OPINION: Tax Cuts Sell Out the Future of the US

OPINION: Tax Cuts Sell Out the Future of the US
Photo Credit: AP/達志影像

What you need to know

Trump’s cuts will leave American incomes worse off in the long-term. Instead of following the US example, the world should instead be looking to boost productivity.

President Trump looks set to make good on his election promise to cut taxes. There are many aspects to these cuts – what they do for industry, inequality, the incentive for multinationals to park profits offshore, and more. However, the old cliché applies: the devil is in the detail.

One important aspect we focus on here is the effect on the macro-economy. And, given the size of America, the global repercussions, including for Australia.

Cutting corporate taxes from 35 percent to 21 percent will boost after-tax profits. This boost increases the return on capital, encouraging firms to invest. Some of the extra profits will find their way to shareholder dividends, some to higher wages through higher labor productivity, boosting spending. On top of that, personal income tax cuts will also lift spending. There will be a boost to economic growth and employment – at least in the short term.

Sound too good to be true? The bad news is that there are more economic effects. The tax cuts are largely unfunded and will increase the budget deficit and national debt. Financing this extra deficit will lift interest rates. Some of the extra funds borrowed by both government and business will come from offshore, boosting capital inflow, lifting the currency and worsening the U.S. trade deficit – a headache for President Trump’s stance on trade policy. Finally, America is already at (or near) "full employment" so there are implications for inflation and monetary policy.

The direction of each of these macroeconomic effects is predictable and widely appreciated. But, while some effects boost growth, others detract from it. We recently explored these issues in a Centre for Applied Macroeconomic Analysis (CAMA) working paper called "Some Global Effects of President Trump’s Economic Program."

Although the exact numerical size of policy changes considered in that paper differ from the current bill, the broad story is the same. In the following summary, we refer to the results for a 50 percent cut in corporate taxes and income taxes but no change in government spending.

The effects of the tax cuts will be to expand the U.S. fiscal deficit by an extra 3.3 percent of GDP relative to the baseline or "business-as-usual" case. A string of these deficits would see U.S. government debt double by 2045 compared to the "no tax cut" case. Consumption and investment rise strongly, as intended, in the first year of the cuts. The effect is short-lived, however, so that GDP spikes by 1.4 percent above base a year on. There is higher growth initially but lower growth over time.

The short-term benefits come at the expense of the future, an effect that is pronounced when we consider the incomes of Americans (GNP). While GDP remains above baseline (production is higher), income as measured by GNP is below baseline by year five. By 2030 U.S. GNP is a full one percent below what it would have been otherwise.

Simply, there is more production activity in the U.S., but the scale of borrowings means more of the U.S. production capacity is owned by foreigners. Over time, in income terms, Americans are worse off.

The tax cuts are not "self-financing" – a result consistent with findings from analysis of Reagan’s tax cuts in 1981 and other recent studies. Extra borrowing causes real long-term interest rates to rise by up to 70 basis points above baseline over the long term. The extra capital inflow worsens the current account and trade deficits by over 3 percent of GDP from baseline a year after the tax cuts. The mechanism here is an initial appreciation of the U.S. dollar of 8 percent above baseline. Exports from all sectors are lower than otherwise, the hardest hit being agriculture.

There are two main channels by which the U.S. outcomes affect other countries. One is the activity channel; more U.S. imports boosts the exports of others – a positive. The other channel is financial as capital markets are linked; higher U.S. interest rates raise global interest rates which dampen investment and spending – a negative.

The net effect depends on trade and financial linkages with the U.S. economy. Take China and Germany as examples. The net effect on China is a small negative because of the tightening of Chinese monetary policy to remain partly pegged to the U.S. dollar. It is slightly positive for Germany, which exports capital goods to the U.S. economy experiencing a rise in investment.

For Australia, there are the same positive and negative forces at play except that as a smaller country there is also the indirect repercussions of developments in China and others. The net effect of the U.S. tax cuts is a small negative initially, but then GDP could be 0.5 percent lower in 2019 than otherwise and long-term real interest rates rise gradually to be nearly 30 basis points higher by 2030. Real wages fall due to less capital in the Australian economy. Owners of that capital now invested in the U.S. earn higher returns.

There are plenty of caveats and the assumptions are spelt out in the study cited. The broad conclusions stand however: there is short-term gain to the U.S. economy but at the expense of the future.

The tax cuts are not self-financing and long-term real interest rates could be 100 basis points higher than otherwise once the defence and infrastructure spending is included (as in our study). The tax cuts must worsen the trade deficit unless U.S. consumers save to finance the investment rise. If consumers save then the stimulus would be much less. Our model suggests they would spend the income tax cuts.

A larger trade deficit is the metric (wrongly) by which the President and others judge trade performance. The risks of rising trade protectionism are real and heightened, which could be another negative for the U.S. and world economies.

The best response is not to match the U.S. tax policy but to focus on policies that raise productivity. This would generate more investment, higher real wages and reduce the budget deficit. Merely following the U.S. economy in a tax-cutting war would shift demand from the future to the present but at the expense of future incomes. Silver bullets are hard to find although productivity-enhancing reform is a good place to look.

The News Lens has been authorized to publish this article from Policy Forum – Asia and the Pacific’s platform for public policy analysis, opinion, debate, and discussion.

TNL Editor: Morley J Weston