Will President Trump rely on his instincts or will he allow the political establishment to dictate tax policy? The answer will determine the extent to which Trump can to deliver on his ambitious promise of real growth in excess of 3%.
During his campaign the President proposed cutting taxes by $1 trillion a year. His instincts on taxes are correct. Every successful tax cut in US history had one thing in common—sharply reduced tax burdens without major offsetting tax increases.
In September, Trump released a detailed tax plan, which The Tax Foundation estimates would cut taxes by about $500 billion a year, or 2.6% of GDP. Interestingly, the Tax Foundation also estimates the size of the 1981 Reagan tax cuts at 2.6% of GDP. Both estimates are based on static analysis, meaning they do not allow for any increase in revenues from faster growth in the economy.
The House GOP plan extols the virtues of tax cuts. However, instead of using successful tax cuts as a guide, the plan looks to the Tax Reform Act of 1986.
The 1986 tax act was a complete failure. Although it reduced some tax rates, it was designed to be revenue-neutral. This means any shortfall in revenue from cutting taxes had to be offset by raising other taxes. Among the offsetting tax increases were a higher tax on capital gains and a major change in depreciation allowances.
Given the complexity of the tax system, any tax increase can have unintended consequences. This was the case with the 1986 tax reform. Its tax increases contributed to a collapse in real estate prices, the failure of over 1,000 banks, and a recession in 1990. President Trump has rightfully criticized the destructive impact of the 1986 reforms.
Similar to 1986, the current GOP tax plan “...envisions tax reform that is revenue neutral.” The Tax Foundation estimates the GOP plan would cost the government $740 billion a year based on static analysis. In order to make up for the lost revenue, the GOP plan increases other taxes by an estimated $500 billion a year. The net tax cut of $240 billion is at the most 1.3% of GDP.
The Tax Foundation estimates that most of the net loss of $240 billion will be made up from faster growth in the economy. As a result, the real loss in revenue to the federal government would amount to only $19 billion a year.
There are two main issues surrounding the ability of the GOP tax plan to generate the type of growth the President hopes to achieve. The first is with respect to the magnitude of the tax cut. The static analysis cut of $240 billion a year represents less than half the magnitude of the 1981 tax cuts. Call it Reagan lite. After allowance for growth, the GOP tax plan represents a statistically insignificant tax cut of only .001 percent of GDP. This is not a major tax cut.
The second issue comes from the plan’s tax increases, primarily the border tax. This restructuring of the corporate tax will disrupt the international supply chain. Doing so promotes the same type of unintended consequences found in the 1986 reform.
President Trump’s instincts on the magnitude and type of tax cuts necessary to ignite rapid growth are correct. His plan is similar to all successful historical tax reforms. One of the President’s challenges to achieving his growth targets will be to convince the Congress to trust his instincts over those of the political establishment.