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Key Takeaways

• Tariffs – largely rejected by economists as an effective tool to improve conditions for consumers and industries – can range from targeted to sweeping with corresponding fallout.
• Extending Trump’s 2017 tax cuts is a priority for the administration, but is estimated to cost about $5 trillion over the next decade.
• Improving government efficiency is a worthy goal, but streamlining the federal bureaucracy and regulatory process will take a long-term, concerted commitment.
• Republican optimism at the start of Trump’s second term is lifting economic vibes considerably. But how long those good feelings last will depend on the outcome of tariff policies and the path of future inflation.

As Donald Trump begins his second presidential term, economic analysts can be certain of perhaps only one thing: an uncertain economic outlook. The first Trump administration taught us there is only a loose relationship between campaign pledges and policy decisions. And where Trump has proposed policies — most notably tariffs — recent history provides only limited guidance on the economic effects. In this brief, we thus avoid predictions and instead stick to facts and frameworks that we hope will shed some light on economic policy over the coming years. 

Tariffs

Arguably his signature policy, President Trump has called tariffs “the most beautiful word in the dictionary” and said he was a “big believer” in tariff policy. At various times, he has proposed a 10 percent universal tariff on all imports from all countries, a across-the-board tariff on all imports from Canada and Mexico, and a 60 percent tariff on all imports from China. 

Despite these statements – and the wide-ranging authority of the president to set tariffs – there is considerable uncertainty on the path of tariff rates under Trump. Below are some possible scenarios, ordered from most limited to most sweeping:

1. Targeted tariffs applied to particular industries and particular countries. The first Trump administration applied targeted “Section 301” tariffs on Chinese firms in industries like steel and aluminum. In response to pushback from Wall Street or diplomatic concessions that provide Trump the opportunity to declare victory, a second Trump administration might backtrack from campaign promises and take this type of narrow approach. While significant in targeted industries, because the tariffs would be focused on a narrow part of the economy, the overall economic effects would be limited.
2. Across-the-board tariffs applied to particular countries. Relative to the first scenario,  this scenario would widen the scope of the tariffs by applying them to all goods from particular countries, such as China, Mexico, and Canada. This type of tariff regime could be significant; China, Mexico, and Canada account for more than 40 percent of all trade with the U.S., including key sectors such as electronics, automobiles, lumber, and crude oil. That said, the administration could soften the blow by granting exceptions to certain firms or products. 
3. Universal tariffs applied to most imports from most countries. As a “nuclear” option, the Trump administration could impose the 10 percent universal tariffs proposed on the campaign trail. He’s proposed 25 percent tariffs on goods from Mexico and Canada, and a 60 percent levy on Chinese products. Without exemptions, these tariffs are estimated to have a substantial impact on the economy, $2,600 per year. 

In the first two scenarios, the overall economic impact would depend on how substitutable imports are between firms and countries. If imports can be purchased from non-targeted countries or firms, rerouted through non-targeted countries, or produced domestically, then the impact will be lowered. In the third scenario, the degree of substitutability between products and foreign countries doesn’t matter, as a universal tariff would, by definition, be applied to every good from every country.  

In addition to substitutability, the overall impact of tariffs also depends on exchange rates. In the third scenario, in which a 10 percent tariff was applied to all imports, the U.S. dollar might appreciate substantially in value. This would soften the impact on U.S. importers, whose dollars would stretch further but harm domestic exporters, whose goods would be more expensive in foreign currency. The full impact of tariffs also depends on whether foreign countries impose retaliatory tariffs in response to the U.S. import tariffs. 

Economists reject tariffs as an effective tool to improve the welfare of Americans or strengthen key industries. In a survey conducted during the first Trump administration, 93 percent of economic experts that the targeted tariffs on steel and aluminum would improve Americans’ welfare, and this was for a targeted policy. Recent has only solidified economists' opposition to this policy instrument. Studies show that tariffs imposed during the first Trump administration were almost entirely borne by U.S. consumers, with disproportionately large impacts on lower-income households which spend a proportion of income on goods made abroad. Indeed, the tariffs did not even help the firms they were designed to protect, with higher input costs and retaliatory tariffs outweighing the direct benefits of the tariff policy. 

