The Simple Economics of What Determines the Foreign Trade Balance: Econ 101

“There’s no reason that we should have big trade deficits with virtually every country in the world.”

“We’re like the piggybank that everybody is robbing.”

“the United States has been taken advantage of for decades and decades”

“Last year,… [the US] lost  … $817 billion on trade.  That’s ridiculous and it’s unacceptable.”

“Well, if they retaliate, they’re making a mistake.  Because, you see, we have a tremendous trade imbalance. … we can’t lose”

Statements made by President Trump at the press conference held as he left the G-7 meetings in, Québec, Canada, June 9, 2018.

 

A.  Introduction

President Trump does not understand basic economics.  While that is not a surprise, nor something necessarily required or expected of a president, one should expect that a president would appoint advisors who do understand, and who would tell him when he is wrong.  Unfortunately, this president has been singularly unwilling to do so.  This is dangerous.

Trump is threatening a trade war.  Not only by his words at the G-7 meetings and elsewhere, but also by a number of his actions on trade and tariffs in recent months, Trump has made clear that he believes that a trade deficit is a “loss” to the nation, that countries with trade surpluses are somehow robbing those (such as the US) with a deficit, that raising tariffs can and will lead to reductions in trade deficits, and that if others then also raise their tariffs, the US will in the end necessarily “win” simply because the US has a trade deficit to start.

This is confused on many levels.  But it does raise the questions of what determines a country’s trade balance; whether a country “loses” if it has a trade deficit; and what is the role of tariffs.  This Econ 101 blog post will first look at the simple economics of what determines a nation’s trade deficit (hint:  it is not tariffs); will then discuss what tariffs do and where do they indeed matter; and will then consider the role played by foreign investment (into the US) and whether a trade deficit can be considered a “loss” for the nation (a piggybank being robbed).

B.  What Determines the Overall Trade Deficit?

Let’s start with a very simple case, where government accounts are aggregated together with the rest of the economy.  We will later then separate out government.

The goods and services available in an economy can come either from what is produced domestically (which is GDP, or Gross Domestic Product) or from what is imported.  One can call this the supply of product.  These goods and services can then be used for immediate consumption, or for investment, or for export.  One can call this the demand for product.  And since investment includes any net change in inventories, the goods and services made available will always add up to the goods and services used.  Supply equals demand.

One can put this in a simple equation:

GDP + Imports = Domestic Consumption + Domestic Investment + Exports

Re-arranging:

(GDP – Domestic Consumption) – Domestic Investment = Exports – Imports

The first component on the left is Domestic Savings (what is produced domestically less what is consumed domestically).  And Exports minus Imports is the Trade Balance.  Hence one has:

Domestic Savings – Domestic Investment = Trade Balance

As one can see from the way this was derived, this is simply an identity – it always has to hold.  And what it says is that the Trade Balance will always be equal to the difference between Domestic Savings and Domestic Investment.  If Domestic Savings is less than Domestic Investment, then the Trade Balance (Exports less Imports) will be negative, and there will be a trade deficit.  To reduce the trade deficit, one therefore has to either raise Domestic Savings or reduce Domestic Investment.  It really is as straightforward as that.

Where this becomes more interesting is in determining how the simple identity is brought about.  But here again, this is relatively straightforward in an economy which, like now, is at full employment.  Hence GDP is essentially fixed:  It cannot immediately rise by either employing more labor (as all the workers who want a job have one), nor by each of those laborers suddenly becoming more productive (as productivity changes only gradually through time by means of either better education or by investment in capital).  And GDP is equal to labor employed times the productivity of each of those workers.

In such a situation, with GDP at its full employment level, Domestic Savings can only rise if Domestic Consumption goes down, as Domestic Savings equals GDP minus Domestic Consumption.  But households want to consume, and saving more will mean less for consumption.  There is a tradeoff.

The only other way to reduce the trade deficit would then be to reduce Domestic Investment.  But one generally does not want to reduce investment.  One needs investment in order to become more productive, and it is only through higher productivity that incomes can rise.

Reducing the trade deficit, if desirable (and whether it is desirable will be discussed below), will therefore not be easy.  There will be tradeoffs.  And note that tariffs do not enter directly in anything here.  Raising tariffs can only have an impact on the trade balance if they have a significant impact for some reason on either Domestic Savings or Domestic Investment, and tariffs are not a direct factor in either.  There may be indirect impacts of tariffs, which will be discussed below, but we will see that the indirect effects actually could act in the direction of increasing, not decreasing, the trade deficit.  However, whichever direction they act in, those indirect effects are likely to be small.  Tariffs will not have a significant effect on the trade balance.

But first, it is helpful to expand the simple analysis of the above to include Government as a separate set of accounts.  In the above we simply had the Domestic sector.  We will now divide that into the Domestic Private and the Domestic Public (or Government) sectors.  Note that Government includes government spending and revenues at all levels of government (state and local as well as federal).  But the government deficit is primarily a federal government issue.  State and local government entities are constrained in how much of a deficit they can run over time, and the overall balance they run (whether deficit or surplus) is relatively minor from the perspective of the country as a whole.

It will now also be convenient to write out the equations in symbols rather than words, and we will use:

GDP = Gross Domestic Product

C = Domestic Private Consumption

I = Domestic Private Investment

G = Government Spending (whether for Consumption or for Investment)

X = Exports

M = Imports

T = Taxes net of Transfers

Note that T (Taxes net of Transfers) will be the sum total of all taxes paid by the private sector to government, minus all transfers received by the private sector from government (such as for Social Security or Medicare).  I will refer to this as simply net Taxes (T).

The basic balance of goods or services available (supplied) and goods or services used (demanded) will then be:

GDP + M = C + I + G + X

We will then add and subtract net Taxes (T) on the right-hand side:

GDP + M = (C + T) + I + (G – T) + X

Rearranging:

GDP – (C + T) – (G – T) – I = X – M

(GDP – C – T) – I + (T – G) = X – M

Or in (abbreviated) words:

Dom. Priv. Savings – Dom. Priv. Investment + Govt Budget Balance = Trade Balance

Domestic Private Savings (savings by households and private businesses) is equal to what is produced in the economy (GDP), less what is privately consumed (C), less what is paid in net Taxes (T) by the private sector to the public sector.  Domestic Private Investment is simply I, and includes investment both by private businesses and by households (primarily in homes).  And the Government Budget Balance is equal to what government receives in net Taxes (T), less what Government spends (on either consumption items or on public investment).  Note that government spending on transfers (e.g. Social Security) is already accounted for in net Taxes (T).

This equation is very much like what we had before.  The overall Trade Balance will equal Domestic Private Savings less Domestic Private Investment plus the Government Budget Balance (which will be negative when a deficit, as has normally been the case except for a few years at the end of the Clinton administration).  If desired, one could break down the Government Budget Balance into Public Savings (equal to net Taxes minus government spending on consumption goods and services) less Public Investment (equal to government spending on investment goods and services), to see the parallel with Domestic Private Savings and Domestic Private Investment.  The equation would then read that the Trade Balance will equal Domestic Private Savings less Domestic Private Investment, plus Government Savings less Government Investment.  But there is no need.  The budget deficit, as commonly discussed, includes public spending not only on consumption items but also on investment items.

This is still an identity.  The balance will always hold.  And it says that to reduce the trade deficit (make it less negative) one has to either increase Domestic Private Savings, or reduce Domestic Private Investment, or increase the Government Budget Balance (i.e. reduce the budget deficit).  Raising Domestic Private Savings implies reducing consumption (when the economy is at full employment, as now).  Few want this.  And as discussed above, a reduction in investment is not desirable as investment is needed to increase productivity over time.

This leaves the budget deficit, and most agree that it really does need to be reduced in an economy that is now at full employment.  Unfortunately, Trump and the Republican Congress have moved the budget in the exact opposite direction, primarily due to the huge tax cut passed last December, and to a lesser extent due to increases in certain spending (primarily for the military).  As discussed in an earlier post on this blog, an increase in the budget deficit to a forecast 5% of GDP at a time when the economy is at full employment is unprecedented in peacetime.

What this implies for the trade balance is clear from the basic identity derived above.  An increase in the budget deficit (a reduction in the budget balance) will lead, all else being equal, to an increase in the trade deficit (a reduction in the trade balance).  And it might indeed be worse, as all else is not equal.  The stated objective of slashing corporate taxes is to spur an increase in corporate investment.  But if private investment were indeed to rise (there is in fact little evidence that it has moved beyond previous trends, at least so far), this would further worsen the trade balance (increase the trade deficit).

Would raising tariffs have an impact?  One might argue that this would raise net Taxes paid, as tariffs on imports are a tax, which (if government spending is not then also changed) would reduce the budget deficit.  While true, the extent of the impact would be trivially small.  The federal government collected $35.6 billion in all customs duties and fees (tariffs and more) in FY2017 (see the OMB Historical Tables).  This was less than 0.2% of FY2017 GDP.  Even if all tariffs (and other fees on imports) were doubled, and the level of imports remained unchanged, this would only raise 0.2% of GDP.  But the trade deficit was 2.9% of GDP in FY2017.  It would not make much of a difference, even in such an extreme case.  Furthermore, new tariffs are not being pushed by Trump on all imports, but only a limited share (and a very limited share so far).  Finally, if Trump’s tariffs in fact lead to lower imports of the items being newly taxed, as he hopes, then tariffs collected can fall.  In the extreme, if the imports of such items go to zero, then the tariffs collected will go to zero.

Thus, for several reasons, any impact on government revenues from the new Trump tariffs will be minor.

The notion that raising tariffs would be a way to eliminate the trade deficit is therefore confused.  The trade balance will equal the difference between Domestic Savings and Domestic Investment.  Adding in government, the trade balance will equal the difference between Domestic Private Savings and Domestic Private Investment, plus the equivalent for government (the Government Budget Balance, where a budget deficit will be a negative).  Tariffs have little to no effect on these balances.

C.  What Role Do Tariffs Play, Then?

Do tariffs then matter?  They do, although not in the determination of the overall trade deficit.  Rather, tariffs, which are a tax, will change the price of the particular import relative to the price of other products.  If applied only to imports from some countries and not from others, one can expect to see a shift in imports towards those countries where the tariffs have not been imposed.  And in the case when they are applied globally, on imports of the product from any country, one should expect that prices for similar products made in the US will then also rise.  To the extent there are alternatives, purchases of the now more costly products (whether imported or produced domestically) will be reduced, while purchases of alternatives will increase.  And there will be important distributional changes.  Profits of firms producing the now higher priced products will increase, while the profits of firms using such products as an input will fall.  And the real incomes of households buying any of these products will fall due to the higher prices.

Who wins and who loses can rapidly become turn into something very complicated.  Take, for example, the new 25% tariff being imposed by the Trump administration on steel (and 10% on aluminum).  The tariffs were announced on March 8, to take effect on March 23.  Steel imports from Canada and Mexico were at first exempted, but later the Trump administration said those exemptions were only temporary.  On March 22 they then expanded the list of countries with temporary exemptions to also the EU, Australia, South Korea, Brazil, and Argentina, but only to May 1.  Then, on March 28, they said imports from South Korea would receive a permanent exemption, and Australia, Brazil, and Argentina were granted permanent exemptions on May 2.  After a short extension, tariffs were then imposed on steel imports from Canada, Mexico, and the EU, on May 31.  And while this is how it stands as I write this, no one knows what further changes might be announced tomorrow.

