Anyone who tells you that the GOP tax bill President Donald Trump signed into law before Christmas is all good or all bad has fallen victim to the particularly viral strain of negative partisanship going around this flu season. On the specifics, the 503-page Tax Cuts and Jobs Act is clearly a mixed bag.
Business tax reforms like the shift to a territorial system and the corporate tax cut were genuinely long overdue. Far from being the ideas of some crazed supply-side economist, they help to move the United States’ corporate tax system into closer alignment with the rest of the developed world. On the other hand, the last-minute decision to cut taxes for the wealthiest individuals, especially at the expense of a much more progressive child tax credit, betrayed the egregious influence of the Republican donor class on an otherwise opaque legislative process.
Yet what may be the most controversial aspect of the tax bill, its impact on the deficit, is clearly an unalloyed good. Indeed, it may even be its saving grace.
According to the Joint Committee on Taxation, the tax overhaul will increase the federal debt by $1.45 trillion between 2018 and 2027. The Penn Wharton Budget Model, which makes some different assumptions, gives a number closer to $2 trillion. In fact, both models understate the true budget impact, as the lions’ share of provisions for individuals set to expire in the years ahead — including $1.2 trillion in across-the-board tax cuts — will likely be renewed or made permanent by Congress when the time comes.
If you’re a budget hawk, this all sounds like a disaster. Even President Barack Obama’s former Treasury secretary, Jack Lew, sounded more like Ron Paul than a liberal economist this week when he warned the bill’s deficit impact risked “leaving us broke.” Thankfully, the budget hawks are all wrong. The US is nowhere near its borrowing limits. If anything, a larger US deficit could do the country, and the world, a lot of good.
Make yields great again
Look no further than the historically low interest rates on US government debt. Right now, a 30-year Treasury bond yields a mere 2.8 percent in interest a year — an astonishingly low price for the US to pay on borrowing that doesn’t come due for a generation.
Why would people be willing to lend to us for such a small return? Our explanation, shared by former Treasury Secretary Larry Summers and others, is a phenomenon known as “secular stagnation.” A concatenation of factors, including aging demographics and a rising middle class in the developing world, have produced a global glut in savings. That savings glut has pushed market rates of interest lower and lower as a growing number of savers run up against a shortage of safe, high-yield investment opportunities.
Consequently, these savers are forced to pour large quantities of money into investments like short-term US Treasuries, which are safe from default but have recently offered slightly negative real rates of return. That is, the US government has been paying its lenders back less, in inflation-adjusted terms, than it borrows from them.
This may seem like a raw deal for America’s creditors, but the alternative is worse. The global financial crisis, after all, was seeded by efforts on the part of private banks to create synthetic securities that seemed as safe as US Treasuries. Complex computer models promised that mortgage debt would always be repaid, and also promised that in the infinitesimal chance that it was not, hedge funds holding complex mortgage-backed securities would be the ones to lose money. It didn’t work out that way. The computer models were wrong, and many ordinary investors lost their savings.
In contrast, when the US government issues bonds — say, to finance deficits — it creates more genuinely safe assets for the world’s safety-starved investors, taking pressure off bubbly markets like housing and allowing the financial sector to focus on better things. Indeed, the US dollar is the reserve currency to the world, backing nearly 65 percent of all global reserves, and trillions of dollars of US dollar-denominated assets far beyond our borders. That effectively makes the US a kind of banker to the global economy. In sum, not only is the US capable of sustaining much higher debt levels than other countries, but when we issue more debt we actually do the global economy a service.
The risks and rewards of Trump’s (yes) Keynesian tax cut
Some critics of the bill, including our Niskanen Center colleague Ed Dolan, are much less sanguine. Dolan has written recently about the risks of the strikingly pro-cyclical nature of the Republican tax cuts. Textbook Keynesian economics dictates that a country should run budget surpluses in the good years to build up ammunition to spend and cut taxes in the bad years. Yet Republicans are cutting taxes just as the economy seems to be gaining steam.
We acknowledge this risk, but think it vastly overestimates the current strength of the US economy and overlooks the significant scars left over from the Great Recession. That underlying weakness makes the case for deficit-funded growth stronger. The employment-to-population ratio — in some ways a better gauge of economic vitality than the official unemployment rate — has still not recovered, inflation is still low, and many, particularly rural, communities are struggling. Critics argue that these problems with the US economy are structural, driven by disincentives to work like disability insurance, or, yes, even the prevalence of addictive video games. Yet such arguments were used to suggest that unemployment below 7 percent was unlikely in a modern economy, and that belief proved false.
Our view is that the demand stimulus created by a large, deficit-financed tax cut will help to spur the economy back to its full potential growth path, and bring displaced workers back into the workforce. Firms have been reluctant to invest in capital in an era of abundant cheap labor, helping keep real wages low. A high pressure economy will reduce that supply of idle labor, and induce employers to deploy more productivity enhancing technology above and beyond the small but real supply-side effects of the corporate rate cut.
Capping the deduction for state and local taxes and doubling the Child Tax Credit also means that poor states, which lack the tax base of New York or California, will receive a greater share of federal spending. That’s also a positive development. In lieu of an explicit fiscal transfer policy moving resources from rich states to poor, states like Mississippi and Alabama have been chronically deprived of aggregate demand, which has helped to create a two-track economy. These reforms will help reverse that trend.
Greater productivity and higher levels of employment make for a stronger, more resilient economy. What’s more, a larger deficit and faster growth will eventually give the Federal Reserve space to prudently raise interest rates. When the next recession comes, the Federal Reserve will then have more room to respond before running up against the interest rate “zero lower bound,” as it did in during the Great Recession.
The poverty of the “starve the beast” argument
Meanwhile, the fear that making the rich pay more in state taxes — or, more precisely, forbidding them to deduct those payments from their federal taxes — will suddenly induce cuts to social services is overwrought. Canada manages to run its healthcare system and most social services at the provincial level without the equivalent of a provincial tax deduction, even though every province except Alberta has a higher top marginal income tax rate than California.
Instead, poor provinces receive direct transfers from rich provinces, who in turn are incentivized to make efficient use of their greater fiscal capacity. The transfers in the Republican plan are harder to see but move us closer toward that system. Indeed, rich states like California have large untapped sources of tax revenue, like the higher property taxes regressively capped by Prop. 13. The new law is leading California to rethink that policy.
According to another common argument, unfunded tax cuts will be used by Congress to justify cuts to important entitlement programs down the road. Fortunately, the theory that tax cuts “starve the beast” of government largesse is empirically unfounded. A famous analysis by the late libertarian economist William Niskanen found that the opposite was true; that, if anything, deficits preceded growth in US government spending.
The explanation is a phenomenon known as “fiscal illusion” whereby deficit financing leads the public to perceive programs as relatively costless; that fuels demand for larger, not smaller, government. (It’s not as if the growth in public spending over the last three decades has been driven by liberal Democrats taking advantage of large budget surpluses.)
If it turns out that economic growth is robust for the rest of this decade, and we avoid another recession, then we may reach the point where the US government will need to become concerned about reducing its debt levels. However, this will be a good problem to have. It will mean that, whatever the other flaws of the tax overhaul its Keynesian underpinnings will have helped us escape the slow growth trap that has ensnared every other developed economy in the world.
Should that come to pass, we would happily endorse tax increases — as part of the Warren-Harris administration’s deficit reduction plan.
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