United States: 2018 Article IV Consultation—Press Release; Staff Report; and Statement by the Executive Director for United States

Unemployment is low, inflation is well contained, and growth is set to accelerate.

Abstract

Unemployment is low, inflation is well contained, and growth is set to accelerate.

Solid Growth, Rising Inflation, Full Employment

1. The near-term outlook for U.S. economy is one of strong growth and job creation. Unemployment is already near levels not seen since the late 1960s and growth is set to accelerate, aided by a near-term fiscal stimulus, a welcome recovery of private investment, and supportive financial conditions. The balance of evidence suggests that the U.S. economy is beyond full employment. The near-term risks to this outlook are balanced but the risks after the next several quarters are skewed to the downside. Staff continue to estimate potential growth will decline over the medium-term to around 1¾ percent at a 3–4 year horizon as demographic pressures lessen labor force growth, productivity recovers toward long-run historical averages, and the boost to investment from the tax reform begins to wane.

uA01fig01

Measures of Labor Market Slack

(percent of labor force)

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Source: BLS and IMF staff estimates.

2. After spending much of the past decade below 2 percent, core PCE inflation is expected to soon rise modestly above that level. So far, wages have been growing broadly in line with (relatively weak) labor productivity growth, leaving unit labor costs virtually unchanged over the past 2 years. In the next several months, as slack is further diminished, wages and unit labor costs are anticipated to increase at a modest pace (Box 1). Labor force participation is expected to be broadly stable over the near-term as cyclical forces offset the downward pull of demographics. Risks to the inflation outlook are judged to be broadly balanced.

uA01fig02

Wage Growth

(y/y in percent)

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Source: Haver Analytics, Federal Reserve Bank of Atlanta, BLS

3. A robust economy, muted inflation, and high levels of consumer and business confidence have supported a run-up in asset prices. The capital position of U.S. banks is strong and asset quality appears to be generally good. Credit remains available to both households and corporations and the cost of borrowing is relatively low (Figure 1). However, equity market valuations are rich, margin debt and various measures of leverage are rising (with increased use of financial leverage to boost returns), and the growth of passively managed investment products has the potential to amplify the impact of asset price swings on the financial system. There has been some deterioration of credit quality in auto and credit card lending as well as for agricultural loans (although these assets represent a relatively small share of the market and are unlikely to give rise to a systemic vulnerability). In addition, underwriting standards for corporate credit, particularly for higher risk borrowers, has weakened. Strains in the student loan market are becoming apparent which could create fiscal costs or knock-on effects to other credit markets. Finally, cyber risks to the financial system—linked to the safeguarding of systems and operations as well as the protection of customer data—are an ongoing concern. This overall assessment is borne out by the growth-at-risk metric of financial stability which finds near-term financial stability risks are broadly similar to those at the time of the last Article IV but medium-term risks are elevated (Figure 2).

Figure 1.
Figure 1.

Financial System Indicators

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Sources: Bank of America Merrill Lynch, Bloomberg, CBOE, Federal Reserve Board, Haver Analytics, IMF, Robert Shiller, S&P Dow Jones Indices LLC..
Figure 2.
Figure 2.

Financial Stability and Growth-At-Risk1

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

1 Source: Methodology is based on IMF Global Financial Stability Report, October 2017, Chapter 3; Adrian et al (2018), “Vulnerable Growth,” American Economic Review (forthcoming) but applied specifically to U.S. financial conditions indices.2 The lower 5 percent quantile of the conditional forecast density of output growth represents the size of the downside risk to growth as a function of domestic financial conditions.3 The conditional forecast densities are for time horizons of one and three years based on the last available data.

Determinants of U.S. Wage Inflation1

U.S. wage growth has been subdued since the end of the great recession, despite robust job growth and a steady fall in unemployment. Estimates of a wage Phillips curve suggest that this weak wage growth is mostly a product of low labor productivity growth. The model fits the data well and its parameters are robust to the use of different measures of labor market slack and show no sign of structural instability over time.

uA01fig03

Decomposing Employment Cost Index (ECI) Growth

(percentage points)

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Sources: Authors’ Estimation

The model also allows a decomposition of the drivers behind compensation growth and shows that, throughout the current recovery, there has been diminishing downward pressure on compensation growth as labor market slack has diminished. However, this has been offset by a similarly-sized and contemporaneous decline in labor productivity growth. Additional factors that have kept the growth rate of real compensation below that of labor productivity include technological progress—linked to the automation of routine tasks—trade globalization, and falling unionization rates.2

These themes are broadly reinforced by results from a micro-econometric model of wage determination, that uses household observations from the Current Population Survey. Controlling for various individual characteristics (including education, gender, and profession), an augmented Mincer-type model reveals that a higher local rate of unemployment puts downward pressure on wages (although this relationship appears to have weakened post great recession). The household level regressions also show that structural changes related to technology, globalization, and market concentration are also relevant. College-educated workers in routinizable jobs face greater downward pressure on their wages while less-educated workers have experienced the most downward wage pressures when they are in jobs that are easiest to offshore. Working in industries that are more concentrated weighs on wages for both college and non-college educated workers.3

uA01fig04

Wage Impact by Skill Level of Structural Factors

(in percent)

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Sources: Authors’ Estimates
1 See Y. Abdih and S. Danninger, 2018 “Understanding U.S. Wage Growth”, IMF Working Paper, WP/18/138.2 See Y. Abdih and S. Danninger, 2017 “What Explains the Decline in the U.S. Labor Share of Income? An Analysis of State and Industry Level Data,” IMF Working Paper WP/17/167.3 The impact on wages show how much wages fall as a worker goes from the median routinizable and offshorable occupation to the 66th percentile or from a 10-percentage point movement of workers to large firms within the same industry.

Authorities’ Views

4. The administration disagreed with the growth outlook that formed the basis of staff’s macroeconomic framework. The IMF’s forecasts were regarded as unduly pessimistic, particularly when it came to the prospects for long-term growth. The administration’s framework is based on average growth of 3 percent over 2018–28. This additional growth, relative to staff forecasts, was a product of a higher no policy change baseline that would lead long-run growth to reach around 2.2 percent. The administration’s outlook also incorporates long-run growth effects arising from a US$1.5 trillion investment in infrastructure (+0.2 percent), the impact of the overhaul of the U.S. tax system (+0.3 percent), higher labor force participation, and a continuing process of de-regulation that has already eliminated 22 existing regulations for each new one that was created (+0.2 percent).

The Macroeconomic Policy Mix

A. Fiscal Policies

5. With this strong cyclical position as backdrop, the U.S. has cut taxes and raised both defense and non-defense discretionary spending. The resulting demand stimulus is expected to raise output, cumulatively, by 1½ percent by 2020, pushing the unemployment rate below 3½ percent. The tax changes are expected to have modestly positive supply-side effects, largely by incentivizing an increase in the capital stock and, in doing so, raising the level of potential GDP (by a cumulative 0.3 percent by 2020). Potential growth is expected to return to its longer-term trend (of 1¾ percent) by 2021. The effects of ongoing deregulation could further raise the level of real GDP by a modest amount (although it is difficult to quantify such effects based on the available research and evidence).

uA01fig05

Fiscal Stance Across the Business Cycle

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

6. The combined effect of the administration’s tax and spending policies will cause the federal government deficit to exceed 4.5 percent of GDP by 2019. This is nearly double what the deficit was just 3 years ago. Such a strongly procyclical fiscal policy is quite rare in the U.S. context and has not been seen since the Johnson administration in the 1960s.

7. Such a procyclical fiscal policy will elevate the risks to the U.S. and global economy. The net effect of this fiscal path will be to provide a near-term boost to the U.S. and to many of its trading partners. However, the shift in the US policy mix and uncertainties about the trade regime increases the range and size of future risks, both for the U.S. and for the global economy. These risks include:

  • Higher Public Debt. The increase in the federal deficit will exacerbate an already unsustainable upward dynamic in the public debt-to-GDP ratio. Even with the planned, modest fiscal consolidation that is scheduled to start in 2020, the federal debt will continue to climb, exceeding 90 percent of annual GDP by 2024 (Annex III).

