By Roy C. Smith
An economist, a politician and a Wall Street banker sat down
to craft a tax bill.
The politician kicks things off. “Guys, the boss has asked
us to come up with a tax cut plan that will fulfill his campaign promises to give
the middle class a break and to increase growth and jobs.”
The banker jumps in. ”Right, the markets, which have priced
in a tax cut, are booming so we have to deliver.”
The economist, more troubled by the task than the others,
says: “it’s not that simple. We are already at full employment (unemployment is
4.1%) with an immigration-impaired workforce that is growing at only 0.5% per
year, so where are the workers for the new jobs going to come from? The economy
is finally starting to grow out of the slump it has been in for the last decade,
so adding stimulus from a tax cut now is likely to produce mainly inflation.
But the cost of a tax cut, around $1.5 trillion over ten years, will have to be
added to the national debt which is already very high. Anyway, growth and jobs do
not always follow stimulus measures. We had ten years of fiscal stimulus under
Obama, with low interest rates and aggressive quantitative easing by the
Federal Reserve, and, even so, growth only averaged about 2%. A tax cut is just
more stimulus; it may push growth above its trend line for a time, but the cost
of the tax cuts must be funded with additional government borrowings that
involve interest costs that will rise, especially if the total amount of
government debt is seen to be too high, or inflation sets it. Our national debt is now (107% of GDP) almost
as large as it was at the end of WWII (118%), which was the highest in our
history. When Reagan was president, debt to GPD was only 37% and unemployment
was 8.3% when he passed his tax cut in 1983.
The banker says, “so what, interest rates are still low and
the government bond market is very strong, despite the downgrading of the US
credit rating by Standard and Poor’s in 2011. When folks get nervous, they
still buy Treasuries. Of course, there is a limit to how much debt we can have
without it hurting us; we don’t know where that limit is, but we’re not at it
yet.”
The politician: “Some of our guys say that a tax cut will
add $4,000 a year in wage increases for workers. If we keep saying it, maybe it’ll
be true. Maybe not, but our voters are expecting it. That’s where the rubber
hits our road.”
The banker: “If we fail to get a tax cut through, we will
look like we don’t have any economic policy at all and are incapable of
governing. That could frighten the markets into a major correction.”
The economist says, “I understand, but wouldn’t it be better
to focus instead on a revenue-neutral program of tax reform that would get rid
of ancient subsidies, loopholes and preferences that block market forces from
determining an optimal allocation of resources to maximize growth and
productivity over the long run. The best way to achieve it this to eliminate
all deductions and apply the combined savings to an across the board tax
reduction of 20% or so. It will be revenue neutral, but the structural changes
will enable more growth.”
The politician says, “that would be a terrible idea.
Eliminating deductions for mortgages and credit card debt, for state and local
taxes and for medical expenses and charitable contributions would be a
disaster. People will think you are taking something that is theirs by right
away from them. And, they would see it as unfair to some taxpayers and benefitting
others disproportionately. Our major donors would desert us. What they want is
a real tax cut, without taking anything away.”
“Well,” said the banker, “a corporate tax cut will increase
corporate cash flows, improve profits and increase equity valuations. Stocks
will rise, so will household wealth and folks will spend more of it. Besides,
our corporate rate (35%) is the highest in the world, so lowering it will make
us more competitive in the world.”
“Except,” said the economist, “our major corporations,
because of large deductions, only really pay about 24% in taxes, about the
average for all companies in the industrialized world, so they are not really
uncompetitive. Those that do get rate cuts might just spend it on increasing
dividends or stock buy-backs ($500 billion in 2017), or on overpriced mergers that
result in major cost cutting. But, in any case, the vast majority of the 5.5
million US corporations are small to mid-sized privately-owned companies that have
mastered the art of minimizing taxes and don’t pay 35% either. Some use
pass-through mechanisms to transfer losses and capital gains to lower their
wealthy investors’ tax rates. All corporate taxpayers are good at gaming the
system. The best way to address corporate taxes is through reforms that eliminate
all corporate deductions and lower all rates from the savings.”
The politician: “There you go again. Our donors don’t want
their corporate deductions taken away either.”
The banker adds, “the market likes traditional tax cuts that
benefit people who will spend the money or invest more. It doesn’t like complex
reforms with a lot of unforeseeable consequences.”
So, the banker and the politician combine forces and brush
the economist’s idea aside. They say we need a middle-class tax cut that will
put money in just about everyone’s pocket. And, besides, the banker says, it
will pay for itself by increasing growth to more than 3%, which will generate a
lot of new tax revenues.
“We still have the deficit problem,” said the economist. Our
fiscal deficit today is 3.5% of GDP; the $1.5 trillion cost of the tax cut is
up front, so we would have to increase debt early on, taking the debt to GDP
ratio up to around 112% and the fiscal deficit about 5.0%. Our fiscal hawks opposed
to increasing the debt ceiling won’t like this at all. And, we will need their
votes to get this thing through.”
The politician: “The deficit is still important to a lot of
our voters. But given a choice between a rising deficit and more money in their
pockets, they will usually pick the latter, which is why we have always been
for tax cuts. But, it can help a lot if we can persuade them that the
economists’ studies are fake, or flawed, or produced by liberals, and not to be
taken seriously. They like the idea of a tax cut being something for nothing,
even if they know in their hearts that it’s not true.
The economist then added, “there is something in what you
say, behavioral economics shows that perceptions can count more than reality. “
“And perceptions are what win elections,” said the
politician.
So, they say down and wrote up a list of public perceptions that
they wanted to reinforce, and that might help sell a tax bill. The government
was helping the middle class and hard-working Americans, it was creating jobs, and
making corporations more competitive, all things they had promised to do.
Besides, their plan will pay for itself; deficits don’t matter, it's the
American entrepreneurial spirit that will Make America Great Again.
Then they went on the write the tax plan they wanted
Congress to approve. It was a mess, but it was the best they could do. Sausages
are made in sausage factories.
Economists know that tax cuts always add debt to the system,
but they don’t always provide the stimulus they are supposed to. Bankers know
they can result in a bullish anticipation of results, but yield a bearish
response when results are disappointing. But even though politicians know that
both may be true, none of it matters if their side isn’t reelected.
