Policy Institutes

A crucial graph in the Wall Street Journal article, “Trump Fiscal Plain Roils the GOP,” relies on estimates from the Tax Policy Center. Unfortunately, the TPC provides only static estimates of revenue effects of House Republican or Trump tax plans.  That is, they assume lower marginal tax rates on families and firms have literally no effect at all on tax avoidance or long-term economic growth. 

The Wall Street Journal graph purports to project budget deficits over the next 10 years under Congressional Budget Office (CBO) baseline, the House Republican tax plan and the Trump tax plan.  This is quite misleading, because all three scenarios treat future federal spending as given, unchangeable.  Federal spending rose from 17.6% of GDP in 2001 to 19.1% by 2007, and is now 20.7% in 2015. The 2017 Budget projects spending to reach to 22.4% by 2021 and keep rising. 

The CBO August baseline projects federal spending to total $50.2 trillion from 2017 to 2026, so a mere 5% reduction in that growth would exceed $2.5 trillion.

Under President-elect Trump’s revised tax proposal, claims the Tax Policy Center, “revenues would fall by $6.2 billion over the first decade before accounting for interest costs and macroeconomic effects. Including those factors, the federal debt would rise by at least $7 trillion over the first decade.” 

Do not confuse these alleged “macroeconomic effects” with dynamic analysis used in Tax Foundation models and academic studies. The Tax Foundation estimates, for example, that the House Republican tax plan “would reduce federal revenue by $2.4 trillion over the first decades on a static basis,” but that figure shrinks to $191 billion once they properly account for improved investment incentives,  greater labor and entrepreneurial effort and therefore faster economic growth. 

By contrast, the Tax Policy Center presents only “macro feedback” estimates for the Trump plan.  The TPC Keynesian model and Penn-Wharton models assume that revenue losses are 2.6% of GDP, the same as static estimates.  But interest rates are higher, adding to deficits and debt.

The TPC Keynesian model is all about alleged effects of budget deficits on demand and interest rates – not about supply-side microeconomic incentives to raise potential output by raising labor force participation, entrepreneurship and investment.  

According to the Tax Policy Center, “The marginal rate cuts would boost incentives to work, save and invest if interest rates do not change [emphasis added] … However, increased government borrowing could push up interest rates and crowd out private investment, thereby offsetting some or all of the plan’s positive effects on private investment unless federal spending was sharply reduced to offset the effect of the tax cuts on the deficit.” 

This is confusing or confused.  TPC begins by admitting lower marginal tax rates on labor and capital “would” provide incentive for more and better labor and capital, and therefore faster long-run growth of the economy and taxable income. In the short run, “TPC estimates that the impact on output could be between 0.4 and 3.6 percent in 2017, 0.2 and 2.3 percent in 2018 and smaller amounts in later years.”  Their mid-range estimate is that “the Trump tax plan would boost the level of output by about 1.7 percent in 2017, by 1.1 percent in 2018, and by smaller amounts in later years.”  Despite faster economic growth for 5 years, the net “feedback effect” supposedly reduces the 10-year static revenue loss by a surprisingly trivial 1.9% (from $6.15 trillion to $6.03 trillion) for reasons hidden inside the Keynesian model.

“The TPC’s Keynesian model takes into account how tax and spending policies alter demand for goods and services… and how close the economy is to full capacity.”  Despite references to supply-side incentives, the Keynesian model does not allow such incentives to enlarge “full capacity” – potential GDP: “TPC plans to build a neoclassical model of potential output whose results could be integrated with those the Keynesian model, but that work is still in progress.”  This denial of supply-side effects is a fatal flaw in the model’s revenue estimates. The Trump tax plan is assumed to raise economic growth for only five years before we bump up against “full capacity” because tax rates are assumed to affect only demand, not supply.

For example, the TPC says “allowing businesses to elect to expense investment would create an incentive for businesses to raise investment spending, further increasing demand.  These effects on aggregate demand would raise output relative to its potential for several years … [emphasis added].

