Tariff Inflation Mythology
Inflation is always and everywhere a monetary & fiscal phenomenon, not due to an import tax, the ominous outlook for the federal debt and deficits
Our Framework for Debt & Deficits
Last week in The Battle over the Budget we asserted the markets would turn their policy focus from trade to the budget, the deficit that is more important for the longer run wealth of our nation. Our longstanding view is the only path to stability in longer maturity Treasuries runs through returning federal government spending to its 1981-2019 median percentage of GDP of 20.3%, the Biden Administration’s budget blowout increased the base rate to 24%, leaving their successor with a formidable task. Our deficit focus is spending, as Winston Churchill put it, “I contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle.” That said, in several conversations this week, including one with one of our favorite journalists, we came up with the following simplified framework for market participants expectations for the deficit outlook.
Government spending is running 8.9% fiscal year-to-date above ‘24, at the current pace, using the CBO projections, outlays will be 23.4% of GDP for the fiscal year ended in September, 3.1% and $943 billion above the longer run trend. The deficit is projected at $1.9 trillion, or 6.2% of GDP. The House reconciliation bill extension of the individual tax rate cuts enacted in the Tax Cuts & Jobs Act, combined with the corporate investment tax incentives and President Trump’s tax expenditures (tips, overtime, etc.) is estimated to reduce revenues against current law by $4.5 trillion over the 10-year time budget window. Let’s simplify to $450 billion per year. Not included in the reconciliation bill is tariff revenues, on the current path of 10% global tariffs plus ~25-30% for China, expected revenues are $300 billion per year. One way to think about these policies is $450 billon per year of individual and corporate income tax cuts, and a $300 billion increase in the consumption tax on imports. Leaving aside the current law versus current policy impact on receipts relative to GDP, who pays for tariffs and timing issues (delaying work requirements on Medicaid until 2029 is the most egregious example of can kicking) debates, reducing taxes on income, all things equal, should increase investment, and taxing imports should reduce consumption.
The House Committees charged with reducing spending are on track for $1.5 trillion of spending cuts, using our straight-line simplifying assumption, $150 billion per year reduction reduces spending to 22.9% of GDP, some distance from the level that will stabilize the debt. As we were writing the note the House Budget Committee vote to advance the spending cuts failed due to legislators who share our concern that spending cuts are insufficient and gimmicky. The net impact of the $450 billion reduction in income taxes, $300 billion increase in the consumption tax on imports (tariffs) and $150 billion of spending cuts, using our straight-line assumption, is a wash for the deficit. If we integrate the delayed timing of tax cuts into our simplified model, the risk is a higher deficit in fiscal year ‘26.
As we will explain in more detail in this week’s note, the impact on equities from the corporate sector tax incentives is positive for our exposure to technology, industrials, materials and energy. The increase in the consumption tax on imports is negative for our underweights in consumer discretionary and staples due to margin compression evident in the April PPI report. The lack of progress on outlays, and as a consequence, debt and the deficit, is unequivocally bad news for longer maturity Treasuries.
This week’s note reviews last week’s inflation and retail sales reports that validated our view that taxes on imports do not cause inflation, tariffs are changes in relative prices, and without monetary or fiscal stimulus they are a tax that reduces output and pressures margins. We also dig deeper into the battle of the budget and the mixed implications for equities and negative impact on fixed income.
