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Will Trump’s Plan Really Boost US Demand?

CAMBRIDGE – Ever since Donald Trump won the US presidential election, the press and financial markets have focused on his proposal to cut taxes and to spend $1 trillion on infrastructure over the next decade. The expectation that these policies will increase aggregate demand has pushed up long-term interest rates by 50 basis points.

But the assumption that Trump’s policies will lead to higher prices and wages doesn’t square with the details of his proposals. Anyone who listened to his speeches or read his campaign material should have noted that he was not proposing that the federal government should carry out the infrastructure investment. He was not calling for a Keynesian fiscal stimulus based on deficit spending. Instead, Trump’s campaign called for a “deficit-neutral system of infrastructure tax credits” to provide incentives for private businesses to undertake projects to build roads, bridges, tunnels, airports, and so forth.

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Of course, it is not clear that Congress will agree to such large new tax credits. And even if it does go along, there is no guarantee that businesses will respond as intended.

Traditional investment tax credits have been used successfully in the past to encourage businesses to expand their capacity to produce the products they make and sell. But how will businesses earn any revenue from owning roads, bridges, and tunnels? And even when there are revenues to be earned, as there could be from airports, businesses might be deterred by the need to rely on long-term pricing agreements.

It is also easy to fall into the trap of thinking of the tax cuts as a way to boost aggregate demand. But congressional Republicans may insist on paying for the cuts in personal income tax by limiting the deductions that individuals now use to lower their tax bills. The tax plan put forward on behalf of the Republicans by Paul Ryan, the speaker of the House of Representatives, calls for eliminating all deductions other than those for charitable contributions and mortgage interest. That change would raise revenue equal to about 1% of GDP, enough to pay for very substantial reductions in individual tax rates.

Ronald Reagan’s famous Tax Reform Act of 1986 was a supply-side policy designed to improve incentives, rather than a traditional demand-side policy designed to put more cash in people’s pockets. The Reagan tax plan used changes in deductions and other accounting rules to pay for major cuts in tax rates that lowered the top rate from 50% to 28%. The lower marginal tax rates induced individuals to work more and to receive more of their potential income in taxable cash rather than in fringe benefits and other forms of compensation that are not subject to tax.

If individuals had not responded to the changed incentives, the Reagan tax cut would have been revenue-neutral. But, because taxpayers did respond to the improved incentives, real pre-tax incomes rose and tax collection actually increased. The Republican Congress would do well to model the Trump tax cuts on Reagan’s supply-side policies.

In the 30 years since the Reagan tax cuts were enacted, tax rates have increased substantially, particularly for higher-income taxpayers. The top rate has increased from 28% to 39.6% on wages and salaries, and to more than 43% on some forms of investment income.

According to the Congressional Budget Office, the effective tax rate fell for most income groups in the 30 years from 1984 to 2013, but it rose substantially for the top 1%. More specifically, for households in the lowest quintile, the effective tax rate in 2013 was 3.3%, about half of what it had been on average over the previous 30 years. Among the middle three quintiles, the effective rate in 2013 was 13.8%, down from an average of 16.6% over the three previous decades. For the next 19% of taxpayers, the effective tax rate fell only slightly. But for the top 1%, the effective tax rate rose 3.4 percentage points, to 34%.

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Against this background of rising tax rates and a shift in the tax burden to those with the highest income levels, it would not be surprising if Congress reduced the top tax rates and broadened the tax base in a revenue-neutral way.

There is of course no reason to seek an increase in aggregate demand at this time. The economy has essentially reached full employment, with the unemployment rate at 4.9% in October. The tight labor market caused the core consumer price index (which excludes food and energy) to rise 2.2% over the past year, up from 1.9% a year earlier. And production workers’ wages rose 2.4%, faster than prices. The Federal Reserve can begin the process of raising interest rates in December without any need for an offsetting fiscal boost to demand.