Cutting US Corporate Tax Is Worth the Cost
One of the main criticisms leveled at congressional Republicans' proposal to cut corporate taxes is that a higher budget deficit would amount to an undesirable fiscal stimulus. But with monetary policy turning contractionary, and most experts predicting a US recession in the next five years, stimulus should be welcomed.
CAMBRIDGE – The United States Congress is close to enacting a major tax reform. The plan’s most important provision reduces the corporate tax rate from 35% to 20% – from the highest among all OECD countries to one of the lowest – and allows US companies to repatriate the profits of their foreign subsidiaries without paying additional US taxes. Opponents of the legislation point to the resulting increase in the federal budget deficit, which will add $1.5 trillion to the government debt over the next ten years.
I dislike budget deficits, and I have long warned about their dangerous effects. Nonetheless, I believe that the economic benefits resulting from the corporate tax changes will outweigh the adverse effects of the increased debt.
The lower rate will attract capital to the US corporate sector. American corporations will invest more in the US, because foreign countries will no longer offer lower tax rates, and will repatriate profits earned by their foreign subsidiaries rather than leaving them abroad. They will also bring back some of the previously earned foreign profits that have been left outside the US, estimated by the Treasury to be worth $2.5 trillion. Foreign companies will expand their investments in the US – or even shift their operations there – to take advantage of the lower tax rate. And within the US, capital will flow from agriculture and housing to higher productivity uses in the corporate sector.
Although it is difficult to estimate the total increase in capital in the corporate sector, I think it is reasonable to assume that over the next ten years it will reach at least $5 trillion. The increased flow of capital to the corporate sector will raise productivity and real wages. If that happens, it will raise annual real GDP in 2027 by about $500 billion, equivalent to 1.7% of total 2027 GDP, implying a gain of $4,000 per household in today’s dollars.
These favorable effects are directly relevant to balancing the primary adverse effects usually associated with a fiscal deficit: that government borrowing crowds out private capital formation; that higher interest payments generally require higher taxes or reductions in spending on defense and nondefense programs; that a budget deficit implies an unwanted increase in aggregate demand when the economy is at full employment; and that a higher debt ratio leaves less capacity for increased emergency government spending.
I believe that none of these problems will materialize during the coming decade. Let’s consider them in turn.
Although the $1.5 trillion of government borrowing caused by the tax bill during the next decade could crowd out an equal amount of private borrowing, the capital stock will grow by an even larger amount. The $1.5 trillion corporate tax cut will go directly to US companies, and the stock of corporate capital will grow further because of the inflow of funds from the rest of the world. Even with increased government borrowing, the proposed tax reform can therefore still raise the corporate capital stock by some $5 trillion over the next decade.
Moreover, the $500 billion increase in total annual income by 2027 would increase tax revenue by $100-150 billion a year. That is enough to cover the $60 billion in interest payments on the $1.5 trillion of extra debt, with money left over to increase government spending or reduce personal taxes.
Likewise, concern that an increase in the fiscal deficit would undesirably stimulate aggregate demand is misplaced. In fact, the stimulative effects of the fiscal deficit and increased corporate investment should be welcomed, for two reasons. First, they will offset the contractionary effects of the expected increase in the federal funds rate and the shrinking size of the Federal Reserve’s balance sheet. And, second, after nine years of economic expansion, most experts expect the US to enter recession sometime in the next five years.
Similarly, concern about the ratio of government debt to GDP, which has doubled in the past decade and is now 77%, is exaggerated. The Congressional Budget Office projects that even with no further legislation, the debt ratio will rise to 91.2% by 2027. The direct effect of the $1.5 trillion deficit implied by the tax reform would be to raise that to 97%. A military emergency or an economic downturn would call for additional debt-financed spending or tax reductions. But even a massive spending program like the $900 billion American Recovery and Reinvestment Act of 2009 would add only an additional three percentage points to the debt ratio. It is hard to believe that a debt ratio of 97% would make that more difficult to achieve than a debt ratio of 92%.
So, for all four of these reasons, I believe that the benefits of cutting the corporate tax rate more than offset the adverse effects normally attributed to budget deficits. But, looking ahead, I believe that reducing the fiscal deficit should be a high priority after the 2018 congressional election. A tax on carbon dioxide emissions or a slowdown of spending growth for federal entitlement programs can start to bring the debt ratio back down toward the 50% level that prevailed before the 2008-2009 downturn. But first it is important to enact the proposed tax reform.
America’s Supply-Side Scam
Congressional Republicans' proposed tax cuts are no recipe to "make America great again." Lacking in saving, outsize US budget deficits spell nothing but serious trouble ahead on the balance-of-payment and trade fronts.