  • A Greater Risk of an Inflation Surprise. As discussed above, the tax reform is expected to have only modest effects on potential output. As such, the planned, expansionary fiscal policy raises the risk of a faster-than-expected rise in inflation as capacity constraints become more binding and the economy pushes further through full employment. Such a rise in inflationary pressures would lead the Federal Reserve to move at a faster pace than is currently priced in by markets, potentially creating volatility and disruptions in U.S. asset markets, tightening financial conditions, decompressing term and other risk premia, and straining leveraged corporates and households (Boxes 2 and 3).

  • International Spillover Risks. The boost to U.S. demand from expansionary fiscal policies will generally support near-term growth in a range of countries. However, the shift in the U.S. policy mix creates important adverse risks for non-U.S. corporates, households, and sovereigns (especially those that have borrowed heavily in U.S. dollars and/or have significant rollover needs). It could also precipitate a marked reversal of capital flows, particularly out of some emerging markets with weaker macroeconomic fundamentals, which has the potential to add to upward pressure on the U.S. dollar and to worsen global imbalances. We are already starting to see symptoms of these spillover effects in some countries.

  • The Risk of Future Recession. Current policies build in a gradual fiscal consolidation starting in 2020, at a time when the monetary tightening cycle is expected to be at its peak. Staff forecasts assume a gradual slowdown during this period with growth leveling off at around 1½ percent, modestly below the economy’s potential growth rate. However, such a gentle convergence of output to potential from above would be historically unusual and this forecast could prove overly optimistic. The output gap could close more abruptly, through a policy-induced recession, with negative spillovers for the global economy.

  • Increased Global Imbalances. The U.S. external position in 2017 was moderately weaker than implied by medium-term fundamentals and desirable policies and the U.S. dollar is judged to be moderately overvalued (Annex II). However, especially with the economy already at full employment, the fiscal boost to demand in the U.S. is likely to translate into higher import growth, an increase in the current account deficit (to around 3½ percent of GDP by 2019–20), upward pressure on the dollar, and a worsening of the international investment position. From the saving-investment perspective, the U.S. is likely to experience lower household saving, higher investment, and a weaker fiscal position (Box 4). The higher U.S. current account deficit is expected to be matched by growing current account surpluses in other systemic economies (notably Germany, China, and Japan). As a result, global imbalances are expected to rise, with the various attendant risks that such imbalances convey (including possibly catalyzing public support for increased protectionism).

uA01fig06

Federal Debt,

(percent of GDP, fiscal year)

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Source: IMF Staff calculations
uA01fig07

GDP Spillovers of Fiscal Reforms,

(percent of GDP)

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Source: IMF staff estimates. Differences from baseline due to the Tax Cuts and Jobs Act and the 2018 appropriations bill.

Authorities’ Views

8. The stronger growth path envisaged by the administration will have an important effect on the fiscal deficit, lowering it by an average of around 0.25 percent of GDP each year over the next 10 years. In addition, the administration intends to significantly reduce federal non-defense outlays while providing an additional US$200 billion to finance infrastructure spending. Around one-half of these expenditure savings would come from a reorganization of the federal government. The remainder would accrue mostly from the repeal of the Affordable Care Act, reforms to the welfare system and student loans, reductions in wasteful Medicare spending (including for prescription drugs), and a phase-down of defense spending currently being undertaken through Overseas Contingency Operations funding. These spending cuts, over the ten-year budget horizon, would result in a 44 percent real reduction in discretionary, nondefense spending. As a result, mandatory spending programs would rise from 68 to 78 percent of noninterest federal spending. On balance, the administration’s planned spending reductions, combined with faster growth, would reduce the deficit to 1.1 percent of GDP by 2028 and lead the federal debt to peak at 82 percent of GDP in 2022, slowly declining thereafter. No negative growth effects are anticipated from those various reductions in federal programs. Rather, this contractionary fiscal policy is fully consistent with an expansionary growth outlook: jobs would be created in the private sector at a pace that more-than-offsets the economic drag from reductions in inefficient federal spending.

Impact of a Nonlinear Phillips Curve1

One of the main risks facing the U.S. economy is that inflation could accelerate faster than currently expected. Indeed, the relationship between inflation and economic slack may be nonlinear, steepening as the economy pushes further through full employment.

uA01fig08

Phillips Curve

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Simulations of the Fed’s FRB/US and the Fund’s G20 MOD models illustrate how such a steepening (see chart) could affect policy and inflation outcomes. The simluations assume a demand impulse of 1.5 percent—comparable to the impulse from the 2018–19 fiscal expansion. In FRB/US, the central bank is assumed to follow an optimal control policy while in G20 MOD the central bank reacts according to a forward-looking Taylor rule.

The results for the two models are qualitatively similar (charts below show the different paths of inflation and policy rates for the linear and nonlinear cases for the two models). Policy rates rise faster and higher when the trade-off between slack and inflation is characterized by a nonlinear Phillips Curve. This tightens U.S. and global financial conditions relative to the case of a linear Phillips Curve. In the nonlinear case, not surprisingly, despite higher policy rates the inflation path is higher than in the linear case.

uA01fig09

Core Inflation

(percent, difference from baseline)

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

uA01fig10

Fed Funds Rate

(percent, difference from baseline)

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

1 Authored by Susanna Mursula (RES), and Peter Williams (WHD.)

The Term Structure of Interest Rates and Forecasting Structural Variables1

In recent years, term premia have been very low and sometimes even negative. This has been due to a combination of a healthy macroeconomic environment of low inflation, above trend growth, and, potentially, the Federal Reserve’s quantitative easing program.

A macro-financial term structure model was estimated, which exploits cross-sectional and temporal information embedded in the yield curve, as well as cyclical economic variables. Expectations about structural factors (e.g., long run inflation expectations or the equilibrium real interest rate) are revised only slowly even after large shocks. As a result, most of the variation in bond yields is explained by changes in term premia, and to a lesser extent economic conditions, rather than shifting long-run expectations.

This term structure model can be used to derive market forecasts of the unemployment rate and interest rates. Based on the current information embedded in the yield curve, the unemployment rate is projected to drop further, to around 3½ percent before trending back to its long-term natural level. The policy rate is expected to modestly overshoot its long-run expected value and long-term rates are expected to rise to around 3.7 percent.

uA01fig11

Unemployment Rate Forecasts

(percent)

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Note: based on the informatrion set at the end of December.
uA01fig12

Interest Rate Forecasts

(percent)

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

1 See E. Kopp and P.D. Williams, 2018 “A Macroeconomic Approach to the Term Premium,” IMF Working Paper, WP/18/140.

Household Saving, Investment and the Implications for the U.S. Current Account

Personal saving. Since the mid-1970s the U.S. has seen a secular decline in the household saving rate. This downward trend reversed after the financial crisis but has, more recently, resumed. To examine whether the 2008–13 rise in the personal savings rate was due to transitory income and wealth shocks or, rather, an indication of structural changes in household behavior, a time-series vector error correction model was estimated for the U.S.1 Econometric tests of that model find little evidence of a post-financial crisis break in the underlying elasticities between household consumption, disposable income and household net worth. Indeed, rolling estimation of the coefficients of the model appear remarkably stable over the past 50 years. The evidence instead points to the 2008–13 rise in the personal saving rate as being mainly the result of the path for disposable income, higher unemployment and the significant fall in wealth that was experienced during this period. Conditioning on staff’s medium-term forecasts, the household saving rate is predicted to continue falling and eventually revert to the secular downtrend that was in place before 2007.

uA01fig13

Personal savings rate,

percent of disposable income

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Source: BEA and IMF staff estimates.

