Friday, November 24, 2017

A Parable of a Tax Bill

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.


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