Why tax cuts don’t “pay for themselves,” cartoonsplained

Donald Trump’s new budget proposal includes a massive amount of tax cuts. His Treasury secretary, Steven Mnuchin, defended a version of this proposal a few weeks ago, saying what many Republicans before him have said: "The [tax cuts] will pay for itself with growth.”

In other words, he's saying that cutting taxes will actually allow the government to collect so much more in taxes that it will offset what was lost via cuts. (The White House is projecting 3 percent growth, which is quite unlikely.)

Critics, including Paul Krugman and George H.W. Bush, have called this "voodoo economics.”

So what's going on here? It comes down to something called "dynamic scoring."

It's a fancy term for taking a policy proposal and predicting the future outcome — but also accounting for how people will react to the changes. The idea of dynamic scoring, in itself, isn't bad. But it's been used to argue that tax cuts actually create enough tax revenue to, well, pay for itself.

So let's explore this with yet another cartoon about sandwiches.

This is the reason some people think tax cuts pay for themselves. Most economists think this is bullshit.

Let's say we're sitting around, trying to come up with a tax plan. And we imagine a world in which everyone is paid in sandwiches.

But when they're paid, the government — that's you — takes a small amount of everyone's sandwich.

One day, you decide you want more sandwiches to give to poor people who don't have sandwiches.

What should you do? Collect a lot more of each person's sandwich, of course.

But here's the problem: When you take too much of people's sandwiches, they're left with less to take home to their families — and less incentive to work for sandwiches.

Some people might decide to work less. Some people will decide not to work at all.

In addition, you're also taking more sandwiches from the company so it doesn't have as many sandwiches to invest back into their businesses.

That means the company can't buy the Fancy Machine it wants to buy...

…which means the Fancy Machine company earns fewer sandwiches — and you collect fewer sandwiches from them, too.

So the next day, you realize there were fewer workers to collect sandwiches from — and the workers that are still there have smaller sandwiches.

Ultimately, you're collecting fewer sandwiches, even though you're taking a larger portion from each person.

You realized collecting more isn't necessarily better, because your actions change the way the workers behave.

So you decide to try another experiment: What if you took less of their sandwich than before?

Now, more people are working — and longer hours, at that — because they get to take home more sandwich.

And ultimately, there are so many sandwiches being earned that the net amount you collect is more than before.

In addition, the company also has more sandwiches, so they can buy the Fancy Machine — and you can collect more taxes from the Fancy Machine company.

So in short, you cut the sandwich tax — and it paid for itself because it drastically increased the amount of sandwiches you can tax.

And now you have more sandwiches than before.

But very few economists actually believe this is how the world works

Most economists believe that cutting taxes will grow the economy a bit. But mainstream economists don’t think tax cuts can entirely pay for themselves.

In that way, this specific prediction is an especially cartoonish illustration (no pun intended) of dynamic scoring.

Why can’t the above scenario work? Let’s dig in.

An economist comes into the room and jumps into your imagination.

She rewinds back to the part where you decreased the amount of sandwich you were taking from everyone.

You predicted that this tax decrease would lead to significantly more people working.

But she says that most economists, including those at the Congressional Budget Office, predict a much smaller impact on how workers and companies behave.

Secondly, since you would collect fewer sandwiches, you wouldn't be able to meet your obligation of handing out sandwiches to people who need them.

So you'd need to go to the sandwich bank to borrow a lot of sandwiches.

And since you’re the federal government, you would need a lot of sandwiches.

This would cause the sandwich bank to run low, causing them to increase interest rates.

So when a business went to the sandwich bank to borrow sandwiches to pay for a Fancy Machine, they would have to pay those higher interest rates.

Because of those costs, they might not buy a Fancy Machine — which means they won't hire people to operate the Fancy Machine, nor will the company earn more using the Fancy Machine.

This is called the “crowding out” effect.

This all means that you, the government, are collecting less

This ultimately means when you cut the sandwich tax, you're going to collect fewer sandwiches.

She jumps out of your imagination, and looks into your eyes. You are deep in thought.

She says this is why most economists believe that tax cuts do not ever increase tax revenue, even if they might grow the economy a little bit.

But how much do tax cuts grow the economy? Uh oh, that’s the question you don’t ask at an economist’s Thanksgiving.

Here’s the thing: Even the right-leaning Tax Foundation does not believe tax cuts pay for themselves. Tax Foundation's Kyle Pomerleau told me, "We remind people, multiple times, every day, that if you cut taxes, revenue will decline, static or dynamic."

But the Tax Foundation makes projections that often show the economy growing a lot in response to cuts. Last year, their analysis found that House Speaker Paul Ryan's plan — which cut $8 trillion over 10 years — would almost entirely pay for itself. To be fair, most of it is through “base broadening,” which basically means other new taxes. But about a third of it is through economic growth:

This caused several prominent economists to have very negative reactions. For example, read this New York Times piece to watch economists throw shade at the Tax Foundation, in ways only economists can.

But those critics say their model used assumptions that weren't in line with existing empirical evidence, and they have a very real and articulated disagreement.

It largely comes down to one specific assumption.

How open is the US economy?

Let's rewind to the portion of the cartoon where the government goes to the sandwich bank because it has a deficit and needs to borrow sandwiches:

In the cartoon, we illustrated a scenario that most mainstream economists agree with: the idea that when the government needs to borrow money, it lowers the supply of savings — and raises interest rates.

In other words, because you've taken so many sandwiches from the bank, when a business goes to borrow money to buy a Fancy Machine, interest rates are so high that they can't afford it anymore.

The Tax Foundation argues that this effect won't happen. They believe businesses will still buy the Fancy Machine.

That's because they believe the sandwich banks around the world will have enough sandwiches to make sure there won't be a shortage of sandwiches you can borrow — and that will keep interest rates down.

They believe the US economy is more open — meaning sandwiches saved up in a foreign bank can flow freely to the US and keep interest rates down.

But the counter to that argument is US trade policy isn't nearly this open, and that the US economy is too large for foreign money to keep business investments afloat.

Critics point to a CBO report that shows that when the government has to borrow more money, investments in things like Fancy Machines drop quite a bit.

In response, the Tax Foundation says interest rates have stayed pretty steady regardless of policy shocks. But their critics — and there are a handful who have written long pieces on this — say they aren’t considering other offsetting factors that keep the rates steady.

This disagreement has caused a huge difference in how different economists project the impact of a tax plan. It can be the difference between predicting that a plan is better than the baseline — or worse.

And it's why the Tax Foundation's scoring is highly offensive to many economists.

Still, even the Tax Foundation’s analysis doesn’t back up the claims made by the Trump administration, which expects 3 percent of economic growth by 2021. The Tax Foundation’s model puts it at around 2.3 percent.

That hasn't stopped the Trump administration from continuing to make these claims. When journalists point out that there’s no evidence tax cuts pay for themselves, they say the administration will show that, contrary to all the evidence, it actually can.

Thanks to Kyle Pomerleau of the Tax Foundation and Chye-Ching Huang of the Center on Budget and Policy Priorities.