Business investment. For much of the current recovery investment growth has been lackluster despite record corporate profits, highly supportive financial conditions, robust business and consumer sentiment, rising equity valuations, and improving labor markets. Econometric estimates2 suggest that weak expected demand growth explains most of the sluggish capital formation since the financial crisis. The marked decline in global oil prices has further weighed on aggregate investment from 2014 onwards. With expectations of solid future demand growth and a recovery in the oil and gas sectors, business investment should continue to strengthen.

uA01fig14

Nonresidential Business Investment

Log index

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Source: BEA; IMF staff projections.

Implications for the Current Account. Upward revisions to growth projections will support a rise in investment-GDP while solid disposable income growth and household wealth gains will lead to a further decline in the saving rate. At the same time, the public sector saving-investment balance is expected to worsen. Combined, these effects are expected to lead to an increase of around 1 percent of GDP in the U.S. current account deficit (bringing it to the highest level seen since the global financial crisis).

1 See S. Ouliaris and C. Rochon, “The U.S. Personal Saving Rate”, IMF Working Paper WP/18/128.2 See E. Kopp, “Determinants of U.S. Business Investment”, IMF Working Paper, WP/18/139.

B. Monetary Policy

9. In light of the planned fiscal stimulus, the Federal Reserve will need to raise policy rates at a faster pace to achieve its dual mandate. The Federal Reserve should be ready to accept some modest, temporary overshooting of its medium-term inflation goal (as is indicated by the range of FOMC participants’ forecasts). Even then, though, policy rates will likely need to rise for a time above the long-run neutral rate. The FOMC participants’ median forecast suggests that both core inflation and the federal funds rate will rise at a moderately slower pace than in staff’s forecasts; this is consistent with their expectation of growth that is somewhat slower than staff’s forecasts in 2018–19. Barring a significant negative shock (for example, one that would lower interest rates back to the effective lower bound), the normalization of the balance sheet should proceed as outlined in the Fed’s policy normalization principles. In executing its monetary policy decisions, the Fed’s continued adherence to the principles of data dependence and clear communication will be vital. In this regard, scheduling a press conference after every FOMC meeting and publishing a quarterly monetary policy report (that details a central economic scenario, and description of risks around that baseline, that is endorsed by the FOMC) could help.

uA01fig15

Policy Rate,

(percent)

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Sources: Federal Reserve and IMF staff estimates.

10. For most economies, the near-term net effect of higher U.S. growth and the expected increase in U.S. interest rates is expected to be beneficial. The largest positive spillovers are likely to accrue to Canada and Mexico, given their close economic ties with the U.S. However, even under this baseline, there could still be stress, particularly for leveraged firms and households (both in the U.S. and abroad) and/or for indebted sovereigns. Indeed, some of these strains are becoming evident in a handful of countries. Presumably, if some of the downside risks outlined above materialize, the outward effects would be far more damaging for a broader set of countries.

Authorities’ Views

11. The risks to the economic outlook and to inflation prospects were assessed to be roughly balanced and further, gradual increases in the federal funds rate would be consistent with a solid expansion of economic activity, strong labor market conditions, and inflation near the FOMC’s 2 percent medium term objective. At this stage, it looked likely that inflation would modestly overshoot 2 percent for a time but it was also likely that some of the recent acceleration in inflation represented transitory price changes (e.g. in health care and financial services). This path for inflation remains consistent with the FOMC’s symmetric inflation objective and could even help anchor longer-run inflation expectations. There was little empirical evidence to suggest that the Phillips Curve was possibly steeper at lower levels of unemployment. However, intensified upward wage and price pressures, driven by supply constraints, was recognized as an important risk. Regardless, the path for the federal funds rate will continue to depend on the FOMC’s assessment of the economic outlook, as informed by incoming data.

Economic Forecast

(percent)

article image
Sources: CBO projections are from the Budget and Economic Outlook April 2018; FOMC projections are from the June 2018 Summary of Economic Projections; Consensus is for the Blue Chip Consensus, May 2018

Restoring Fiscal Sustainability and Rebuilding Fiscal Space

12. Measures should be taken to raise the primary fiscal surplus of the general government to around 1¼ percent of GDP (1½ percent of GDP for the federal government) to put the debt-to-GDP ratio on a downward path. The U.S. has some fiscal space but should not use it at this stage in the cycle. Rather policies should be designed to:

  • Reform social security including by raising the income ceiling for contributions, indexing benefits to chained inflation, and accelerating the planned increase in the retirement age.

  • Contain healthcare cost inflation through technological solutions that increase efficiency, greater cost sharing with beneficiaries, and changing mechanisms for remunerating healthcare providers.

  • Increase the federal revenue-GDP ratio by putting in place a broad-based carbon tax, a federal consumption tax, and a higher federal gas tax.

uA01fig16

Federal debt held by the public

(percent of GDP, fiscal year)

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Source: IMF staff estimates.

Such a set of policies would both allow the public debt-to-GDP ratio to fall and create the fiscal space for policies to support low- and middle-income families, promote investments in human and physical capital, and increase medium-term growth. Over the near term, the impact from a gradual (but steady) tightening in the fiscal position is likely to restrain growth to levels that are below staff’s baseline forecast. However, if supply side policies are successful, potential and actual growth rates would be higher over the medium-term.

13. In the absence of a change in policy that reverses the planned increase in the fiscal deficit, the resource costs of the tax reform, approved spending increases, and the fiscal pressures arising from population aging will preclude the federal government from having the fiscal space to undertake a range of policies that are needed to sustainably raise potential growth. Such policies cut across a range of areas and have been identified and extensively discussed in previous Article IV consultations. As just one concrete example, and in addition to those policies summarized in Box 5, there is broad agreement within the U.S. that increasing federal spending on infrastructure is urgently needed. Fiscal space for such spending will need to be created. However, the planned expansion in the federal deficit described above will leave few budget resources available for infrastructure spending. Indeed, the recently approved budget bill for 2018–19 provides little incremental funding for infrastructure (despite the US$200 billion in appropriations requested by the administration). Even with the administration’s positive efforts to streamline the regulatory structure, assess the viability of user fees, expand public-private partnerships and tax-preferred private activity bonds, improving U.S. infrastructure will need to be backed by a sustained increase in federal spending. This increase in spending should be structured around competitive programs geared toward high priority projects rather than formula-based, automatic allocations. However, any increase in federal outlays on infrastructure would need to be designed within an overall spending envelope that allows for a steady reduction in the federal deficit and debt over the next several years.

Macro-Structural Policies to Boost Potential Growth1

Tackling Poverty

  • Expand the eligibility for, and increase the generosity of, the Earned Income Tax Credit (EITC) to support lower income households and incentivize work. To lessen the risk an expanded EITC leads to a decline in pre-tax wages at the bottom of the income distribution, combine the change in the EITC with an increase in the federal minimum wage.

  • Upgrade federal and state social assistance to simplify and unify the multitude of programs, increase the generosity of direct transfer programs, avoid “cliffs” in social benefits by smoothing the phase-out for those near the poverty line, and better target federal payments to program outcomes.

Improving Education

  • Better prioritize spending on early childhood education and institute universal pre-K.

  • Provide greater support for science, technology, engineering and mathematics programs.

  • Redesign the funding model for public schools to reduce funding differences across districts and provide more resources to schools with a high concentration of students from low-income households.

  • Expand apprenticeship and vocational programs to offer attractive, non-college career paths to workers of all ages.

  • To improve the current relatively unimpressive levels of college degree attainment, the U.S. should focus more on preparing students for college and fostering retention once they are enrolled.

  • Explore alternative federal financing options for tertiary education (including income contingent repayment loans and an expansion in needs-based grant programs) to increase access for students from low- and middle-income households.

Providing Family Friendly Benefits and Expanding the Labor Force

  • Institute paid family leave.

  • Provide means-tested assistance for child and dependent care expenses.

  • Undertake a skills-based immigration reform.

Better Healthcare

  • Protect the gains in health care 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.

  • Drawing on existing pilot programs, and the deployment of new technologies, provide incentives to increase efficiency and pricing transparency from healthcare providers with a goal of containing inflation in healthcare services.

