In the Nation's Interest

Demystifying the Tax Reform Bill

The director of the White House Office of Management and Budget has described some of the key provisions of the Republican tax “reform” bill as “gimmicks.” Meanwhile, leading figures on the two sides of the tax debate are jousting over whether the bill will or will not reduce or eliminate its own budget cost by increasing economic growth. These two strains of the partisan donnybrook are related.

Let’s start with growth. Tax cut advocates say that the congressional bills would stimulate ongoing faster growth by “reducing the cost of capital,” which is economese for making it cheaper to put a new building or machine in service for a business. Skeptics of the tax bill point out that the cost of capital is determined by both the tax treatment of the investment and the interest rate, and that using real world numbers, the interest rate can be more powerful. They continue that the currently debated tax bills, by increasing budget deficits and the debt, will force up interest rates high enough to choke off much or all of the direct incentive effect of the tax cuts. So who is more right?

That depends in substantial part, of course, on how much the current bills increase the deficits in the first round, before the growth effects occur. For starters, Congress was not willing to take the high road and try to pay for all of its tax cuts. Instead, it gave itself a $1.5 trillion “mulligan” to increase red ink because it believed that growth would come to the rescue.

But that is where the “gimmicks” come in. Even $1.5 trillion was not enough for the Congress’s appetite. So the Senate made some of its tax cuts that were most important to the paycheck-to-paycheck taxpayers temporary to terminate before the end of the 10-year budget horizon. Not to worry, the advocates say. We’ll never let those tax cuts expire, we promise. But if they are correct, that also says that the additional $1.5 trillion in the deficit isn’t the whole story. Figure another $240 billion to keep the tax cuts for the working stiff coming.

Then the Senate bill repeals the ObamaCare individual health insurance mandate. On paper, this saves $318 billion. But that savings depends upon households dropping their coverage, and therefore not collecting the available insurance subsidies. One would expect that the larger the subsidy, the less likely the household would be to pass it up. Experts are rethinking these “savings.”

In short, with many other little “gimmicks,” the $1.5 trillion in greater deficits is looking a lot more like $2 trillion. So now for the growth. The nonpartisan congressional tax estimators have done their “dynamic scoring,” and say that the additional economic growth from the bill will pay for only an estimated $500 billion of the tax cut.

Advocates are disappointed, but call that bonus one-third of the $1.5 trillion “mulligan.” The $500 billion growth-bonus estimate may prove optimistic, but it is only one-fourth of the total first-round loss of $2 trillion, counting the “gimmicks.” Unfortunately, it is highly unlikely that the tax-cut advocates will get any additional supply-side growth bonus for the “gimmicks.”

The conclusion is that we are deeper in the hole after the tax cut growth bonus than some apparently think. The financial markets make their judgments not on paper estimates that are intended to satisfy the Congress’s parliamentary rules, but rather on what they believe will be the actual addition to the public debt. That is, it is the job of financial analysts to see through the “gimmicks.”

The stock market likes this news. The tax cuts will give a significant boost to the after-tax earnings of public corporations, and that is precisely what share prices are all about. The stock market does not care whether firms actually invest more, or just pay their tax cuts out in higher dividends or other accretions to shareholders. In fact, the markets might even prefer the latter. So for now, the stock market is happy with the proposed tax changes, whether they boost investment and economic growth or not. The threat of budget deficits to interest rates and our nation’s future prosperity comes later.

 

This column was originally featured in The Hill.