With this uneven application of the tariffs by country, one should expect to see shifts in the imports by country.  What this achieves is not clear.  But there are also further complications.  There are hundreds if not thousands of different types of steel that are imported – both of different categories and of different grades within each category – and a company using steel in their production process in the US will need a specific type and grade of steel.  Many of these are not even available from a US producer of steel.  There is thus a system where US users of steel can apply for a waiver from the tariff.  As of June 19, there have been more than 21,000 petitions for a waiver.  But there were only 30 evaluators in the US Department of Commerce who will be deciding which petitions will be granted, and their training started only in the second week of June.  They will be swamped, and one senior Commerce Department official quoted in the Washington Post noted that “It’s going to be so unbelievably random, and some companies are going to get screwed”.  It would not be surprising to find political considerations (based on the interests of the Trump administration) playing a major role.

So far, we have only looked at the effects of one tariff (with steel as the example).  But multiple tariffs on various goods will interact, with difficult to predict consequences.  Take for example the tariff imposed on the imports of washing machines announced in late January, 2018, at a rate of 20% in the first year and at 50% should imports exceed 1.2 million units in the year.  This afforded US producers of washing machines a certain degree of protection from competition, and they then raised their prices by 17% over the next three months (February to May).

But steel is a major input used to make washing machines, and steel prices have risen with the new 25% tariff.  This will partially offset the gains the washing machine producers received from the tariff imposed on their product.  Will the Trump administration now impose an even higher tariff on washing machines to offset this?

More generally, the degree to which any given producer will gain or lose from such multiple tariffs will depend on multiple factors – the tariff rates applied (both for what they produce and for what they use as inputs), the degree to which they can find substitutes for the inputs they need, and the degree to which those using the product (the output) will be able to substitute some alternative for the product, and more.  Individual firms can end up ahead, or behind.  Economists call the net effect the degree of “net effective protection” afforded the industry, and it can be difficult to figure out.  Indeed, government officials who had thought they were providing positive protection to some industry often found out later that they were in fact doing the opposite.

Finally, imposing such tariffs on imports will lead to responses from the countries that had been providing the goods.  Under the agreed rules of international trade, those countries can then impose commensurate tariffs of their own on products they had been importing from the US.  This will harm industries that may otherwise have been totally innocent in whatever was behind the dispute.

An example of what can then happen has been the impact on Harley-Davidson, the American manufacturer of heavy motorcycles (affectionately referred to as “hogs”).  Harley-Davidson is facing what has been described as a “triple whammy” from Trump’s trade decisions.  First, they are facing higher steel (and aluminum) prices for their production in the US, due to the Trump steel and aluminum tariffs.  Harley estimates this will add $20 million to their costs in their US plants.  For a medium-sized company, this is significant.  As of the end of 2017, Harley-Davidson had 5,200 employees in the US (see page 7 of this SEC filing).  With $20 million, they could pay each of their workers $3,850 more.  This is not a small amount.  Instead, the funds will go to bolster the profits of steel and aluminum firms.

Second, the EU has responded to the Trump tariffs on their steel and aluminum by imposing tariffs of their own on US motorcycle imports.  This would add $45 million in costs (or $2,200 per motorcycle) should Harley-Davidson continue to export motorcycles from the US to the EU.  Quite rationally, Harley-Davidson responded that they will now need to shift what had been US production to one of their plants located abroad, to avoid both the higher costs resulting from the new steel and aluminum tariffs, and from the EU tariffs imposed in response.

And one can add thirdly and from earlier, that Trump pulled the US out of the already negotiated (but still to be signed) Trans-Pacific Partnership agreement.  This agreement would have allowed Harley-Davidson to export their US built motorcycles to much of Asia duty-free.  They will now instead be facing high tariffs to sell to those markets.  As a result, Harley-Davidson has had to set up a new plant in Asia (in Thailand), shifting there what had been US jobs.

Trump reacted angrily to Harley-Davidson’s response to his trade policies.  He threatened that “they will be taxed like never before!”.  Yet what Harley-Davidson is doing should not have been a surprise, had any thought been given to what would happen once Trump started imposing tariffs on essential inputs needed in the manufacture of motorcycles (steel and aluminum), coming from our major trade partners (and often closest allies).  And it is positively scary that a president should even think that he should use the powers of the state to threaten an individual private company in this way.  Today it is Harley-Davidson.  Who will it be tomorrow?

There are many other examples of the problems that have already been created by Trump’s new tariffs.  To cite a few, and just briefly:

a)  The National Association of Home Builders estimated that the 20% tariff imposed in 2017 on imports of softwood lumber from Canada added nearly $3,600 to the cost of building an average single-family home in the US and would, over the course of a year, reduce wages of US workers by $500 million and cost 8,200 full-time US jobs.

b)  The largest nail manufacturer in the US said in late June that it has already had to lay off 12% of its workforce due to the new steel tariffs, and that unless it is granted a waiver, it would either have to relocate to Mexico or shut down by September.

c)  As of early June, Reuters estimated that at least $2.5 billion worth of investments in new utility-scale solar installation projects had been canceled or frozen due to the tariffs Trump imposed on the import of solar panel assemblies.  This is far greater than new investments planned for the assembly of such panels in the US.  Furthermore, the jobs involved in such assembly work are generally low-skill and repetitive, and can be automated should wages rise.

So there are consequences from such tariffs.  They might be unintended, and possibly not foreseen, but they are real.

But would the imposition of tariffs necessarily reduce the trade deficit, as Trump evidently believes?  No.  As noted above, the trade deficit would only fall if the tariffs would, for some reason, increase domestic savings or reduce domestic investment.  But tariffs do not enter directly into those factors.  Indirectly, one could map out some chains of possible causation, but these changes in some set of tariffs (even if broadly applied to a wide range of imports) would not have a major effect on overall domestic savings or investment.  They could indeed even act in the opposite direction.

Households, to start, will face higher prices from the new tariffs.  To try to maintain their previous standard of living (in real terms) they would then need to spend more on what they consume and hence would save less.  This, by itself, would reduce domestic savings and hence would increase the trade deficit to the extent there was any impact.

The impacts on firms are more various, and depend on whether the firm will be a net winner or loser from the government actions and how they might then respond.  If a net winner, they have been able to raise their prices and hence increase their profits.  If they then save the extra profits (retained earnings), domestic savings would rise and the trade deficit would fall.  But if they increase their investments in what has now become a more profitable activity (and that is indeed the stated intention behind imposing the tariffs), that response would lead to an increase in the trade deficit.  The net effect will depend on whether their savings or their investment increases by more, and one does not know what that net change might be.  Different firms will likely respond differently.

One also has to examine the responses of the firms who will be the net losers from the newly imposed tariffs.  They will be paying more on their inputs and will see a reduction in their profits.  They will then save less and will likely invest less.  Again, the net impact on the trade deficit is not clear.

The overall impact on the trade deficit from these indirect effects is therefore uncertain, as one has effects that will act in opposing directions.  In part for this reason, but also because the tariffs will affect only certain industries and with responses that are likely to be limited (as a tariff increase today can be just as easily reversed tomorrow), the overall impact on the trade balance from such indirect effects are likely to be minor.

Increases in individual tariffs, such as those being imposed now by Trump, will not then have a significant impact on the overall trade balance.  But tariffs still do matter.  They change the mix of what is produced, from where items will be imported, and from where items will be produced for export (as the Harley-Davidson case shows).  They will create individual winners and losers, and hence it is not surprising to see the political lobbying as has grown in Washington under Trump.  Far from “draining the swamp”, Trump’s trade policy has made it critical for firms to step up their lobbying activities.

But such tariffs do not determine what the overall trade balance will be.

D.  What Role Does Foreign Investment Play in the Determination of the Trade Balance?

While tariffs will not have a significant effect on the overall trade balance, foreign investment (into the US) will.  To see this, we need to return to the basic macro balance derived in Section B above, but generalize it a bit to include all foreign financial flows.

The trade balance is the balance between exports and imports.  It is useful to generalize this to take into account two other sources of current flows in the national income and product accounts which add to (or reduce) the net demand for foreign exchange.  Specifically, there will be foreign exchange earned by US nationals working abroad plus that earned by US nationals on investments they have made abroad.  Economists call this “factor services income”, or simply factor income, as labor and capital are referred to as factors of production.  This is then netted against such income earned in the US by foreign nationals either working here or on their investments here.  Second, there will be unrequited transfers of funds, such as by households to their relatives abroad, or by charities, or under government aid programs.  Again, this will be netted against the similar transfers to the US.

Adding the net flows from these to the trade balance will yield what economists call the “current account balance”.  It is a measure of the net demand for dollars (if positive) or for foreign exchange (if a deficit) from current flows.  To put some numbers on this, the US had a foreign trade deficit of $571.6 billion in 2017.  This was the balance between the exports and imports of goods and services (what economists call non-factor services to be more precise, now that we are distinguishing factor services from non-factor services).  It was negative – a deficit.  But the US also had a surplus in 2017 from net factor services income flows of $216.8 billion, and a deficit of $130.2 billion on net transfers (mostly from households sending funds abroad).  The balance on current account is the sum of these (with deficits as negatives and surpluses as positives) and came to a deficit of $485.0 billion in 2017, or 2.5% of GDP.  As a share of GDP, this deficit is significant but not huge.  The UK had a current account deficit of 4.1% of GDP in 2017 for example, while Canada had a deficit of 3.0%.

The current account for foreign transactions, basically a generalization of the trade balance, is significant as it will be the mirror image of the capital account for foreign transactions.  That is, when the US had a current account deficit of $485.0 billion (as in 2017), there had to be a capital account surplus of $485.0 billion to match this, as the overall purchases and sales of dollars in foreign exchange transactions will have to balance out, i.e. sum to zero.  The capital account incorporates all transactions for the purchase or sale of capital assets (investments) by foreign entities into the US, net of the similar purchase or sale of capital assets by US entities abroad.  When the capital account is a net positive (as has been the case for the US in recent decades), there is more such investment going into the US than is going out.  The investments can be into any capital assets, including equity shares in companies, or real estate, or US Treasury or other bonds, and so on.

But while the two (the current account and the capital account) have to balance out, there is an open question of what drives what.  Look at this from the perspective of a foreigner, wishing to invest in some US asset.  They need to get the dollars for this from somewhere.  While this would be done by means of the foreign exchange markets, which are extremely active (with trillions of dollars worth of currencies being exchanged daily), a capital account surplus of $485 billion (as in 2017) means that foreign entities had to obtain, over the course of the year, a net of $485 billion in dollars for their investments into the US.  The only way this could be done is by the US importing that much more than it exported over the course of the year.  That is, the US would need to run a current account deficit of that amount for the US to have received such investment.

If there is an imbalance between the two (the current account and the capital account), one should expect that the excess supply or demand for dollars will lead to changes in a number of prices, most directly foreign exchange rates, but also interest rates and other asset prices.  These will be complex and we will not go into here all the interactions one might then have.  Rather, the point to note is that a current account deficit, even if seemingly large, is not a sign of disequilibrium when there is a desire on the part of foreign investors to invest a similar amount in US markets.  And US markets have traditionally been a good place to invest.  The US is a large economy, with markets for assets that are deep and active, and these markets have normally been (with a few exceptions) relatively well regulated.

Foreign nationals and firms thus have good reason to invest a share of their assets in the US markets.  And the US has welcomed this, as all countries do.  But the only way they can obtain the dollars to make these investments is for the US to run a current account deficit.  Thus a current account deficit should not necessarily be taken as a sign of weakness, as Trump evidently does.  Depending on what governments are doing in their market interventions, a current account deficit might rather be a sign of foreign entities being eager to invest in the country.  And that is a good sign, not a bad one.