  • Assess the scope to apply antitrust or other solutions to cases where the market concentration of health providers or insurers has increased and where premiums for non-group policies have been rising rapidly.

1 See 2017 U.S. Article IV Staff Report, IMF Country Report 17/239 for further details.

Authorities’ Views

14. There is no intention to raise taxes and the administration is committed to protecting those budget programs (like social security and Medicare) that retirees rely upon. Both federal consumption taxes and carbon taxes were improbable sources of revenue. There would be efforts, however, to realize savings by negotiating better deals and leveraging the U.S. Government’s buying power (e.g. for prescription drugs). Maintaining health care cost inflation below the nominal rate of growth of the economy was seen as a priority for the administration. The administration’s view is that tax cuts and deregulation would unleash the American economy and the remaining fiscal adjustment would be undertaken through spending restraint. This would be achieved through an upgrading of information technology (to deliver better results and increase accountability), modernization of the federal workforce (including through the reskilling of existing workers, facilitating the removal of workers failing to meet performance standards, and making managers more nimble and agile), and the elimination of low-value functions of the federal government. There was agreement that there is an urgent need to address infrastructure needs through a combination of US$200 billion in direct federal funding over the next 10 years which would catalyze US$1.5 trillion in infrastructure spending by state, local and private providers. An expansion of tax- advantaged Private Activity Bonds would provide competitive financing for such projects. Finally, efforts to streamline permitting decisions and the disposal of land and properties that are no longer needed by the federal government are expected to encourage new infrastructure projects, generate revenue to finance such activities, and spur local economic development.

The Tax Cuts and Jobs Act

15. There is broad agreement on the objectives underpinning the Tax Cuts and Jobs Act (TCJA). Specifically, as pointed out by the administration, the U.S. tax code has long needed an overhaul in order to simplify the system; make the U.S. business tax competitive; provide tax relief to lower- and middle-income Americans; lower statutory rates and broaden tax bases; increase equity (including by taxing households at similar levels of income in a uniform way, independent of their type of business or source of income); not provide income tax cuts for the wealthy; and to achieve all of these objectives without adding to the fiscal deficit.

16. In this regard, the Act contains many positive steps. These include efforts to reduce the scope of personal income tax deductions, lower marginal tax rates, create incentives for private investment, tackle base erosion and cross-border profit shifting, and reduce debt bias.

17. However, the approved tax policy changes have a high budgetary cost at a time when the federal budget is in urgent need of revenues. In addition, the temporary nature of many provisions creates significant tax policy uncertainty and instability in the tax system. As discussed above, the authorities should seek to prevent the tax policy changes from adding to the fiscal deficit by increasing the revenue-to-GDP ratio (largely through a greater reliance on indirect taxes).

uA01fig17

Statutory Central Government Corporate Tax Rate,

(percent)

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Source: Organization for Economic Cooperation and Development.

18. There remains scope to strengthen various provisions of the code to better achieve the objectives outlined above:

A. Business Tax

19. The reduction in the statutory business tax rate, to around the OECD average, and the expensing of certain types of capital spending are positive changes that, taken in isolation, will help incentivize investment, and lessen the incentive for base erosion and profit shifting. The Act, though, continues to allow for the deductibility of interest with a cap as a share of earnings. Such deductibility for debt-financed investment spending that can be immediately expensed conveys an overly generous benefit and continues to incentivize debt financing. In addition, the cap introduces a procyclical distortion into the system (because the cap becomes more binding when earnings weaken which, in a downside scenario, could exacerbate strains and bankruptcies in the corporate sector). Further, the temporary nature of the expensing provision distorts the timing of firms’ investment decisions (to favor investing before the provisions expire). To further increase the competitiveness of the U.S. business tax and to further lessen the distortion it creates in investment decisions, it would be preferable to go further in the direction of the TCJA and move the U.S. to a cashflow tax, permanently allowing for the expensing of all capital outlays and fully eliminating the deduction for interest spending on newly-contracted debt. The decision to levy a very low, one-time tax rate on the stock of unrepatriated profits conveys significant benefits to taxpayers that chose not to repatriate profits. Finally, the preliminary evidence is that, following the tax reform, U.S. multinationals have significantly increased their plans for share buybacks and dividend payouts.

uA01fig18

Announced Equity Buybacks*

(billions of U.S. dollars)

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Source: Bloomberg.* 2018Q2 is through May 7.

B. Personal Income Tax

20. The changes to the personal income tax have many positive aspects. These include the elimination of most itemized deductions, a higher standard deduction and the elimination of personal exemptions, limits on the deduction for state and local taxes, and a lower cap on the mortgage interest deduction. Most U.S. households will see a reduction in their income tax in the next few years. However, the net effect of the tax policy changes—which also include reductions in the burden of the alternative minimum tax and a reduction in the marginal rate for higher income households—provides greater benefits to those in the upper deciles of the income distribution.

uA01fig19

Tax Cuts and Jobs Act: Effect by Income Category,,

(static costing; in 2019)

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Source: Joint Committee on Taxation

21. As a result, these changes are likely to exacerbate income polarization. They also will do little to address the pressing needs of the working poor, both of which are important, macroeconomically relevant issues that have been raised in past Article IV consultations (see 2016 Article IV and 2017 Article IV). Indeed, the relative burden on low- and middle-income households rises as various provisions expire. To better target tax relief to lower- and middle-income Americans and prevent reductions in the income tax for the wealthy, it would be preferable to recalibrate the rate structure so as to concentrate tax relief to those earning close to or below the median income (with tax relief phasing out for those earning above 150 percent of the median income—the top third of the income distribution). As part of this change, and in line with past advice, the coverage and generosity of the Earned Income Tax Credit could be increased and there is space to eliminate loopholes and special regimes for high income earners, including the carried interest provision. The combination of these proposed changes would support low- and middle-income households, strengthen private sector demand, incentivize work, and raise living standards.

C. Pass-Throughs

22. Allowing for a 20 percent deduction for pass-through income creates an important mechanism for high income individuals to reduce their tax obligations by recharacterizing personal income as pass-through income. With around one half of the U.S. corporate tax base constituted as pass-throughs, this is counter to the authorities’ objectives of increasing equity—especially between those taxpayers that can, and cannot, arrange their activities to take advantage of the deduction—and simplifying the system. The TCJA does contain guardrails that limit the use of the pass-through deduction. However, it is unclear how effective those provisions will be in preventing an erosion of the personal income tax base from high income individuals or from stopping pass-throughs from redesigning their operations to maximize their ability to qualify for the 20 percent deduction.

D. International Provisions

23. The TCJA has the potential to significantly reshape the international tax system. The U.S. has abandoned its system of global taxation with deferral and moved to a modified territorial system that embeds anti-avoidance measures and a minimum tax on the offshore profits of U.S. multinationals. Staff had previously recommended moving to a territorial system, with a minimum tax on offshore profits, as an important step to simplify the corporate tax system while helping to contain global tax competition and profit-shifting. However, there is scope to strengthen the design of various of the international provisions in the Act:

  • To better curtail global tax competition, the minimum tax (the Global Intangible Low Taxed Income, GILTI) provision should be imposed on a country-by-country basis so that it falls on all profits earned in low tax jurisdictions (rather than on the average global profits of multinationals that are in excess of a deemed 10 percent return on tangible assets). As it stands, the link of this provision to worldwide profits and to tangible capital will create complex and distortionary effects on firm’s global investment decisions and may dilute its effectiveness in dis-incentivizing cross-border tax competition.

  • The lower tax rate for exporters (the Foreign Derived Intangible Income, FDII) should be eliminated to avoid the economic distortion that arises from providing a more favorable tax treatment for exports than for domestic sales. This would provide more of a level playing field for global investment decisions.

