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Monthly Economic Letter

April 2018
Feature article

What’s the new U.S. tax plan all about?

Tax cuts are expected to spur growth and investment

The U.S. government enacted a major overhaul to its tax code in December at a cost of US$1.5 trillion dollars over 10 years to the treasury. The tax legislation was hotly debated across party lines with Republicans arguing it will create prosperity and improve the efficiency of the economy, while Democrats argued it will increase income inequality and burden the country with rising debt.

The changes are expected to improve economic growth in the short-term, but create risks for a slowdown over the longer term. For Canada, the question is whether lower corporate tax rates will draw business investment south of the border.

What’s in the tax overhaul?

The U.S. tax plan—the Tax Cuts and Jobs Act 2017—is highlighted by a reduction in the federal corporate income tax rate from 35% to 21% that came into effect on January 1. In addition, businesses can now expense investments on machinery and equipment, rather than amortize them over a number of years, which should boost investment.

Offsetting these benefits, however, is a reduction in the amount of business interest expense eligible for deduction (from 100% to 30% of adjusted taxable income). As well, companies with profits held abroad will be taxed at reduced rates in the U.S., effectively repatriating foreign earnings held abroad.

The plan also includes personal income tax cuts, including a generous one for the wealthy. The highest individual bracket has been cut to 37% from 39.6% and the threshold at which it is applied has been raised to $600,000 from $480,000 (for joint filers). There is also a near doubling of the standard personal income tax deduction and the plan envisages an eventual repeal of the estate tax.

The U.S. economy should see higher growth, at least in the short-term

Most analysts are forecasting GDP growth to accelerate to 2.8% in 2018 as the tax cuts kick in, boosting corporate profits and business investment. Businesses are expected to spend US$660 billion on improving or replacing assets this year, an increase of 8% compared to 2017, according to Goldman Sachs research.

But those benefits come at a fiscal cost. The tax plan and a separate budget deal will push the deficit to over US$1 trillion next year and add US$2.4 trillion to the federal debt over the next 10 years.

Rising income inequality and debt could slow growth in the longer term

Since middle—and lower—income households spend more of their disposable income, and benefit less than the wealthy from these new tax cuts, it raises the question of whether strong consumer spending can be sustained. With U.S. consumers responsible for two-thirds of economic growth, unless other sectors of the economy pick up, overall growth could decelerate.

While stronger economic growth is expected in the short-term, it is unlikely to be sufficient to prevent the deficit and the debt from rising. As the government spends more than it takes in, it will either need to cut spending or raise taxes.

Higher taxes tomorrow will mean higher costs for businesses. Firms will pass these costs on to consumers in the form of higher prices, creating inflation. And this will put pressure on the Federal Reserve to raise interest rates, possibly more quickly than anticipated, which would also slow the economy.

U.S. closes the corporate tax gap with Canada

The tax reform has brought the U.S. corporate tax code closer to Canada’s tax system. Before the U.S. tax plan was enacted, the corporate income tax rate (including national and sub-national governments) in the U.S. was 38.9%, compared to 26.7% in Canada, according to the OECD. Today, the U.S. rate has declined to 25.8%, about 1% below Canada’s.

The elimination of Canada’s advantage on this score has raised concern among some observers that Canada will lose investment to south of the border.

Canada remains an attractive location for business to invest. A rich pool of well-educated workers, government-funded health care, better integration of immigrants and lower levels of violence are just a few of the benefits companies consider.

To get a clear picture, the federal government is conducting detailed analysis of the U.S. federal tax reforms to assess any potential impacts on Canada.

What does it mean for entrepreneurs?

  • Expect continuing strong U.S. growth, at least in the next few quarters.
  • The Federal Reserve is expected to continue its cycle of tightening, likely raising interest rates by 25 basis points in June. The Bank of Canada is expected to hold its rate steady during the next few months. Thus, the interest rate differential between Canada and the U.S. will grow, putting downward pressure on the Canadian dollar.
  • With a weaker loonie and strong U.S. growth, Canadian exporters can take advantage of a growing market with the competitive edge a lower currency provides.
Canadian economy at a glance

Despite slowing in January, Canada’s economy continues to show strength across most sectors

Canada’s economy contracted in January by 0.1% compared to December, mainly due to the decline in the mining, oil and gas sector (-2.7% over the month) and real estate (-0.5%). Together these sectors represent about one-fifth of Canada’s economic output. The decline in mining, oil and gas appears to be a deceleration from high levels of growth experienced in mid-summer last year to a more moderate pace. Real-estate activity contracted in January compared to December largely due to transactions that were made at the end of last year to avoid new mortgage rules, which came into force on January 1.

Even if January’s performance proves to set the tone for the whole year, the economy should still grow compared to last year, as indicated in the graph below. The graph also shows how volatile the oil-and-gas sector is, for example contracting nearly 10% in 2009 before rebounding to growth of +10% in 2010. The second graph shows the impact of a slowdown in growth in the real estate sector.

Nearly all other sectors, including manufacturing, wholesale and retail trade, construction and professional services, grew during January and remain at elevated levels compared to last year’s results.