E.  An “Exorbitant Privilege”

The dollar (and hence the US) has a further, and important, advantage.  It is the world’s dominant currency, with most trade contracts (between all countries, not simply between some country and the US) denominated in dollars, as are contracts for most internationally traded commodities (such as oil).  And as noted above, investments in the US are particularly advantageous due to the depth and liquidity of our asset markets.  For these reasons, foreign countries hold most of their international reserves in dollar assets.  And most of these are held in what have been safe, but low yielding, short-term US Treasury bills.

As noted in Section D above, those seeking to make investments in dollar assets can obtain the dollars required only if the US runs a current account deficit.  This is as true for assets held in dollars as part of a country’s international reserves as for any other investments in US dollar assets.  Valéry Giscard d’Estaing in the 1960s, then the Minister of Finance of France, described this as an “exorbitant privilege” for the US (although this is often mistakenly attributed Charles de Gaulle, then his boss as president of France).

And it certainly is a privilege.  With the role of the dollar as the preferred reserve currency for countries around the world, the US is able to run current account deficits indefinitely, obtaining real goods and services from those countries while providing pieces of paper generating only a low yield in return.  Indeed, in recent years the rate of return on short-term US Treasury bills has generally been negative in real terms (i.e. after inflation).  The foreign governments buying these US Treasury bills are helping to cover part of our budget deficits, and are receiving little to nothing in return.

So is the US a “piggybank that everybody is robbing”, as Trump asserted to necessarily be the case when the US is has a current account deficit?  Not at all.  Indeed, it is the precise opposite.  The current account deficit is the mirror image of the foreign investment inflows coming into the US.  To obtain the dollars needed to do this those countries must export more real goods to the US than they import from the US.  The US gains real resources (the net exports), while the foreign entities then invest in US markets.  And for governments obtaining dollars to hold as their international reserves, those investments are primarily in the highly liquid and safe, short-term US Treasury bills, despite those assets earning low or even negative returns.  This truly is an “exorbitant privilege”, not a piggybank being robbed.

Indeed, the real concern is that with the mismanagement of our budget (tax cuts increasing deficits at a time when deficits should be reduced) plus the return to an ideologically driven belief in deregulating banks and other financial markets (such as what led to the financial and then economic collapse of 2008), the dollar may lose its position as the place to hold international reserves.  The British pound had this position in the 1800s and then lost it to the dollar due to the financial stresses of World War I.  The dollar has had the lead position since.  But others would like it, most openly by China and more quietly Europeans hoping for such a role for the euro.  They would very much like to enjoy this “exorbitant privilege”, along with the current account deficits that privilege conveys.

F.  Summary and Conclusion

Trump’s beliefs on the foreign trade deficit, on the impact of hiking tariffs, and on who will “win” in a trade war, are terribly confused.  While one should not necessarily expect a president to understand basic economics, one should expect that a president would appoint and listen to advisors who do.  But Trump has not.

To sum up some of the key points:

a)  The foreign trade balance will always equal the difference between domestic savings and domestic investment.  Or with government accounts split out, the trade balance will equal the difference between domestic private savings and domestic private investment, plus the government budget balance.  The foreign trade balance will only move up or down when there is a change in the balance between domestic savings and domestic investment.

b)  One way to change that balance would be for the government budget balance to increase (i.e. for the government deficit to be reduced).  Yet Trump and the Republican Congress have done the precise opposite.  The massive tax cuts of last December, plus (to a lesser extent) the increase in government spending now budgeted (primarily for the military), will increase the budget deficit to record levels for an economy in peacetime at full employment.  This will lead to a bigger trade deficit, not a smaller one.

c)  One could also reduce the trade deficit by making the US a terrible place to invest in.  This would reduce foreign investment into the US, and hence the current account deficit.  In terms of the basic savings/investment balance, it would reduce domestic investment (whether driven by foreign investors or domestic ones).  If domestic savings was not then also reduced (a big if, and dependant on what was done to make the US a terrible place to invest in), this would lead to a similar reduction in the trade deficit.  This is of course not to be taken seriously, but rather illustrates that there are tradeoffs.  One should not simplistically assume that a lower trade deficit achieved by any means possible is good.

d)  It is also not at all clear that one should be overly concerned about the size of the trade and current account deficits, at where they are today.  The US had a trade deficit of 2.9% of GDP in 2017 and a current account deficit of 2.5% of GDP.  While significant, these are not huge.  Should they become much larger (due, for example, to the forecast increases in government budget deficits to record levels), they might rise to problematic levels.  But at the current levels for the current account deficit, we have seen the markets for foreign exchange and for interest rates functioning pretty well and without overt signs of concern.  The dollars being made available through the current account deficit have been bought up and used for investments in US markets.

e)  Part of the demand for dollars to be invested and held in the US markets comes from the need for international reserves by governments around the world.  The dollar is the dominant currency in the world, and with the depth and liquidity of the US markets (in particular for short-term US Treasury bills) most of these international reserves are held in dollars.  This has given the US what has been called an “exorbitant privilege”, and permits the US to run substantial current account deficits while providing in return what are in essence paper assets yielding just low (or even negative) returns.

f)  The real concern should not be with the consequences of the dollar playing such a role in the system of international trade, but rather with whether the dollar will lose this privileged status.  Other countries have certainly sought this, most openly by China but also more quietly for the euro, but so far the dollar has remained dominant.  But there are increasing concerns that with the mismanagement of the government budget (the recent tax cuts) plus ideologically driven deregulation of banks and the financial markets (as led to the 2008 financial collapse), countries will decide to shift their international reserves out of the dollar towards some alternative.

g)  What will not reduce the overall trade deficit, however, is selective increases in tariff rates, as Trump has started to do.  Such tariff increases will shift around the mix of countries from where the imports will come, and/or the mix of products being imported, but can only reduce the overall trade deficit to the extent such tariffs would lead somehow to either higher domestic savings and/or lower domestic investment.  Tariffs will not have a direct effect on such balances, and indirect effects are going to be small and indeed possibly in the wrong direction (if the aim is to reduce the deficits).

h)  What such tariff policies will do, however, is create a mess.  And they already have, as the Harley-Davidson case illustrates.  Tariffs increase costs for US producers, and they will respond as best they can.  While the higher costs will possibly benefit certain companies, they will harm those using the products unless some government bureaucrat grants them a special exemption.

But what this does lead to is officials in government picking winners and losers.  That is a concern.  And it is positively scary to have a president lashing out and threatening individual firms, such as Harley-Davidson, when the firms respond to the mess created as one should have expected.

The Mismanagement of Fiscal Policy Under Trump: Deficits When There Should be Surpluses

A.  Introduction

Since World War II, the US has never run such high fiscal deficits in times of full employment as it will now.  With the tax cuts pushed through by the Republican Congress and signed into law by Trump in December, and to a lesser extent the budget passed in March, it is expected that the US will soon be running a fiscal deficit of over $1.0 trillion a year, exceeding 5% of GDP.  This is unprecedented.

We now have good estimates of how high the deficits will grow under current policy and in a scenario which assumes (optimistically) that the economy will remain at full employment, with no downturn.  The Congressional Budget Office (CBO) published on April 9 its regular report on “The Budget and Economic Outlook”, this year covering fiscal years 2018 to 2028.  In this report to Congress and to the public, the CBO assesses the implications of federal budget and tax policy, as set out under current law.  The report normally comes out in January or February of each year but was delayed this year in order to reflect the tax bill approved in December and also the FY18 budget, which was only approved in March (even though the fiscal year began last October).

The forecast is that the deficits will now balloon.  This should not be a surprise given the magnitude of the tax cuts pushed through Congress in December and then signed into law by Trump, but recall that the Republicans pushing through the tax bill asserted deficits would not increase as a result.  The budget approved in March also provides for significant increases in legislated spending – especially for the military but also for certain domestic programs.  But as will be discussed below, government spending (other than on interest) over the next decade is in fact now forecast by the CBO to be less than what it had forecast last June.

The CBO assessment is the first set of official estimates of what the overall impact will be.  And they are big.  The CBO forecasts that even though the economy is now at full employment (and assumed to remain there for the purposes of the scenario used), deficits are forecast to grow to just short of $1 trillion in FY2019, and then continue to increase, reaching over $1.5 trillion by FY2028.  In dollar terms, it has never been that high – not even in 2009 at the worst point in the recession following the 2008 collapse of the economy.

That is terrible fiscal policy.  While high fiscal deficits are to be expected during times of high unemployment (as tax revenues are down, while government spending is the only stabilizing element for the economy when both households and corporations are cutting back on spending due to the downturn), standard policy would be to limit deficits in times of full employment in order to bring down the public debt to GDP ratio.  But with the tax cuts and spending plans this is not going to happen under Trump, even should the economy remain at full employment.  And it will be far worse when the economy once again dips into a recession, as always happens eventually.

This blog post will first discuss the numbers in the new CBO forecasts, then the policy one should follow over the course of the business cycle in order to keep the public debt to GDP under control, and finally will look at the historical relationship between unemployment and the fiscal deficit, and how the choices made on the deficit by Trump and the Republican-controlled Congress are unprecedented and far from the historical norms.

B.  The CBO Forecast of the Fiscal Deficits

The forecasts made by the CBO of the fiscal accounts that would follow under current policies are always eagerly awaited by those concerned with what Congress is doing.  Ten-year budget forecasts are provided by the CBO at least annually, and typically twice or even three times a year, depending on the decisions being made by Congress.

The CBO itself is non-partisan, with a large professional staff and a director who is appointed to a four-year term (with no limits on its renewal) by the then leaders in Congress.  The current director, Keith Hall, took over on April 1, 2015, when both the House and the Senate were under Republican control.  He replaced Doug Elmensdorf, who was widely respected as both capable and impartial, but who had come to the end of a term.  Many advocated that he be reappointed, but Elmensdorf had first taken the position when Democrats controlled the House and the Senate.  Hall is a Republican, having served in senior positions in the George W. Bush administration, and there was concern that his appointment signaled an intent to politicize the position.

But as much as his party background, a key consideration appeared to have been Hall’s support for the view that tax cuts would, through their impact on incentives, lead to more rapid growth, with that more rapid growth then generating more tax revenue which would partially or even fully offset the losses from the lower tax rates.  I do not agree.  An earlier post on this blog discussed that that argument is incomplete, and does not take into account that there are income as well as substitution effects (as well as much more), which limit or offset what the impact might be from substitution effects alone.  And another post on this blog looked at the historical experience after the Reagan and Bush tax cuts, in comparison to the experience after the (more modest) increases in tax rates on higher income groups under Clinton and Obama.  It found no evidence in support of the argument that growth will be faster after tax cuts than when taxes are raised.  What the data suggest, rather, is that there was little to no impact on growth in one direction or the other.  Where there was a clear impact, however, was on the fiscal deficits, which rose with the tax cuts and fell with the tax increases.

Given Hall’s views on taxes, it was thus of interest to see whether the CBO would now forecast that an acceleration in GDP growth would follow from the new tax cuts sufficient to offset the lower tax revenues following from the lower tax rates.  The answer is no.  While the CBO did forecast that GDP would be modestly higher as a result of the tax cuts (peaking at 1.0% higher than would otherwise be the case in 2022 before then diminishing over time, and keep in mind that these are for the forecast levels of GDP, not of its growth), this modestly higher GDP would not suffice to offset the lower tax revenues following from the lower tax rates.