  • The Base Erosion Anti-Abuse Tax (BEAT) will likely serve its intended function of helping to curtail various base erosion and profit shifting behaviors, but it is also likely to be punitive for a range of legitimate commercial activities that are not linked to tax avoidance. The provision also creates a broad-ranging preference for domestic over foreign production and creates new incentives for companies to rearrange their operations to avoid application of the BEAT. These shortcomings would be mitigated, and international tax planning strategies would be better contained, by only applying this provision to those transactions that are designed to transfer profits to related parties that are located in low tax jurisdictions.

E. International Tax Policy Spillovers

24. The far-reaching and innovative features of the TCJA create a complex array of both positive and negative spillovers for other countries, which stakeholders are still analyzing. The move to territoriality heightens the likelihood of profits and investments being shifted from the U.S. into lower tax jurisdictions (there is evidence that a similar move in the U.K. indeed increased outward investment to lower tax jurisdictions). However, the marked reduction in the statutory rate and preferential treatment for some exporters in the U.S. are important countervailing forces, and could encourage other jurisdictions to lower their tax rates, particularly when they are clearly above the new U.S. statutory rate. One potential effect of the innovative GILTI and FDII provisions is to potentially encourage the location of tangible investments abroad (especially in cases where the firm’s effective foreign tax rate is low). This tendency will be strengthened for those projects that generate sizable commercial payments with related parties in other jurisdictions (since these may become subject to the BEAT if such intercorporate transactions are paid from a U.S. entity). At the same time, the GILTI provision is likely to discourage offshore jurisdictions from competing for U.S. investments by reducing their tax rate below 13.125 percent. It may even provide a floor on competition in the statutory rate, to the benefit of other relatively high tax rate jurisdictions. Furthermore, the reform could encourage other jurisdictions to consider ways, other than rate reductions, to compete for tangible investment. These could include faster depreciation rates (or even expensing), consideration of their own version of the BEAT, or other measures designed to achieve a similar, broad anti-profit shifting goal. The final impact on other countries (some of which have expressed WTO- and treaty-related concerns) is likely to vary considerably according to their circumstances.

Authorities’ Views

25. The administration regards the provisions of the Tax Cuts and Jobs Act to be a historic achievement that will spur economic growth while providing middle-class families with a significant tax cut. Treasury modeled the revenue impact of higher growth effects compared to previous projections using the Administration’s projections of approximately a 2.9 percent real GDP growth rate over 10 years contained in the Administration’s Fiscal Year 2018 Budget. The administration’s policies, relative to the baseline, would add around 0.7 percent to the annual real GDP growth rate over 10 years, with approximately half of this increase in growth coming from changes in corporate taxation. Further growth effects would arise from changes to pass-through taxation and the individual income tax as well as regulatory reform, infrastructure development and welfare reform. Expensing is regarded as a powerful tool to “front-load” the growth effects from the tax plan. This higher growth was estimated to generate enough revenue to cover the static cost of the tax bill. They also noted that, just in the few weeks and months after signing the Act into law, over six million American workers were given special bonuses, wage increases or other benefits. The authorities regarded that the new international provisions of the business tax system would encourage investment and jobs to return to the U.S. from abroad as well as prevent a “race to the bottom” by no longer encouraging companies to set up offshore entities in low tax jurisdictions.

Trade Policy

26. The U.S. has traditionally maintained a very open trade regime. Over the years, this has supported U.S. growth and job creation and helped raise living standards. U.S. leadership on trade has encouraged a range of countries to open their own trade regime, removing tariff and nontariff barriers. However, public concern over the side-effects of open trade has increased. It is in this context that various steps have been taken, or have been proposed, by the administration to impose new tariffs or otherwise restrict imports into the U.S.

27. As a prelude to these actions, the administration has undertaken several trade policy actions and reviews. These include an investigation into whether aluminum and steel imports “threaten to impair the national security” under Section 232 of the 1962 Trade Expansion Act, an investigation into whether China’s actions, policies, and practices (related to technology transfer, intellectual property, and innovation) are unreasonable or discriminatory and burden or restrict U.S. commerce under Section 301 of the 1974 Trade Act, a review of “Buy American” provisions in government procurement, and a study to assess the causes underpinning the U.S. trade deficit (specifically for those trading partners that have a significant bilateral deficit in goods trade with the U.S.) which was completed but has not been made publicly available. The U.S. also opened up a renegotiation of the North American Free Trade Arrangement (Box 6) and of the free trade agreement with South Korea.

28. In the past few months, the U.S. has imposed tariffs on a variety of imports. Based on section 232 of the Trade Expansion Act, the administration has concluded that steel and aluminum imports threaten to impair national security and has imposed a tariff of 25 and 10 percent on steel and aluminum, respectively (with exemptions for Australia and Argentina (both metals) and Brazil and South Korea (steel only)). Safeguard tariffs have also been imposed under Section 201 of the 1974 Trade Act on washing machines and solar panels based on a finding that imports of these goods have seriously injured U.S. producers. The section 301 investigation has concluded that China is pursuing unfair trade practices (related to the forced transfer of U.S. technology and intellectual property), and tariffs have been proposed on around US$150 billion of imports from China. The U.S. has filed a request for consultations with China at the WTO to address China’s technology licensing requirements. China has responded to these U.S. actions by proposing a list of tariffs on US$50 billion of U.S. products and requesting dispute consultations with the U.S. at the WTO. Most recently, the U.S. has temporarily put on hold the proposed tariffs on China, pending further discussions, but has initiated a section 232 investigation of imports of automobiles and automotive parts.

29. There is broad agreement that the global economy needs to be able to rely on an open, fair, and rules-based international trade system. These measures, though, are likely to move the globe further away from such a system, with adverse effects for both the U.S. economy and for trading partners. Specifically, they risk:

  • Catalyzing a cycle of retaliatory trade responses from others, creating important uncertainties that are likely to discourage investment at home and abroad.

  • Expanding the circumstances where countries cite national security motivations to justify broad-based import restrictions. This has the potential to undermine the rules-based global trading system and lead to heightened restrictions on trade in goods and services.

  • Interrupting global and regional supply chains in ways that are likely to be damaging to a range of countries, and to U.S. multinational companies, that are reliant on these supply chains.

  • Impacting a range of countries, particularly some of the more vulnerable emerging and developing economies, through increased financial market or commodity price volatility associated with these trade actions.

30. The U.S should work constructively with its trading partners to reduce trade barriers and to resolve trade and investment disagreements without resorting to tariff and non-tariff barriers. In such discussions, specific levels of the bilateral trade balance between the U.S. and other countries should not be viewed as either an anchor or a target (given that they are determined by a range of macroeconomic and structural forces and that targeting them is unlikely to reduce a country’s overall trade deficit). Rather, the goal should be to pursue the important gains that are to be had, for all parties, from strengthening the rules-based, multilateral trading system and from securing more ambitious bilateral and plurilateral agreements on trade and investment. The size, diversity, and dynamism of the U.S. economy leaves it especially well poised to benefit from such trade and investment liberalization. However, it is possible there will be important effects on both labor markets and the income distribution from greater trade integration. The consequences for trade-affected U.S. workers should not be ignored and policy efforts should focus on mitigating the downsides through training, temporary income support, and job search assistance (including through a broader deployment of the existing trade adjustment assistance program).

Authorities’ Views

31. The administration regards recent steps to impose tariffs as a step toward creating the leverage needed to achieve more free, fair and reciprocal trade. They regarded that most U.S. trading partners maintain regimes that create explicit and implicit barriers to U.S. exports and that there was a need to rebalance trade relationships, something that had been neglected by past administrations. They regarded the Chinese economy as a non-market system that was deeply distorted by pervasive subsidies, preferential industrial policies that unfairly bolster Chinese firms, obstacles to imports from the U.S., and various forms of discrimination against foreign firms (including forced technology transfer, disregard for intellectual property rights, and cyber theft). For NAFTA, their goal is to modernize the agreement and rebalance trade, particularly with Mexico and for the auto sector and were hopeful an agreement could be reached later this year. The U.S. was looking to change rules of origin so as to increase U.S. and North American content in the production chain; to require stronger labor standards (including fair collective bargaining); and to incorporate strong currency provisions into the final agreement. The administration noted that while Europe was one of the U.S. closest allies, they nevertheless maintained more trade protections on U.S. products than did the U.S. on European products. The authorities emphasized their strong commitment to the WTO and listed WTO reform as a key trade priority, welcoming reform proposals from other members. They recognized the risk to the global system of relying on national security as grounds for trade action, but expressed that lack of progress in international fora warranted such actions.

