Oregon Office of Economic Analysis

Right now the U.S. economy is near full employment and operating at full capacity. The unemployment rate is low, and set to decline further as job growth continues to outpace labor force gains. Wages are rising, and inflation is picking up after five years of running below target. It is clear the business cycle has not yet waned. However, it is important to keep in mind that when economists talk about GDP being at potential – our office included – it really is a beaten down potential, or one of lower expectations today than a few years ago. Now, it makes some sense that potential GDP is lower today than before the financial crisis, which tends to leave scars and expose issues that take longer to heal. However, just how much lower potential GDP is today remains an open question that relies on estimates and methodological choices to answer. As you can see in this edition of the Graph of the Week, the U.S. economy today is just a bit above the Congressional Budget Office’s most recent estimate of potential GDP. However it remains four percent below their 2014 estimates and eleven percent below their 2007 estimates.

Now, the economy may truly be at capacity and will continue to run into supply side constraints, possibly sooner than expected. However, it may also be further from full employment or potential GDP than is commonly believed. This is why some economists believe that current federal fiscal policy — the combination of tax cuts and spending increases — has relatively limited risks. Or at least risks that skew toward the upside, rather than the downside. As such, to the extent that this fiscal experiment of providing stimulus into a relatively strong economy can wring out those last few percentage points of prime-age employment, or increase business investment and raise potential GDP further, then it is worth taking the opportunity to try. Full employment and a tight labor market do work wonders, even if they cannot cure all ills.

That said, while all of the major studies of the Tax Cut and Jobs Act find the legislation to be stimulative, the impacts on economic growth are very much on the margin. This is in part due to the nature of the legislation, which permanently reduces corporate taxes and provides temporary personal income tax reductions that skew toward high-income households, and in part due to the strength of the business cycle. In a strong economy, government stimulus is more likely to crowd-out private investment and activity than in a weak economy. Furthermore, some of the tax windfall for both individuals and corporations will be saved and not spent or invested in growth enhancing endeavors. You get less bang for your buck due the cyclical strength, and due to the design of the cuts.

Our office will have more on the impacts of tax reform on the economy and state revenues on Friday when we release our next quarterly forecast.