Month: March 2021

Inflation expectations will determine the success of the US stimulus package

Thanks largely to low interest rates, the US’s stimulus package is fiscally manageable. Fiscal restraint will be required however, to ensure it remains so.
The US not only has old-fashioned cheques (checks), but checks in the post (mail) nogal. No fewer than 90 million cheques worth $1,400 each have been mailed so far to Americans earning less than $400,000, with more to come.  The dollars will find their way out of the Federal Reserve Bank (Fed) into individual banking accounts, or cashed in, which will add to both bank deposits and the cash reserves of the banks with the Fed. Deposits with US banks are up by 26% since January 2020 and the cash reserves of US banks are up by 92%. Both represent huge firepower for additional spending on goods and services, and bank lending over the next year.
US growth in cash reserves of the banking system and growth in bank deposits
US growth in cash reserves of the banking system and growth in bank deposits chart
Source: Federal Reserve Bank of St Louis and Investec Wealth & Investment
The debt-to-GDP ratio will rise to over 130% and the fiscal deficit will soon approach 30% of current GDP. But interest rates remain exceptionally low – the average interest paid on all US debt is only 2% a year and interest payments account for 9% of all federal spending. In 1990, interest payments accounted for 23% of the federal budget at an average interest rate on the debt of about 10%. In short, these are now comfortable fiscal conditions. These ratios improved appreciably in the 1990s, thanks to lower deficits. The borrowing requirements of governments can and indeed have to be restrained by some mixture of spending less and taxing more – both hard to do.  Another $3 trillion of US government spending on so-called infrastructure is coming down the pike. There will be no fiscal crisis for the US on the horizon, if US borrowing costs remain low. But can they?
Average interest paid on US debt and Interest paid as a percentage of all Federal government spending
Average interest paid on US debt and Interest paid as a percentage of all Federal government spending chart
Source: Federal Reserve Bank of St Louis and Investec Wealth & Investment
It will depend on how much inflation is expected over the next 10 years. The higher the expectation of inflation, the higher the cost of raising government debt will be. Interest rates rise with higher inflation expectations in an almost lockstep way. The expected annual inflation rate over the next 10 years in the bond market is of the order of an unthreatening 2.2%. The higher the cost of borrowing, the more likely governments may resort to printing more money to fund their spending, which in turn will reinforce spending and increase the rate of inflation (and raise expectations of inflation).

All will depend on the scale of US borrowing expected over the next 10 years.  It will have to slow down to something like normal to prevent the US Budget from being overwhelmed by higher interest rates. Janet Yellen, the Treasury Secretary, told Congress that taxes will have to rise to pay for the extra $3 trillion. Will they, or will the unpopular prospect of higher taxes restrain spending ambition? It will take more than taxing the rich to pay the piper.

US ratio of Federal government debt and fiscal deficits to GDP
US ratio of Federal government debt and fiscal deficits to GDP chart
Source: Federal Reserve Bank of St Louis and Investec Wealth & Investment
US Federal government deficits
US Federal government deficits chart
Source: Federal Reserve Bank of St Louis and Investec Wealth & Investment
Fed Chairman Jerome Powell is relaxed about inflation for now and he remains determined to help the US economy get back to full employment. He is waiting to see what will happen and he believes he has the tools to dial inflation back should it rise temporarily – as is widely expected.

So what are these tools? Mainly, it is the power to control short-term interest rates by adding or taking away dollars from the system. He does not however control how much the government spends, how much it taxes and how much it will have to borrow. The higher he sets short-term interest rates, of course, the less popular he will become. His political independence should not be taken as a permanent given.

Powell is confident that inflation is well anchored around the current 2% annual rate, the Fed target for inflation. Actual inflation however depends on expected inflation and on the difference between actual GDP and potential GDP – the output gap. Powell believes the Fed has this gap under control. But without active co-operation from fiscal policy to restrain government spending over the long run, this inflation anchor could easily slip away. As with the Fed, we will wait and watch.

National Treasury’s tax epiphany

There is more to tax than what appears on the surface – ask National Treasury and South African homeowners.

National Treasury has had an epiphany. It has acknowledged that higher taxes can lead to slower growth and that lower taxes can lead to faster growth. Hence the decision to forgo R40bn of planned income tax increases and to propose a reduction in the corporate tax rate to 27%. All in the interests of faster growth. Hallelujah.

The Budget Review recognises that taxes have complicated feedback effects. It recognises that the burden of higher corporate taxes ends up being passed on to consumers of goods and services, in the form of higher prices and lower incomes for those who provide labour and other services to the corporation. The supply of capital to the SA enterprise and hence the supply of goods, services and the demand for labour and land, is determined by the required after-tax returns of investors. Higher taxes will reduce expected returns and so the supply of capital, goods, services and the demand for labour. The supply of capital for SA is sourced globally and the required returns are determined in the global market, as the Review recognises.

The Review could have added that personal income tax rates have supply side effects. It is the after-tax benefits provided to taxpayers by governments that establish the standard of living, which in turn determines the willingness to supply labour to an economy. The more internationally mobile the providers of labour services are, the more of a global market South African firms have to compete in for the supply of indispensable skills. Raising income tax rates at the margin drives the emigration of human capital and leads to higher prices to cover higher after-tax costs of inputs. Lower taxes could help do the opposite, that is increase supply of capital and skills. Faster growth becomes possible with a lower tax burden.

The share of income of those who will report taxable income of more than R1.5m in 2021-02 (a mere 113,192 taxpayers) are in the highest of nine tax brackets. They report 12% of all income and will pay over 26% of all personal income tax. Only when annual incomes are above R500,000 does the share of income taxes paid exceed the share of incomes earned. The numbers of high earners and taxpayers in SA have been stagnating. We need more of them to help grow the economy and provide for the relief of poverty.

It is the mix of taxes and the benefits supplied by governments that determines the standard of living and that drives the migration of labour and capital. The burden of income taxes in South Africa is highly progressive, as are the benefits of government spending. Higher income earners in South African pay much of the personal income tax and draw very little on government benefits provided.

Figure 1: Population by the nine income tax brackets (millions)

Population by the nine income tax brackets (millions) chart

Source: Budget Review 2021-2020, Chapter 4 Table 4.5, Investec Wealth & Investment, 24/02/2021

Figure 2: Share of income and income tax paid of the nine income tax brackets (percent)

Source: Budget Review 2021-2020, Chapter 4 Table 4.5, Investec Wealth & Investment, 24/02/2021

Share of income and income tax paid of the nine income tax brackets chart

Figure 3: Average income tax saved (rand per annum) per member of each tax bracket (total income tax saving = R51bn)

Average income tax saved (rand per annum) per member of each tax bracket chart

Source: Budget Review 2021-2020, Chapter 4 Table 4.5, Investec Wealth & Investment, 24/02/2021

For evidence of the relationship between taxes paid and benefits provided by government, one need only compare residential property prices in Cape Town with those in the other cities and towns. They can watch the business television channels, to be aware that magnificent homes in Johannesburg or Durban can be had for the price of a small two-bedroomed apartment in Cape Town. This is because of the more favourable mix of higher property taxes (not necessarily higher wealth tax rates) that are paid in return for comparatively good services provided by the local government.

Homeowners should be aware that higher taxes can more than pay for themselves when there is good government. And higher taxes will destroy their wealth when the service is inadequate for the taxes paid.