Because tariffs are passed through into consumers' prices, they also carry inflationary risks. As a rule of thumb, Goldman Sachs estimates that a one percentage point increase in the effective U.S. tariff rate raises prices (core PCE) by 0.1 percent and lowers GDP by 0.05 percent (assuming full retaliation and that tariff revenue is recycled back to the economy). Using this rule, Goldman calculates that the 25 percent tax rates announced for Canada and Mexico would raise US inflation by 0.7 percent (core PCE) and reduce GDP by 0.4 percent. The Budget Lab at Yale University that a broad 10 percent tariff on goods imports, with a 60 percent tariff on Chinese imports, would cause a 1.4 to 5.1 percent rise in consumer prices, before substitution. This cost is the equivalent of $1,900 to $7,600 per household in 2023 dollars. 

Tax cut extensions

In the coming months, a debate about extending the 2017 Tax Cuts and Jobs Act (TCJA) will take center stage. Under current law, taxes affected by the bill will return to their 2016 levels as of January 1, 2026. Extending the tax cuts is a priority for Trump and congressional Republicans but will come at a heavy price, with estimates in the over a 10-year period. In the end, the net cost will depend on how many “pay-fors” (offsetting revenue or declines in other spending) will be included in a tax extension bill. 

There is also an important procedural element at play. Under current rules, the extension has to be “budget neutral” to pass without a supermajority in the Senate. To meet this requirement, congressional Republicans are floating the idea that because taxes are currently at rates determined by the TCJA, the policy should be scored under a “current policy baseline,” which treats policies as ongoing even though they are scheduled to expire. Conceptually, this is like arguing your Netflix account is free this year because you've already decided to renew your subscription.

Assuming common sense prevails, Republicans will need to come up with pay-fors to extend the tax cuts. This difficulty with pay-fors, however, is that they involve politically challenging cuts to health care or Social Security or deep cuts to non-defense discretionary (NDD) spending that are also politically challenging. The platform of Trump’s campaign called for no cuts to Medicare or Social Security, with tariffs, improved government efficiency, and Biden’s EV credits as pay-fors. his first administration, President Trump proposed a massive $1.8 trillion NDD spending cut. Yet despite control of the House and Senate, NDD spending actually increased each of the years Trump was in office, highlighting the difficulty of actually achieving this type of cost cuts. 

Deficits

Not all deficit spending is bad. Deficit spending can serve an important macroeconomic function during recessions. Policies that have positive net present value should be undertaken even if they require additional borrowing since the future revenues will more than pay back for upfront costs. A prominent but certainly not the only example of this type of positive NPV investment is government spending on . Limited deficit spending can be sustainable; if the primary deficit is small, and the interest rate on debt is less than GDP growth, then the debt-to-GDP ratio will shrink over time. 

That said, unsustainable borrowing imposes a burden on future generations’ ability to make investments of their own and limits fiscal space to borrow in a crisis. While Japan, for example, has a debt-to-GDP ratio that is nearly double ours, the U.S. might still be vulnerable to a U.K.-style “Truss moment,” where expected future deficits cause markets to abandon sovereign debt quickly, driving up interest rates. The exact point at which this occurs is unknowable, but as debt levels increase, we inch closer to this line. 

Currently, deficits and debt are historically high and are on track to get higher. U.S. debt held by the public (which excludes money the government owes itself) is of GDP. CBO estimates that under current policy – and so excluding potential TCJA extensions – this number will grow to over 120 percent of GDP in 10 years. Most experts agree that a balance of increased revenue and reduced spending will be needed to reduce the debt. However, politicians do not have a great track record of imposing short-term costs for long-term benefits, and Trump may find that the path of least resistance is to kick the can down the road. 

Deregulation

Increased government efficiency is a worthy goal. In polls, Americans broadly support the Department of Government Efficiency (DOGE)’s mission of increasing the efficiency of government and using the savings to pay down the debt. However, making progress on these goals requires political capital and perseverance, and it’s unclear how much appetite and resolve the newly formed DOGE will have to carry out this task. 