Taking account of all the legislative changes in tax law since its prior forecasts issued in June 2017, the CBO estimated that fiscal revenues collected over the ten years FY2018 to FY2027 would fall by $1.7 trillion from what it would have been under previous law.  However, after taking into account its forecast of the resulting macroeconomic effects (as well as certain technical changes it made in its forecasts), the net impact would be a $1.0 trillion loss in revenues.  This is almost exactly the same loss as had been estimated by the staff of the Joint Committee on Taxation for the December tax bill, which also factored in an estimate of a (modest) impact on growth from the lower tax rates.

Fiscal spending projections were also provided, and the CBO estimated that legislative changes alone (since its previous estimates in June 2017) would raise spending (excluding interest) by $450 billion over the ten year period.  However, after taking into account certain macro feedbacks as well as technical changes in the forecasts, the CBO is now forecasting government spending will in fact be $100 billion less over the ten years than it had forecast last June.  The higher deficits over those earlier forecast are not coming from higher spending but rather totally from the tax cuts.

Finally, the higher deficits will have to be funded by higher government borrowing, and this will lead to higher interest costs.  Interest costs will also be higher as the expansionary fiscal policy at a time when the economy is already at full employment will lead to higher interest rates, and those higher interest rates will apply to the entire public debt, not just to the increment in debt resulting from the higher deficits.  The CBO forecasts that higher interest costs will add $650 billion to the deficits over the ten years.

The total effect of all this will thus be to increase the fiscal deficit by $1.6 trillion over the ten years, over what it would otherwise have been.  The resulting annual fiscal deficits, in billions of dollars, would be as shown in the chart at top of this post.  Under the assumed scenario that the economy will remain at full employment over the entire period, the fiscal deficit will still rise to reach almost $1 trillion in FY19, and then to over $1.5 trillion in FY28.  Such deficits are unprecedented for when the economy is at full employment.

The deficits forecast would then translate into these shares of GDP, given the GDP forecasts:

The CBO is forecasting that fiscal deficits will rise to a range of 4 1/2 to 5 1/2% of GDP from FY2019 onwards.  Again, this is unprecedented for the US economy in times of full employment.

C.  Fiscal Policy Over the Course of the Business Cycle

As noted above, fiscal policy has an important role to play during economic downturns to stabilize conditions and to launch a recovery.  When something causes an economic downturn (such as the decision during the Bush II administration not to regulate banks properly in the lead up to the 2008 collapse, believing “the markets” would do this best), both households and corporations will reduce their spending.  With unemployment increasing and wages often falling even for those fortunate enough to remain employed, as well as with the heightened general concerns on the economy, households will cut back on their spending.  Similarly, corporations will seek to conserve cash in the downturns, and will cut back on their spending both for the inputs they would use for current production (they cannot sell all of their product anyway) and for capital investments (their production facilities are not being fully used, so why add to capacity).

Only government can sustain the economy in such times, stopping the downward spiral through its spending.  Fiscal stimulus is needed, and the Obama stimulus program passed early in his first year succeeded in pulling the economy out of the freefall it was in at the time of his inauguration.  GDP fell at an astounding 8.2% annual rate in the fourth quarter of 2008 and was still crashing in early 2009 as Obama was being sworn in.  It then stabilized in the second quarter of 2009 and started to rise in the third quarter.  The stimulus program, as well as aggressive action by the Federal Reserve, accounts for this turnaround.

But fiscal deficits will be high during such economic downturns.  While any stimulus programs will add to this, most of the increase in the deficits in such periods occur automatically, primarily due to lower tax revenues in the downturn.  Incomes and employment are lower, so taxes due will be lower.  There is also, but to a much smaller extent, some automatic increase in government spending during the downturns, as funds are paid out in unemployment insurance or for food stamps for the increased number of the poor.  The deficits will then add to the public debt, and the public debt to GDP ratio will rise sharply (exacerbated in the short run by the lower GDP as well).

One confusion, sometimes seen in news reports, should be clarified.  While fiscal deficits will be high in a downturn, for the reasons noted above, and any stimulus program will add further to those deficits, one should not equate the size of the fiscal deficit with the size of the stimulus.  They are two different things.  For example, normally the greatest stimulus, for any dollar of expenditures, will come from employing directly blue-collar workers in some government funded program (such as to build or maintain roads and other such infrastructure).  A tax cut focused on the poor and middle classes, who will spend any extra dollar they receive, will also normally lead to significant stimulus (although probably less than via directly employing a worker).  But a tax cut focused on the rich will provide only limited stimulus as any extra dollar they receive will mostly simply be saved (or used to pay down debt, which is economically the same thing).  The rich are not constrained in how much they can spend on consumption by their income, as their income is high enough to allow them to consume as much as they wish.

Each of these three examples will add equally to the fiscal deficit, whether the dollar is used to employ workers directly, to provide a tax cut to the poor and middle classes, or to provide a tax cut to the rich.  But the degree of stimulus per dollar added to the deficit can be dramatically different.  One cannot equate the size of the deficit to the amount of stimulus.

Deficits are thus to be expected, and indeed warranted, in a downturn.  But while the resulting increase in public debt is to be expected in such conditions, there must also come a time for the fiscal deficits to be reduced to a level where at least the debt to GDP ratio, if not the absolute level of the debt itself, will be reduced.  Debt cannot be allowed to grow without limit.  And the time to do this is when the economy is at full employment.  It was thus the height of fiscal malpractice for the tax bills and budget passed by Congress and signed into law by Trump not to provide for this, but rather for the precise opposite.  The CBO estimates show that deficits will rise rather than fall, even under a scenario where the economy is assumed to remain at full employment.

It should also be noted that the deficit need not be reduced all the way to zero for the debt to GDP ratio to fall.  With a growing GDP and other factors (interest rates, the rate of inflation, and the debt to GDP ratio) similar to what they are now, a good rule of thumb is that the public debt to GDP ratio will fall as long as the fiscal deficit is around 3% of GDP or less.  But the budget and tax bills of Trump and the Congress will instead lead to deficits of around 5% of GDP.  Hence the debt to GDP ratio will rise.

[Technical note for those interested:  The arithmetic of the relationship between the fiscal deficit and the debt to GDP ratio is simple.  A reasonable forecast, given stated Fed targets, is for an interest rate on long-term public debt of 4% and an inflation rate of 2%.  This implies a real interest rate of 2%.  With real GDP also assumed to grow in the CBO forecast at 2% a year (from 2017 to 2028), the public debt to GDP ratio will be constant if what is called the “primary balance” is zero (as the numerator, public debt, will then grow at the same rate as the denominator, GDP, each at either 2% a year in real terms or 4% a year in nominal terms) .  The primary balance is the fiscal deficit excluding what is paid in interest on the debt.  The public debt to GDP ratio, as of the end of FY17, was 76.5%.  With a nominal interest rate of 4%, this would lead to interest payments on the debt of 3% of GDP.  A primary balance of zero would then imply an overall fiscal deficit of 3% of GDP.  Hence a fiscal deficit of 3% or less, with the public debt to GDP ratio roughly where it is now, will lead to a steady debt to GDP ratio.

More generally, the debt to GDP ratio will be constant whenever the rate of growth of real GDP matches the real interest rate, and the primary balance is zero.  In the case here, the growth in the numerator of debt (4% in nominal terms, or 2% in real terms when inflation is 2%) matches the growth in the denominator of GDP (2% in real terms, or 4% in nominal terms), and the ratio will thus be constant.]

Putting this in a longer-term context:

Federal government debt rose to over 100% of GDP during World War II.  The war spending was necessary.  But it did not then doom the US to perpetual economic stagnation or worse.  Rather, fiscal deficits were kept modest, the economy grew well, and over the next several decades the debt to GDP ratio fell.

For the fiscal balances over this period (with fiscal deficits as negative and fiscal surpluses as positive):

Fiscal balances were mostly but modestly in deficit (and occasionally in surplus) through the 1950s, 60s, and 70s.  The 3% fiscal deficit rule of thumb worked well, and one can see that as long as the fiscal deficit remained below 3% of GDP, the public debt to GDP ratio fell, to a low of 23% of GDP in FY1974.  It then stabilized at around this level for a few years, but reversed and started heading in FY1982 after Reagan took office.  And it kept going up even after the economy had recovered from the 1982 recession and the country was back to full employment, as deficits remained high following the Reagan tax cuts.

The new Clinton budgets, along with the tax increase passed in 1993, then stabilized the accounts, and the economy grew strongly.  The public debt to GDP ratio, which had close to doubled under Reagan and Bush I (from 25% of GDP to 48%), was reduced to 31% of GDP by the year Clinton left office.   But it then started to rise again following the tax cuts of Bush II (plus with the first of the two recessions under Bush II).  And it exploded in 2008/2009, at the end of Bush II and the start of Obama, as the economy plunged into the worst economic downturn since the Great Depression.

The debt to GDP ratio did stabilize, however, in the second Obama term, and actually fell slightly in FY2015 (when the deficit was 2.4% of GDP).  But with the deficits now forecast to rise to the vicinity of 5% of GDP (and to this level even with the assumption that there will not be an economic downturn at some point), the public debt to GDP ratio will soon be approaching 100% of GDP.

This does not have to happen.  As noted above, one need not bring the fiscal deficits all the way down to zero.  A fiscal deficit kept at around 3% of GDP would suffice to stabilize the public debt to GDP ratio, while something less than 3% would bring it down.

D.  Historical Norms

What stands out in these forecasts is how much the deficits anticipated now differ from the historical norms.  The CBO report has data on the deficits going back to FY1968 (fifty years), and these can be used to examine the relationship with unemployment.  As discussed above, one should expect higher deficits during an economic downturn when unemployment is high.  But these deficits then need to be balanced with lower deficits when unemployment is lower (and sufficiently low when the economy is at or near full employment that the public debt to GDP ratio will fall).

A simple scatter-plot of the fiscal balance (where fiscal deficits are a negative balance) versus the unemployment rate, for the period from FY1968 to now and then the CBO forecasts to FY2028, shows:

While there is much going on in the economy that affects the fiscal balance, this scatter plot shows a surprisingly consistent relationship between the fiscal balance and the rate of unemployment.  The red line shows what the simple regression line would be for the historical years of FY1968 to FY2016.  The scatter around it is surprisingly tight.  [Technical Note:  The t-statistic is 10.0, where anything greater than 2.0 is traditionally considered significant, and the R-squared is 0.68, which is high for such a scatter plot.]

An interesting finding is that the high deficits in the early Obama years are actually very close to what one would expect given the historical norm, given the unemployment rates Obama faced on taking office and in his first few years in office.  That is, the Obama stimulus programs did not cause the fiscal deficits to grow beyond what would have been expected given what the US has had in the past.  The deficits were high because unemployment was high following the 2008 collapse.

At the other end of the line, one has the fiscal surpluses in the years FY1998 to 2000 at the end of the Clinton presidency.  As noted above, the public debt to GDP ratio stabilized soon after Clinton took office (in part due to the tax increases passed in 1993), with the fiscal deficits reduced to less than 3% of GDP.  Unemployment fell to below 5% by mid-1997 and to a low of 3.8% in mid-2000, as the economy grew well.  By FY1998 the fiscal accounts were in surplus.  And as seen in the scatter plot above, the relationship between unemployment and the fiscal balance was close in those years (FY1998 to 2000) to what one would expect given the historical norms for the US.