Impact of a Successful Renegotiation of NAFTA

Negotiations on an updated North-American Free Trade Agreement have been ongoing since August 2017. This box provides an assessment of the potential effects of a successful renegotiation for Canada, Mexico and the United States. The analysis focusses on tariff and non-tariff measures, as well as on rules on origin in the motor vehicles and auto parts sectors.

The scenario that is simulated assumes the elimination of all tariffs between the three signatories, a one-percent increase in good trade efficiency, a reduction by 25 percent of service trade inefficiencies, and a reduction in compliance costs from rules of origin provisions.

All three countries would benefit from a successful NAFTA renegotiation:

  • Real GDP would increase in all three countries.

  • Trade among the three countries would increase by 4 percent overall.

  • Canada’s bilateral trade surplus with the U.S. would fall by 25 percent; Mexico’s surpluses with Canada and the U.S. would remain largely unchanged.

uA01fig20

Percentage Change in Real GDP due to Successful NAFTA Renegotiation

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

The composition of production in the three countries would also change. Apparel and textile sectors would be growth areas in Mexico, apparel and motor vehicles would be the net gainers in Canada, while dairy products and textiles would expand in the U.S. Motor vehicles and auto parts output would increase in all three countries. The effects on services industries would be relatively small.

uA01fig21

Percent Changes in Output Volumes with Different Treatment of Rules of Origin for Motor Vehicles and Parts

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Tighter rules of origin in the automotive sector would offset some of these positive effects. If tighter rules of origin requirements were put in place, U.S. exports of auto parts to Canada and Mexico would decline, as would U.S. imports of vehicles from both countries. A greater share of the demand for parts and vehicles would be met from imports that come from outside of the NAFTA countries; Mexico’s auto industry would the most negatively affected.

Financial System Oversight

32. Important gains have been made in strengthening the financial oversight structure since the global financial crisis. Some useful steps are underway to recalibrate and simplify financial regulations and better tailor them to underlying risks:

  • Legislation has been signed into law that raises the total asset threshold to US$250 billion for bank holding companies (BHC) to be classified as systemic. This strikes a reasonable balance between a mandatary application of enhanced prudential standards and providing the Federal Reserve with the ability to deem BHCs with assets between US$100–250 billion as systemic and subject to such standards. This change will help lessen compliance costs for medium-sized BHCs but will necessarily increase the burden on high-quality and independent supervision to manage financial stability risks. Consideration should be given to continuing to apply stress-tests at a regular frequency for those banks that have assets between US$100–250 billion. In any case, implementation of these changes should be done in a way that does not weaken the ability of supervisors to take early remediation and risk mitigation actions for BHCs with assets below US$250 billion.

  • Modest changes have been made to exclude custodial assets from the calculation of the Supplementary Leverage Ratio, include highly liquid municipal bonds in the definition of High Quality Liquid Assets (subject to limits and haircuts), and exempt BHCs with total assets under US$10 billion from the Volcker rule. These appear to represent appropriate tailoring of the Dodd-Frank Act framework for financial oversight, although care should be taken to ensure that it does not deviate materially from international standards.

  • The Federal Reserve and the Office of the Comptroller of the Currency have proposed modifying the enhanced supplementary leverage ratio (eSLR) for globally systemic important banking organizations (GSIBs) to set the ratio at 3 percent plus a buffer of 50 percent of the entity’s risk-based capital surcharge. This would make the risk-based capital requirement, rather than the leverage ratio, binding for most GSIBs. The proposal is still somewhat more stringent than international minimum standards but would, however, diminish the buffers that have helped increase U.S. banking system resilience.

  • The Treasury has argued for changes to the resolution framework to strengthen the courts’ ability to deal with complex financial failures under a new special, streamlined bankruptcy procedure. This new process would complement—but not replace—the existing Orderly Liquidation Authority and more tightly circumscribe the authority granted to the FDIC—including in the use of public money—when it resolves a financial institution. It will be important that this change is implemented in a way that does not limit the flexibility of the resolution regime, hinder rapid action, or complicate cross-border resolution.

  • Finally, the Treasury has proposed steps to increase the transparency and analytical rigor of the FSOC’s designation process. These include comprehensive cost-benefit analysis and the provision of clear guidance for financial institutions that are designated as systemic. In assessing systemic risks, evaluations would be based on an activity-based framework and designation would be used only as a last resort (when systemic risks cannot be sufficiently mitigated through other means). These changes have the potential to strengthen the designation process but much will depend on how they are executed. Clarifying the changes to the process and the implementation of those changes should be done at an early stage.

  • The Federal Reserve has advanced for comment a proposal to lessen the compliance requirements for the Volcker Rule (a part of the Dodd-Frank Act that aimed at restricting the ability of banks to engage in proprietary trading). The complexity, and in some cases ambiguity, of the regulation has long been considered a problem that creates regulatory uncertainty, raises compliance costs, and was difficult to enforce. The proposed measures are largely aimed at simplifying the regime, making it easier to enforce, and moving toward a more risk-based standard. Such changes are justified based on the experience to date with the rule but it will be important to clarify how the revised rule will be enforced and how much latitude banks will have for self-policing as well as carefully monitor the effects of its implementation.

33. When each is taken in isolation, the steps proposed to better tailor financial regulations are likely to have only a modest impact on financial stability risks. However, there are also potentially important interactions between the various regulatory changes, that largely move in a procyclical direction, and the effects of the procyclical fiscal policy that is currently in place. This is of even greater concern since, as discussed above, medium-term financial vulnerabilities have been steadily building and medium-term financial stability risks are elevated. More analysis is needed to build a clear picture of the combined effect of all these changes taken together.

34. Future changes to financial oversight should ensure that the current risk-based approach to regulation, supervision and resolution is preserved. Risk based capital and liquidity standards, combined with strong supervision, should remain a central tool in incentivizing financial institutions to manage well the risks they undertake. In support of these capital and liquidity requirements, the Comprehensive Capital Analysis and Review exercise should be maintained and strengthened, including in its assessment of liquidity and contagion risks. While tailoring is fully justified, a greater burden of managing financial stability risks will be placed on high-quality and independent supervision. The FSOC should continue its efforts to respond to emerging threats to financial stability and, in this work, there is scope to strengthen, and more fully resource, the Office of Financial Research. Finally, the U.S. should remain engaged in developing the international financial regulatory architecture and should be fully committed to agreed international standards.

35. There remains a need to strengthen the oversight of nonbanks. As has been highlighted in previous consultations, there are potential weaknesses in oversight arising from the absence of harmonized national standards or consolidated supervision for insurance companies. Also, recent proposals to limit the engagement of federal authorities in international supervisory fora could prove cumbersome for the insurance standard setting process and the development of the global capital standard. Progress has been made in money market reform but residual vulnerabilities, in repo markets and for money market funds, remain. There is also a need to introduce a comprehensive liquidity risk management framework for asset managers (that includes liquidity risk stress tests). Little progress has been made in reforming the housing finance system or the government sponsored enterprises. Finally, impediments to data sharing among regulatory agencies remain and there are data blind spots, particularly related to the activities of nonbanks, that preclude a full understanding of the nature of financial system risks, interlinkages and interconnections.