Over the past few months, the economy has been gearing down to a more sustainable rhythm. The Bank of Canada’s Business Outlook Survey shows that businesses continue to see positive momentum for future sales, and investment remains at healthy levels. However, businesses are expressing greater concern about labour shortages and rising wages in some areas of the country. Indeed, average weekly earnings have picked up over the past few months, especially in regions of the country with greater labour shortages, such as Quebec, Ontario and British Columbia.

As the chart above shows, non-oil producing regions are facing capacity constraints and businesses are offering higher wages to attract and retain the workers they need. Minimum wage increases also appear to be pulling up wages, in particular in the services sector.

While businesses continue to face competitive pressures to keep prices low, headline inflation is gradually rising, hitting 2.2% in February. Part of this is due to rising fuel prices. The Bank of Canada’s preferred measures of core inflation are a little lower, but have also been rising since last year.

What does it mean for entrepreneurs?

  1. If your business is exposed to the housing sector or oil and gas, a slowdown is occurring which may be moving these sectors to a more sustainable pace of expansion.
  2. To attract and retain the right employees, you may have to offer higher wages. Other benefits may be attractive though to employees and could help keep your costs in check. Consider employing the strategies in our study Future-Proof Your Business: Adapting to Technological and Demographic Trends to stay competitive.
  3. With interest rates currently relatively low, but rising, and wages picking up, now is a good time to upgrade or invest in new equipment and technology for your business to increase your efficiency.
U.S. economy at a glance

What would a trade war do to the U.S. economy?

The impact might be less than the headlines lead you to believe

The U.S. economy grew at a 2.3% pace in 2017 and most analysts expect an acceleration to 2.8% in 2018 as federal tax cuts boost corporate profits. Job growth has been strong—averaging 190,000 new jobs per month in the last year—and the unemployment rate remains low at 4.1%.

With the economy doing so well, why is the Trump administration risking a trade war?

The President campaigned for election promising to raise gross domestic product growth to 4%. However, the U.S. exports less than its imports, creating a trade deficit, which acts as a drag on growth. And the country with which the U.S. has the largest trade deficit is China, at $375-billion in merchandise trade.

The Trump administration wants that deficit to shrink by at least $100 billion, according to White House advisor, Peter Navarro. To achieve this objective, Trump has demanded China do more to open its market to American firms. And he’s done more than just talk.

U.S. first to impose tariffs

President Trump announced import tariffs of 25% on steel and 10% on aluminum, as well as $50 billion in trade actions on China related to intellectual property rights and technology transfer in telecommunications equipment, consumer electronics and other goods. On April 3, the U.S. released a list of 1,333 products it imports from China on which it will impose an additional duty of 25%. The items include flat-screen televisions, medical devices, aircraft parts and batteries. Morgan Stanley estimates these tariffs will have a minimal impact on the Chinese economy (only a 0.1 percentage point reduction to growth). In addition, the Treasury Department is still expected to impose new investment restrictions on Chinese firms operating in the U.S.

China has repeatedly said it does not want a trade war. Earlier this year, the country announced they intend to remove or ease restrictions for foreign investors in the country’s financial, manufacturing, telecommunications, medical services, education, elderly care and new energy vehicles sectors.

However, in reaction to the Trump administration’s tariffs on steel and aluminum, Beijing announced retaliatory tariffs worth $3 billion on 128 items it imports from the U.S. The action includes 15% tariffs on items such as fruit, wine, ethanol and steel pipes as well as 25% tariffs on items such as pork and recycled aluminum. Then, following the U.S. announcement to impose tariffs on 1,333  items, the Chinese government declared it would impose an additional 25% levy on 106 items valued at $50 billion, including soybeans, beef, cotton, automobiles, chemicals and aircraft made by Boeing and General Dynamics Corporation. China also filed a WTO complaint over the U.S.' tariff measures on Chinese goods.

What will be the impact on the U.S. and world economy?

The U.S. steel and aluminum import tariffs are unlikely to hurt China given it accounts for just 7% of U.S. steel imports and 10% of aluminum imports, according to Federal Reserve Bank of Dallas. Whereas, China’s tariffs on U.S. automobiles and aircraft will bite more. The U.S.’s largest exports to China last year were aircraft and aircraft parts, totaling more than $16 billion. And GM sells more of its cars in China than in the U.S.

Still, it’s difficult to judge how all these measures will affect the U.S. economy. The U.S. list targets items that are considered to benefit from the country’s Made in China 2025 plan, which focuses on advanced microchips, driverless cars and robotics, but excludes items considered disruptive to U.S. economic growth and to consumers, such as clothing, toys and smart phones. It seems unlikely we are moving towards a crippling global trade war.

Certainly, we’re nowhere near the situation in the 1930s when the U.S. introduced the Smoot-Hawley Tariff Act. It touched off a trade war that led to a doubling of global tariff rates and a halving of world trade. Most experts agree it prolonged the Great Depression.

