal trade and international investment can lead to economic growth and job creation but unfair trade practices have disadvantaged U.S. workers and businesses, leading to large and persistent trade imbalances. Trade-distorting practices—such as dumping, non-tariff barriers, forced technology transfer, non-economic capacity, subsidies and other non-market behavior and government support—should be eliminated to foster evenhanded competition. At the same time, existing agreements—written decades ago—need to be assessed as to their continued adequacy for promoting free and fair trade. The administration is seeking to ensure that trade and investment agreements with the U.S. serve to enhance economic growth, break down barriers to exports, contribute favorably to its trade balance, and strengthen its manufacturing base. Efforts are planned to improve the functioning of the WTO dispute settlement system and to ensure full and transparent implementation and timely enforcement of WTO agreements, as originally written. The administration intends to focus more on bilateral negotiations with trading partners to ensure more rapid progress toward new and revised trade agreements that focus on reciprocity.

E. Deregulation

47. A central plank of the new administration’s economic plan is to revisit federal regulations in a range of areas. In international comparisons, the U.S. already scores favorably on regulatory barriers to entrepreneurship, trade, and investment. In addition, U.S.-specific research on the evidence of negative economic implications of regulations is scant. Nonetheless, a simplification and streamlining of federal regulations as well as an effort to harmonize rules across states would likely boost efficiency and could stimulate job creation, productivity, and growth. There may also be scope to achieve desired outcomes through means other than regulation (e.g., to replace regulatory limits on carbon with a broad-based carbon tax). However, in reforming the current regulatory system, care is needed to avoid negative consequences for the environment, workplace safety, and protections for lower-income workers.

uA01fig36

Regulation Indicators

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Source: OECD. Higher values denote greater levels of regulation.

48. Authorities’ views. The current regulatory system is both ineffective and inefficient, imposing significant dead-weight costs on businesses, states, and local governments. Federal permitting practices—including those for new infrastructure projects—are unnecessarily burdensome. Work is already underway to identify those regulations that eliminate jobs, inhibit job creation, or are outdated or ineffective. For every new regulation that is introduced, two will be eliminated and the net cost of all new regulations will be zero. The effect of these efforts will have a large positive effect on growth and investment with minimal side effects on environmental, safety, or worker protections.

Maintaining a Productive and Flexible Workforce

A range of measures could be taken to increase the adaptability of households and businesses, mitigate secular trends in income polarization and poverty, raise labor force participation, create the environment to increase investments in human capital, and boost productivity. Many of these macro-critical areas would both raise potential growth and help ensure that gains in income and opportunities improve the living standards of the majority of the population.

A. Education

49. Access to better and more cost-effective education can raise productivity and increase the flexibility of U.S. workers to adjust to structural shifts in labor demand or displacement by technology or trade. There is also broad evidence that investments in education can lessen the intergenerational persistence of poverty. There is a significant lifetime income premium to completing a college degree, which points to both the strong demand for skills and to the adaptability premium that higher education can offer. It is encouraging, therefore, that 70 percent of U.S. high school graduates enroll in college. However, outcomes are less encouraging: only 60 percent of enrollees graduate within 6 years, those graduating have significant debt (median of around US$20,000 for those with a bachelor’s degree), and delinquency rates are rising. In addition, the aggregate data hides significant disparities in outcomes across both race and family income level. This has implications for long-term growth, inequality, and for near-term demand (with growing evidence that the high level of student debt is constraining consumption and household formation).

50. Policy solutions would need to focus on a range of areas. In particular:

  • K-12 education. Funding can be better prioritized toward early childhood education (including instituting universal pre-K) and to support science, technology, engineering, and mathematics programs. There is also a strong case to redesign the financing model for public schools to reduce funding differences across districts and provide more resources to schools with high concentrations of students from low-income households.

  • Vocational education. The administration’s support for federal, state, and local efforts to offer attractive, non-college career paths (e.g., through apprenticeship and vocational programs) is welcome and there is significant scope to expand these programs.

