How Much Punch Will the Economy Get from a Tax Cut

Posted: Nov 14, 2017 10:00 AM
How Much Punch Will the Economy Get from a Tax Cut

The House tax planseeks to balance competing interests and would make the tax system fairer and boost growth, but both liberal critics and the administration are making terribly exaggerated claims.

The Tax Policy Center, headed by a former Obama administration official, charges the bill will mostly benefit businesses and the wealthy, while Treasury Secretary Steven Mnuchin and White House chief economist Kevin Hassett claim the plan will pay for itself by boosting growth to 2.9 percent and household incomes by $4,000 to $9,000 a year.

Increasing the standard deduction to $24,000 per couple would free the overwhelming majority of lower and middle-class Americans from tedious record-keeping and tax-code complexities, by permitting the vast majority to file the one-page short from.

Eliminating deductions for state income and most property taxes would end the terribly unfair practice of forcing a $35,000 year waitress in Virginia or Wyoming to pay higher federal income taxes to subsidize the preferences of rich Californians and New Yorkers for very expansive local government bureaucracies and much richer public employee pensions than the waitress will ever enjoy.

As for the administration, economists approach spending and tax cuts from two angles: the Keynesian demand jolt and supply-side incentives to invest - the "dynamic effects."

A $150 billion annual tax cut allocated equally between corporate and personal tax cuts (including the estate-tax reductions and lower 25 percent rate for some pass-through corporate income) would increase the demand for goods and services through the usual Keynesian multiplier.

We should expect a one-time boost to GDP of $180 billion $225 billion and $30 billion to $40 billion in new tax revenues. However, those estimates do not consider dynamic gains from encouraging more investment and permanently higher growth.

Other industrialized countries have been shifting tax burdens from businesses to individuals by leaning heavily on personal income and value-added taxes while slicing corporate rates. European families may get inexpensive health care and higher education, but they pay for those with higher personal taxes than their American counterparts.

Tax experts estimate U.S. effective corporate tax rates are substantially higherthan elsewhere. For 2018, cutting the U.S. corporate burden by $75 billion would reduce the federal take by 20 percent.

According to estimates compiled by Hassett and R. Glenn Hubbard, that should boost corporate investment by ten percent to 20 percent and, in the current environment of deregulation, it seems likely the overall benefit would be in the upper half of that range.

If Congress approves, as is proposed, similar relief from the highest personal income tax rates for non-labor income from capital invested in pass-through corporations, a 20 percent reduction in taxes on profits overall could have significant consequences for labor productivity.

The economy is near full employment, and with states raising minimum wages, business can be expected to devote most of the new investment to boosting labor productivity through robotics, computer software, worker training and better scheduling of work time rather than by adding to headcount.

Workers would gain principally through opportunities to move to better jobs and earn higher wages but raising pay seven percent to 15 percent as the president's Council on Economic Advisers claims is a rather broad leap considering the expected jolt to gross domestic product growth.

During the recent recovery, labor productivity has advanced about one percent a year, and it seems reasonable to say that a 20 percent business tax cut would boost labor productivity and economic growth by about 0.2 percentage points.

During the recovery from the financial crisis, annual GDP growth has averaged about 2.2 percent growth and, with household balance sheets and business profitability continuing to improve, we could expect going forward perhaps 2.4 percent growth without any change in policy. The Trump tax cuts could reasonably be expected to permanently raise that to 2.6 percent on a long-term basis.

Overall the combined Keynesian and dynamic growth effects would boost tax revenues by about $85 billion.

Those estimates are not large enough to support the administration's claim that tax cuts would finance themselves.