Fiscal FactChecker: Tax Reform and Economic Growth

This blog is part of the “Fiscal FactChecker” series designed to examine the accuracy of budget-related statements made during the 2016 presidential campaign.

Claim: Tax Reform Can Accelerate Economic Growth

Since the 2016 Presidential campaign began, a number of candidates have touted tax reform – either overhauling or replacing the current income tax – as a way to promote economic growth. In fact, well-designed tax reform can and probably would promote economic growth; though perhaps not by as much as some of the candidates claim.

Both the Joint Committee on Taxation (JCT) and Department of Treasury have attempted to measure the economic impact of tax reform. Depending on the type of tax reform, official estimates suggest the size of the economy can be boosted by between 0.1 and 2.4 percent on average over 10 years. This is equivalent to a 0.02 to 0.5 percent change in the annual growth rate, which would increase projected average real economic growth to somewhere between 2.35 and 2.8 percent over the next decade.

Tax reform could help to promote growth in several ways. Most significantly, it can improve incentives to work and invest (increasing labor and capital supply, respectively) by reducing effective marginal rates and can reduce the crowd-out of productive investment by increasing revenue collection for deficit reduction. Tax reform can also eliminate distortions in the tax code to help money flow to activities and investments which produce more welfare or yield greater economic returns, reduce the cost of tax compliance and avoidance, encourage certain pro-growth activities such as research and development, or improve America's global competitiveness.

Interest Rates Continue to Fall in CBO's Forecast

CBO’s latest budget baseline projects ten-year deficit numbers to be slightly smaller than previously estimated, despite the passage of legislation increasing the deficit. The biggest cause: a drop in projected interest rates, which lead CBO to revise down total interest spending by $385 billion, or about 7 percent, through 2025.

CBO now expects rates on three-month Treasury bills to be lower for the next three years before stabilizing at 3.4 percent in 2020, one year later than projected in January. CBO expects longer-term bonds to pay permanently lower interest rates, with ten-year notes ultimately reaching only 4.3 percent instead of 4.6 percent.

This downward revision represents the continuation of a trend we noted last year. Compared to its March 2011 projections, CBO now sees $2.2 trillion less interest spending over the 2011-2021 period, a drop of nearly 40 percent. About 90 percent of that drop is due to lower projections for interest rates and technical factors, and the rest is due to lower debt levels than projected in 2011.

High Debt Drags Down the Economy

According to the Congressional Budget Office (CBO), rising debt levels could reduce projected annual income by between $2,000 and $6,000 per person by 2040, while a deficit reduction plan could instead increase income levels and reduce interest rates on government debt, an effect that would flow through to mortgages and other loans.

This is just one of many economic findings included in CBO's latest Long-Term Budget Outlook, which shows very clearly that rising debt could be detrimental to the American economy.

While CBO's standard long-term projections are based on "benchmark" economic projections which generally assume no major changes in fiscal policy, they also warn of the limits of such projections. As CBO explains, rising debt can have feedback effects by crowding out private investment in favor of public debt and ultimately slowing economic growth.

CBO's report quantifies these effects and their effect on debt. Under current law – where debt grows from about three-quarters of the size of the economy today to equal to the size of the economy by 2040 – CBO estimates GNP would be 2 percent smaller by 2040. If lawmakers continue to add to the debt in many of the ways that they have recently as in the Alternative Fiscal Scenario (AFS) – and debt reaches 156 percent of GDP by 2040 – CBO estimates the economy would shrink by an additional 5 percent, or roughly 7 percent in total. On the other hand, a $4 trillion deficit reduction would increase the size of the economy by 5 percent as compared to the Extended Baseline and 3 percent above the benchmark level.


Not Living Up to Potential: CBO Sheds Light On Its Economic Projections

As we've mentioned frequently, budget projections and economic forecasts are inextricably linked in determining both the nominal dollar budget numbers and their size compared to GDP. Naturally, the ten-year projections that budget agencies like the Congressional Budget Office and Office of Management and Budget make are very uncertain, so deviations from those forecasts can have profound effects on the budget. A recent CBO report helpfully provides some background on how they make their economic projections and in particular, why they assume that the economy will never actually reach potential GDP.

For background, potential GDP is the amount of output the economy would produce if it was at full capacity but not at a level which would risk accelerating inflation. Thus, it does not represent literally the maximum possible output at the time but rather a trend line around which actual GDP moves during the business cycle. Thus, the growth rate of potential GDP and its relationship to actual GDP are very important in longer-term budget projections.

Of course, actual GDP is currently below potential by more than 2 percent, and it has been below it since mid-2006 and for 12 of the past 13 years. Here's how CBO describes its incorporation of cyclical effects:

For roughly the first half of its 10 year projection period (which currently runs through 2025), CBO projects the growth of actual output by estimating both the potential and the cyclical components of economic activity. For the latter part of the projection period, however, CBO does not estimate cyclical components.

