Will US tax reform really pay for itself?

Liseth Galvis - 06 December 2017

The Republican party's far-reaching tax reforms – still being hammered out by the legislators – include the bold ambition to reduce the marginal rate of corporate tax from 35 per cent to 20 per cent. Other provisions will simplify the tax code, reducing the number of individual income tax brackets from seven to three with tax rates of 12, 25 and 35 per cent. The administration has high hopes that these measures will translate into more investment, more jobs, sustainably faster economic growth and an improvement in living standards.

How credible are these expectations? Government debt levels in the US are already substantial and have increased dramatically since the financial crisis, shifting from 62 per cent of GDP in 2007 to 106 per cent of GDP in 2016 (figure 1). The International Monetary Fund (IMF) has expressed its concerns about Trump’s tax reforms, downgrading its GDP forecast for the US in 2018 from 2.5 to 2.1 per cent, and arguing that the tax cuts will increase the debt burden of future generations and reduce fiscal discipline.

A study from the Urban Institute and Brookings Institution's Tax Policy Center scores the cost of the reforms at around US$1.5trn over 10 years, also casting doubt on the validity of Trump’s claim that "the proposed tax legislation will pay for itself through economic growth". While it certainly can be the case that a tax cut can raise money for the government, by restoring incentives and stimulating business activity, it is far from a universal result. In a recent poll from the University of Chicago, of 42 renowned economists asked to evaluate the above-mentioned claim of Donald Trump, 100 per cent disagreed. While some will, no doubt, regard this as a contrary indicator, the crucial issue is the corporate response to the tax cut.

In the context of significant labour market disruption, the transmission mechanism from corporation tax cuts to wages is tenuous. It is far from clear that the workforce will be the primary beneficiary of the improvement in corporate financial health. Large corporations may prioritize shareholder payments over salary increases and job creation. Other firms could elect to trim their prices to strengthen their market position. Corporate investment decisions are influenced by many factors beyond corporation tax rates and additional income does not translate always into capex growth.

A crucial aspect of the tax reforms is their long-term fiscal sustainability. If, for any reason, GDP growth falls behind the administration’s expectations, public sector debt and debt service payments will escalate. The US fiscal deficit has been on a rollercoaster journey in the past decade, from 1.1 per cent GDP to 9.8 per cent (post-crisis) and back to 3.2 per cent. To row back on fiscal discipline when the macro-economy is still performing reasonably well carries substantial risks.

The Trump administration is staking its economic credibility on these reforms. Even as they come to fruition, the President knows that Senate approval hangs by a thread. For the fiscal hawks in the Republic party, seeing government debt soar to record levels would be a bitter pill to swallow. And the President risks an even larger rift from the wider American public if the promised economic acceleration fails to materialise. This is a high-stakes gamble, even for a casino magnate.

Figure 1.

Data source: usgovernmentspending.com

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