The release of Trump’s tax plan comes with an expected debate and a familiar question: do tax cuts pay for themselves? The answer is, probably no,. But this doesn’t stop people from bringing up this argument when tax reform is proposed. I mean, you can’t blame them – cutting taxes boosts economic growth, which increases taxable income, and therefore increases revenue collected.
However, this logic is too simple and doesn’t account for other factors that impact the federal budget. It’s not a political issue, it’s simply fact. According to Politifact,“there’s no real evidence in the last 20 years that growth from tax cuts has made up lost revenue.”
This article will explain why tax cuts and overall tax reform can make the economy more efficient, but tax cuts in and of themselves don’t balance budgets.
Theory Behind Tax Cuts
The theory behind tax cuts paying for themselves is really simple – cut taxes in the short run to boost economic activity in the long run. Think of it as a pie…
Instead of taking a bigger piece of a small pie, you can take a smaller piece of a bigger pie. In the second scenario everyone wins – more pie to go around and the government still gets its cut.
But how does cutting taxes boost economic growth? Well, the theory is pretty straightforward – if people can take home more of their own income, then they’ll put that money back into the economy. More money into the economy means more income for businesses. More income for businesses means more profits for shareholders and employees. More money for shareholders and employees means more money will be spent in the economy which makes its way back into businesses – and the cycle continues.
How Does The Math Work?
It’s nice to talk about theory, but is the math behind self funded tax cuts even feasible? How much economic growth will you need to make up for lost revenue? When will you break even? Well, we talked about the theory, so let’s dive into the numbers.
Lets start with the revenue side of the equation. Since the 1940’s the federal government has collected, on average, 17% of Gross Domestic Product (GDP) annually. This means that for every dollar of GDP, the US government collects 17 cents through individual, corporate, payroll, and excise taxes.
It’s estimated that Trump’s tax plan could cost anywhere from $3 trillion to $5 trillion over the next decade. So, essentially, Trump’s tax plan would have to generate $17.6 trillion to $29.4 trillion over the next decade in additional GDP growth. How did I come up with these numbers? Simple, if the US government collects taxes approximately 17% of GDP, then you would need $17.6 to $29.4 trillion in additional GDP to make up for the loss in revenue.
Assume that the current economy is growing at an average annual rate of 2%. If you gave a $5 trillion tax cut over the next decade, you would need to generate consecutive growth of 4.4% over the next decade. If you were more conservative and gave a $3 trillion tax cut, then you’d only need consecutive annual growth of 3.5%. If you give a $2 trillion tax cut, then you’d only need 1% more growth in GDP year after year.
These growth rates seem achievable, especially considering the most recent quarter of GDP growth at 3%. But is the math really this simple? Proponents of self funding tax cuts would say yes and leave it at that. But there is another side to the equation – government spending.
Like tax receipts, federal spending has a direct relationship with GDP. On average, federal spending has been at or around 20% of GDP over the last few decades. So what does that mean? Well, simply put, if your tax receipts are 17% of GDP and your outlays are 20% of GDP then you’ll have a budget deficit each year of about 3% of GDP.
If the entire point of tax reform is to reduce the amount of taxes the government collects as a portion of GDP, then you’ll always run a deficit. Even if federal spending decreases on its own due to fewer people collecting government assistance, you’ll still run a significant deficit year after year. Why is this?
Well, with a bigger economy comes increased cost simply due to inflation. Since many government assistance programs are tied to the consumer price index, government spending will naturally increase year after year. Same goes with wages for government employees, equipment purchased through military spending, and even interest paid on federal debt.
Simply put, tax cuts do not pay for themselves because they don’t offset increased government spending. Don’t believe me? Well, just look at the data – even with periods of strong growth, the last time federal spending was below 17% of GDP was 1966.
Let’s go back to that pie analogy. Making a bigger pie will yield bigger pieces, but it will also lead to larger cost – more flour, more dough, more sugar, a bigger pan, etc. So, although the government is taking a bigger slice of pie, it’s paying a significant amount of money to make the pie in the first place.
Well, What If We Cut Spending?
So what if we cut taxes and cut spending at the same time? Wouldn’t you get the increased economic growth from the tax cuts while balancing the budget? Well, not exactly. If the point of cutting taxes is putting more money into the economy, then spending cuts just pulls that money right out. Essentially, you’d be taking from the poor and giving to the rich.
Yes, you can make the case that money in the hands of individuals will yield higher growth than inefficient government programs, but the impact is marginal from a macro prospective.
Think of it this way – someone who receives money from Social Security will likely spend the entire amount on goods and services. Therefore, 100% of this government expenditure gets recycled back into the economy. On the other hand, a tax cut to a millionaire will most likely be partially spent into the economy and partially invested into the stock market. This will lead to stock market gains but would do little to nothing for the rest of the economy.
So What’s The Point?
The point is that tax cuts don’t pay for themselves and tax reform has nothing to do with balancing the budget. The original intent of the tax code was simply to answer the age-old question: who is going to pay for the cost of managing the federal government and its many programs? Along the way it’s become a means to persuade human behavior.
Want to increase home ownership? Simply create tax incentives for homeowners through the mortgage interest deduction and the real estate tax deduction. Want to increase retirement savings? Simply create qualified plans that allows taxpayers incentives to save for retirement. Want to boost business purchases of equipment? Simply create incentives that allows accelerated depreciation or a total write-off in the year of purchase.
So we all agree that the federal government needs to collect taxes to pay for government programs (roads, bridges, defense spending, etc.). But the debate surrounding tax reform is how to collect tax revenue without distorting economic outcomes – not whether tax cuts pay for themselves.