But the tax cuts and budget passed by Congress and signed by Trump will now lead the fiscal accounts to a path far from the historical norms.  Instead of a budget surplus (as in the later Clinton years, when the unemployment rate was similar to what the CBO assumes will hold for its scenario), or even a deficit kept to 3% of GDP or less (which would suffice to stabilize the debt to GDP ratio), deficits of 4 1/2 to 5 1/2 % of GDP are foreseen.  The scatter of points for the fiscal deficit vs. unemployment relationship for 2018 to 2028 is in a bunch by itself, down and well to the left of the regression line.  One has not had such deficits in times of full employment since World War II.

E.  Conclusion

Fiscal policy is being mismanaged.  The economy reached full employment by the end of the Obama administration, fiscal deficits had come down, and the public debt to GDP ratio had stabilized.  There was certainly more to be done to bring down the deficit further, and with the aging of the population (retiring baby boomers), government expenditures (for Social Security and especially for Medicare and other health programs) will need to increase in the coming years.  Tax revenues to meet such needs will need to rise.

But the Republican-controlled Congress and Trump pushed through measures that will do the opposite.  Taxes have been cut dramatically (especially for corporations and rich households), while the budget passed in March will raise government spending (especially for the military).  Even assuming the economy will remain at full employment with no downturn over the next decade (which would be unprecedented), fiscal deficits will rise to around 5% of GDP.  As a consequence, the public debt to GDP ratio will rise steadily.

This is unprecedented.  With the economy at full employment, deficits should be reduced, not increased.  They need not go all the way to zero, even though Clinton was able to achieve that.  A fiscal deficit of 3% of GDP (where it was in the latter years of the Obama administration) would stabilize the debt to GDP ratio.  But Congress and Trump pushed through measures to raise the deficit rather than reduce it.

This leaves the economy vulnerable.  There will eventually be another economic downturn.  There always is one, eventually.  The deficit will then soar, as it did in 2008/2009, and remain high until the economy fully recovers.  But there will then be pressure not to allow the debt to rise even further.  This is what happened following the 2010 elections, when the Republicans gained control of the House.  With control over the budget, they were able to cut government spending even though unemployment was still high.  Because of this, the pace of the recovery was slower than it need have been.  While the economy did eventually return to full employment by the end of Obama’s second term, unemployment remained higher than should have been the case for several years as a consequence of the cuts.

At the next downturn, the fiscal accounts will be in a poor position to respond as they need to in a crisis.  Public debt, already high, will soar to unprecedented levels, and there will be arguments from conservatives not to allow the debt to rise even further.  Recovery will then be even more difficult, and many will suffer as a result.

The Republican Tax Plan: Government Debt Will Rise by More Than the $1.0 Trillion Commonly Cited

A.  Introduction

News reports are saying that the Senate Republican tax plan, rushed through and passed on a 51 to 49 vote late on a Friday night (actually, at 2 am on Saturday), will add an estimated $1.0 trillion to the national debt over the next ten years.  The number is based on figures provided in a staff report from the Joint Committee on Taxation (JCT) of Congress on the estimated tax revenue impacts.  But that is not what the JCT numbers say.  The actual increase in the federal debt will be almost a quarter more than that $1.0 trillion figure, even taking the JCT estimates as fine.  The problem is that they are being misinterpreted.

The JCT acts as a professional staff responsible for assessing the impacts of tax proposals before Congress (on behalf of both the Senate and the House), and must act in accord with instructions provided by the Congressional leadership.  They have traditionally worked out the revenue implications of the proposals sent to them (normally on a year by year basis over a ten-year horizon) as well as the distributional implications (what will be the effects by income group).  When Republicans took control of both the Senate and the House following the 2012 elections, JCT staff were also directed to provide what has been labeled “dynamic scoring”, which attempts to come up with an estimate of how economic growth may be affected and the revenue implications of that.  The assumption is that tax cuts will spur growth, and that with higher growth there will be an increase in tax revenues which would then (partially or possibly fully) offset what the revenue losses would otherwise be as a result of the tax cuts.

This is the old “supply-side economics”, which politicians starting with Reagan would cite as saying that tax cuts can pay for themselves.  The reality has been far different, as previous posts on this blog have argued.  The tax cuts of Reagan and Bush were followed by higher deficits, and slower (or at least not faster) growth than what followed after the tax increases approved under Clinton and Obama.  A fair reading of these experiences would not be that tax increases are good for growth and tax cuts bad for growth, but rather that the impacts, whatever they are, are too small to see in the data.

But the JCT staff are now required to provide some such estimate, and to do this they have to use economic models.  The constraints of such an approach will be discussed below.  But there is also a separate issue, which has unfortunately been confused with the impact of the growth estimates.  The issue is that the figures being provided by the JCT, on the year by year impact on tax revenues of the tax plan, are being confused with how far government debt will rise as a result of those tax losses.  Reporters are adding up the year by year tax revenue impacts over the ten year period of the forecasts, and concluding that that total will equal the resulting increase in government debt.  But that is not correct.  That simple addition of the year by year figures on tax losses leaves out the additional interest that will need to be paid on the debt incurred to cover those now higher fiscal deficits.  That additional interest will be significant.

B.  The Impact of Increased Interest on the Addition to the Federal Debt

The black curve in the chart at the top of this post, rising to $1,414 billion by FY2027, shows the simple accumulation of the lost tax revenues (year by year) following from the Senate Republican tax plan (November 16 version, as assessed by the JCT on November 17).  While the final plan passed by the Senate was a bit different (loopholes were being added or expanded up to the final hours, with also some offsetting tax increases), the net change in revenues in the final, approved, bill was relatively small, at $34 billion over the ten years (raising the cost to $1,448 billion from the $1,414 billion cost the JCT had estimated for the earlier version).  The JCT estimates of the macro impacts based on the $1,414 billion total will be close to what it would have been had they had the time to assess the final plan.

That path leading to the $1,414 billion cost total reflects the simple sum of the year by year tax revenue losses as a result of the Republican tax plan.  But those revenue losses will lead to larger deficits.  The larger deficits will mean additional federal debt, and interest will have to be paid on that additional debt.

Such additional interest needs to be paid year by year, and will accumulate over time.  The blue curve at the top, rising to $1,717 billion, is an estimate of what this would be, using the June 2017 interest rate forecasts (on government debt) from the Congressional Budget Office, and assuming, conservatively, interest paid in arrears with a one-year lag.  The total is $300 billion higher than the $1,414 billion figure.  That is, under this scenario federal government debt would increase by $1,717 billion over what it would otherwise have been by FY2027, not by the $1,414 billion figure.  News reports commonly got this wrong.  It is not that the JCT got it wrong.  Rather, news reports misinterpreted what the JCT figures were saying.

The question then is whether there will be macro economy impacts, as the supply-siders assert, and if so, how large they would be.  The JCT provided on November 30, estimates of what these might be.  Based on a weighted average of results from three different economic models of the economy, the JCT estimated that at the end of the ten year period (i.e. in 2027), GDP would be 0.8% higher than it would be otherwise.  That is, the growth rate would on average be 0.08% per year higher than otherwise.  This is not much but still is something.  The resulting higher GDP would raise tax revenues above what they would otherwise be following the tax cuts.  Tax revenues would still decline – they just would not decline by as much as before.  Federal debt would still rise.  The higher deficits over the ten years would sum to $1,007 billion by 2027 (the green curve in the chart above).  And once again, news reports concluded that the new JCT figures were saying that federal debt would rise by $1.0 trillion over the ten year period once those macro impacts were taken into account.

But the JCT figures are not saying that.  They simply show the year by year impacts.  And as before, the JCT figures do not include the impact of the increase in interest that will need to be paid on a federal debt that would be higher than otherwise due to the tax cuts.  Adding in these interest payments, on a growing debt resulting from the yearly reduction in tax revenues in this tax plan, leads to the red curve in the chart.  The JCT figures imply, once one adds in the now higher interest payments due, a federal debt that by 2027 would be $1,245 billion higher than what it would otherwise be.  This is roughly a quarter higher, or an extra $240 billion, over the figure the news reports are citing.  This is not a small difference.

C.  Other Points

There are a few other points worth noting:

a)  One can see in the chart at the top of this post how the additions to the federal debt level off in 2026, and in most cases then decline.  This is because most of the provisions that would cut individual income taxes are ended as of the end of CY2025 under the Republican proposal.  The losses in tax revenues from the tax plan would then continue to grow through FY2026 (due to the overlap between CY2025 and FY2026, and the fact that final taxes due for CY2025 will be paid in April 2026) leading to still growing debt in 2026, but then level off or fall after that.  By FY2027, the JCT assessment found that most individuals would end up with higher taxes due.  Indeed, the Senate Republican tax plan is structured so that individuals in FY2027 would on average end up paying more in taxes than they would if this tax plan were never to go into effect.  In contrast to the sunsetting of the individual income tax cuts, the corporate income tax cuts would be made permanent.  And if, as the Republicans say they actually want, the individual income tax cuts are also made permanent, then the federal debt will grow by even more than what would result under the current plan.  They cannot have it both ways.

b)  Furthermore, while the focus here is on the impacts on total revenues collected and hence on the federal debt, there will also be critical distributional implications.  The JCT assessment of the November 16 version of the Republican tax plan found that if one adds together the impacts on households of all the proposals (on both the individual and the business side), that in 2027, those families with incomes of less than $75,000 would be paying more in taxes than they would if this tax plan were never approved (taking averages for each income group, as individual experiences will vary).  However, those with incomes of $75,000 or more would all be enjoying tax cuts.  The figures on a per family basis (technically per taxpayer unit) are shown in my earlier blog post on the Republican plan.  But it is not just in 2027 that certain income groups will be paying more in taxes.  Adding up the net impacts by income group over the full ten years, one finds that those with incomes of up to $30,000 will be paying more in taxes in total over the full ten years (of about $900 per family on average).  These are the families who are least able to afford a tax hike.

c)  It is important to clarify one statement in the JCT report on the macro impacts.  It makes reference to a $50 billion figure for “an increase in interest payments on the Federal debt”.  This is stated in the opening paragraph, and then in a bit more detail on page 6 in the section labeled “Budgetary effects”.  This increase in interest due is netted out in the figure summing to the $1,007 billion for the total cost over ten years of the Republican plan.

At first I had thought this interest cost reflected what I am discussing here – the increase in interest payments that will be due over the period as a result of the greater borrowing following from the higher deficits.  However, the $50 billion number is far too small, as the higher amount due in interest from the higher debt would be more like $240 billion.  I at first thought there might have been a mistake in the JCT calculations.  But a close reading of the JCT report shows that the $50 billion figure is actually referring to something else.  That something else is that one should expect general interest rates to rise in the economy as a result of the higher fiscal deficits, and that this will then lead to higher interest due on the existing federal government debt.  The increase in interest rates might be relatively small, but with the large government debt, even a small increase in interest rates can matter.  And one can calculate that a $50 billion increase in interest due would result from a rise in average interest rates on government debt of 0.025%, i.e. from the 3.7% that the CBO forecasts for most of this period, to 3.725%.

One must therefore not confuse the $50 billion in increased interest payments due on the existing federal debt (which the JCT estimates), with the increase in interest that will be due as a result of the year by year higher federal deficits, which must then be funded by borrowing.  The JCT, following the instructions given to it by the Congressional leadership, is not estimating the latter.  But the latter does add to the federal debt, and hence the addition to the federal debt by 2027 as a consequence of this Republican tax plan would be more like $1,245 billion than the $1,007 billion that the news media is mistakenly saying.

d)  As noted above, the JCT arrives at a forecast, based on the models it is using, that GDP would be 0.8% higher in 2027 than it would otherwise be.  The increase is small (increased growth of just 0.08% a year), but something.  News reports have made much of it.  But not noted (from what I have seen) is any discussion in the news reports of what the JCT estimated would happen after that.

