California and the U.S. Election Implications for a "Blue" State
By Lynn Reaser, Ph.D., CBE
Californians and the rest of the world were in shock on November 8th, as Donald Trump upended the pundits and the polls to claim victory as the next president of the United States. Stocks initially sold off that night but rallied sharply on Wednesday and in following days. What policies are the new president and Congress likely to enact, how will financial markets respond, and what will be the implications for California?
Mr. Trump has identified tax reform and tax reduction as issues he intends to address at the beginning of his administration. He intends to lower marginal tax rates for individuals and business. International taxation will be addressed to encourage companies to bring overseas cash back to the states. The estate tax stands to be eliminated. The President-elect intends to simplify the tax system, with fewer tax brackets and deductions. Deductions for mortgages and charitable contributions will be retained, although some deductions for the wealthy could be capped.
Californians will benefit from lower tax rates, although California taxes will now be a larger percent relative to total taxes compared with most other states. State taxpayers will be relieved to have the mortgage and charitable deductions mostly retained. Residents also will applaud any tax simplification, especially if the state follows through with some of its own efforts at tax reform.
The President-elect has targeted business regulation as a significant constraint on growth. Appointees to various agencies, including the Federal Communications Commission (FCC), Environmental Protection Agency (EPA), Federal Trade Commission (FTC), Food and Drug Administration (FDA), and many others, could either curb the addition of new regulations or reduce the current structure.
Many California businesses, especially small and mid-size firms without lobbying support in Washington, could benefit from an easing of the regulatory burden. They might still decry the burden of state and local regulations, but federal changes might prompt a review of those laws, rules, and procedures to enhance efficiency. Alternatively, state and local regulations might be tightened to offset any loosening at the federal level.
Both campaigns agreed that a new President should emphasize more infrastructure spending. Mr. Trump has spoken of a $1 trillion investment in roads, bridges, water systems, the electrical grid, and other projects over the next ten years. He has suggested that public-private partnerships play a key part in these endeavors, including possible tax credits for companies involved in such ventures.
California could benefit substantially from such investments, especially in light of its large requirements in terms of deteriorating or outdated infrastructure. Leading state firms in construction and engineering could also see significant new business opportunities.
Mr. Trump has voiced his support for a larger defense budget even as he has argued that our allies should bear a larger share of the military burden worldwide. A significant step-up in U.S. defense spending would represent a shift in the secular decline in military spending as a share of our gross domestic product (GDP), which was only briefly interrupted following the events of 9/11. To enable such an increase would require a lifting of some of the budget caps now part of the Budget Control Act of 2011 that were set to restrain the size of the budget deficit over the next several years.
California, as a prime recipient of Department of Defense (DoD) funds, would gain from more dollars. San Diego, for example, depends on the direct and indirect effects of the military for about one-fifth of its economy. In addition to uniformed and civilian DoD employees, more defense dollars could benefit aerospace firms, suppliers of cyber security systems, shipbuilders, software companies, and the many entities in the complex network of defense-related supply chains.
Mr. Trump took a hard line on immigration during the campaign, including building a "wall" along the U.S./Mexican border, deporting illegal immigrants, and restricting the entry of new immigrants. Whether an actual wall will be constructed remains uncertain, but the border will be reinforced. Major deportations could be delayed and immigration policies remain to be defined. The President-elect has said that immigration will be one of his top priorities when he assumes office in January.
California could see important repercussions as a result of immigration policies. The state has long relied on the flow of people between it and Mexico for critical labor in the agricultural, tourist, and other industries. Family connections are also closely linked. Until these issues are resolved, uncertainty will hang over many of the state�s businesses and individuals.
The president-elect has indicated that the new Administration will veer away from the generally free-trade policies of the past several years to a much more protectionist stance. He has indicated that the North American Free Trade Agreement (NAFTA) will be renegotiated with Mexico and Canada and that the Trans-Pacific Partnership (TPP), which was never ratified by Congress, will be scrapped. In addition, China could see tariffs of as much as 45% to slow its exports of goods to the U.S. while other nations could also face higher trade barriers.
Many of the economists and business leaders who may be advising Mr. Trump could urge caution in this anti-globalization drive. They could argue that trade can be a "win-win" strategy as opposed to a situation where one party�s gain can only occur with another�s loss. Mr. Trump, in fact, has endorsed trade but will insist that it become more "fair."
California�s pivotal position on the Pacific Rim and its close trade relations with Mexico make it vulnerable to any curbs on the international flow of goods, services, and investments. It would bear serious consequences of any �trade war,� where our trading partners could retaliate with their own trade restrictions in response to our actions. Technology companies, in particular, are dependent, on complex supply chains spanning across Asia. The state also has key linkages in Mexico�s maquiladoras, the export-oriented plants that are particularly important in the aerospace, medical device, electronics, and automotive sectors. These plants benefit from duty-free imports and materials and have expanded to employ 2.7 million people across Mexico. In Tijuana alone, which is highly interconnected with San Diego, more than 206,000 people work in approximately 600 facilities. California benefits from a stronger economy south of its border and has also recently seen the opening of supply chains of Mexican firms to the exporters in our own state.
