Magazine | March 25, 2019, Issue

Taxes Pruned, the Economy Grows

Former Speaker of the House Paul Ryan at news conference announcing the passage of the “Tax Cuts and Jobs Act” at the U.S. Capitol in Washington, D.C., November 16, 2017 (Aaron P. Bernstein/Reuters)
And the Congressional Budget Office bears it out

Is the tax cut expected to pay for itself? Yes — if we use the Congressional Budget Office’s forecast and any economically logical standard, the tax cut makes both current and future generations better off.

The CBO now expects the nominal gross domestic product to increase nearly $750 billion more per year by 2020 than in its forecast prior to the tax cut. It originally attributed about one third of that growth to the tax-cut legislation — even by that estimate, the cut more than pays for itself. The CBO expects that, through a combination of real GDP growth and a burst of inflation, the cut will produce more tax revenue when the middle-class tax cuts expire than would have been the case without the cut. The expected increase in tax revenue, together with the elimination of the health-care mandate, which saves more money than it costs, and other pushes and pulls, more than pays for the interest expense from deficits that accumulate in the interim. That expense includes additional interest paid on all federal debt from an expected rise in interest rates stemming from the tax cut. The eventual increase in tax revenue enables the cut to pay off its debt gradually. With its financing costs covered and the debt accumulated from the cut now declining, the legislation leaves future generations to enjoy more real after-tax GDP than would have been the case without the tax cut. Distributional analysis indicates that households across all income levels share these gains.

Contrary to popular belief, a tax cut doesn’t need to recover its lost tax revenues to make future generations more prosperous. That’s an illogically high standard used as spin by opponents of tax cuts. If you borrow money to buy an asset that permanently produces more income than the cost of the interest on the money you borrowed to buy the asset, you and your children are made richer by the additional income the asset produces, not poorer by the amount of the money you borrowed. That’s why investors make investments. The 2018 tax-cut legislation is no different.

Borrowing makes future generations poorer only if borrowers consume rather than invest the proceeds, leaving future generations with no increased earning capacity to pay for the interest on the debt. By increasing real GDP and collecting more in additional taxes than the incremental cost of its financing, the tax cut makes future generations better off.

Unfortunately, some zealous proponents of tax cuts foolishly promised that cuts would immediately produce more tax revenues. Opponents of tax cuts seized on that standard — that a tax cut hasn’t paid for itself until it has paid down all of its resulting debt — for propaganda purposes.

It is simply not the case that an investment that leads to a permanent increase in income large enough to cover its financing cost need ever pay back its debt. A permanent increase in GDP and tax revenues — what this legislation produces — produces a permanent increase in debt capacity.

Without this basic understanding of finance, all deficits look the same, with no apparent difference between deficit-financed consumption and its opposite, legislation that increases GDP and fully covers its financing cost, as this legislation does. Deficit-financed consumption increases debt without increasing America’s capacity to finance the increased interest expense. That hurts future generations, unlike this tax-cut legislation. Misinformed deficit hawks and opponents of tax cuts fail to differentiate between the two kinds of deficits.

A more relevant comparison asks whether this investment is better than alternative investment opportunities. It is surely the case that the business-tax cuts on their own would have grown GDP without producing the large deficits created by the middle-class tax cuts. The latter create little, if any, long-term growth. But it’s hardly obvious that the legislation would have passed without the cuts for the middle class.

Cuts that lower taxes for most voters, as this legislation does, run the risk that lawmakers will extend the cuts beyond their stipulated expiration. For that reason and others, I opposed the middle-class cuts. But analysis that avoids debating the legislation in its entirety — legislation that includes not only cuts but also a partial expiration of those cuts and a rollback of the health-care mandate, both measures contributing substantially to deficit reduction — deceives the public. Saying that the tax-cut legislation is risky is different from saying that the enacted legislation doesn’t pay for itself. Every investor knows that gains come with risk. There is no free lunch.

Another deceptive strategy used by opponents of the cut is to conflate GDP levels and growth rates. The cut produces a one-time increase in GDP that unfolds gradually over many years. Once increased, GDP returns to its prior long-term growth rate, but it now grows from a permanently higher level.

This permanent long-term gain is somewhat obfuscated by the CBO’s forecast. Reductions in the business-tax rate increase the rate of investment, which gradually increases GDP. At the same time, reductions in the personal-tax rate lead taxpayers to work harder until those cuts expire. This causes short-term growth to overshoot expected long-term growth. Growth declines at the end of the forecast period, when the personal-tax cuts expire and work rates return to pre-cut levels. The business-tax cuts lead to a permanent increase in GDP. Eventually, growth, together with the expiration of the personal-tax cuts and the rollback of the health-care mandate, produce enough additional revenue and cost reduction to more than pay for the additional financing cost that occurs as a result of the cut. This surplus eventually produces more deficit reduction than would have been the case without the legislation.

From the broader perspective, the relevant question is whether the Republican-controlled Congress passed legislation that made future generations more prosperous. It did that and more. The tax cut not only pays for itself, but the CBO now expects nominal GDP to be much higher than the increase needed to pay for the tax cut.

Perhaps the CBO underestimated growth and these expected additional gains would have occurred anyway. Other actions implemented by the Republican administration, such as deregulation and the appointment of conservative judges, may have also contributed to accelerated growth. But a strong case can be made that a large share of the additional growth would not have occurred without a Republican-controlled government and its pro-business tax-cut legislation.

Despite growing concerns that a glut of risk-averse savings now slows growth, the CBO assumes that increased government borrowing from the deficit-financed tax cut will significantly crowd out increased investment that the business-tax cuts would otherwise produce. Evidence suggests that the risk of crowding out is currently reduced. Today, a quarter of all sovereign debt garners negative interest rates; interest rates remain low late in the business cycle when normally they would be rising; and subprime consumers outbid investors for savings prior to the financial crisis, indicating that savings are not constraining growth. Ironically, larger deficits, rather than slowing growth by crowding out investment, may accelerate it by utilizing otherwise underutilized savings. At the very least, the CBO probably overestimates the extent to which deficits crowd out investment at this time.

The CBO also underestimates how increased work effort accelerates the accumulation of knowledge, which is critical for today’s information- and innovation-driven growth. And the CBO fails to take into account that impending legislation may drive economic change. If optimism grows in advance of anticipated legislative changes, it is difficult to know exactly what caused it.

No surprise that since 2016, when Republicans won control of the presidency and both houses of Congress, the Dow Jones Industrial Average has soared over 40 percent — an extraordinary gain eight years into a business cycle. The Dow has stalled at that level since Democrats gained control of the House and threatened disruption. Unlike the U.S. stock market, the German stock market, for example, has given back most of its gains since the 2016 U.S. election. These patterns make it hard to believe that the gains in the U.S. stock market have not been to some extent the result of investor confidence stoked by Republican legislation such as the tax cut.

One thing is certain: American investors and the CBO grew more optimistic at the time of the tax cut. And half a year later, when the world beyond the U.S. borders is growing more pessimistic, the CBO has grown yet more optimistic. However much of that optimism you attribute to the tax cut, by any reasonable standard the legislation is on track to more than pay for itself — most likely, by a wider margin than the CBO admitted in its original forecast.

Ed Conard — Mr. Conard is an American Enterprise Institute visiting scholar, a former Bain Capital partner, and the author of The Upside of Inequality: How Good Intentions Undermine the Middle Class.

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