April 28, 2017
The long-awaited Trump tax plan is still sketchy on details but, on balance, it is a good thing. It will stimulate investment spending which will, in turn, boost productivity growth. Faster productivity growth will lift the economic speed limit for the U.S. economy from 1.8% currently to perhaps 3.0% by the end of the decade. Unfortunately, that is not the 3.5-4.0% growth rate that President Trump envisions. To the extent that actual growth falls short of that mark his package will not be “revenue neutral”, which means that the budget deficit and debt outstanding will increase. The deficit is already on a path to hit $1.4 trillion annually by 2026. Any further increase is undesirable. However, stimulating GDP growth to a 3.0% pace will create jobs, raise wages, and increase the growth rate in our standard of living. It seems to us that the positive impact of these proposed tax cuts on the economy far outweigh the negative impact on the deficit which, as described below, may be far smaller than the Congressional Budget Office estimates.
How fast can the economy grow? The economy’s speed limit is the sum of two numbers: the growth rate of the labor force plus the growth rate of productivity. Back in the 1990’s the labor force climbed by 1.5%, productivity was growing by 2.0%, which means that the economy’s speed limit (or potential growth rate) was 3.5%. Today, however, the labor force is climbing by 0.8%, productivity is growing by 1.0%, so the speed limit has dropped to 1.8%. The slow labor force growth largely reflects the impact of retiring baby boomers which will continue for another decade. To boost the speed limit policy makers must boost the growth rate of productivity. That growth rate, in turn, is determined largely by the pace of investment spending.
That takes us to the Trump tax policy. It is focused largely on the business community. He proposes to cut the corporate tax from 35% to 15%. The lower rate applies to businesses of all types – corporations, partnerships, and small businesses of all sizes. He plans to impost a one-time tax on an estimated $2.6 trillion of corporate earnings that are currently parked overseas. And he proposes to end taxation on offshore income by adopting what is known as a “territorial” tax system which means that U.S. companies will pay no U.S. tax on income earned overseas (rather than the 35% rate they would pay under the current system).
At the same time he plans to simplify the individual tax code from seven tax brackets currently to three – 10%, 20%, and 35%. He would end the alternative minimum tax and eliminate the estate tax. He would simultaneously eliminate all itemized deductions except for home mortgage interest and charitable giving.
Tax cuts of this magnitude will reduce tax revenues and boost the budget deficit. That scares people who are legitimately concerned about budget/federal debt issues in the years ahead. But what if the proposed tax cuts boost GDP growth from 1.8% today to something higher like 3.0%? The additional income generated by faster GDP growth will enhance tax revenues and, at least partially, offset the impact of the tax cuts.
Trump has said he expects the tax cuts to boost GDP growth to 3.5-4.0%. His tax plan documents do not specific his specific growth assumptions, but he has talked about numbers in that ballpark in the past. That is a reach. Go back to the potential growth rate equation. Labor force growth is probably going to be stuck at about 0.8% for another decade as the boomers continue to retire. For Trump to reach his goal he needs productivity to accelerate to 2.7-3.2%. Therein lies the problem. Looking back over the past 40 years there is only one period when productivity climbed at a 3.0% pace for any protracted period of time. That was the late 1990’s and early 2000’s which reflected the introduction of the internet in the mid-1990’s followed by the cloud and apps in the early 2000’s. That was an unprecedented period of development. It is unreasonable to expect productivity growth of that magnitude as the result of tax cuts. However, to believe that productivity growth could be 2.0-2.5% is not unrealistic. That would boost potential GDP from 1.8% today to 2.8-3.3% (0.8% growth in the labor force plus 2.0-2.5% growth in productivity). If he is successful in boosting potential GDP to roughly the 3.0% mark that makes his tax reforms and tax cuts a desirable package.
But 3.0% GDP growth is not 3.5-4.0%, and tax revenues would fall short of the White House’s projections. Given that the budget deficit is already projected to climb from about $500 billion currently to $1.4 trillion within a decade that is not a desirable outcome. However, if GDP growth jumps to 3.0% and Trump anticipates growth or 3.5-4.0%, the shortfall should be relatively small.
If, in addition to his proposed tax cuts, Trump is willing to consider cuts in so-called entitlement expenditures such as Social Security, Medicare, and Medicaid he could achieve faster GDP growth and no long-term increase in the budget deficit. Such a combo would be deemed as “revenue neutral”. That would be the best of all possible worlds.
Republicans and Democrats agree that tax reform is long overdue. Hopefully, they can agree on a “revenue neutral” package of tax cuts and reduced spending similar to what was just described. The bipartisan Erskine-Bowles Commission agreed on such a package back in 2010. If seven years ago a bipartisan group of Republicans and Democrats could reach an agreement on what needs to be done, they can do it again.
The issue of revenue-neutrality is more than just an academic issue. To boost the deficit outside a 10-year window requires a two-thirds majority in the Senate, i.e., it would need support from some Democrats. A simple majority can pass the bill, but it would expire at the end of 10 years. A major tax overhaul should clearly be a permanent change not a temporary one.
Hopefully, some agreement can be reached to make these proposed changes revenue neutral and thereby permanent. But if that is unattainable, temporary changes in the tax code that produce faster GDP growth, more jobs, higher wages and faster growth in our standard of living are a desirable alternative.