On the contrary, more investment spending clearly increases supply – increasing capacity and potential GDP.  Lower marginal tax rates on added labor income likewise raise the supply of human capital (participation rates and incentives to invest in education).

If Trump’s tax policy “would boost incentives to work, save and invest” then the future economy and tax base must be larger than otherwise.  It follows that future deficits cannot be nearly as large as the static TPC estimates claim.  It also follows that there will also be more savings with which to finance both public and private borrowing.

Tax Policy Center estimate of a 10-year $6.2 trillion revenue loss is used to predict higher interest rates, and those higher interest rates prevent the economy from growing faster, which in turn vindicates the static assumption of a $6.2 trillion revenue loss.  

The circularity of this tangled fable is remarkably illogical.  How could interest rates remain higher if private investment is crowded out leaving GDP growth unchanged?

The TPC tells a similar story about the House Republican tax plan.  “Although the House GOP tax plan would improve incentives to save and invest, it would also substantially increase budget deficits unless offset by spending cuts, resulting in higher interest rates that would crowd out investment [emphasis added].”  This too is an unsupported assertion. The TPC analysis predicts more private savings and therefore cannot simply assume deficits “would crowd out investment.”

The TPC’s stubborn notion that deficits raise interest rates dates back to a 2004 Brookings paper by Bill Gale and Peter Orzsag which estimated that “a sustained 1 percent of GDP rise in projected deficits would raise current yields by between 20 and 60 basis points, holding other factors constant.”   In reality, actual and projected deficits have been much higher since 2004, yet bond yields fell dramatically.  Japan routinely runs deficits of 5-7% of GDP with bond yields near zero.

The TPC alludes to the Penn-Wharton Budget model as though it is less Keynesian than their own (or that of the CBO).  Yet the architect of that model, Kent Smetters argues that “tax cuts will lead the government to increase its borrowings, which in turn will increase the debt with the general public… Such debt will compete with private capital for household savings and international capital flows.” Like the TPC, Smetters first assumes the TPC static revenue loss is a meaningful number and then goes on to theorize about U.S. and foreign investors making fewer private investments because they (rather than U.S. and foreign central banks) must supposedly purchase more Treasury bills and bonds.  Like the TPC model, the Smetters model also assumes potential output is unaffected by greater investment and work effort, so faster growth in the first few years must supposedly be offset by slower growth after 2024. Assume slow productivity gains and slow labor force growth, then slow GDP growth must (by definition) be the best we can do.

The Tax Policy Center estimates that the revised Trump plan would reduce revenues by 2.6% of GDP (regardless of economic growth).  But it is important to realize that this “loss” is only in comparison with the rising CBO baseline.  With no change in tax policy, the CBO projects the individual income tax will rise faster than GDP every year with no adverse effects on the economy.  The individual income tax is projected to be 8.5% in 2017, then 8.7% in the following year, then 8.9%, 9.1%, 9.2% 9.3%, 9.4%, 9.5%, 9.6%, 9.7%, 9.8% and so on.  

This ever-increasing tax burden is mainly because ever-increasing real wages will supposedly push more and more families into the 35% and 39.6% tax brackets, and also subject them to Obamacare’s 0.9% surtax on labor and 3.8% surtax on investments. 

If revenues from the individual income tax instead remain at the unusually high 2003-2015 level of  8.3 percent of GDP (which would beat any previous 10-year average), then revenues over the next ten years will turn out to be $2.62 trillion smaller than the CBO projects. 

In other words, nearly half of the Tax Policy Center’s $6.2 trillion static revenue loss from the revised Trump plan is due to the CBO’s implausible assumption of endless automatic tax increases, rather than to a huge “tax cut” (at least in the House GOP plan) when compared with taxes we have actually been paying.

The Urban-Brookings Tax Policy Center produced some estimates of the tax revenues supposedly lost by the most recent (September) Trump tax plan, which raised the top tax rate from 25% to 33%.  

These estimates are being widely misunderstood by the Wall Street Journal, New York Times and others, so it may help to actually see the TPC 10-year totals organized by tax changes proposed for individuals, corporations and pass-through businesses. 

