Will a growing debt eat away at economic growth?
Editor’s note: The day this piece was posted, the Tax Foundation announced it was correcting the report discussed. The bill’s boost to GDP is expected to fall from 3.9 percent to 3.6 percent in the corrected study.
The House GOP’s new tax bill would reduce revenue by almost $1.5 trillion over the next ten years, according to the Joint Committee on Taxation (JCT). This is an amount that works out to $12,000 per household, and it includes cuts to corporate taxes, individual income taxes, and the estate tax. The revenue loss would not be offset by reduced spending, though it could be partly offset by economic growth. The government would make up the remaining losses by borrowing money.
Normally, the argument against raising the deficit is put in simple terms — by whatever party is out of power, of course. Our debt is already about 77 percent of our GDP, a number that will rise to 91 percent by 2027 under current law and will only get worse from there. Realistically speaking, this is going to force a combination of tax increases and entitlement cuts at some point in the future, and the longer we wait, the more brutal those measures will have to be. Starting from such a precarious position, we have no business making our deficits even worse, whether by cutting taxes or by increasing spending. The debt could hit 100 percent of GDP in 2028 if we lose a full $1.5 trillion in revenue, not to mention that some of the bill’s tax cuts arbitrarily expire before the decade is up, which will put pressure on Congress to extend them.
But there’s an additional layer of complication to the debate over tax cuts funded through higher deficits, one amply illustrated in competing studies of the GOP tax plan from the Tax Foundation and the University of Pennsylvania’s Wharton School. The former says the plan would boost economic growth and create jobs, and that as a result we would lose significantly less than $1.5 trillion in revenue. The latter, by contrast, says the bill would have essentially no long-term effect on the economy.
Much of the difference lies in the organizations’ assumptions about how deficits affect growth. I’m not going to resolve here which is right and which is wrong; that’s a live issue among professional economists, of which I am not one. But as Congress contemplates pushing up the deficit (boo!) by cutting taxes (yay!), let’s consider the risks and potential benefits of that combination of policies — and how we can deal with the uncertainty.
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We’ll start with the Tax Foundation. The organization predicts “3.9 percent higher GDP over the long term, 3.1 percent higher wages, and an additional 975,000 full-time equivalent jobs.” Furthermore, it projects that the “after-tax incomes of all taxpayers would increase by 4.4 percent in the long run,” a benefit fairly evenly distributed across the economic spectrum.
The group says the plan will reduce tax revenue by $1 trillion when economic growth is taken into account. Interestingly, without accounting for growth, it pegs the revenue loss at almost $2 trillion over a decade, higher than the estimate from the JCT. (The gap apparently stems from some differences in the data and assumptions the two groups use in their modeling.) This means the Tax Foundation foresees enough economic growth to create $1 trillion in federal revenue, and to cut the total revenue loss in half.
Basically, lower corporate taxes mean more capital. And in turn, more capital makes workers more productive, a key ingredient of wage growth and of economic growth more broadly.
That huge gain doesn’t come from the reforms to the individual income tax. In fact, the Tax Foundation estimates those reforms’ effect on economic growth at zero. Instead, “the larger economy and higher wages are due chiefly to the significantly lower cost of capital under the proposal, which is mainly due to the lower corporate income tax rate.” The statutory corporate rate would fall from 35 percent to 20 percent under the plan, putting the U.S. roughly in line with the average for other developed countries.
The “cost of capital” is a bit of economics jargon, and it’s key to the argument that corporate-tax cuts spur growth, making them a boon to the average person and not just people who own stock in corporations. In addition to its prominent role in the Tax Foundation’s analysis, it was the centerpiece of a hotly disputed White House Council of Economic Advisers (CEA) report estimating that corporate-tax reform would boost the typical family’s wages at least $4,000 a year.
The idea is that when a company considers investing in capital — machinery and computers and the like — it estimates whether the investment will bring in a big enough return to justify itself once taxes, depreciation, and opportunity costs (i.e., the other things the company could have done with the money instead) are considered. All else being equal, when taxes are lower this “required rate of return” is lower as well, and thus more capital investments will be deemed worth making. “Likewise,” the CEA wrote, “by lowering the user cost of capital and making more investments profitable, multinational corporations and foreign capital can be attracted to invest in the U.S. economy.”
Basically, lower corporate taxes mean more capital. And in turn, more capital makes workers more productive, a key ingredient of wage growth and of economic growth more broadly. That’s why, in the Tax Foundation’s model, “70 percent of the full burden of the corporate income tax is borne by labor, due to the negative effects of the tax on investment and wages” — and thus when you cut the corporate tax, most of the benefits end up helping workers rather than just boosting payments to shareholders.
