Tuesday, December 5, 2017

Will the Tax Cut Make a Difference?

By Roy C. Smith

Leaving aside how the sausage got made, the Trump administration got its tax cut and all the bragging rights related to it. But will it boost growth?

Here are some things we know already. The US economy has recovered momentum in the last two quarters, perhaps inspired by Mr. Trump but it is hard to tell. Goldman Sachs is now optimistically forecasting a 2.5% growth rate in 2018, a big improvement from the average of 2% for the last decade. Goldman Sachs includes in its forecast a growth pickup of 0.3% from the tax cuts. This is nice, but seems rather small for a tax cut that, even with dynamic scoring (that takes the new growth into account), still has a price tag of about $1 trillion to be added to the national debt.

There is, however, a lot of uncertainty with this tax bill which favors the corporate sector over consumers. Most of the tax revenues from corporations come from the 3,600 publicly traded corporations and large privately-owned companies that don’t actually pay the 35% maximum rate, but a lower rate that averages around 24%. Cutting the maximum rate to 20% won’t make much difference. The rest of corporate taxes are collected from the 5 million or so small businesses that generally don’t make enough profit, especially after expensing family payrolls and other things, to pay the full rate, so there shouldn’t be that much revenue lost from their cuts. In any event, not all the tax savings will be reinvested in new plant and equipment – some will be used for dividends, stock buybacks or debt reduction that contributes much less to GDP growth. Estimating such things and future corporate tax revenues to the government is done more by modeling than by knowing a lot about how corporations will act. This suggests that both the net benefit and the revenue loss from the corporate tax cuts may be much less than expected.

Further, the “middle-class” taxpayers (those who rank in the upper 50% to 90% of income earned) will receive a mixed bag of benefits and added costs from the tax bill. The wealthier end of this group is likely to lose more in deductions than they gain in cuts. And, 47% of all citizens don’t pay federal income tax at all, so won’t benefit from cuts. How much of a net increase in consumption will result from what Mr. Trump calls the “biggest tax cut is history” is hard to know, but it could be quite modest.

In any case, the tax bill occurs when the economy is experiencing a growth spurt following a decade of slow-growth recovery from the financial crisis. Annualized growth for the last two quarters has averaged 3.2% with unemployment expected to drop below 4%. Adding a stimulus now may boost inflation more than real growth.

More worrisome, however, is the longer-term growth outlook. Even with the tax cuts, several growth forecasts, including Goldman Sachs’, fall off again to the 1.9% area after 2018 due to labor shortages, impeded by tougher immigration policies, and rising inflation and interest rates.

Meanwhile, the federal deficit is increasing because Social Security and Medicare costs are expanding to accommodate the retiring baby-boomers. According to a June 2017 report by the Congressional Budget Office, the fiscal deficit reached 3.7% of GDP (up from 3.0) and is estimated to be 5.2% by 2027. With the tax cuts added, the deficit will reach 5.1% in 2021, according to Goldman Sachs, and total debt will be nearly as high a percentage of GDP (110%) as it was at its peak year in 1945. This would represent a serious increase in the deficit burden that traditionally has been a concern to Republicans, but is not now (except for one Senator, Bob Corker, who is retiring). Of course, if the tax cuts, on balance, don’t reduce revenues as much as expected, the deficit will increase less than otherwise.

The tax cut is mainly a political event. Their economic impact is likely to be less than advertised.

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