The estimates themselves are questionable as are related estimates of the distribution of tax cuts by income groups.  I will deal with those issues in separate posts.  

What most needs emphasizing at this point is that although reporters are writing as though the Trump package is about personal income tax cuts, that only accounts for 22% of the estimated revenue loss (relative to bloated CBO estimates).  Moreover, the 10-year $1.5 trillion loss of revenue from modestly lower individual income tax rates is much smaller than estimated revenue increases from repealing personal exemptions ($2 trillion) and capping itemized deductions ($559 billion).  

The only significant net reduction in taxes on non-business income is from (1) repeal of the alternative minimum tax ($413 billion), and (2) more than doubling the standard deduction ($1.7 trillion) – neither change being of any help to top-income taxpayers. 

TAX POLICY CENTER ESTIMATES OF 10-YEAR REVENUE LOSS FROM TRUMP TAX PLAN, 2016-2026, $ billions

Repeal Obamacare 3.8% investment income tax 

-145

Repeal alternative minimum tax

-413

Repeal head of household filing status

131

Repeal personal exemptions

2,000

Individual income tax rates of 12, 25, and 33 percent 

-1,490

Increase standard deduction to $35,000/couple ($24,000 in GOP plan)

-1,688

Cap itemized deductions at $100,000 ($200,000 joint return)

559

Childcare refundable tax credit

-132

Repeal estate, gift and GST taxes but tax capital gains at death.

-174

TOTAL INDIVIDUAL TAX LESS PASS-THROUGH BUSINESS = 22% of Total

-1,353

 

 

Elective flat rate of 15 percent on pass-through income  

-895

Shifting of wages and salaries to 15% business income (tax avoidance)

-649

Allow expensing of non-corp investment & disallow interest deduction for those electing to expense

-689

Tax carried interests as ordinary business income

10

Repeal certain pass-through business tax expenditures

58

TOTAL PASS-THROUGH BUSINESS = 35.2% of Total

-2,164

 

 

Reduce corporate rate to 15% & repeal corporate AMT

-2,355

Allow expensing of corp investment & disallow interest deduction for those electing to expense.

-593

Deemed repatriation 10 yrs. of untaxed foreign earnings then tax foreign subsidiaries on accrued profit

148

Repeal certain corporate tax expenditures

167

 

 

TOTAL CORPORATE BUSINESS = 43.8% of Total

-2,633

 

 

TOTAL STATIC REVENUE LOSS  

-6,150

In a recent CNBC interview, Donald Trump’s pick for Commerce Secretary, Wilbur Ross, explained why he thought the Trans-Pacific Partnership was a “horrible deal.”  His main complaint was that the agreement has “terrible rules of origin.”  Specifically, he warned, “In automotive, a majority of a car could come from outside TPP, namely could come from China, and still get all the benefits of TPP.”  Presumably this is what Trump was talking about when he said China would “come in … through the back door.”

All trade agreements have rules of origin that specify how much of a product’s manufacturing has to occur within a member country for it to qualify for tariff preferences.  These rules differ from product to product and are the result of negotiation and industry pressure.  Under the TPP’s rules of origin for automobiles and most auto parts, at least 45% of an import’s value must have been created within one or more TPP members for the good to qualify.

So, technically, Ross is correct.  A hypothetical car could contain 55% Chinese content and still be eligible for TPP preferences as long as all the rest came from Japan, Mexico, the United States, or some combination of TPP members.  What Ross is missing, however, is why this is a good thing.  

For one thing, liberal rules of origin help alleviate the problem of trade diversion.  Reducing protectionist trade barriers removes artificial impediments to economic growth by enabling greater specialization that relies on a country’s comparative advantages.  But trade agreements only remove barriers between some countries, leaving others in place.  When all countries’ exports are burdened equally, investment still flows to where products can be made most efficiently.  Tariff preferences, while better than no liberalization at all, have the downside of incentivizing investment based on where there are preferences, creating their own sort of inefficiency.