In other words, CBO attempts to project economic growth in the first five years of its budget window but relies on a simplifying assumption that the economy is in “steady-state” in the second five years, rather than trying to predict booms or busts. In the past, CBO assumed that actual GDP would be exactly equal to potential GDP in this steady state. However, recently CBO adjusted that assumption.

Starting in last year's February baseline, CBO assumed that the economy would only reach 0.5 percent below potential and grow at the same rate as potential GDP thereafter. As before, CBO does not attempt to project the business cycle in the second five years, instead assuming an average of likely outcomes.

Top 14 Charts About the Budget in 2014

This year was an eventful one for the federal budget. To explain the year's events, CRFB wrote 427 blogs, 17 papers, and created more than a hundred charts. Below are some of our favorite charts that represent the budget events of 2014.

1. Debt scheduled to reach record levels only seen around WWII within 25 years

Our long-term debt problem remains unsolved, despite some commentators' claims that the debt is not worth worrying about. For instance, economist Paul Krugman said not to worry because the debt in 25 years will only reach the levels we had in World War II. In Actually, Paul, the Debt is Still a Problem, we showed how returning to World War II levels of debt is actually quite alarming. Not only will debt levels be too high, but they are projected to keep rising upwards, without a sharp decline like the 1950s.

2. 2014 deficit decreased by 66%, but only after an 800% rise

September marked the end of the 2014 fiscal year, and saw year-end deficits fall to their lowest level since the Great Recession. Some claimed victory over the debt and urged moving onto other issues. In our report, Deficit Falls to $483 Billion, but Debt Continues to Rise, we showed that these low deficits are nothing to celebrate. In dollar terms, the deficit may have decreased by 66 percent, but that was after it had risen by almost 800 percent during the Great Recession. Moreover, debt remains at a post-WWII record high, and trillion-dollar deficits are likely to return within a decade. 


3. Debt is worse if Congress does not pay for changes

These debt projections assume that Congress will be fiscally responsible and pay for all new legislation. However, if they stick to the all-too-common practice of continuing various policies or enacting new ones without offsetting the cost, the debt situation could be almost 10 percent of GDP worse, as this animated chart from Everything You Need to Know About Budget Gimmicks shows. 

Fed and Treasury 'rowing in opposite directions'

The Federal Reserve's efforts to help the economy recover through quantitative easing (QE), twisting, and tapering have made front page news without fail. Although it has gotten less attention, the Treasury Department has also been changing the way it finances the national debt to take advantage of lower interest rates, inadvertently counteracting some of the intended effect of the Fed's policies on the economy. That's exactly what a new Brookings working paper by Robin Greenwood, Samuel Hanson, Joshua Rudolph, and Lawrence Summers argues: during the past 5 years, the Fed and the Treasury have been "rowing in opposite directions."

In 2008, the Fed reduced interest rates to near zero in an attempt to help the economy grow. But nominal interest rates cannot go below zero, so conventional monetary tools stopped working. To further stimulate the economy, the Fed took extraordinary measures and began purchasing long-term government bonds and government guaranteed debt (like Mortgage Backed Securities, or MBS). These measures reduced the amount of long-term debt available for public investors and lowered long-term rates.

But while the Fed was engaging in these unconventional transactions, the Treasury was selling more long-term debt to lengthen the average maturity of the national debt, thereby locking in today's low rates and mitigating the risks of higher interest rates in the future, essentially providing a partial counterbalance to the Fed’s policies.

Deficit-Financed Tax Cuts May be Counterproductive

A new paper suggests that tax cuts that add to the deficit provide little boost to economic growth and may actually hinder it. Last week, the Tax Policy Center (TPC) put out a paper entitled “Effects of Income Tax Changes on Economic Growth,” summarizing the academic literature.  According to the authors, Bill Gale from Brookings and Andrew Samwick from Dartmouth, the net economic impact of a deficit-financed income tax cut is either small or negative, with the negative effects of additional debt likely overwhelming the economic benefit of lower rates, particularly over the long term.

Tax cuts have the potential to grow the economy, but their benefit depends on how they are structured and financed. For tax changes to promote growth, changes should encourage work and investment through lower rates, efficiently encourage new economic activity (rather than providing a windfall for previous investments), reduce economic distortions, and create minimal (if any) increases in the budget deficit.

The key question is, how do you pay for tax cuts?  If tax cuts are deficit-financed, the negative economic effects of debt will crowd out investment, which can outweigh any positive growth impact from the tax cut. CBO has found that an “Alternative Fiscal Scenario” representing roughly a $2 trillion increase in deficits over ten years would lead to a 7.5 percent smaller economy in 25 years, while a deficit reduction plan of $4 trillion would increase the size of the economy by 2 percent. Increased revenue has been a key part of many bipartisan plans for deficit reduction, including Simpson-Bowles and Domenici-Rivlin.

Importantly, however, the lack of growth from deficit-financed tax cuts is distinct from the effects of either tax reform, which pairs rate reductions with base broadening, or tax cuts that are financed through simultaneous spending reductions to reduce government consumption. Using base broadening to pay for lower rates avoids crowding out other investment, but would likely temper the economic gains because some base broadening can push up effective marginal tax rates on taxpayers who were taking advantage of the closed loopholes.