  • Tertiary education. The high levels of private and public expenditure on higher education, alongside relatively unimpressive attainment statistics, suggest the need for a greater focus on preparing students for college and fostering retention once they are enrolled. Alternative state and federal financing options for tertiary education—such as expanding the programs for, and lowering the payment caps on, income contingent repayment loans or increasing needs-based grant programs—may help increase access for students from lower- and middle-income households. Such financing options are proposed in the budget but they are, unfortunately, accompanied by significant cuts to overall student loan programs and an intention to increase the monthly payment cap for income contingent loans.

uA01fig37

Tertiary Education

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Source: OECD latest available data
uA01fig38

Student Debt

(US$ trillion)

Citation: IMF Staff Country Reports 2017, 239; 10.5089/9781484312681.002.A001

Source: Federal Reserve.

51. Authorities’ views. The administration is committed to expanding school choice through greater federal funding for charter schools and vouchers for private and religious schools. This will be financed, in part, by consolidating and streamlining a range of federal programs that co-fund state and local after-school, teacher training, student support, and academic enrichment programs. Existing income dependent repayment programs for student loans would be consolidated into one standardized program and the cap on monthly payment would be increased to 12.5 percent of discretionary income (with forgiveness of the loan after 15 years of payment). Overall federal funding of student loans would, however, be reduced in part through the elimination of subsidized loan programs.

B. Family-Friendly Benefits

52. The cost and availability of childcare is a constraint to labor force participation. As one example, the labor force participation rate for women with children under 6 years old is 66 percent (around 8 percent below that of similar aged cohorts without young children). It is also of concern that one-in-four single parent households are living in poverty. The administration recognizes that family-friendly benefits can be an important policy lever to slow the downward trend in labor force participation and support low- and middle-income families. In this regard, the budget’s intention to create a program that offers six weeks of paid leave to new parents and provide help for families struggling with child and dependent care expenses are positive steps.

C. Supporting Low- and Middle-Income Households

53. Mitigating the ongoing hollowing out of middle-income earners and reducing the currently high levels of poverty would raise labor supply, boost human capital and productivity, and improve living standards. In addition to the reforms discussed above—education, family-friendly benefits, and expanding the EITC—other policies that could help include:

  • Disability insurance. As proposed in the budget, there is scope to strengthen the design of the disability insurance program to provide incentives for beneficiaries to work part time or eventually return to full time work (rather than drop out of the labor force). Such a reform ought to be undertaken carefully, however, to prevent legitimate recipients being excluded from this important safety net.

  • Social assistance. There is significant scope to upgrade federal and state-level social programs to better help the most vulnerable. “Cliffs” in social benefits—such as Medicaid, the Supplemental Nutrition Assistance Program, the Child Health Insurance Program, Temporary Assistance for Needy Families, and housing assistance—could be reassessed with a view to smoothing the phase-out for the near-poor. This would not only reduce disparities but also encourage labor force participation for those earning above, but close to, the federal poverty line. There is scope to simplify and unify the various programs underlying the safety net, increase the generosity of direct transfer programs, learn from the diversity of experiences at the state-level to identify the most effective approaches, and better-target federal payments to program outcomes. These improvements to social programs could be undertaken with a relatively small budgetary cost.

54. Authorities’ views. There is no rationale to expand existing safety net programs. Welfare reform should be geared toward encouraging those individuals that rely on government programs to return to the workforce. This could be achieved by tightening eligibility for programs (including SNAP, EITC, and the child tax credit) and requiring able-bodied adults to work in order to receive benefits. The administration has, however, proposed putting in place six weeks of paid parental leave funded partially by savings that are generated in the federal unemployment insurance system.