Health care stands as one of the largest uncertainties facing California in the aftermath of the election. The President-elect has suggested that the Affordable Care Act will be restructured in major ways. He has indicated support for two of its provisions: allowing children to remain on their parents� insurance policies until they turn 26 and prohibiting health insurance firms from denying patient coverage on the basis of any preconditions. Beyond those two measures, the entire program remains in question, although the President-elect recognizes that the program must receive his Administration�s early and urgent attention.
California�s vast health care network and its funding will be in limbo until these issues are resolved. The state�s system of insurers, hospitals, out-patient centers, doctors and other health care resources could now face a major disruption in the model they had planned and built for. The state�s Medi-Cal system, providing health care for the state�s poor, now covers one out of every three Californians. Its financial viability now stands in jeopardy with uncertainty about the extent of future federal support.
Mr. Trump has called for the expansion of the nation�s oil and gas reserves, including the construction of pipelines to facilitate the delivery of those resources. In contrast, he has indicated little support for alternative sources of energy and suggested that tax credits for solar and wind power be halted. With a skeptical view of the causes or solutions to global warming, the new president could reduce its support or even withdraw from the United Nations Framework Convention on Climate Change.
California could find itself at major odds with national energy policy as the state has set a course to move towards alternative energy sources and to reduce greenhouse gases. It has established a market for trading pollution credits, has targeted a goal for utilities to generate one-half of their energy from alternative sources (wind, solar, or geothermal) by 2030, and has called for cities to adopt Climate Action Plans. California is unlikely to reverse its course in these policies and could bear the short-term consequences of higher energy costs compared with other states that may follow strategies more aligned with new national policies.
The Stock Market
After an initial sell-off, stock prices have rallied strongly since the election. Expectations of stronger economic growth, boosted by tax cuts, less regulation, and more infrastructure spending, have climbed. Markets currently believe that some of the more negative aspects of Mr. Trump�s policies, such as protectionist measures, will be scaled significantly back.
California will benefit from a rising stock market through several different channels. Capital gains will boost consumer spending and also raise the flow of personal income taxes that account for about two-thirds of the state�s total revenues. A rising stock market could boost prospects for Initial Public Offerings (IPOs) in the state�s vibrant technology field. Higher equity returns could also help the prospects of the state�s pension funds, which face huge liabilities as state workers and teachers retire.
The Bond Market and Interest Rates
Interest rates have shot up following the election, with an increase of one-half percentage point in various long-term rates, ranging from yields on 10-year Treasury to 30-year fixed-rate mortgages. Expectations of stronger gains in real gross domestic product (GDP), employment, and capital spending have combined with an expectation of higher future inflation and deficits. The president-elect could also have the opportunity to appoint five or more new members of the seven-member Board of Governors of the Federal Reserve in the next two years. The new president is likely to appoint a new Fed Chairman in January 2018 when Dr. Yellen�s term expires. These new appointees could support a more rapid process of �normalization� of interest rates to higher levels.
California�s housing market could be somewhat adversely impacted by higher mortgage rates, although there will be some offsetting forces. The initial impact of higher rates may be to boost sales as people purchase before rates move even higher. After that, there is likely to be some slowing in price appreciation. That slowing together with continued strong job gains and rising wages should limit the negative impact of higher interest rates.
California municipal bonds could be adversely impacted by higher interest rates. Some negative impact could also come from the expectation of increases in the supply of new bonds with more infrastructure spending and the reduction in the tax advantage from lower federal income tax rates. However, California�s economic strength and its improving finances should bolster its credit rating while strong demand for tax-exempt securities will continue from its residents.
The dollar has soared in value since the election on prospects that U.S. economic growth could rise substantially and interest rates will climb vis-�-vis the rest of the world. Possible damage to U.S. trading partners with a rise in protectionist policies has also driven the flow of capital, especially from emerging market economies, into the U.S.
California exporters will find it harder to export to various countries throughout the world and tourism could see the impact of fewer foreign visitors. At the same time, companies could benefit from the lower costs of imported materials, unless disrupted by higher tariffs, and consumers could realize the resulting savings. Capital investments in California could also be boosted by individuals trying to avoid further losses in the value of their local currencies.
The election implies major changes for the nation and perhaps California in particular. The state's economy should benefit substantially from tax cuts, regulatory relief for many of its businesses, and more infrastructure spending. The most important questions and risks facing the state include policies on immigration, trade, and health care. Financial markets believe the positive forces will prevail. Californians can hope they are right.
Lynn Reaser is chair of the Treasurer's Council of Economic Advisors and chief economist at the Fermanian Business and Economic Institute for Point Loma Nazarene University. The opinions in this article are presented in the spirit of spurring discussion and reflect those of the author and not necessarily the treasurer, his office or the State of California.