Authorities’ Views

36. The administration is committed to make financial regulation efficient and appropriately tailored to the size and systemic risk profile of the institutions, while preserving the improvements made since passage of the Dodd-Frank Act. Changes to the eSLR were necessary to make risk-based capital standards the binding constraint (rather than the minimum leverage ratio, which is supposed to serve as a backstop). Similarly, the orderly liquidation framework was maintained, including the orderly liquidation fund, but the role of courts has been strengthened. The increased room for maneuver provided by the Economic Growth, Regulatory Relief, and Consumer Protection Act will be used to further tailor the supervision of small and medium-sized bank holding companies. Separately, the FSOC will use an activities-based approach to systemic risks, relying to the extent possible on the primary regulators, with designation of systemically important financial institutions reserved for instances where this approach is insufficient; in addition, the designation process will be more transparent and accompanied by a clear path for de-designation. Implementing a stress capital buffer instead of fixed capital surcharges formalizes the capital constraint for large bank holding companies. The authorities do not see the banking system as an imminent source of financial stability risk, and risks from institutions outside the regulated perimeter are assessed to be moderate (insurance industry, asset management, crypto currencies and cyber risk).

Competition Policy

37. The market power of corporations is becoming more pronounced across a range of major U.S. industries, with important macroeconomic effects.1 Margins between prices and variable costs—markups—have been rising steadily since the 1980s, and at an accelerated pace since 2010. Measures of industry concentration and profitability mirror this increase in market power. Corporate level data for U.S. publicly traded firms suggest that these trends have been driven by an increase in rents that are accruing to a relatively small, but growing, number of “superstar” firms (some of which have been created through mergers and acquisitions). The same dynamics appear to be underway in other advanced economies, although not in emerging market economies.

uA01fig22

Markups in Advanced Economies

(ratio of price to variable cost)

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Source: IMF staff estimates. Note: Sales weighted averages.
uA01fig23

Distribution of Markups of U.S. Firms

(ratio of price to variable cost)

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Source: IMF staff estimates for U.S. publicly traded firms.

38. While there is significant heterogeneity in the causes underlying this rising market power, the evidence suggests that these developments are having important effects on macroeconomic outcomes. These include:

  • Potentially depressing future investment and R&D spending. There appears to be a non-monotonic relationship between market power, market concentration, and investment spending (on both physical capital and on R&D). At low levels of markups, an increase in market power is associated with more investment but eventually higher markups begin to weaken the incentives to invest, particularly for companies operating in industries with high levels of market concentration. These findings suggest that firms initially invest heavily (in both physical capital and R&D) to establish their market power. However, once the industry becomes concentrated and firms have consolidated their market position, they act more like monopolists, limiting investment below that which would occur in the competitive case.

  • Putting downward pressure on the labor share of income. Higher markups and higher market concentration are associated with a declining labor share. Company level data suggests that, as companies increase their market power, they start to appropriate a growing share of the rents from production, leaving smaller returns accruing to labor (with knock-on effects to the income distribution and consumption growth).

uA01fig24

Investment Rate versus Markup

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Note: Dashes indicate 90 percent confidence interval.Source: IMF staff estimates for U.S. publicly traded firms.

39. The right policy responses to this increase in market power are complex.

  • In cases where barriers to entry or increasing returns are driving the increase in market power, and where that power is being used to price discriminate, restrict supply or engage in predatory pricing, there is a clear role for applying antitrust policies.

  • In other cases, network and information externalities or increasing returns to scale may justify an oligopolistic structure. However, supernormal profits or rents from such market power should be taxed fairly. Care is needed, though, in not unintentionally placing an unfair tax burden on returns that arise from up-front investments (in areas such as R&D, for example). This could be achieved, for example, by moving to a cashflow tax or another form of rent tax.

  • In either case, public policy should certainly focus on ensuring that markets remain contestable and on preventing corporate practices that constitute a restraint of trade. It may also sometimes be appropriate for the entity providing the service to be regulated.

  • Finally, insofar as increased market power arises from greater efficiency or technological innovation, there may be a public policy role to help workers displaced by such changes in market structure, including through relocation or retraining support. Such support should be broad-based and apply to all workers that are facing a transition (whether it is a symptom of changes in trade patterns, of technology, or of shifts in market power).

Authorities’ Views

40. The administration is committed to protecting consumers from anticompetitive, deceptive, and unfair business practices without unduly burdening legitimate business activity. There is some evidence of increasing concentration in some industries, and close antitrust scrutiny is warranted. At the same time, the evidence regarding broad economy-wide trends in market power is inconclusive. Market power indicators do not lend themselves to meaningful comparisons across industries. While market power does not currently represent a significant risk to the U.S. economic outlook, the administration intends to rigorously enforce antitrust laws to prevent anticompetitive mergers or other anticompetitive business practices.

Staff Appraisal

41. Economic outlook. The near-term outlook for the U.S. economy is one of strong growth and job creation. These positive outturns have supported, and been reinforced by, a favorable external environment with a broad-based pick up in global activity. Next year, the U.S. economy is expected to mark the longest expansion in its recorded history. However, the same policies that are boosting near-term prospects are creating a number of vulnerabilities for the medium-term.

42. Fiscal policy. The U.S. is pursuing a procyclical fiscal policy that will elevate the risks to the U.S. and global economy. The planned expansion in the fiscal deficit should be reversed. The administration’s chosen policy path will add to an already-unsustainable public debt, contribute to a rise in global imbalances, and increase risks of future recession, with concomitant negative spillovers to the global economy. The increase in the federal deficit is expected to have only modest effects on potential output and will leave few budget resources available for the government to invest in a range of urgently needed supply-side reforms that would boost medium-term growth and raise living standards.

43. Monetary policy. The sizable fiscal stimulus will likely mean that the Federal Reserve will need to raise policy rates at a faster pace to achieve its dual mandate. Policy rates will likely need to rise, for a time, above the long-run neutral rate. In executing its monetary policy decisions, the Fed’s continued adherence to the principles of data dependence and clear communication will be vital. An inflation surprise, driven by capacity constraints becoming more binding and the economy pushes further through full employment, represents an important risk that, if realized, would create volatility and disruptions in U.S. and international financial markets with negative spillovers to other countries.

44. Tax policies. The U.S. should aim to increase its revenue-to-GDP ratio through a greater reliance on indirect taxes. Personal income tax relief should be targeted at those earning close to or below the median income, including through a more generous and expansive Earned Income Tax Credit. The business tax should transition to a cashflow tax, making permanent the immediate expensing of capital spending and eliminating interest deductibility for new debt. International provisions should be redesigned to impose a minimum tax that is targeted more narrowly to low-tax jurisdictions and to avoid discriminatory treatment between imports, exports, and production for domestic use.

45. Trade. The U.S and its trading partners should work constructively together to reduce trade barriers and to resolve trade and investment disagreements without resorting to the imposition of tariff and non-tariff barriers. The various trade measures that have been unilaterally proposed or enacted by the administration are likely to move the globe further away from an open, free, fair, reciprocal and rules-based global trading system. This would both damage the U.S. economy and lead to negative spillovers to trading partners including by catalyzing a cycle of retaliatory trade responses from others and expanding the circumstances where countries cite national security motivations to justify broad-based import restrictions.

46. Financial stability. Important gains have been made in strengthening the financial oversight structure since the global financial crisis. Near-term risks to financial stability appear to be broadly similar to those at the time of the last Article IV but medium-term risks are elevated. These risks include those that arise from high equity market valuations, rising leverage and a weakening of underwriting standards for corporate credit, the growth of passively managed investment products and the uncertainties pose by cyber risks. Recent proposals to simplify regulations generally represent further improvements but also place a greater burden on high-quality and independent supervision to manage financial stability risks. Future changes to financial oversight should continue to ensure that the current risk-based approach to regulation, supervision and resolution is preserved. There is an ongoing need to strengthen regulatory and supervisory oversight of nonbanks.

47. Outward spillovers. The net effect of U.S. policy choices—related to the budget and tax policy—will be to provide a near-term boost to trading partner output but also to increase the range and size of future risks and uncertainties and add to global imbalances. Insofar as the chosen policy mix prompts a tightening of global financial conditions, countries with high levels of U.S. dollar debt and/or a significant rollover need are likely to come under pressure. There is also a risk of a marked reversal of capital flows, away from emerging markets, which could be disruptive. We are already starting to see symptoms of these negative spillover effects in other countries.

