Expectations of large business and income tax cuts have driven much of the positive reaction of stock markets and business confidence to the new US administration during late 2016 and the first half of 2017. The White House has claimed that it can boost annual GDP growth over 5-10 years to 3% through lower taxes. In contrast, US long-term potential GDP growth is now estimated at around 1.5-2% (Fernald, 2016). This reflects a slowdown in employment growth to around 0.5% annually due to population aging, combined with moderate labour productivity growth of 1-1.5%. Hitting a 3% growth rate over more than one or two years would require tax cuts to sustainably raise annual GDP growth by more than 1 percentage points.
Our baseline forecast assumes a modest fiscal stimulus over 2017-2019, countered by the negative impact of more restrictive immigration and trade policies. This leads to GDP growth of 2% annually in 2017-2019, declining to 1.8% afterwards. We have already outlined significantly more pessimistic scenarios for the US economy, such as an adverse policies driven recession. However, given all the talk of fiscal stimulus, it is worth contemplating significantly more optimistic scenarios as well.
Assuming most of either President Trump’s or the Republican Congress’ big tax reform plans are eventually implemented, can tax cuts increase economic growth to 3%? Our analysis suggests that under the most optimistic assumptions, a full implementation of these tax cut plans could raise annual GDP growth to 2.6% over the next ten years, but more realistic assumptions on the financing of these cuts imply much smaller effects.
Large tax cuts remain possible in 2017-2018, despite growing political obstacles
There are now strong doubts on the ability of the White House and the Republican Congress to coordinate large fiscal policy changes in 2017.
Tensions between more economically conservative and more moderate factions in the Republican Party are continuing, threatening to stall any major legislation. The recent political crisis over the firing of FBI director James Comey has also cost President Trump significant political capital with key Republicans in congress, reducing the scope for collaboration. In particular, Republican Senate Majority Leader Mitch McConnell announced that he’ll oppose tax cuts if they lead to higher deficits, while rejecting many of the spending reductions in the White House’ recent budget proposal. The Republicans in the House of Representatives have approved a revised Republican healthcare bill replacing Obamacare, potentially freeing up 100 billion USD annually in spending to offset lower tax revenues. However, passage of new healthcare legislation in the Senate remains highly uncertain. Five Republican senators have already announced their opposition to the current version of the bill, implying that it would be rejected without further amendments.
Our baseline forecast assumes modest fiscal policy changes, due to these political constraints. Nevertheless, the probability of large tax changes sometime over 2017-2018 remains high. Lowering taxes remains one of the most important policy objectives of Republicans, and failure to deliver on this front despite control of both Congress and the White House could permanently damage the party’s reputation. A bigger concern for Republicans is losing their Congressional majority in the 2018 legislative elections, but at this stage Democrats are still facing an uphill battle to regain Congress.
How much growth can tax cuts deliver?
The key elements of both White House and GOP tax plans are cutting business taxes and the top marginal income tax rate. Marginal tax rates on annual incomes above 100,000 USD would decline by up 7 percentage points (depending on the income band). The top corporate profits tax rate would decline from 35% to 15-20%, while non-corporate firms would be taxed at 15-25% in comparison to the current top income tax rate of 39.6% (the most common currently applied rate for non-incorporated business).
The business tax reform is likely to be the most effective in raising labour productivity and GDP, even though few companies pay the top 35% rate. Since the tax is on profits, it automatically deducts wages and other current production expenses. Therefore, business taxes mostly affect investment decisions. Exemptions on capital depreciation and interest payments reduce the effective tax rate further, but a significant negative impact on business investment remains.
In addition to reducing the official tax rate, both President Trump’s and the Republican Congress reform proposals would allow businesses to automatically deduct capital expenditures, further reducing the disincentives to investment. For the purpose of estimating the consequences of tax changes on investment, the best measure is the marginal tax rate (MTR). This is the tax rate on a hypothetical new investment project that is just expected to break-even. According to the Tax Policy Center (TPC, 2016), the MTR on business investment in the US now 22%. The proposed Republican tax cuts would reduce this to 6-7%, potentially providing a big boost to business capital and labour productivity.
The TPC provides one of the most credible analyses of the impact of Republican tax reform plans, using a sophisticated fiscal policy model that incorporates many demographic and income and wealth distribution details. These details are important for understanding the impact of large fiscal changes on national saving and investment. While the analysis was based on the end of 2016 plans, Trump’s latest tax plan from May is similar to his previous one. The TPC estimates a moderate positive or negative impact on growth from Republican tax plans over the next 10 years, ranging from a 1% GDP increase by 2026 for the House Republicans’ plan to -0.5% for Trump’s plan. This implies a change in annual GDP growth over ten years close to zero. The initial impact could raise GDP growth in the first year by more than 1%, but with slightly lower growth rates in the following years (TPC, 2016).
The impact of the proposed tax cuts depends a lot on how they are financed. The TPC study assumes that they are financed by higher government deficits. Lower business and labour taxes directly stimulate investment and labour supply, boosting capital, employment and output. But if the decline in taxes is financed mostly by higher government borrowing, significant increases in long-term interest rates reduce private investment and capital. While some estimates suggest the higher economic growth effects of the business tax cuts can offset around half the revenue loss (Mankiw and Weinzierl, 2005), government debt would still increase without other spending reductions or tax increases.
Cutting taxes with offsetting government spending reductions would lead to a higher long-term rise in economic activity. GDP could increase by more than 8% in 2017-2026 without deficit financing, raising annual GDP growth towards 2.6% (Tax Foundation, 2016). However, in practice there is likely to be limited room for the up to 400 billion USD in annual government spending cuts that would be required to avoid any increase in deficits. President Trump has promised he won’t cut spending on Medicare, defence, or social security which are the biggest programmes. This leaves other discretionary spending which has already been significantly cut before, as well as other social spending on food stamps and unemployment insurance. Further cuts to these programmes are likely to be politically unpopular. They would also reduce the short-term fiscal stimulus effects on the economy from lower taxes, presenting a trade-off between the short-term and longer-term impacts. As a result, they would increase the probability of Republicans losing their Congressional majority in 2018.
A plausible upside scenario
In summary, Republicans are having major difficulties in agreeing on how to pay for major tax cuts. This makes it hard to envision a large fiscal stimulus getting off the ground. If the Republicans can reach a compromise, it would involve some mix of more moderate declines in spending combined with more moderate increases in debt than those estimated in the TPC (2016) analysis. A plausible estimate is that such a tax reform would raise annual GDP growth over a ten-year horizon to 2.2-2.4%, at the mid-point between the higher deficit financing scenario and the no-deficit financing scenario. However the economic impact for most households would likely be much smaller or even negative. Most of the tax cuts will go to the top 20% or even 1% of the income distribution (TPC, 2016), and the income gains to lower or middle income households could be easily overwhelmed by the negative effects of lower social spending and higher interest rates due to increasing government debt.
Details and Analysis of the Donald Trump Tax Reform Plan, Alan Cole, 2016
Reassessing Longer-Run US Growth: How Low?, John Fernald, FRBSF working paper, 2016
Dynamic Scoring: A Back-of-the-Envelope Guide, N. Gregory Mankiw and Matthew Weinzierl, working paper, 2005
An Analysis of Donald Trump’s Revised Tax Plan, Jim Nunns, Len Burman, Ben Page, Jeff Rohaly and Joe Rosenberg, Tax Policy Center, 2016
An Analysis of the House GOP Tax Plan, Jim Nunns, Len Burman, Ben Page, Jeff Rohaly and Joe Rosenberg, Tax Policy Center, 2016