The JCT discusses this on page 6 of its report.  It notes that due to the reversal of most of the individual income tax cuts (while leaving in place measures that would lead to higher individual income taxes), coupled with the rising interest rates resulting from the higher deficits (the $50 billion figure discussed above, but growing over time), the impact on GDP by the end of the third decade of such measures would be partially or wholly offset.  The growth effects die out over time.  As a result, we will then be left with a higher federal debt, but GDP the same or similar, and hence a government debt burden that is then higher for our grandchildren than would be the case if this tax plan were never approved.

e)  And it is critically important to recognize that the JCT could only arrive at its estimates of what the impact would be on GDP via economic models.  They did recognize that any individual economic model has issues, and therefore they used three different ones.  The 0.8% increase in GDP forecast for 2027 was the weighted average outcome of those three, weighting them not equally, but rather by 40/40/20.  Each model approaches the issue differently.  And while the JCT report is honest on what they did, and did report on the numbers used for some of the key parameters in each of the models, one would have liked to see more.

To start, only the 0.8% figure was given, resulting from the weighted average of the individual model forecasts.  One would have liked to have seen what the individual model results were.  Were they all fairly close to the 0.8% figure (in which case one would take some comfort in the similar findings), or did the different models produce quite different forecasts?  If the latter, one can not place much confidence in the overall weighted average as providing a robust estimate.

But more fundamentally, one needs to recognize that these are forecasts produced by models.  The results the models will produce will depend on the model structure assumed (as set by the analyst), and on the specific values assumed for the key model parameters.  The fact that the JCT used three different models for this (and reasonably so) shows how unsettled such analysis is.  Different models can come up with completely different results, as different aspects of the economy will be emphasized by each modeler.

The fundamental problem is that it is difficult to impossible to be able to say from actual data observed what the best model might be.  The overall net effects on growth are just too small, and there is so much going on also with the economy that one cannot come up with robust estimates of the impacts of such changes in tax law.  It is important to recognize that changes in tax law can have expansionary effects in some areas (including not just in different sectors but also in different areas of economic behavior) and contractionary effects in others.  The overall impact will depend on the net impact of them all, and this can be small to non-existent as the individual effects can go in opposite directions.  Hence one does not see in the observed data on GDP any indication that such changes in tax law (as have occurred in the past) have led to higher (or lower) GDP.

This was discussed in a previous post on this blog with regard to the impact on labor supply (and hence output) from a change in individual income tax rates.  There are income effects as well as substitution effects, their impacts go in opposite directions, and the net impact may then be small or not there at all as they simply offset each other.  There is a similar problem with assessing the impact on investment from changes in the corporate income tax proposals.  While some would argue that a lower corporate income tax rate will spur investment, the proposal also to limit the deductibility of interest on borrowed funds will act to reduce the incentive to invest.  The weighted average cost of capital (after taxes) will be higher when interest is not deductible, and the decision to invest depends on the balance between the (after-tax) expected return on investment and the (after tax) weighted average cost of capital for the funds being invested.

The net impact on the economy is therefore an empirical question, and one cannot say from ex-ante theorizing alone what that net impact might be.  One can construct models based on different theories, but then the net impact will depend on the model structures assumed and the specific values chosen for the various parameters used.  These can be difficult to impossible to estimate independently.

Finally, any such models will only be able to focus on a few of the possible changes in tax law.  They will not have the granularity to assess properly the literally hundreds of changes in law that the Republican tax plan includes.  Depending on the success or not of different interest groups and their lobbyists, the Republican tax plan has special favors, or harms, for different groups, and no economic model can capture all of them.  The models used by the JCT are, of necessity, much broader.

D.  Conclusion

To conclude, the JCT report on the macro impacts from the Republican tax plan is important and valuable, but is typically being misinterpreted.  The increase in the federal debt resulting from the tax cuts will be significantly higher than what one obtains by a simple summation of the year by year revenue impacts, as those impacts do not take into account the interest that will need to be paid on the now higher federal debt.  Those additional interest payments will be significant, and the addition to the federal debt will be about a quarter higher by the end of ten years than what a simple sum of the year by year losses in tax revenue would come to.

The JCT also concluded that its best estimate of the impact on GDP of the tax plan after ten years was that GDP would be 0.8% higher.  This is not much – an increase in the growth rate of just 0.08% a year.  Furthermore, even this would die out by the end of the third decade, in the tax plan as proposed.  The nation would then end up with a higher debt, a GDP which is about the same, and hence a debt to GDP ratio which is higher.

But of necessity, the estimates of the impact on GDP from the tax plan are crude.  The JCT was required to come up with such an estimate, but the only way to do this is to assume some economic model applies.  There is no good basis for choosing one, so the JCT used three, and the 0.8% figure is a weighted average of what those three different models forecast.  It would have been nice to see what each of those three forecasts were, to see if they were broadly similar.

All one can reasonably conclude is that the net impact on GDP is likely to be small.  This is consistent with what we have seen historically.  Any impacts on GDP, positive or negative, from such tax law changes have been too small to see in the data.  And there is certainly no reason to believe that such changes in tax law will lead to such a strong response in growth that the tax cuts “will pay for themselves”.  This has never happened before, and the JCT results indicate it will not happen now.

An Analysis of the Trump Tax Plan: Not a Tax Reform, But Rather a Massive Tax Cut for the Rich

A.  Introduction

The Trump administration released on September 27 its proposed tax plan.  It was exceedingly skimpy (only nine pages long, including the title page, and with all the white space could have been presented on half that number of pages).  Importantly, it was explicitly vague on many of the measures, such as what tax loopholes would be closed to partially pay for the tax cuts (simply saying they would do this somehow).  One can, however, examine measures that were explicitly presented, and from these it is clear that this is primarily a plan for massive tax cuts for the rich.

It is also clear that this is not a tax reform.  A tax reform would be revenue neutral.  The measures proposed would not be.  And a reform would focus on changes in the structure of the tax system.  There is little of that here, but rather proposals to cut various tax rates (including in several cases to zero), primarily for the benefit of those who are well off.

One can see this in the way the tax plan was approached.  In a true tax reform, one would start by examining the system, and whether certain deductions and tax exemptions are not warranted by good policy (but rather serve only certain vested interests).  Closing such loopholes would lead to higher revenues being collected.  One would then determine what the new tax rates could be (i.e. by how much they could be cut) to leave the overall level of tax collection the same.

But that was not done here.  Rather, they start with specific proposals on what the new tax rates “should” be (12%, 25%, and 35% for individuals, and 20% for corporations), and then make only vague references to certain, unspecified, deductions and tax exemptions being eliminated or reduced, in order not to lose too much in revenues (they assert).  They have the process backward.

And it is clear that these tax cuts, should they be enacted by Congress, would massively increase the fiscal deficit.  While it is impossible to come up with a precise estimate of how much the tax plan would cost in lost revenues, due to the vagueness on the parameters and on a number of the proposals, Republicans have already factored into the long-term budget a reduction in tax revenues of $1.5 trillion over ten years.  And estimates of the net cost of the Trump plan range from a low of $2.2 trillion over ten years ($2.7 trillion when additional interest is counted, as it should be), to as high as $5 trillion over ten years.  No one can really say as yet, given the deliberate lack of detail.

But any of these figures on the cost are not small.  The total federal debt held by the public as of the end of September, 2017, was $14.7 trillion.  The cost in lost revenue could equal more than a third of this.  Yet Republicans in Congress blocked the fiscal expenditures we desperately needed in the years from 2010 onwards during the Obama years, when unemployment was still high, there was excess capacity in our underutilized factories, and the country needed to rebuild its infrastructure (as we still do).  The argument then was that we could not add to our national debt.  But now the same politicians see no problem with adding massively to that debt to cover tax cuts that will primarily benefit the rich.  The sheer hypocrisy is breath-taking.

Not surprisingly, Trump officials are saying that there will be no such cost due to a resulting spur to our economic growth.  Trump himself asserted that his tax plan would lead the economy to grow at a 6% pace.  No economist sees this as remotely plausible.  Even Trump’s economic aides, such as Gary Cohn who was principally responsible for the plan, are far more cautious and say only that the plan will lead to growth of “substantially over 3 percent”.  But even this has no basis in what has been observed historically after the Reagan and Bush tax cuts, nor what one would expect from elementary economic analysis.

The lack of specificity in many of the proposals in the tax plan issued on September 27 makes it impossible to assess it in full, as major elements are simply only alluded to.  For example, it says that a number of tax deductions (both personal and corporate) will be eliminated or reduced, but does not say which (other than that they propose to keep the deductions for home mortgage interest and for charity).  As another example, the plan says the number of personal income tax brackets would be reduced from seven currently to just three broad ones (at 12%, 25%, and 35%), but does not say at what income levels each would apply.  Specifics were simply left out.

For a tax plan where work has been intensively underway for already the eight months of this administration (and indeed from before, as campaign proposals were developed), such vagueness must be deliberate.  The possible reasons include:  1) That the specifics would be embarrassing, as they would make clear the political interests that would gain or lose under the plan; 2) That revealing the specifics would spark immediate opposition from those who would lose (or not gain as others would); 3) That revealing the specifics would make clear that they would not in fact suffice to achieve what the Trump administration is asserting (e.g. that ending certain tax deductions will make the plan progressive, or generate revenues sufficient to offset the tax rate cuts); and/or 4) That they really do not know what to do or what could be done to fix the issue.

One can, however, look at what is there, even if the overall plan is incomplete.  This blog post will do that.

B.  Personal Income Taxes

The proposals are (starting with those which are most clear):

a)  Elimination of the Estate Tax:  Only the rich pay this.  It only applies to estates given to heirs of $10.98 million or more (for a married couple).  This only affects the top 0.2%, most wealthy, households in the US.

b)  Elimination of the Alternative Minimum Tax:  This also only applies to those who are rich enough for it to apply and who benefit from a range of tax deductions and other benefits, who would otherwise pay little in tax.  It would be better to end such tax deductions and other special tax benefits that primarily help this group, thus making the Alternative Minimum Tax irrelevant, than to end it even though it had remained relevant.

c)  A reduction in the top income tax rate from 39.6% to 35%:  This is a clear gain to those whose income is so high that they would, under the current tax brackets, owe tax at a marginal rate of 39.6%.  But this bracket only kicks in for households with an adjusted gross income of $470,700 or more (in 2017).  This is very close to the minimum income of those in the top 1% of the income distribution ($465,626 in 2014), and the average household income of those in that very well-off group was $1,260,508 in 2014.  Thus this would be a benefit only to the top 1%, who on average earn over $1 million a year.