D. Immigration

55. A skills-based immigration system would enhance labor force participation and productivity. Demographic changes will lead to a steady decline in participation in the coming years, slowing labor force growth from an annual average of over 1 percent over the last 25 years to less than ½ percent in the coming decade. The dependency ratio—the share of the old and young population as percent of the working age population—is expected to rise from about 60 percent today to 75 percent by 2037. This is even with around 0.6 million new immigrants entering the labor force each year. A comprehensive, skills-based reform of the immigration system has the potential to expand the labor force, improve the dependency ratio, and raise the average level of human capital. This could have significant positive effects on long-term potential growth and help ease the medium-term fiscal challenges.

56. Authorities’ views. The immigration system should be reformed to encourage merit-based admissions for legal immigrants, prohibit the entry of illegal immigrants, and substantially reduce the number of refugees that are permitted to resettle in the U.S. The administration will increase spending on border security and law enforcement. Efforts are underway to examine inefficiencies in the admission of skilled immigrants under the H1B visa program to avoid undercutting local wages and reducing the employment prospects for U.S. citizens.

E. Healthcare

57. Following the significant changes to the U.S. health care system under the previous administration, efforts are underway to reshape policies and scale back federal government involvement in the health system. Proposed changes include removing the individual and employer mandates, eliminating various taxes and subsidies, reversing the Medicaid expansion, and giving states greater flexibility and control over health care policy. The balance of evidence—including the independent analysis of the Congressional Budget Office—suggests that eliminating penalties for those who choose not to purchase health insurance will either lead to a loss in coverage (with likely adverse selection effects as better risks drop out of the insurance markets) or necessitate an increase in federal subsidies (to maintain similar levels of coverage). There are also important distributional implications with the proposed changes implying a significant increase in costs for older and poorer individuals whereas the embedded tax relief would be mostly incident on higher income households. There are polarized societal views over the appropriate way forward which makes reaching a consensus on policy difficult to achieve.

58. Health care policies should protect those gains in coverage that have been achieved since the financial crisis (particularly for those at the lower end of the income distribution). Doing so will have positive implications for well-being, productivity, and labor force participation. This, in turn, will strengthen growth and job creation, reduce economic insecurity associated with the lack of health coverage, and have positive effects for the medium-term fiscal position. Such changes ought to be undertaken carefully to avoid compromising the pooling of risks (an essential foundation for a well-functioning health insurance system) or excluding those with limited incomes from the healthcare system.

59. Mechanisms to contain inflation in the cost of healthcare services need to be examined. This could include an evaluation of existing pilot programs that are being undertaken as well as an application of new technologies to increase efficiencies and pricing transparency. Reducing the growth in healthcare costs will have important implications for the general government fiscal position. There also ought to be some assessment of the scope for anti-trust actions where the market concentration of providers or insurers has risen and where premiums for non-group policies have been rising rapidly.

60. Authorities’ views. In the administration’s view, the Affordable Care Act is fundamentally flawed and a new approach is required to improve Medicaid sustainability, target scarce federal resources to those most in need, eliminate taxes on investment income and the penalties that underpin the individual mandate, and stabilize and reform the individual insurance market. Proposed reforms will help families purchase coverage through tax credits and health savings accounts. In addition, regulatory oversight will be devolved to the states to make decisions that work best for their local markets. In the administration’s assessment, the Congressional Budget Office estimate of the loss of coverage under this new legislation attributes an overly large impact of the individual mandate on coverage decisions and uses an outdated baseline that projects a far healthier market under the status quo than is likely to occur.

Staff Appraisal

61. The favorable near-term outlook is clouded by important medium-term imbalances. The U.S. economic model is not working as well as it could in generating broadly shared income growth. It is burdened by a rising public debt. The U.S. dollar is moderately overvalued (by around 10–20 percent) and the external position is moderately weaker than implied by medium-term fundamentals and desirable policies. The current account deficit is expected to be close to 3 percent of GDP over the medium-term, and the net international investment position has deteriorated markedly in the past several years. Most critically, relative to historical performance, post-crisis growth has been too low and too unequal.