Specifically, on the regulatory side, passing new rules or undoing old ones requires a lengthy process of notice and comment rulemaking. In the first Trump administration, many rules were rushed through and did not hold up in court. On the legislative side, reducing government waste requires spending political capital as one person's idea of waste is nearly always the cherished project of a powerful lawmaker. Investors know this and are not betting on substantial changes in government spending. In a Goldman Sachs survey, two-thirds of investors expect cuts of less than $100 billion per year or 1.5 percent of annual government expenditure. 

Fed independence 

On the campaign trail, President Trump repeatedly questioned the Federal Reserve Bank’s independence, asserting that the president should have a “say” in monetary policy. Central bank independence is perhaps the most sacrosanct principle of economic governance. If political meddling causes a central bank to lose its credibility for inflation fighting, market participants will expect higher inflation in the future, generating a self-fulfilling prophecy. To maintain credibility, nearly every developed country and many developing nations have independent central banks. 

Chairman Powell, whose term runs through 2026, has stated that he will not step down if Trump asks, and Trump has recently said that he has no plans to remove him. Still, Trump has already exerted some influence on the Fed, with the Vice Chair of Supervision, Michael Barr, stepping down from his role to avoid a legal battle with the Trump administration over his ouster. Pressure from Wall Street may help deter Trump’s worst instincts. However, if Fed independence was eroded, the consequences could be . 

Energy 

The 2022 Inflation Reduction Act (IRA) has resulted in an in clean energy manufacturing investment, concentrated in electric vehicles and batteries. On the campaign trail, Trump called for repealing key provisions of the law. However, even with a majority in both chambers of Congress, repealing the IRA will be politically challenging, as roughly 75 percent of the post-IRA investments have gone to Republican congressional districts. 

In addition to subsidies through the IRA, the Biden administration accelerated the adoption of EVs through rulemaking on fuel efficiency and tailpipe emissions. The auto industry and fossil-fuel producers have heavily opposed these regulations, setting up a battle between them and Trump confidant and Telsa owner Elon Musk who benefits from these regulations.  

On the fossil fuel side, Trump has called for a surge in oil production, with newly confirmed Treasury Secretary Scott Bessent pledging to increase production by 3 million barrels of oil-equivalent per day. While the 3 million number might be best rationalized for its symmetry with the rest of Bessent’s “3-3-3” plan of 3 percent GDP growth, a 3 percent deficit, and 3 million additional barrels of oil per day, achieving even modest increases in oil production may be hard. Domestic oil production has boomed to a record high, increasing by 2.5 million barrels over the last four years. While the Trump administration will look to relax regulations and other restrictions on energy extraction, there are limited productive oil fields that can be brought into production. And additional supply from these deregulatory policies will put downward pressure on prices, limiting the effects of output. 

Vibes

A much-discussed feature of the economy under the Biden administration was the disconnect between strong economic fundamentals and weak vibes, as measured by consumer sentiment. Our own research has shown the importance of and the lingering effects in explaining this gap. The question going forward will be whether sour economic sentiment will persist under Trump. 

The past two months have offered a real-time experiment on the effects of partisanship. When we first estimated the effect on sentiment of polarization, we found that excessive Republican pessimism during the Biden administration was dragging sentiment down by roughly 7 points. Moving forward, these forces should work in the other direction, pushing up the reported consumer sentiment number.

The big unknown for sentiment is the impact of tariffs. Our research shows that consumers are mostly acclimated to the new, higher price levels. However, if tariffs reignite inflation, consumers may turn more pessimistic, dragging sentiment down again. 

Financial markets

While predicting the stock market is a fool's errand, a strong real economy paired with an anticipated deregulatory push has stock market analysts feeling buoyant. The bank forecast has the S&P 500 growing 12 percent this year. One lingering concern is concentration, with the 10 biggest stocks representing of the S&P 500’s total value. In bond markets, the consensus bank forecast has the U.S. 10-year treasury ending the year at 4.14 percent below its current level. Rates could rise if stubborn inflation causes the Fed to slow its rate cuts or if tariffs push inflation up again.