The Trump plan document does include a rather odd statement that the congressional tax-writing committees could consider adding an additional, higher, tax bracket, for the very rich, but it is not at all clear what this might be.  They do not say.  And since the tax legislation will be written by the congressional committees, who are free to include whatever they choose, this gratuitous comment is meaningless, and was presumably added purely for political reasons.

d)  A consolidation in the number of tax brackets from seven currently to just three, of 12%, 25%, and 35%:  Aside from the clear benefit to those now in the 39.6% bracket, noted above, one cannot say precisely what the impact the new tax brackets would have for the other groups since the income levels at which each would kick in was left unspecified.  It might have been embarrassing, or contentious, to do so.  But one can say that any such consolidation would lead to less progressivity in the tax system, as each of the new brackets would apply to a broader range of incomes.  Instead of the rates rising as incomes move up from one bracket to the next, there would now be a broader range at which they would be kept flat.  For example, suppose the Trump plan would be for the new 25% rate to span what is now taxed at 25% or 28%.  That range would then apply to household incomes (for married couples filing jointly, and in 2017) from $75,900 on the low end to $233,350 at the high end.  The low-end figure is just above the household income figure of $74,869 (in 2016) for those reaching the 60th percentile of the income distribution (see Table A-2 of this Census Bureau report), while the top-end is just above the $225,251 income figure for those reaching the 95th percentile.  A system is not terribly progressive when those in the middle class (at the 60th percentile) pay at the same rate as those who are quite well off (in the 95th percentile).

e)  A ceiling on the tax rate paid on personal income received through “pass-through” business entities of just 25%:  This would be one of the more regressive of the measures proposed in the Trump tax plan (as well as one especially beneficial to Trump himself).  Under current tax law, most US businesses (95% of them) are incorporated as business entities that do not pay taxes at the corporate level, but rather pass through their incomes to their owners or partners, who then pay tax on that income at their normal, personal, rates.  These so-called “pass-through” business entities include sole proprietorships, partnerships, Limited Liability Companies (LLCs), and sub-chapter S corporations (from the section in the tax code).  And they are important, not only in number but also in incomes generated:  In the aggregate, such pass-through business entities generate more in income than the traditional large corporations (formally C corporations) that most people refer to when saying corporation.  C corporations must pay a corporate income tax (to be discussed below), while pass-through entities avoid such taxes at the company level.

The Trump tax plan would cap the tax rate on such pass-through income at 25%.  This would not only create a new level of complexity (a new category of income on which a different tax is due), but would also only be of benefit to those who would otherwise owe taxes at a higher rate (the 35% bracket in the Trump plan).  If one were already in the 25% bracket, or a lower one, that ceiling would make no difference at all and would be of no benefit.  But for those rich enough to be in the higher bracket, the benefit would be huge.

Who would gain from this?  Anyone who could organize themselves as a pass-through entity (or could do so in agreement with their employer).  This would include independent consultants; other professionals such as lawyers, lobbyists, accountants, and financial advisors; financial entities and the partners investing in private-equity, venture-capital, and hedge funds; and real estate developers.  Trump would personally benefit as he owns or controls over 500 LLCs, according to Federal Election Commission filings.  And others could reorganize into such an entity when they have a tax incentive to do so.  For example, the basketball coach at the University of Kansas did this when Kansas created such a loophole for what would otherwise be due under its state income taxes.

f)  The tax cuts for middle-income groups would be small or non-existent:  While the Trump tax proposal, as published, repeatedly asserts that they would reduce taxes due by the middle class, there is little to suggest in the plan that that would be the case.  The primary benefit, they tout (and lead off with) is a proposal to almost double the standard deduction to $24,000 (for a married couple filing jointly).  That standard deduction is currently $12,700.  But the Trump plan would also eliminate the personal exemption, which is $4,050 per person in 2017.  Combining the standard deduction and personal exemptions, a family of four would have $28,900 of exempt income in 2017 under current law ($12,700 for the standard deduction, and personal exemptions of four times $4,050), but only $24,000 under the Trump plan.  They would not be better off, and indeed could be worse off.  The Trump plan is also proposing that the child tax credit (currently a maximum of $1,000 per child, and phased out at higher incomes) should be raised (both in amount, and at the incomes at which it is phased out), but no specifics are given so one cannot say whether this would be significant.

g)  Deduction for state and local taxes paid:  While not stated explicitly, the plan does imply that the deduction for state and local taxes paid would be eliminated.  It also has been much discussed publicly, so leaving out explicit mention was not an oversight.  What the Trump plan does say is the “most itemized deductions” would be eliminated, other than the deductions for home mortgage interest and for charity.

Eliminating the deduction for state and local taxes appears to be purely political.  It would adversely affect mostly those who live in states that vote for Democrats.  And it is odd to consider this tax deduction as a loophole.  One has to pay your taxes (including state and local taxes), or you go to jail.  It is not something you do voluntarily, in part to benefit from a tax deduction.  In contrast, a deduction such as for home mortgage interest is voluntary, one benefits directly from buying and owning a nice house, and such a deduction benefits more those who are able to buy a big and expensive home and who qualify for taking out a large mortgage.

h)  Importantly, there was much that was not mentioned:  One must also keep in mind what was not mentioned and hence would not be changed under the Trump proposals.  For example, no mention was made of the highly favorable tax rates on long-term capital gains (for assets held one year or more) of just 20%.  Those with a high level of wealth, i.e. the wealthy, gain greatly from this.  Nor was there any mention of such widely discussed loopholes as the “carried interest” exception (where certain investment fund managers are able to count their gains from the investment deals they work on as if it were capital gains, rather than a return on their work, as it would be for the lawyers and accountants on such deals), or the ability to be paid in stock options at the favorable capital gains rates.

C.  Corporate Income Taxes

More than the tax cuts enacted under Presidents Reagan and Bush, the Trump tax plan focuses on cuts to corporate income (profit) taxes.  Proposals include:

a)  A cut in the corporate income tax rate from the current 35% to just 20%:  This is a massive cut.  But it should also be recognized that the actual corporate income tax paid is far lower than the headline rate.  As noted in an earlier post on this blog, the actual average rate paid has been coming down for decades, and is now around 20%.  There are many, perfectly legal, ways to circumvent this tax.  But setting the rate now at 20% will not mean that taxes equal to 20% of corporate profits will be collected.  Rather, unless the mechanisms used to reduce corporate tax liability from the headline rate of 35% are addressed, those mechanisms will be used to reduce the new collections from the new 20% headline rate to something far less again.

b)  Allow 100% of investment expenses to be deducted from profits in the first year, while limiting “partially” interest expense on borrowing:  This provision, commonly referred to as full “expensing” of investment expenditures, would reduce taxable profits by whatever is spent on investment.  Investments are expected to last for a number of years, and under normal accounting the expense counted is not the full investment expenditure but rather only the estimated depreciation of that investment in the current year.  However, in recent decades an acceleration in what is allowed for depreciation has been allowed in the tax code in order to provide an additional incentive to invest.  The new proposal would bring that acceleration all the way to 100%, which as far as it can go.

This would provide an incentive to invest more, which is not a bad thing, although it still would also have the effect of reducing what would be collected in corporate income taxes.  It would have to be paid for somehow.  The Trump proposal would partially offset the cost of full expensing of investments by limiting “partially” the interest costs on borrowing that can be deducted as a cost when calculating taxable profits.  The interest cost of borrowing (on loans, or bonds, or whatever) is currently counted in full as an expense, just like any other expense of running the business.  How partial that limitation on interest expenses would be is not said.

But even if interest expenses were excluded in full from allowable business expenses, it is unlikely that this would come close to offsetting the reduction in tax revenues from allowing investment expenditures to be fully expensed.  As a simple example, suppose a firm would make an investment of $100, in an asset that would last 10 years (and with depreciation of 10% of the original cost each year).  For this investment, the firm would borrow $100, on which it pays interest at 5%.  Under the current tax system, the firm in the first year would deduct from its profits the depreciation expense of $10 (10% of $100) plus the interest cost of $5, for a total of $15.  Under the Trump plan, the firm would be able to count as an expense in the first year the full $100, but not the $5 of interest.  That is far better for the firm.  Of course, the situation would then be different in the second and subsequent years, as depreciation would no longer be counted (the investment was fully expensed in the first year), but it is always better to bring expenses forward.  And there likely will be further investments in subsequent years as well, keeping what counts as taxable profits low.

c)  Tax amnesty for profits held abroad:  US corporations hold an estimated $2.6 trillion in assets overseas, in part because overseas earnings are not subject to the corporate income tax until they are repatriated to the US.  Such a provision might have made sense decades ago, when information systems were more primitive, but does not anymore.  This provision in the US tax code creates the incentive to avoid current taxes by keeping such earnings overseas.  These earnings could come from regular operations such as to sell and service equipment for foreign customers, or from overseas production operations.  Or such earnings could be generated through aggressive tax schemes, such as from transferring patent and trademark rights to overseas jurisdictions in low-tax or no-tax jurisdictions such as the Cayman Islands.  But whichever way such profits are generated, the US tax system creates the incentive to hold them abroad by not taxing them until they are repatriated to the US.

This is an issue, and could be addressed directly by changing the law to make overseas earnings subject to tax in the year the earnings are generated.  The tax on what has been accumulated in the past could perhaps be spread out equally over some time period, to reduce the shock, such as say over five years.  The Trump plan would in fact start to do this, but only partially as the tax on such accumulated earnings would be set at some special (and unannounced) low rates.  All it says is that while both rates would be low, there would be a lower rate applied if the foreign earnings are held in “illiquid” assets than in liquid ones.  Precisely how this distinction would be defined and enforced is not stated.

This would in essence be a partial amnesty for capital earnings held abroad.  Companies that have held their profits abroad (to avoid US taxes) would be rewarded with a huge windfall from that special low tax rate (or rates), totalling in the hundreds of billions of dollars, with the precise gain on that $2.6 trillion held overseas dependant on how low the Trump plan would set the tax rates on those earnings.

It is not surprising that US corporations have acted this way.  There was an earlier partial amnesty, and it was reasonable for them to assume there would be future ones (as the Trump tax plan is indeed now proposing).  In one of the worst pieces of tax policy implemented in the George W. Bush administration, an amnesty approved in 2004 allowed US corporations with accumulated earnings abroad to repatriate that capital at a special, low, tax rate of just 5.25%.  It was not surprising that the corporations would assume this would happen again, and hence they had every incentive to keep earnings abroad whenever possible, leading directly to the $2.6 trillion now held abroad.

Furthermore, the argument was made that the 2004 amnesty would lead the firms to undertake additional investment in the US, with additional employment, using the repatriated funds.  But analyses undertaken later found no evidence that that happened.  Indeed, subsequent employment fell at the firms that repatriated accumulated overseas earnings.  Rather, the funds repatriated largely went to share repurchases and increased dividends.  This should not, however, have been surprising.  Firms will invest if they have what they see to be a profitable opportunity.  If they need funds, they can borrow, and such multinational corporations generally have no problem in doing so.  Indeed, they can use their accumulated overseas earnings as collateral on such loans (as Apple has done) to get especially low rates on such loans.  Yet the Trump administration asserts, with no evidence and indeed in contradiction to the earlier experience, that their proposed amnesty on earnings held abroad will this time lead to more investment and jobs by these firms in the US.

d)  Cut to zero corporate taxes on future overseas earnings:  The amnesty discussed above would apply to the current stock of accumulated earnings held by US corporations abroad.  Going forward, the Trump administration proposes that earnings of overseas subsidiaries (with ownership of as little as 10% in those firms) would be fully exempt from US taxes.  While it is true that there then would be no incentive to accumulate earnings abroad, the same would be the case if those earnings would simply be made subject to the same current year corporate income taxes as the US parent is liable for, and not taxable only when those earnings are repatriated.

It is also not at all clear to me how exempting these overseas earnings from any US taxes would lead to more investment and more jobs in the US.  Indeed, the incentive would appear to me to be the opposite.  If a plant is sited in the US and used to sell product in the US market or to export it to Europe or Asia, say, earnings from those operations would be subject to the regular US corporate income taxes (at a 20% rate in the Trump proposals).  However, if the plant is sited in Mexico, with the production then sold in the US market or exported from there to Europe or Asia, earnings from those operations would not be subject to any US tax.  Mexico might charge some tax, but if the firm can negotiate a good deal (much as firms from overseas have negotiated such deals with various states in the US to site their plants in those states), the Trump proposal would create an incentive to move investment and jobs to foreign locations.