62. Addressing these issues requires taking steps to spark faster economic and productivity growth, stimulate job creation, incentivize business investment, balance the budget, bring down the public debt, and create the room to finance priorities such as infrastructure. The administration’s objectives are broadly aligned with these priorities but the consultation revealed differences in a range of policy areas and left open questions as to whether the administration’s proposed policy strategies are best suited to achieve their intended purpose.

63. Strengthening growth outcomes and ensuring a more broad-based improvement in living standards will require a transformation of the U.S. economic model. Such policies should include building a more efficient tax system, reprioritizing federal spending, a more effective regulatory system, labor market reforms, increasing infrastructure spending, improving education and developing skills, strengthening healthcare coverage while containing costs, offering family-friendly benefits, maintaining a free, fair, and mutually beneficial trade regime, and reforming the immigration and welfare systems.

64. The right policy package represents an upside to productivity, labor force growth, and capital formation as well as to overall living standards. In many cases, these efforts will require incremental federal resources (e.g., to finance infrastructure, better education and health systems, improved social assistance, and family friendly benefits), which should be accommodated within an overall budget envelope that shrinks the federal deficit starting in FY2018 and steadily reduces the public debt-GDP ratio. This can be achieved by reprioritizing existing spending, addressing entitlements, and ensuring tax reform generates a front-loaded increase in the revenue-GDP ratio.

65. Important gains have been made in strengthening the financial oversight structure since the global financial crisis. There is scope to fine-tune some aspects of the system as has been proposed by the U.S. Treasury. However, the current risk-based approach to regulation, supervision, and resolution should be preserved.

66. The Federal Reserve should continue to raise policy rates gradually. Given the downside risks to inflation and the constraints of the effective lower bound, policymakers should be ready to accept some modest, temporary overshooting of its inflation goal that allows inflation to approach the 2 percent medium-term target from above. The recent addendum to the policy normalization principles and plans provides market participants with a clear path for changes in reinvestment policy that will help avoid undue volatility in fixed-income markets.

67. It is recommended that the next Article IV consultation take place on the standard 12-month cycle.

Table 1.

United States: Selected Economic Indicators 1/

(percentage change from previous period, unless otherwise indicated)

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Sources: BEA; BLS; FRB; Haver Analytics; and IMF staff estimates

Components may not sum to totals due to rounding

Contribution to real GDP growth, percentage points

Table 2.

United States: Balance of Payments

(annual percent change unless otherwise indicated)

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Sources: BEA; FRB; Haver Analytics; and IMF staff estimates
Table 3.

United States: Federal and General Government Finances

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Sources: Congressional Budget Office; Office of Management and Budget; and IMF staff estimatesNote: Fiscal projections are based on the March 2016 Congressional Budget Office baseline adjusted for the IMF staff’s policy and macroeconomic assumptions. The baseline incorporates the key provisions of the Bipartisan Budget Act of 2015, including a partial rollback of the Sequester spending cuts in fiscal year 2016. In fiscal years 2017 through 2021, the IMF staff assumes that the sequester cuts will continue to be partially replaced, in proportions similar to those already implemented in fiscal years 2014 and 2015, with back-loaded measures generating savings in mandatory programs and additional revenues. Projections also incorporate the Protecting American From Tax Hikes Act of 2015, which extended some existing tax cuts for the short term and some permanently. Finally, Fiscal projections are adjusted to reflect the IMF staff’s forecasts for key macroeconomic and financial variables and different accounting treatment of financial sector support and of defined-benefit pension plans and are converted to a general government basis.

Includes staff’s adjustments for one-off items, including costs of financial sector support

Excludes net interest

Excludes net interest, effects of economic cycle, and costs of financial sector support

Percent of potential GDP

Table 4.

United States: Core FSIs for Deposit Takers

Percent unless stated otherwise

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Source: IMF staff estimates.

Annex I. External Sector Assessment

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