Productivity growth and the sugar high

| March 29, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The prevailing view is that the 2017 tax cut produced a classic example of fiscal stimulus: a boost to the demand side of the economy which moves through the system quickly and then dissipates, producing a so-called sugar high for the economy. However, the 2017 tax reform mainly impacted the economy by improving incentives for businesses to invest, not by providing households with a one-off cash injection. An overwhelming proportion of economists and market participants are convinced that the economy will decelerate sharply in 2019, partly due to an erosion of fiscal stimulus. This year will provide a crucial test of dueling narratives of how fiscal policy affects the economy. A key metric that will help settle the debate is productivity growth. A pickup in efficiency gains on the back of strong investment growth last year suggests that the tax reform’s economic boost has a substantial supply side component, and thus will have staying power in 2019 and likely beyond.

Business investment surges

The 2017 corporate tax reform had three key provisions that encouraged more business investment.

  • First, the top marginal corporate income tax rate was slashed.
  • Second, a change in how income is taxed reduced the incentive for firms to relocate overseas.
  • Third, and most importantly, corporations are now allowed to fully expense many types of investments for tax purposes in the first year rather than following a multi-year depreciation schedule.

The combination of these three changes should provide a boost to business investment that lasts a lot longer than two or three quarters, which is the duration of the already-dissipated sugar high contention of the consensus.

In reality, business fixed investment exhibited strength throughout 2018, rising at a 7.0% annualized clip over the four quarters of last year, up from an already-robust 6.3% rise in 2017 (by comparison, this aggregate declined by 0.7% in 2015 and rose by an anemic 1.8% in 2016). The sugar-high crowd got excited when business fixed investment cooled in the third quarter, advancing at only a 2.5% pace.  By the time fourth quarter GDP figures came out in February, showing a rebound to over 5% annualized growth, the narrative of sagging business investment growth had already taken root, and analysts were seemingly uninterested in evidence that did not promote the story.

The most striking performance within the business investment aggregate last year was the intellectual property component, which mainly consists of research and development outlays and purchases of software. Growth in this category had trended in the mid-single digits through 2017 but exploded higher by 10.2% last year. As with the broader aggregate, sugar-high proponents were quick to declare an end to the strong performance after the quarterly advance slowed to 5.6% in Q3, but Q4 returned to double-digit growth (for the third quarter out of four last year).  This is the very best kind of investment to see, as these sorts of outlays are most likely to yield long-lasting gains in labor productivity by transforming business practices, and/or creating all new products and services to sell to consumers and businesses.

Productivity growth follows

One of the defining characteristics of the anemic expansion from 2009 through 2016 was that business investment was sub-par through most of the period.  When businesses are not spending to improve their operations, it is difficult for workers to become more productive.  It is no coincidence that productivity growth slowed to an abysmal 0.6% annual average from 2011 through 2016 (see Exhibit 1).

Exhibit 1: Nonfarm business productivity growth (Q4/Q4)

Source: BLS

The pickup in business investment in 2017 and 2018 has already yielded benefits in terms of productivity growth, which posted a 1.0% advance in 2017 and a 1.8% rise in 2018, the best annual performance since 2009.

2019: Make-or-break year

This year will be the pivotal one for settling the debate over whether the effects of corporate tax reform were brief and already past or will continue for an extended period.  The year is likely to have gotten off to a sluggish start, as uncertainties related to the federal government shutdown and the possibility of tariff hikes reportedly led many firms to retreat to the sidelines to allow the dust to settle.  However, if the completion of a trade deal in the spring provides greater certainty, businesses should resume a robust clip of investment growth, as they continue to take advantage of the improved tax and regulatory environment.  Business fixed investment will almost certainly slow after a stellar 2018 performance, but another annual rise in the 5% range would suggest persistent strength and help to propel the economy to another period of growth well above 2%.  In contrast, the latest Blue Chip consensus calls for a gain of closer to 3% in 2019, consistent with a moderation to around 2% overall GDP growth.

Implications of faster productivity growth

If productivity growth is moving persistently higher, there are wide-ranging and meaningful implications for the medium-term economic outlook.  First, an acceleration in productivity growth is a sure path to a non-inflationary pickup in wage gains.  If workers are able to produce more widgets per hour due to a better assembly line, companies can afford to pay them more without having to raise widget prices – further loosening the link between wage hikes and inflation.  Second, an acceleration in trend productivity growth should translate on a one-for-one basis to potential real GDP growth.  The economy’s potential growth rate is generally thought to equal the sum of the increase in labor supply and productivity growth.  The former depends mostly on demographics and is currently running close to ¾% per year.  Thus, trend productivity growth in the neighborhood of ½%, where it averaged from 2011 through 2016, implies potential growth of about 1¼%, well below the FOMC’s 1.8% long-run estimate, which likely explains why the unemployment rate fell so rapidly during that time period despite lackluster GDP growth.  In contrast, if productivity growth is accelerating on a persistent basis, say to 1.5%, then potential real GDP growth is suddenly above 2%.  Third, if trend growth is higher, then the equilibrium real interest rate for the economy, what the Fed calls r*, should also be higher, on pretty close to a one-for-one basis.  While higher productivity growth reduces inflationary pressures for any given growth outcome in the short run, by raising the return on investment, it requires a higher interest rate to reach equilibrium, which means higher “neutral” interest rates in the long run.  There are numerous other major implications of faster trend productivity growth, nearly all of them good, e.g. lower budget deficits all else equal, so the business investment and productivity figures will be worth keeping a close eye on in 2019.

john.killian@santander.us 1 (646) 776-7714

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