NEW HAVEN – Tax cuts masquerading as tax reform are the best way to describe the thrust of Washington’s latest policy gambit. The case is largely political – namely, the urgency of a Republican Congress to deliver a legislative victory for a Republican president. The consequences, however, are ultimately economic – and, unsurprisingly, likely to be far worse than the politicians are willing to admit.
Taking the lead from President Donald Trump, the political case for tax cuts is that they are essential to “make America great again.” Over-taxed and cheated by bad trade deals, goes the argument, America needs tax relief to revive its competitive prowess.
Notwithstanding the political pandering to hard-pressed middle-class families, corporate America is clearly the focus of these efforts, with proposed legislation aiming to reduce business tax rates from 35% to 20%. Never mind that US companies currently pay a surprisingly low effective corporate tax rate – just 22% – when judged against post-World War II experience.
And pay no attention to the latest tally of international competitiveness by the World Economic Forum, which finds the US back in second place (out of 137 countries). And, of course, don’t draw comfort from the lofty stock-market valuations of the broad constellation of US companies. Forget all that, Republicans insist: cut business taxes, they say, and all that ails America will be cured.
There are times when the politicization of economic arguments becomes dangerous. This is one of those times. The US simply can’t afford the current tax cuts making their way through Congress. According to the nonpartisan Congressional Budget Office, the cuts will result in a cumulative deficit of about $1.4 trillion over the next decade. The problem arises because America’s chronic saving shortfall has now moved into the danger zone, making it much more difficult to fund multi-year deficits today than was the case when cutting taxes in the past.
The so-called Kennedy tax cuts of 1964 and the Reagan tax cuts of 1981 are important cases in point. The net national saving rate – the broadest measure of domestic saving, which includes depreciation-adjusted saving of households, businesses, and the government sector – averaged 10.1% during those two years (1964 and 1981). In other words, back then the US could afford to enact major tax cuts.
That is not the case today, with the net domestic saving rate a mere 1.8% of national income. Even during the two tax cuts that followed – the second installment of Reagan’s fiscal program in 1986, and the initiatives of George W. Bush in 2001 – the net national saving rate averaged 4.2%, more than double the current level.
Both experience and macroeconomic theory indicate what to expect. Saving-short economies simply cannot go on deficit-spending binges without borrowing surplus saving from abroad. That is what brings the balance-of-payments and trade deficits directly into the debate over fiscal policy.
Significantly, the US current account was in slight surplus during the big tax cuts of 1964 and 1981 – in sharp contrast to today’s deficit of 2.6% of GDP. With fiscal deficits likely to push an already-low domestic saving rate even lower – possibly back into negative territory, as was the case from 2008-11 – there is a great risk of a sharply higher current-account deficit. And a bigger current-account deficit means that the already-large trade deficit will only widen further, violating one of the main tenets of Trumponomics – that making America great again requires closing the trade gap.
It is at this point where the tale goes from fact to fiction. Trump and the congressional Republican majority insist that the proposed tax cuts will be self-financing, because they will spur economic growth, causing revenues to surge. This so-called supply-side argument, first advanced in support of the Reagan-era tax cuts, has been a lightning rod in US fiscal policy debates ever since.
Reality has turned out quite differently than the supply-siders envisioned. Yes, the economy recovered spectacularly from a deep recession in 1981-1982. But that was due largely to an aggressive easing of monetary policy following the Federal Reserve’s successful assault on double-digit US inflation.
By contrast, the fiscal nirvana long promised by supply siders never materialized. Far from vanishing into thin air, federal budget deficits ballooned to 3.8% of GDP during the 1980s, taking public debt from 25% of GDP in 1980 to 41% by 1990.
Not only did the supply siders’ self-funding promises go unfulfilled; they also marked the beginning of the end for America’s balance-of-payments equilibrium. From 1960 to 1982, the current account was basically in balance, with a surplus averaging 0.2% of GDP. On the heels of the budget deficits of Reaganomics and the related plunge in national saving, the current account swung sharply into deficit, averaging -2.4% of GDP from 1983 to 1989. And it has remained in deficit ever since (with the exception of a temporary reprieve in the first two quarters of 1991 due to external funding of the Gulf War).
Far from a recipe for greatness, the Trump fiscal gambit spells serious trouble. Lacking in saving, outsize US budget deficits point to sharp deterioration on the balance-of-payment and trade fronts. Nor will creative supply-side accounting alter that outcome. A “dynamic scoring” by the nonpartisan Tax Policy Center suggests growth windfalls might prune the multiyear deficit from $1.4 trillion to $1.3 trillion over the next decade – hardly enough to finesse America’s intractable funding problem.
George H.W. Bush said it best when he was campaigning for the Republican presidential nomination in April 1980. He rightly criticized the “voodoo economic policy” of his opponent, Ronald Reagan. For today’s saving-short US economy, déjà vu is a painful understatement of what lies ahead.