D.  Conclusion

The Trump administration’s tax plan is extremely skimpy on the specifics.  As one commentator (Allan Sloan) noted, it looks like it was “written in a bar one evening over a batch of beers for a Tax 101 class rather than by serious people who spent weeks working with tax issues”.

It is, of course, still just a proposal.  The congressional committees will be the ones who will draft the specific law, and who will then of necessity fill in the details.  The final product could look quite different from what has been presented here.  But the Trump administration proposal has been worked out during many months of discussions with the key Republican leaders in the House and the Senate who will be involved.  Indeed, the plan has been presented in the media not always as the Trump administration plan, but rather the plan of the “Big Six”, where the Big Six is made up of House Speaker Paul Ryan, Senate Majority Leader Mitch McConnell, House Ways and Means Committee Chairman Kevin Brady, Senate Finance Committee Chairman Orrin Hatch, plus National Economic Council Director Gary Cohn and Treasury Secretary Steven Mnuchin of the Trump administration.  If this group is indeed fully behind it, then one can expect the final version to be voted on will be very similar to what was outlined here.

But skimpy as it is, one can say with some certainty that the tax plan:

a)  Will be expensive, with a ten-year cost in the trillions of dollars;

b)  Is not in fact a tax reform, but rather a set of very large tax cuts;

and c)  Overwhelmingly benefits the rich.

The Impact of the Reagan and Bush Tax Cuts: Not a Boost to Employment, nor to Growth, nor to the Fiscal Accounts

Private Employment Following Tax Law Changes

A.  Introduction

The belief that tax cuts will spur growth and new jobs, and indeed even lead to an improvement in the fiscal accounts, remains a firm part of Republican dogma.  The tax plans released by the main Republican presidential candidates this year all presume, for example, that a spectacular jump in growth will keep fiscal deficits from increasing, despite sharp cuts in tax rates.  And conversely, Republican dogma also holds that tax increases will kill growth and thus then lead to a worsening in the fiscal accounts.  The “evidence” cited for these beliefs is the supposed strong recovery of the economy in the 1980s under Reagan.

But the facts do not back this up.  There have been four major rounds of changes in the tax code since Reagan, and one can look at what happened after each.  While it is overly simplistic to assign all of what followed solely to the changes in tax rates, looking at what actually happened will at least allow us to examine the assertion underlying these claims that the Reagan tax cuts led to spectacular growth.

The four major changes in the tax code were the following.  While each of the laws made numerous changes in the tax code, I will focus here on the changes made in the highest marginal rate of tax on income.  The so-called “supply-siders” treat the highest marginal rate to be of fundamental importance since, under their view, this will determine whether individuals will make the effort to work or not, and by how much.  The four episodes were:

a)  The Reagan tax cuts signed into law in August 1981, which took effect starting in 1982. The highest marginal income tax rate was reduced from 70% before to 50% from 1982 onwards.  There was an additional round of tax cuts under a separate law passed in 1986, which brought this rate down further to 38.5% in 1987 and to 28% from 1988 onwards. While this could have been treated as a separate tax change episode, I have left this here as part of the Reagan legacy.  Under the Republican dogma, this should have led to an additional stimulant to growth.  We will see if that was the case.  There was also a more minor change under George H.W. Bush as part of a 1990 budget compromise, which brought the top rate partially back from 28.0% to 31.0% effective in 1991.  While famous as it went against Bush’s “read my lips” pledge, the change was relatively small.

b)  The tax rate increases in the first year of the Clinton presidency.  This was signed into law in August 1993, with the tax rate increases applying in that year.  The top marginal income tax rate was raised to 39.6%.

c)  The tax cuts in the George W. Bush presidency that brought the top rate down from 39.6% to 38.6% in 2002 and to 35.0% in 2003.  The initial law was signed in June 2001, and then an additional act passed in 2003 made further tax cuts and brought forward in time tax cuts being phased in under the 2001 law.

d)  The tax rate increases for those with very high incomes signed into law in December 2012, just after Obama was re-elected, that brought the marginal rate for the highest income earners back to 39.6%.

We therefore have four episodes to look at:  two of tax cuts and two of tax increases.  For each, I will trace what happened from when the tax law changes were signed up to the end of the administration responsible (treating Reagan and Bush I as one).  The questions to address are whether the tax cut episodes led to exceptionally good job growth and GDP growth, while the the tax increases led to exceptionally poor job and GDP growth. We will then look at what happened to the fiscal accounts.

B.  Jobs and GDP Growth Following the Changes in Tax Law

The chart at the top of this post shows what happened to private employment, by calendar quarter relative to a base = 100 for the quarter when the new law was signed. The data is from the Bureau of Labor Statistics (downloaded, for convenience, from FRED).  A chart using total employment would look almost exactly the same (but one could argue that government employment should be excluded as it is driven by other factors).

As the chart shows, private job growth was best following the Clinton and Obama tax increases, was worse under Reagan-Bush I, and abysmal under Bush II.  There is absolutely no indication that big tax cuts, such as those under Reagan and then Bush II, are good for job growth.  I would emphasize that one should not then jump to the conclusion that tax increases are therefore good for job growth.  That would be overly simplistic.  But what the chart does show is that the oft-stated claim by Republican pundits that the Reagan tax cuts were wonderful for job growth simply has no basis in fact.

How about the possible impact on GDP growth?  A similar chart shows (based on BEA data on the GDP accounts):

Real GDP Following Tax Law Changes

Once again, growth was best following the Clinton tax increases.  Under Reagan, GDP growth first fell following the tax cuts being signed into law (as the economy moved down into a recession, which by NBER dating began almost exactly as the Reagan tax cut law was being signed), and then recovered.  But the path never catches up with that followed during the Clinton years.  Indeed after a partial catch-up over the initial three years (12 calendar quarters), the GDP path began to fall steadily behind the pace enjoyed under Clinton.  Higher taxes under Clinton were clearly not a hindrance to growth.

The Bush II and Obama paths are quite similar, even though growth during these Obama years has had to go up against the strong headwinds of fiscal drag from government spending cuts.  Federal government spending on goods and services (from the GDP accounts, with the figures in real, inflation-adjusted, terms) rose at a 4.4% per annum pace during the eight years of the Bush II administration, and rose at a 5.6% rate during Bush’s first term.  Federal government spending since the late 2012 tax increases were signed under Obama have fallen, in contrast, at a 2.8% per annum rate.

There is therefore also no evidence here that tax cuts are especially good for growth and tax increases especially bad for growth.  If anything, the data points the other way.

C.  The Impact on the Fiscal Accounts

The argument of those favoring tax cuts goes beyond the assertion that they will be good for growth in jobs and in GDP.  Some indeed go so far as to assert that the resulting stimulus to growth will be so strong that tax revenues will actually rise as a result, since while the tax rates will be lower, they will be applied against resulting higher incomes and hence “pay for themselves”.  This would be nice, if true.  Something for nothing. Unfortunately, it is a fairy tale.

What happened to federal income taxes following the changes in the tax rates?  Using CBO data on the historical fiscal accounts:

Real Federal Income Tax Revenues Following Tax Law Changes

Federal income tax revenues (in real terms) either fell or at best stagnated following the Reagan and then the Bush II tax cuts.  The revenues rose following the Clinton and Obama tax increases.  The impact is clear.

While one would think this should be obvious, the supply-siders who continue to dominate Republican thinking on these issues assert the opposite has been the case (and would be, going forward).  Indeed, in what must be one of the worst economic forecasts ever made in recent decades by economists (and there have been many bad forecasts), analysts at the Center for Data Analysis at the conservative Heritage Foundation concluded in 2001 that the Bush II tax cuts would lead government to “effectively pay off the publicly held federal debt by FY 2010”.  Publicly held federal debt would fall below 5% of GDP by FY2011 they said, and could not go any lower as some federal debt is needed for purposes such as monetary operations.  But actual publicly held federal debt reached 66% of GDP that year.  That is not a small difference.

Higher tax revenues help then make it possible to bring down the fiscal deficit.  While the deficit will also depend on public spending, a higher revenue base, all else being equal, will lead to a lower deficit.

So what happened to the fiscal deficit following these four episodes of major tax rate changes?  (Note to reader:  A reduction in the fiscal deficit is shown as a positive change in the figure.)

Change in Fiscal Deficit Relative to Base Year Following Tax Law Changes

The deficit as a share of GDP was sharply reduced under Clinton and even more so under Obama.  Indeed, under Clinton the fiscal accounts moved from a deficit of 4.5% of GDP in FY1992 to a surplus of 2.3% of GDP in FY2000, an improvement of close to 7% points of GDP.  And in the period since the tax increases under Obama, the deficit has been reduced by over 4% points of GDP, in just three years.  This has been a very rapid base, faster than that seen even during the Clinton years.  Indeed, the pace of fiscal deficit reduction has been too fast, a consequence of the federal government spending cuts discussed above.  This fiscal drag held back the pace of recovery from the downturn Obama inherited in 2009, but at least the economy has recovered.

In contrast, the fiscal deficit deteriorated sharply following the Reagan tax cuts, and got especially worse following the Bush II tax cuts.  The federal fiscal deficit was 2.5% of GDP in FY1981, when Reagan took office, went as high as 5.9% of GDP in FY1983, and was 4.5% of GDP in FY1992, the last year of Bush I (it was 2.5% of GDP in FY2015 under Obama).  Bush II inherited the Clinton surplus when he took office, but brought this down quickly (on a path initially similar to that seen under Reagan).  The deficit was then 3.1% of GDP in FY2008, the last full year when Bush II was in office, and hit 9.8% of GDP in FY2009 due largely to the collapsing economy (with Bush II in office for the first third of this fiscal year).

Republicans continue to complain of high fiscal deficits under the Democrats.  But the deficits were cut sharply under the Democrats, moving all the way to a substantial surplus under Clinton.  And the FY2015 deficit of 2.5% of GDP under Obama is not only far below the 9.8% deficit of FY2009, the year he took office, but is indeed lower than the deficit was in any year under Reagan and Bush I.  The tax increases signed into law by Clinton and Obama certainly helped this to be achieved.

D.  Conclusion

The still widespread belief among Republicans that tax cuts will spur growth in jobs and in GDP is simply not borne out be the facts.  Growth was better following the tax increases of recent decades than it was following the tax cuts.

I would not conclude from this, however, that tax increases are therefore necessarily good for growth.  The truth is that tax changes such as those examined here simply will not have much of an impact in one direction or the other on jobs and output, especially when a period of several years is considered.  Job and output growth largely depends on other factors.  Changes in marginal income tax rates simply will not matter much if at all. Economic performance was much better under the Clinton and Obama administrations not because they raised income taxes (even though they did), but because these administrations managed better a whole host of factors affecting the economy than was done under Reagan, Bush I, or Bush II.

Where the income tax rates do matter is in how much is collected in income taxes.  When tax rates are raised, more is collected, and when tax rates are cut, less is collected.  This, along with the management of other factors, then led to sharp reductions in the fiscal deficit under Clinton and Obama (and indeed to a significant surplus by the end of the Clinton administration), while fiscal deficits increased under Reagan, Bush I, and Bush II.

Higher tax collections when tax rates go up and lower collections when they go down should not be a surprising finding.  Indeed, it should be obvious.  Yet one still sees, for example in the tax plans issued by the Republican presidential candidates this year, reliance on the belief that a miraculous jump in growth will keep deficits from growing.

There is no evidence that such miracles happen.