Lower taxes spur growth, Trump says. The historical record isn’t so simple.
Finding the patterns
President Trump’s newly signed tax-cut measure has already prompted some corporations to make wage-hike and investment promises. Yet the Reagan era and other history offers cautionary evidence on taxes and growth.
—Within hours of Congress’s passage of a historic tax package last week, at least five corporations announced they were handing out worker bonuses, employee-related investments, or raises in their starting pay.
Two of them – AT&T and Comcast – also pledged big new investments in US facilities and infrastructure.
These moves are exactly the kind of economic kickstart that Republicans say will propel the economy into higher gear, creating new jobs and putting more money in the pockets of ordinary Americans through higher wages and tax cuts.
"All of this, everything in here, is really tremendous things for business, for people, for the middle class, for workers," said President Trump last week as he signed the measure into law.
Will real and lasting economic gains follow the announcements and sound bites? That’s an important question not just for Republican political prospects, but more broadly for the conservative idea that tax cuts help build a stronger economy.
Some growth spurt is likely, in part because corporate tax cuts could lure some multinationals’ money from overseas to be invested in the US. Yet many forecasters are skeptical a bump-up in gross domestic product will be very large. Add in predictions of larger federal deficits, and a risk for Mr. Trump is that his plan will end up solidifying already large public doubts about putting tax cuts at the heart of fiscal policy without paying for them.
At some point, a nation’s debt payment gets so large there’s no money left for private investment, which chokes off growth altogether. When Reagan enacted his 1981 tax cut, the federal debt represented 25 percent of GDP. Today, it is around 76 percent.
“One of the criticisms of building debt is that it really does leave you with less room to maneuver,” says Alan Viard, an economist at the conservative American Enterprise Institute.
An estimated $1 trillion or more in extra debt under the Trump plan will mean less wiggle room on federal spending in an era of rising entitlement costs. It also means less leeway to address emergencies such as a recession.
‘A very big gamble’
Fans of the new Tax Cuts and Jobs Act hope it will unleash a virtuous cycle of investment and optimism, expanding the economy in a self-sustaining way. A multiyear boom occurred after President Ronald Reagan pushed through a huge tax cut in 1981. Economies are too complex and dynamic to know for sure whether a comparable boom will happen again.
“There's good policy in there,” says Gordon Gray, fiscal policy director of the American Action Forum, a center-right think tank in Washington. “And the proof will be when and if companies actually bring [profits] home and put it to work.”
Others are worried.
“It's a very big gamble,” says Joel Slemrod, director of the Office of Tax Policy Research at the University of Michigan in Ann Arbor. “The political benefit from this hinges on an economic effect that is not at all assured.”
Congress’s Joint Committee on Taxation predicts the US economy will be about 0.7 percent larger in 2027 with the tax cuts than without them. That’s pretty similar to other mainstream forecasts, while some optimistic outlooks call for roughly double that extra economic growth. Gains could be front-loaded in the early part of the 10-year period, with GDP rising perhaps an extra 0.3 percent next year.
What about that boom after 1981? Wasn’t that growth triggered by the tax cut? Actually, the causes are open to wide interpretation. Some researchers conclude it was the big decline in interest rates that fueled the growth. Other economists say the economy was bound to recover on its own after a sharp recession.
Trump’s tax cuts also aren’t enormous by historical standards. Reagan’s 1981 tax measure actually stands as the biggest since the World War II era – more than three times as big as Trump’s, when the estimated drop in revenue is measured as a percentage of the economy.
One advantage of Mr. Reagan’s measure was timing. Often, tax cuts for individuals are prompted by recessions and geared to boosting demand and short-term growth. Reagan’s tax cut took hold just as the deep 1981-82 recession was getting under way. Trump’s tax cut for individuals is smaller and looks ill-timed since the economy is growing solidly and is at or near full employment.
A test of corporate behavior
Crucial to the Trump plan’s success is corporate behavior. How much will their cash windfall flow into wage hikes and job-creating investments? Democrats point to a flurry of announced share buybacks as a sign companies will plow more of it into enriching shareholders, with few benefits to the wider economy.
Still, although corporate tax cuts are hugely unpopular with voters, there is fairly broad agreement among economists that they can give some boost investment and economic growth.
“The business side of this reform is the beating heart of the economic growth promise of this bill,” says Mr. Gray of the American Action Forum.
The reasons are twofold. First, the 35 percent US corporate tax rate is higher than those of any other developed nations. Even though many corporations pay far less than that, the loophole-ridden system was ripe for reform that could make it fairer and simpler.
Second, amid lackluster economic growth since the Great Recession, GOP policymakers argue a lower corporate rate will induce more companies to locate in the United States.
The idea hews to timeless economic logic: Tax something less and you’ll get more of it.
Long-term growth trends
But America’s economic record of the past seven decades doesn’t exactly leave one brimming with confidence that tax cuts are the key to faster growth. Correlation between tax rates and long-term growth is hard to prove.
From 1950 to 1970, for example, the highest-earning households paid an average top marginal income tax rate of 85 percent. And yet the economy grew at nearly 3.9 percent. From 1971 to 1986, when the average tax rate fell to 52 percent, the economy grew more slowly: just 2.9 percent. Growth in more recent years sometimes suggests the same pattern: lower taxes, lower growth.
That doesn’t mean that tax hikes stimulate growth, point out Jane Gravelle and Donald Marples, economists at the Congressional Research Service (CRS), in a 2014 study. But it does suggest that tax rates alone don’t determine economic growth, they write.
“If the economy tanks within the next three years, it makes it harder to claim this tax bill was a miracle,” says Professor Slemrod in Ann Arbor. But “it's not going to end the argument.”