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The Tax Foundation’s analysis is more or less what conservatives have had in mind when pushing “dynamic scoring,” as opposed to the old “static scoring”: Tax cuts benefit the economy, and a stronger economy means more tax revenue, so tax cuts “pay for themselves” to some significant degree (if not entirely).
But it turns out two can play at that game. The Penn Wharton study is dynamic, too, and its results are shockingly different. It finds that there would be some economic growth by 2027 . . . but not much: GDP would be a whopping 0.33 to 0.83 percent bigger. By 2040, the study estimates that this growth will have faded out entirely, and indeed that the economy might be slightly smaller than it would have been otherwise. It puts the ten-year revenue loss in the range of $1.4 to $1.7 trillion.
Without growth, the “distributional impact” of the plan changes too. Penn Wharton doesn’t estimate this aspect of the bill, unfortunately, but we can get some sense of the matter by looking at the no-growth “static” scores from the Tax Foundation and the Tax Policy Center. In both, those in the top 1 percent get the biggest tax breaks, even as a percentage of their income. It’s less clear what happens to those in the rest of the top 10 percent: The Tax Foundation finds they will actually be worse off than they’d be without the plan by 2027, while the TPC says they will get a pretty typical benefit from the cuts — though, within this range, the folks from the 95th to the 99th percentiles do a lot better than the folks from the 90th to the 95th.
Why do the GOP’s tax cuts fail to boost the economy in Penn Wharton’s analysis? Because they’re funded with deficit spending, and in this version of dynamic scoring, deficit spending reduces investment.
Why do the GOP’s tax cuts fail to boost the economy in Penn Wharton’s analysis? Because they’re funded with deficit spending, and in this version of dynamic scoring, deficit spending reduces investment.
The simplest way to put the argument, gleefully skipping over a host of nuances involving interest rates and the like, is this: When the government borrows money, by definition it has to find people to lend it that money. Some percentage of the time, these people will lend the government money that they otherwise would have invested in the American private sector. Thus the deficit “crowds out” private investment, counteracting the pro-investment effect of cutting the corporate tax.
This is hardly settled science. A Congressional Budget Office paper in 2014 rounded up the literature and reported a “high degree of uncertainty”: “For each dollar’s increase in the federal deficit, the effect on investment ranges from a decrease of 15 cents to a decrease of 50 cents, with a central estimate of a decrease of 33 cents.”
The Tax Foundation doesn’t even model this effect. “While past empirical work has found evidence of crowd-out, the estimated impact is usually small,” it contends in the new report. “Furthermore, global savings remain high, which may help explain why interest rates remain low despite rising budget deficits.” (A forthcoming paper from the group will make this argument in more detail, according to a footnote.)
Penn Wharton, in its explanation of why it models things the way it does, points out that “since the year 2000, foreign savers purchased about 40 percent of annual increases in Treasury security issues impelled by higher federal deficits” — implying the rest had to have come from U.S. savers, who most likely would have found other domestic investments otherwise.
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Again, my goal isn’t to settle this dispute. But there are a few takeaways.
First, even in the Tax Foundation’s more optimistic analysis, the bill would reduce federal revenue by $1 trillion over a decade. So Republicans should stop pretending that they won’t be making the debt significantly worse if they continue down this path. If they think it’s a good trade to hike the debt in exchange for (hopefully) boosting the economy, they should make their case openly.
And second, the uncertainty around economic growth is important in itself, because it means we need to plan for numerous possible outcomes. As an instinctive deficit hawk, my preferred approach would be to pass a tax-reform bill that’s revenue-neutral on its face or at least close to it — and then use any resulting growth to reduce the debt. This means rate cuts must be paid for by eliminating deductions and carve-outs or by (gasp) reducing spending.
(Another option might be to add triggers to the bill that automatically sunset the tax cuts if the expected growth doesn’t materialize. But it’s hard to say when we should see growth even if it does happen. According to the aforementioned CEA report, the benefits of corporate-tax reform could show up in three to five years or in “at least double that time.”)
Everyone wants their taxes cut; no one wants to pass on more debt to future generations: That’s the biggest tradeoff inherent in this bill. But in addition, if we do decide to take on more debt, we’re not entirely sure whether we’ll be growing a bigger economy to pass on to our kids as well — or just be pocketing the money we get to keep thanks to the tax cuts, and nothing more.