President Harry Truman was fond of saying, “Give me a one-handed economist. All of my economists say, ‘on the one hand and on the other…’”
The fact that economists don’t know the specific economic outcomes that a change in policy will cause should hardly be a surprise. The complexities of our international economic system, coupled with the strong possibility of unintended consequences impacting outcomes, renders specific projections difficult at best.
Such is the case with today’s proposed tax cut. In its simplest form, a tax cut for both individuals and businesses will place more money in the hands of those who spend or invest it. Consumer spending represents about 70 percent of the nation’s gross domestic product so if people have more to spend they purchase more thereby increasing economic activity leading to stronger economic growth and greater national income.
Further, as consumers increase their purchasing, businesses have an incentive to invest in factories, equipment and new technologies thereby hiring more employees and producing more goods and services along with higher employment. This is especially true if the tax cut can even out the playing field among international companies. Modern global corporations often seek out the lowest tax rates and will relocate to a country with the least expensive tax base.
The corporate tax rates in the U.S. is 39.1 percent, including the average of federal, state and local taxes. Collectively, the U.S. has one of the highest tax rates in the world and as a result the U.S. is losing companies as they move overseas taking the taxes they would pay elsewhere.
Those in favor of a tax cut suggest that lowering tax rates would encourage companies and the taxes they pay to remain in the U.S. More important, lower individual tax rates would give citizens the ability to spend and save more. The growth in the economy caused by an individual and corporate tax cut would stimulate great economic activity. By cutting taxes the economy would grow and so would tax revenue.
This was the basis for Ronald Reagan’s tax cut in 1986. Economists in favor of cutting taxes point out tax revenue grew from $500 billion to $1 trillion by the end of the 1980s because of the tax cut. Those opposed to the present tax cutting proposal say that any growth that occurred in the 1980s and 1990s was the result of productivity increases and had little to do with diminished taxes. They also suggest that the tax cuts led to significant increases in the federal deficit.
Deficits are problematic for two reasons. The growing government borrowing to finance the debt “crowds out” borrowing for investments in new product lines and businesses. Secondly, greater borrowing may lower the credit rating of the U.S. making future borrowing more expensive.
Given these potential outcomes, is a tax cut worth the risk now that the economy in general is in fairly good shape? Will a decrease in corporate tax rates only lead other countries to lower their rates leading to a race to the bottom in tax revenue of all countries? Finally, what impact will the various proposals for cutting taxes have on the progressivity of our tax system? A progressive tax taxes individual based on income. The higher the income the larger the tax. There is no shortage of vocal advocates and detractors for and against the multitude tax changes that are contained in the various tax plans proposed by Congress.
These and other questions are not easy to answer. What is clear is that in the short run tax cuts will produce deficits. In the longer run tax cuts also stimulate growth thereby perhaps not only paying for themselves, but increasing growth and income for all Americans. It is a tough call for economists to make regardless of the number of hands they have.