While the talk of a global trade war has escalated in recent weeks, the world has come a long way since the Great Depression with such mechanisms as the World Trade Organization and regional free trade agreements as a bulwark against a full-scale, recession-inducing trade war. Bloomberg Economics estimated that a global trade war would cost the world economy about $470 billion by 2020, or 0.5 percent of output.

Furthermore, the U.S. economy is remarkably robust and should remain so at least in the short-to-mid-term. If businesses take advantage of corporate tax cuts to invest in new and improved equipment and machinery, productivity should rise, supporting higher wages, without triggering higher inflation.

Continued employment growth and steadily rising wages will support consumer spending, which has been, and is likely to remain, the key driver of U.S. economic growth.

What does it mean for entrepreneurs?

  1. The U.S. will see strong growth this year, with consumer spending continuing to be a key driver. U.S. consumers will also support global growth with their voracious appetite for imports. Both a strong U.S. economy and strong global growth will be supportive to Canadian economic growth.
  2. More tough trade talk from the U.S is expected to continue. However, we will see what impact the measures actually have only when actual implementation is complete.
Oil market update—April 2018

Oil prices remain above US$60 a barrel as oil stocks are down and demand is up.

Falling stocks are bringing the market into balance

Oil stocks in the OECD have declined to just above their five-year average (see graph). While stocks rose seasonally in January, the International Energy Agency’s preliminary analysis suggests a decline in February.

The key forces driving stocks down has been the robust compliance among OPEC and partners in their supply reduction as well as higher than usual refining activity, in part due to freezing temperatures in North America and Asia (Japan and Korea).

OPEC and other oil producing nations’ compliance with supply cut remains impressive

Members of the Organization of Petroleum Exporting Countries (OPEC) and other nations joining the supply cut of 1.8 million barrels a day have achieved remarkable compliance—at 147% in February. (This high level is due to the lower than agreed production in Venezuela. See February oil market update). The improvement in these countries’ fiscal balances—as they are now earning more revenue at higher prices despite lower production—is stimulating discussion of extending the cuts throughout 2018 and possibly for the first 3 to 6 months of 2019, and potentially creating a 10-20 year agreement between Saudi Arabia and Russia, according to reporting by Reuters.

Record refining activity draws down stocks

Record global refining activity in the fourth quarter of 2017 helped to draw down oil stocks. The first three months of 2018 have been less impressive, as U.S. refineries climbed down to 91% capacity compared to 94% in December. However, Indian and Chinese refineries have increased production compared to the prior year and the IEA expects 2018 to be another record year for global refining.

Rising demand will further draw down stocks

Based on strong demand in the first couple of months of 2018, the IEA has raised its forecast for 2018 demand growth slightly upwards to 1.5mb/d, mainly driven by the U.S, Turkey, Poland, India and Brazil.

Saudi Arabia and Russia—the key architects of the supply reduction agreement—have committed to continue with their cuts and to exit the agreement in an orderly fashion. The rise in demand for oil will mean that stocks will draw down further, giving further support to prices.

Bottom line

Continuing supply cut compliance, record refining activity and strong demand will support oil prices in around the US$60/barrel mark over the coming months.

Other economic indicators

Bank of Canada holds its key interest rate steady

The Bank of Canada held its key interest rate steady at its policy committee meeting on April 18, 2018. While inflation has picked up, it is still below the Bank’s target and with continued uncertainty due to an increasingly protectionist stance by our southern neighbour, the Bank argued it was not the right moment to raise rates.

The loonie was in a tailspin in March

The dollar depreciated against the greenback for a second consecutive month since the beginning of 2018, closing at 77.55 cents U.S. at the end of last month. The loonie averaged 77.3 cents U.S. in March, though it dropped as low as 76.4, its lowest point in almost nine months as Canada’s economic indicators softened and protectionist sentiment south of the border heated up. Recent positive signals from the Americans about NAFTA negotiations related to automotive sector should be supportive for the loonie.

Business confidence took a step backward

In March, the Canadian Federation of Independent Business (CFIB) Business Barometer Index lost some of the ground it had gained at the beginning of the year. The Index fell by 1.6 points hitting 60.7. In part, the decline is related to the proportion of owners who say their business is in good shape which fell to 38%, the lowest in 16 months. SME owners’ confidence deteriorated mostly in the trade sector, both in retail and wholesale, and in manufacturing. On the other hand, business owners operating in natural resources were the most optimistic of all with an increase of 8.1 points compared to February. Overall though a reading of greater than 60 is still quite favourable and paints a positive picture of business confidence despite a slight decline. While almost one entrepreneur out of five plans to hire more full-time employees in the following months, 61% of them consider that wages are causing difficulties to the business.

Credit conditions remain relatively easy

While financial institutions continue to gradually raise their interest rates, the effective interest rate of businesses has remained low and stable in recent weeks. It stood at nearly 3.4% at the end of March, a rise of 0.54 basis points since the Bank of Canada started to hike its rate. Businesses continue to see favourable credit conditions overall as commercial banks have not passed on the full 75 points in rate hikes by the Bank of Canada since July 2017.

Key indicators–Canada