Ross himself alludes to this problem in his CNBC interview when he notes that “Mexico has 44 treaties with other countries that make it very advantageous to do international shipping from Mexico rather than from the United States.”  But if the rules of origin in Mexico’s treaties allow for high levels of non-Mexican content, some of those goods shipping out of Mexico might be largely made in America.  Mexico’s treaties could benefit American companies that use Mexican parts just as the TPP could benefit Chinese companies that use American parts.

Strict rules of origin, on the other hand, threaten to interfere with cross-border supply chains.  With or without trade agreements, the fact is that many industries have expanded beyond national borders.  Any automobile purchased in the United States, regardless of brand, is going to have lots of foreign-made parts.  The manufacturing process from raw material to pickup truck involves the labor of people in countries all around the world.  The phenomenon of global supply chains unlocks new levels of comparative advantage—instead of car-making, the relevant activities are things like engine-making, glass blowing, software design, and assembly.  Each part of the process is more valuable if the other parts are done as efficiently as possible.  U.S. autoworkers are more productive (and therefore better compensated) when these supply chains are not hindered by tariffs.

Some industries, of course, would rather have protection than efficiency.  The reason that Ross is focusing on automobiles in his criticism of the TPP is that Detroit automakers are highly invested in North American supply chains.  They benefit from tariff-free trade under NAFTA, but NAFTA has very strict rules of origin for autos—requiring over 60% of content to be from the region. 

Replacing that arrangement with the TPP’s 45% rule would open up a lot of competition not only from Japan but from China and Thailand as well.  The TPP would eliminate some of the benefits Canadian and Mexican suppliers currently enjoy under NAFTA’s preferential access.  More competition among suppliers, however, will lower costs for U.S. operations and make the industry as a whole more competitive.

Like other Trump advisors, Ross has expressed a preference for bilateral trade agreements rather than regional ones.  Combined with strict rules of origin, this strategy (if pursued) would worsen the problem of trade diversion; promote inefficient, policy-driven supply chains; enrich rent-seeking cronies at the expense of economic growth; and generate the least possible benefit from trade liberalization.  That’s why previous administrations (Obama with the TPP; George W. Bush with the Free Trade Area of the Americas) have preferred a regional approach. 

Ultimately, Ross’s analysis of the impact of the TPP is fatally flawed due to his erroneous understanding of trade as a zero-sum game.  Trade is a cooperative endeavor in which people in different countries seek mutual advantage through exchange.  Allowing people in China to benefit from trade with Americans is not a failing of the TPP.  On the contrary, it’s one of the ways the TPP would help create value for U.S. companies and better jobs for American workers.  

Cato’s forum on Capitol Hill yesterday featured Senator James Lankford of Oklahoma. The senator mainly talked about his Federal Fumbles report, but he also mentioned his proposed “Taxpayers Right-to-Know Act.”

The legislation complements the priorities of President-elect Trump who complained about “waste, fraud and abuse all over the place,” and promised “we will cut so much, your head will spin.” To know where to cut, Trump and his team will need to learn about hundreds of programs and determine which ones are the biggest failures.

The Trump team can study DownsizingGovernment.org for spending cut ideas. But it would be also useful if the Office of Management and Budget (OMB) provided better information about each federal program.

That’s the thrust of Lankford’s Right-to-Know Act. It would “require OMB to list all [federal] programs, their funding levels, the number of beneficiaries of the programs, and link each program to all related evaluations, assessments, performance reviews, or government reports.” On its website, the OMB would also list the statutes authorizing each program and the number of federal employees, contractors, and grantees who administer them.

Transparency reforms should be extended to the websites of all federal agencies. I’d like to see agencies highlight on their homepages auditor reports on the performance of each program. I’d like to see the “About” pages on agency websites discuss both the pros and cons of agency activities, and not just present one-sided visions. I’d like to see federal agencies provide detailed cost-benefit analyses of each one of their spending programs.

Federal agencies work for us. We pay the bills. Agencies should inform us about their failures as well as their successes. Lankford’s legislation would be a step forward, but more needs to be done. 

In the photo from the left: Justin Bogie of the Heritage Foundation, me, Senator Lankford, and Tom Schatz of Citizens Against Government Waste.

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