Can Trump’s GOP Defuse America’s Debt Crisis with Supply Side Economics?

Supply-side deregulation can exert near-term downward pressure on prices, buying time and helping the Fed keep interest rates low

Donald J. Trump and the Republican majority in the 119th Congress will be taking charge of a government in a highly precarious fiscal situation. Net interest payments on the national debt in fiscal year 2024 consumed almost 18 percent of all federal revenues and surpassed national defense outlays. Based on projections from Congress’s budget analysts at the Congressional Budget Office (CBO), under current law the interest bite into revenues rises in 2034 to 23 percent, and by our calculations to 31 percent of revenue excluding Social Security taxes.

But it’s even worse. Interest payments are determined by interest rates, and the analysts’ forecasts for interest rates are extremely benign. CBO projects that the average interest rate on the federal debt will hardly move over the next 10 years, resting at 3.36% and 3.38% respectively in 2025 and 2034.

Such interest rate forecasts may prove too optimistic. The debt might put more upward pressure on interest rates, and the forces that might have held rates down – the role of Treasury debt as a haven for foreign investors, and low productivity and labor force growth – might go into reverse. Stress test the budget to just a one percentage point higher rate and the 2034 share of non-Social-Security revenue eaten by interest reaches over 40%. This is dangerous territory.

Obviously, there is a need to cut spending, and we hope the incoming government will accomplish that. But the budget situation also makes controlling inflation particularly crucial. If a new bout of inflation were to induce the Federal Reserve to raise real interest rates to fight it, the federal government would have to devote even more of its revenues to interest payments.

What can the incoming government do about this? One view is that the only thing that really matters for inflation in the long run is fiscal policy itself, a point emphasized by our colleague John Cochrane. Many other factors we commonly think might drive inflation are either one-time shocks to the price level, or only affect relative prices as opposed to overall prices. At the same time, as John has also explained, relative price shocks can affect measured inflation for quite a while. Furthermore, a series of regulatory or deregulatory measures over a period of years would generate a series of changes in the price level that would show up as inflation and likely provoke a Fed response.

Given that the long-run might not come for quite some time and that supply shocks can affect measured inflation for quite some time in ways that the Fed would not simply look past, implementing policies that will expand the supply side of the economy will be helpful and advisable for keeping inflation and hence real interest rates low. The risk that the Fed will hike rates in response to increases in measured inflation is one that the federal government can scarcely afford.

In the framework of supply-side economics, championed by economist Art Laffer, not only lower taxes but also reduced regulation and other policies that support private investment are key to boosting economic growth. Such actions will put downward pressure on prices – even if it is because the actions amount to a series of price level effects that add up to a rise in inflation and even if only operate on inflation through the near-term channel of relative prices. Large supply-driven increases in output on all key goods and services that comprise consumption, but especially energy and housing, would therefore be helpful to buy the government the time it will need to get its fiscal house in order.

Energy makes up 7.5 percent of the Consumer Price Index (CPI), but in 2022 energy prices alone contributed 2 percentage points to headline inflation. President Trump has promised to “drill baby drill.” Specifically, we believe this means he should and will be rescinding the series of executive orders (“EO”) and regulations signed and implemented by President Biden that aimed to curb emissions in service of climate goals but deleteriously reduced energy production.

This includes reinstating President Trump’s 2021 EO (reversed by Biden) that was aimed at promoting energy independence through streamlining the environmental reviews that hamper fossil fuel production. Additionally, the administration would be wise to axe President Biden’s new regulations targeting methane emissions implemented through the Environmental Protection Agency. Reversing course on these environmental regulations will spur greater energy production, reducing energy costs for all Americans.

Expanding electricity markets to drive down the cost of electricity will also be important. Artificial intelligence data centers are expected to add massive electricity demand in the U.S. by 2030. Embracing technology like nuclear energy could help expand access while keeping prices low.

Shelter comprises a full 36% of CPI. From 2022 to 2023, the 7.9 percent increase in shelter cost accounted for nearly 60 percent of the total increase in core prices, with home prices hitting record highs over the last few years. New policies must counter these forces by increasing supply, specifically by making it much easier to build new homes.

The Department of Housing and Urban Development (“HUD”) has a number of regulations in force that hinder building. For example, HUD disincentivizes building in low-income areas due to concerns as this may worsen “segregation.” Aside from the recent evidence showing that American cities in actuality are more integrated than they have been since 1910, this regulation places a major supply-side obstacle to reducing housing prices in low-income areas. Furthermore, in one HUD impact study, the adoption of energy conservation regulations led to an increase of $7,229 per home in construction costs.

The other key component of supply side economics is a pro-growth tax regime of low rates and a broad base, which encourages production. The bonus depreciation of the Tax Cuts and Jobs Act (TCJA) is phasing out and will expire fully in 2027, as will a number of the expiring individual provisions. Many of these expiring TCJA provisions are essential for economic growth, which is the primary motivation for extending them.

Lowering tax rates is generally thought to have short-term inflationary impacts through demand but the longer-term supply-side effects are deflationary. We therefore recommend that spending cuts be implemented to offset both the budgetary pressure and possible short-term effects on inflation. In this case it is in fact fortunate that so many aspects of government spending have been demonstrated to be ineffective, counterproductive, or wasteful.

As for the possible increase in tariffs, many economists argue that such policies inflationary. The same caveats apply regarding tariffs looking more like one-time price increases that affect relative prices. But should these economists prove correct then the need for offsetting supply-side deregulatory measures is even stronger.

The interest burden on the budget will be one of the new government’s greatest challenges. Supply-side deregulation will help exert downward pressure on prices in the near term, allowing the Fed to keep interest rates low and stopping our interest payments from consuming the federal budget.