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

Table 1.

United States: Selected Economic Indicators

(percentage change from previous period, unless otherwise indicated)

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

Contribution to real GDP growth, percentage points.

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

Table 2.

United States: Balance of Payments

(percentage change from previous period, unless otherwise indicated)

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

United States: Federal and General Government Finances

(percent of GDP)

article image
Sources: Congressional Budget Office; Office of Management and Budget; and IMF staff estimates.Note: Fiscal projections are based on the June 2017 Congressional Budget Office baseline adjusted for the IMF staff’s policy and macroeconomic assumptions. Projections incorporate the effects of tax reform (Tax Cuts and Jobs Act, signed into law end-2017) as well as the Bipartisan Budget Act of 2018 passed in February 2018. 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. Data are compiled using SNA 2008, and when translated into GFS this is in accordance with GFSM 2014. Due to data limitations, most series begin 2001.

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)

article image
Note: 2017 data is the average from 2017Q1-Q3.DCCBS: Domestically controlled cross-border, cross sector consolidation basis.DC: Domestic consolidation basis.DCCB: Domestically controlled, cross-border consolidation basis.CBDI: Cross-border consolidation basis.FBB: Foreign bank branch consolidation basis.OTHER: Other consolidation basis.NA: Not Applicable.MIXED: Mixed.

Annex I. Risk Assessment Matrix1

article image
article image

Annex II. External Sector Assessment

article image

Annex III. Public Debt Sustainability Analysis

The U.S. budget deficit started rising in 2016, following a decline during 2010–15, and the U.S. public debt-to-GDP ratio is on an unsustainable path. Under the baseline scenario, public debt is projected to rise over the medium term, as age-related spending pressures on entitlement programs assert themselves and interest rates normalize. In addition, tax cuts and discretionary spending increases enacted since late-2017 are adding to the pressure on the U.S. public finances. Gross financing needs are large, but manageable given the global reserve currency status of the U.S. dollar. A credible medium-term fiscal adjustment featuring reprioritization of budget programs and revenue-gaining tax reform is needed to put public debt on a downward path.

1. Background. Significant fiscal consolidation measures were legislated in 2011–13 to tackle the high public debt ratio, which had doubled at the federal government level since 2007 because of the Great Recession and associate fiscal measures. The Bipartisan Budget Acts of 2013, 2015, and 2018 partially reversed the cuts scheduled to take place since FY2014, partially replacing them with savings generated through cuts to mandatory spending in later years. On the other hand, the Tax Act of 2015 and the Tax Cuts and Jobs Act of 2017, extended many tax cuts through the medium term and made some permanent, in addition to introducing new tax cuts. This will lead to higher deficits in the medium and long term.

2. Baseline. The staff’s baseline is based on current laws. Under this baseline, public debt is projected to continue rising as age-related spending pressures on entitlement programs assert themselves and interest rates normalize. Federal debt held by the public is projected to increase from about 77.4 percent of GDP in 2017 to around 95.6 percent of GDP in 2027, with general government gross debt rising from about 107.8 percent of GDP to 120 percent of GDP during this period.

3. Adjustment scenario. The 2017 general government primary deficit was 2.5 percent of GDP. In staff’s view, aiming for a medium-term general government primary surplus of about 1¼ percent of GDP (a federal government surplus of about 1½ percent of GDP) would be appropriate to put the public debt ratio firmly on a downward path. The target primary surplus would have to be larger to bring the debt ratio closer to pre-crisis levels by 2030.

uA01fig25

Federal debt held by the public

(percent of GDP, fiscal year)

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Source: IMF staff estimates.

4. Debt servicing costs. The fiscal projections benefit from the current favorable interest rate-growth differential. Reflecting accommodative monetary policy and the safe-haven status of the United States, real interest rates have fallen well below GDP growth. Under the staff’s baseline, the effective interest rate is projected to rise gradually from the currently still low level of 1 percent and reach 3.7 percent by 2027 (which is near its2006–16 average level). Thus, real interest rates will become a major debt-creating flow over the medium-term.

5. Realism. Baseline economic assumptions and fiscal projections are generally within the error band observed for all countries. While ambitious, the projected fiscal adjustment is realistic based on the consolidation episodes observed in 1990–2011.

6. Stress tests. The public debt dynamics are highly sensitive to growth and interest rate assumptions, primarily reflecting the fact that the U.S. public debt ratio already exceeds 100 percent of GDP. An increase of 200 basis points in the sovereign risk premium would raise the debt ratio to about 130 percent of GDP by 2027, about 10 percentage points of GDP above the baseline. Similarly, were real GDP growth to be one standard deviation below the baseline, the public debt would increase by about 10 percentage points above the baseline. A scenario involving a 1 percentage point of GDP larger fiscal deficit over the next two years would increase public debt by about 5 percentage points above the baseline in 2027. A combined macro-fiscal shock could raise the public debt ratio to as high as 145 percent of GDP by 2027. An exchange rate shock is unlikely to have important implications for debt sustainability in the United States given that all debt is denominated in local currency and the reserve currency status of the dollar.

7. Mitigating factors. The depth and liquidity of the U.S. Treasury market as well as its safe-haven status at times of distress represent a mitigating factor for relatively high external financing requirements.

Figure 1.
Figure 1.

United States: Public DSA-Baseline Scenario

(Percent of GDP, unless otherwise indicated)

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Source: IMF staff1/ Public sector is defined as general government2/ Based on available data3/ Bond Spread over German Bonds4/ Defined as interest payments divided by debt stock at the end of previous year5/ Derived as [(r – p(1+ g ) – g + ae(1+r)]/(1+ g+ p +gp)) times previous period debt ratio, with r = interest rate; p = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation6/ The real interest rate contribution is derived from the denominator in footnote 4 as r – π (1+g) and the real growth contribution as -g7/ The exchange rate contribution is derived from the numerator in footnote 2/ as ae(1+r).8/ For projections, this line includes exchange rate changes during the projection period. Also includes ESM capital contribution, arrears clearance, SMP and ANFA income, and the effect of deferred interest9/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year
Figure 2.
Figure 2.

United States: Public DSA-Composition of Public Debt and Alternative Scenarios

Composition of Public Debt

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Source: IMF staff
Figure 3.
Figure 3.

United States: Public DSA-Realism of Baseline Assumptions

Forecast Track Record, versus all Countries

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Source : IMF staff1/ Plotted distribution includes all countries, percentile rank refers to all countries. Projections made in the spring WEO vintage of the preceding year2/ Data cover annual obervations from 1990 to 2011 for advanced and emerging economies with debt greater than 60 percent of GDP. Percent of sample on vertical axis
Figure 4.
Figure 4.

United States: Public DSA-Stress Tests

Macro-Fiscal Stress Tests

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Source: IMF staff
Figure 5.
Figure 5.

United States: Public DSA-Risk Assessment

Heat Map Baseline (2015–2025)

Citation: IMF Staff Country Reports 2018, 207; 10.5089/9781484366073.002.A001

Source: IMF staff1/ The cell is highlighted in green if debt burden benchmark of 85% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant2/ The cell is highlighted in green if gross financing needs benchmark of 20% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant3/ The cell is highlighted in green if country value is less than the lower risk-assessment benchmark, red if country value exceeds the upper risk-assessment benchmark, yellow if country value is between the lower and upper risk-assessment benchmarks. If data are unavailable or indicator is not relevant, cell is white. Lower and upper risk-assessment benchmarks are: 400 and 600 basis points for bond spreads; 17 and 25 percent of GDP for external financing requirement; 1 and 1.5 percent for change in the share of short-term debt; 30 and 45 percent for the public debt held by non-residents4/ An average over the last 3 months, 17-Feb-18 through 18-May-185/ Includes liabilities to the Eurosystem related to TARGET

Annex IV. Implementation of FSAP Recommendations1

article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image