Wednesday, 22 of November of 2017

Economics. Explained.  

Tax Cuts Imply Bigger Budget Deficits – Or Do They?

November 10, 2017

Everybody is analyzing the impact of the House and Senate tax cut proposals.  The Congressional Budget Office estimates that the package will increase budget deficits by $1.5 trillion during the next 10 years.  Trump supporters claim that the tax cuts will stimulate the economy to such an extent that the additional tax revenues kicked off by faster growth will offset the impact of lower tax rates and that future budget deficits might even shrink.  Who’s right?  The answer seems to depend upon the method of scoring used to evaluate the various tax proposals, and the time horizon selected.

The non-partisan Congressional Budget Office is the official arbiter used by Congress to score the potential budget impact of any proposed changes in taxes or government spending.   It estimates that the proposed tax cuts will increase the budget deficit by $1.5 trillion over the next 10 years.  But it is important to understand that the CBO estimate must be calculated using what is known as “static” scoring.  What that means is that the CBO must apply the lower tax rates to its current estimate of GDP growth.  Not surprisingly, doing so reduces tax revenues and results in an expectation of larger budget deficits in the years ahead.  But that is an archaic method of calculation and results in a totally misleading conclusion.

Also, because Congress uses a 10-year time horizon when it produces its annual budget proposals, the CBO evaluates the impact of any tax or spending proposal using a 10-year window.  But there is nothing magic about 10 years.  Sometimes it is useful to examine these changes using a longer reference period.

While the CBO uses static scoring the economy is dynamic.  Lower tax rates will surely cause some behavioral changes.  What if businesses spend more money on investment?  What if they bring back some of the estimated $4.0 trillion of earnings currently locked overseas and invest it in the U.S.?  What if firms hire more workers?  Those are all reasonable expectations that will boost investment spending for years to come, increase the growth rate of productivity, and raise our economic speed limit from 1.8% currently to perhaps 2.8% by the end of the decade.  Faster growth increases tax revenues.

The Trump administration wants its tax cut proposals evaluated using “dynamic” scoring which takes into consideration the impact of both lower tax rates and faster GDP growth.   Using such a method, they believe that the additional tax revenues generated by faster growth will largely offset the impact of lower tax rates during the next 10 years.  And over a longer time horizon, say 20 years, faster GDP growth will boost tax revenues enough to shrink the projected budget deficits.

So,  wider deficits to the tune of $1.5 trillion over 10 years?  Or smaller budget deficits over a somewhat longer time frame?

Almost certainly tax cuts will trigger some of the behavioral changes described above which means that the CBO estimate that budget deficits will increase by $1.5 trillion over 10 years is way off the mark and misleading.

But only a die-hard supply-sider would conclude that lower tax rates will be revenue neutral during the upcoming 10-year time period.

Unfortunately, estimates of the impact from dynamic scoring vary widely and differ to a large extent upon the political persuasion of the organization making the estimate – which is exactly why the CBO is not permitted to use it.

For what it is worth, we believe that taking the growth effects of these policy changes into consideration the loss of tax revenues might be $0.5 billion during the next 10 years rather than $1.5 trillion. If one were to use a longer budget window we believe tax revenues will increase and actually shrink budget deficits beyond 2026.

We wholeheartedly support a cut in the corporate tax rate from 35% to 20%.  We support the idea of allowing U.S. firms to re-patriate overseas earnings at a favorable tax rate of 10% rather than the 35% rate they would have to pay currently.  And we support the notion of full expensing of investment.  Doing so would eliminate complicated depreciation and amortization schedules and substantially cut compliance costs for all American businesses.  It is the right thing to do and will certainly boost investment spending for years to come, raise potential GDP growth and, in the longer-term, shrink budget deficits.  We hope that our policy makers in Washington will not be distracted by the CBO’s estimate of $1.5 trillion less tax revenue over 10 years.  It uses an archaic and misleading method of calculation, and is constrained to a 10-year time span.  The positive effect of faster growth may accrue largely in the years beyond the normal budget window.

Stephen Slifer

NumberNomics

Charleston, S.C.


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