House Jobs Plan Doesn't Work for the Deficit

House Republicans plan to vote this week on a jobs package combining bills that would "build a robust economy and foster job creation." While promoting economic growth should be a top priority after a lackluster jobs report and a slow recovery, policymakers should also be fiscally responsible. Unfortunately, the House Republican approach would make the debt much worse. We've compiled the cost estimates for the various bills, and the package would cost more than $570 billion over ten years, before interest.

The package includes a combination of tax, spending, and regulatory changes, many of which could help to spur short or long-term economic growth. The majority of the costs in the legislation come from permanently extending and expanding a few expired tax provisions which focus on promoting research and investment. Unfortunately, the legislation would include over $570 billion of costs, but only $400 million worth of savings. Without offsets, the package will add substantially to the debt.

This increase in debt isn’t only bad for the fiscal situation; it also works against the exact purpose of the bill. As CBO has noted, a high national debt creates drag on economic growth by crowding out private investment, reducing output, and increasing interest rates. The package's care-free attitude towards increasing the debt will dampen any economic growth that would occur from the legislation.

As we've argued many times, if something is worth having, it is worth paying for. The fact that a package has the potential to promote growth does not mean we should allow it to add to the debt over the long run. In the past, we’ve suggested numerous offsets to pay for unemployment insurance, highway spending, extending tax provisions, veterans health care, or the Medicare "doc fix." Any of those, or any number of others, could be attached to this package to make it more fiscally responsible.

Provisions in the September 2014 House Jobs Package
Policy Ten-Year Costs, 2015-2024
Expand and make permanent bonus depreciation $269 billion
Expand and make permanent the research & experimentation tax credit $156 billion
Expand and make permanent 2013 levels of small business expensing (Section 179) $73 billion
Change the definition of full-time employment from 30 to 40 hours/week $46 billion
Repeal medical device tax $26 billion
Make permanent two expired tax breaks relating to S Corporations $2 billion
Exempt from the employer mandate servicemembers and veterans who already have health insurance $1 billion
Codify standards for regulations that create private mandates < $0.1 billion
Require agencies to submit a monthly report of proposed and final regulations < $0.1 billion
Require major regulations to get Congressional approval "significant"
Exempt most private equity financial advisors from SEC registration negligible
Exempt certain merger & acquisition brokers from SEC registration negligible
Streamline the process to obtain permits to extract critical and strategic minerals from public land negligible
Permanently ban states and localities from imposing taxes on internet access $0
Increase timber production on federal lands  - $0.4 billion [savings]
Total, House Republicans Jobs Package  $572 billion*

What Happened to Interest Rates?

One of the biggest stories in CBO's August budget update was the huge downward revision to expected spending on interest to service the debt, down by $615 billion in total through 2024.

Primarily, this revision stems from lower projected interest rates, resulting in $465 billion less spending over ten years. Another $90 billion came from technical changes (mostly from estimates of payments on inflation-protected debt securities), and $60 billion came from a lower debt burden as a result of all the revisions in the new baseline (a change known as debt service). The interest rate story is the most interesting, though, since it has the largest implications for the federal government's interest burden in the future.

Our analysis of the report noted that interest rates had been revised down both in the short term and the longer term. In 2014, the rate on ten-year Treasury notes is now expected to average 2.8 percent rather than 3.1 percent, and to stabilize by 2019 at 4.7 percent instead of 5.0 percent. CBO made a similar revision to projected three-month T-bill rates. As a result of these changes, interest spending was revised down by more than $30 billion through 2016 and by $50-65 billion annually in the 2017-2024 period.

This downward revision by CBO continues a recent trend of declining projections as interest rates have stayed depressed for longer and the economy has been slower to recover than CBO originally anticipated.

Economic Effects of the President's Budget: It's All About Immigration Reform

In its release this week of the economic effects of the President's budget, CBO found it would increase the size of the economy, mainly due to immigration reform. As a result, under the President's budget Gross National Product (GNP) would be about 2.1 percent higher in 2024 than before the enactment of the budget, though GNP per capita would be about 1 percent lower. Importantly, higher economic growth would lead to additional revenue collection and lower deficits. Because CBO accounted for certain economic effects of immigration in its analysis of the President's budget, the additional economic effects would actually increase the deficit by less than $100 billion over ten years.

In analyzing the economic impact of the President's budget, CBO finds six main ways in which the budget would affect economic growth:

  • Increasing the size of the U.S. population, thus raising the number of workers;
  • Increasing federal budget deficits in the short term, mainly through higher government spending, which would boost aggregate demand and the use of labor and capital;
  • Reducing federal budget deficits in the long term, which would increase national saving and private investment;
  • Raising the marginal tax rate on labor income, thereby discouraging work;
  • Raising the marginal tax rate on capital income, thereby discouraging saving; and
  • Increasing federal investment in ways that would increase productivity and the skill level of the workforce.
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