The Impact of Tax Cuts Versus Tariffs on the U.S. Economy

Current Economic Landscape

The much-anticipated post-election rally appears to be losing momentum as inflation concerns resurface. The S&P 500 index has recently dropped below the critical 6,000 level, and Treasury yields are hovering near four-month highs. Compounding this uncertainty is the Federal Reserve’s assertion that it is not in a hurry to reduce interest rates. Amid these circumstances, Peter Berezin, chief global strategist at BCA Research, has heightened the likelihood of a U.S. recession within the next 12 months to 75%.

Berezin’s Economic Assessment

Berezin’s rationale for this elevated recession probability stems from the belief that the economic benefits derived from President Donald Trump’s tax cuts and deregulation are unlikely to outweigh the adverse effects of proposed government spending cuts and tariffs on imports. While he anticipates a full extension of the Tax Cuts and Jobs Act (TCJA) and potentially a reduction in the corporate tax rate to 15% for domestic manufacturers, he warns that these benefits could be offset by cuts in critical social programs. Many Republicans are inclined to reduce governmental support for Medicaid, food stamps, housing assistance, and other safety nets that aid the less fortunate.

Berezin expresses concern that, despite the relative small size of these programs, they possess significant economic multiplier effects, as recipients typically spend the income or transfer payments they receive.

The Tariff Dilemma

Adding to this economic conundrum are Trump’s proposed tariffs. Berezin is skeptical that they are merely a negotiating tactic, observing a deeper intent behind Trump’s policies. “For Trump, tariffs are not a means to an end; they are the end in themselves. Trump genuinely desires to erect a tariff wall around the U.S.,” he states.

Notably, a recent study by The Budget Lab at Yale showed that Trump’s tariffs could reduce real disposable income for median U.S. households by between $1,900 and $7,600 annually. Berezin argues that even if all this lost income were offset by tax cuts, the overall impact on aggregate demand would remain negative. This is largely because tariffs disproportionately affect lower-income consumers, who are more likely to spend their income promptly.

The Tax Cuts and Jobs Act’s Limited Impact

Reflecting on previous economic trends, Berezin recalls that the passage of the TCJA in 2017 did not significantly boost capital spending. He notes that the potential magnitude of any further tax cuts is diminished compared to Trump’s initial term, while the potential negative repercussions from a renewed trade conflict are amplified.

Implications for Borrowing Costs

As tax cuts potentially increase the federal debt by $5.35 trillion over the next decade, primarily due to the extension of provisions in the TCJA, the implications for borrowing costs cannot be ignored. Expanded government borrowing could lead to more Treasury issuances and potentially higher yields. Coupled with inflationary pressures from tariffs and wage increases as immigration policies tighten, the Fed’s stance may shift. Thus, Berezin anticipates that the Fed will approach rate cuts with caution, wary of the potential for inflation to spiral out of control.

Conclusion: The Bearish Outlook for Markets

In summary, Berezin raises alarm about the possibility of a U.S. recession, adjusting his probability from 65% to 75%. The projections from entities like Goldman Sachs and Bank of America indicate that Trump’s proposed corporate tax rate cut from 21% to 15% could increase S&P 500 earnings per share by approximately 4%. However, he cautions that the market may have already absorbed this potential uplift.

Furthermore, Barclays estimates that a 60% tariff on Chinese imports, alongside a 10% tariff on other nations, could decrease S&P 500 EPS by 3.2%. The unwelcome prospect of retaliatory tariff measures would worsen the earnings outlook, raising it to 4.7%.

For bond markets, the initial effect of a trade war could be a rise in inflation; however, a subsequent economic slowdown could ultimately lead to deflationary benefits for bonds. In light of these considerations, Berezin advocates for a “modest underweight on stocks and a modest overweight on bonds,” suggesting a complete shift toward bonds once clearer recession signals emerge.

In an increasingly complex financial landscape, investors should remain vigilant and cautiously observe the unfolding interplay between fiscal policies, tariffs, and their overall impact on economic stability and market dynamics.