Will American Tax Cuts Pay For Themselves: The Tyranny of Fiscal Math

Most experts are now banking on passage of tax reform, with all that is remaining to be done is a reconciliation between House and Senate bills that have already passed and a final signature from President Trump. The website PredictIt places the odds of a corporate tax cut by the end of the year at 75% and of a personal tax cut at 63%. Passage of the bill, though, is not going to end long-running debates around economic philosophy. Case in point: what are the ramifications for the long-run deficit after the Tax Cut & Jobs Act, the official name of the bill, is signed into law.

The Congressional Budget Office (CBO) has said that the House bill would cost $1.7 trillion over a decade and the Senate version would cost $1.4 trillion. But, those numbers assume nothing else changes in the economy as a result of the legislation, in other words, its’ scored statically. The CBO is required to provide an analysis of the macroeconomic effect of tax reform, but has not yet completed the study. The current base case from the CBO is growth of 2.1% in 2017 (private economists are averaging a projection of 2.2% at the moment), 2.2% next year and then growth a touch lower than 2% for the remainder of the next ten years.

So, what would the impact to the deficit of tax reform likely be if changes in economic growth are factored in? That question is not all that easy to answer. Partly because those performing the analysis are tempted to throw the dart and then draw the bullseye around it. If one wants the tax bill to pay for itself, there is a corresponding GDP figure that will get them there.

To arrive at an answer, one must first determine which behaviours they think will be changed by changing the incentive systems of taxation. Perhaps lower income taxes will encourage more hours to be worked or lower investment taxes lead to higher investment. Then, after quantifying those changed behaviours, a GDP impact must be estimated and then that impact must be converted into an estimate of the potential increase in federal tax revenues. None of those steps is a science and different economists would estimate their levels differently.

The Joint Committee on Taxation did perform a dynamic analysis of the Senate bill and estimated that the $1.4 trillion cost over ten years would be reduced to $1.0 trillion if growth effects are considered. The economic growth caused by tax reform is estimated to be an anemic 0.8% or less than 0.1% each year over the course of the coming decade. How did the Joint Committee arrive at its estimates?

For the most part, they believe the biggest impact of the tax reform bill will be felt in higher consumption by putting more money in the hands of consumers. Consumption, per the Joint Committee, will rise by 0.6%. Since consumption is 2/3rds of GDP, that is equivalent to a 0.4% impact to GDP – half of the total projected increase.

The remaining half of the economic boost comes through increased investment and more people willing to work. The Committee also estimates that lower taxes on investment through a lower corporate tax rate and lower pass-through rate as well as depreciation benefits will raise the total capital stock in the United States by 1.1%. Lower marginal tax rates are also expected to boost employment by 0.6%. Interestingly, the Joint Committee expects zero economic boost from changes to the estate tax.

Nominal GDP is currently $19 trillion, so 0.8% of that is about $150 billion. If 20% of that is collected in tax revenue and the figure rises each year with inflation and growth, it is not hard to get to the Committee’s figure of $450 billion over a decade in incremental revenue.

Others, though, have offered a more optimistic forecast of the macroeconomic effects of the tax bill. Speaking on Meet the Press about her decision to vote in favor of the Senate bill, Maine Senator Susan Collins said: ““If you take the CBO’s formula and apply it, just four-tenths of one percent increase in the GDP generates revenues of a trillion dollars. … So I think if we can stimulate the economy, create more jobs, that does generate more revenue.” You can watch her full interview below.

Is she correct? She is in regards to the need of a 0.4% boost in GDP each year in order for the tax cuts to pay for themselves. If roughly 0.1% of a boost would result in $450 billion more revenue over a decade, four times that would obviously yield $1.8 trillion and comfortably pay for the $1.4 trillion in direct lost revenue. But, from where will the 0.4% boost come from? That figure is well in excess of the growth that the Joint Committee on Taxation forecast.

The Tax Foundation completed its own analysis of the Senate’s plan. The Tax Foundation is a think tank founded in 1937 by a group of businessmen and it is generally favorable to tax cuts and hostile to increases in spending and taxes. The think tank views the Committee’s estimates as far too conservative, stating:

However, JCT’s results should be viewed as likely underestimating the economic growth spurred by this tax bill. The range of estimates from JCT includes several important assumptions that limit its growth results, particularly, assumptions regarding the Federal Reserve’s response to potential inflation and the United States being an open economy that assumes financial flows don’t change quickly. This, in practice, makes the results more similar to those of a closed economy.

In other words, The Tax Foundation think the Committee overestimated the extent to which the Federal Reserve would raise interest rates if the economy heated up as well as underestimated the amount of foreign investment that foreign actors would devote to the United States once they incorporate lower tax rates into their investment analysis. The Foundation estimates the dynamic cost of the plan to be $516 billion.

The initial Senate bill, and the one analyzed by the Foundation, had static revenue reductions of $1.7 trillion – so the $1.26 trillion in economic benefits that are estimated in their analysis is not quite “apples to apples” with the Joint Committee on Taxation, but the growth seen by the Foundation is well higher than other estimates, including a 10% rise in the capital stock, a nearly 3% rise in wages, and the creation of an incremental 925,000 jobs.

The rosiest scenario yet comes from a group of economists writing to Treasury Secretary Mnuchin in a letter republished by The Wall Street Journal. Among the signatories of the letter was Glenn Hubbard, Dean of the Columbia Business School, who Senator Collins also singled out for his research in her decision to vote in favor of the tax bill. Those economists see a 15% rise in the capital stock from reduced corporate taxes and other benefits of tax reform and a resulting 4% boost to GDP. In order to arrive at such an estimate a metric known as “user cost of capital” is employed. User cost of capital is essentially calculated as an equivalent rent price to an owner for a capital investment, or generally interest and capital costs plus depreciation. The economists apply a rule of thumb that a 1% decline in the user cost of capital increases the capital stock by 1%. So, after estimating that the tax bill will lower user cost of capital by 15%, they estimate a 15% increase in the capital stock and a 3% increase in GDP, or 0.3% per year.

Ultimately, the actual growth generated through tax reform is impossible to quantify precisely. But, when supporters point to the fact that only a 0.4% increase in real GDP per year would cause tax reform to be budget neutral, they may be pointing to and hoping for something altogether different than the specific estimates laid out by various groups.

During the post-war period, the United States has averaged real GDP growth of 3.2% per year. That rate has been shrinking in past years and post-recession has been about 2%. But, with the run-up to the financial crisis binge borrowing, growth in the few years preceding 2008 are lower than what they seem because lenders and borrowers were essentially “borrowing” economic growth from the future.

There has been no shortage of explanations for this growth slowdown, including shifting demographics and secular declines in productivity. Those supporting supply side economics tend to favor the explanation that high taxes and the regulatory burden is what has driven growth down and not structural headwinds. When people with viewpoints similar to Senator Collins look at the math, 0.4% is not a daunting figure because it would result in trend growth of about 2.4%, still well below trend growth in the past.

With no specific study of the Tax Cut & Jobs Act able to produce math, that theory of the growth slowdown is about the only explanation available that would comfortably predict no increase in the long-term deficit should the bill pass. It is strikingly optimistic, however.

In a recent survey of economists conducted by The University of Chicago that asked whether tax reform would produce substantially higher GDP, Austan Goolsbee responded, “Of course not. Does anyone care about actual evidence anymore?” It seems people care more for the wishing and hoping strategy. We have no choice but to hope they are right.

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