God is a Capitalist

Sunday, October 29, 2017

Trump's tax plan doesn't excite

Knowing my interest in economics, several people have asked me what I think of President Trump’s tax plan. From what I understand, the plan would reduce corporate taxes and the top rate on personal income taxes. Politicians will spend enormous energy debating, editing and refining this plan over the next several months, but it amounts to little more than rearranging the deck chairs on the Titanic.

My attitude infuriates Republican groupies who see the plan as the salvation of the country. But we old folks have seen it before. President Reagan slashed the top personal income tax rate from about 90% to around 35% and the economy took off like a rocket, or so Republicans keep telling themselves. In reality, the economy rebounded sharply from one of the worst recessions in the 20th century if we sum the 1981 and 1982 recession that six months separated. Together they were as bad as the “Great Recession” that began in 2008. If the Fed or the government don’t do something stupid, as Hoover did with the Smoot-Hawley tariff, entrepreneurs will always make the economy rebound sharply after such a deep recession.

Next, Reagan pumped billions of dollars into the economy with a massive military buildup in his poker game with the USSR. The military spending caused the budget deficit and federal debt to explode. Republicans had until then opposed deficit spending for long periods but learned to love it under Reagan and still seem to be very fond of it. Deficits and the debt don’t disturb anymore.

Trump sounds a lot like Reagan: he wants to build up our “emaciated” military and cut taxes. The result will probably be the same as we experienced with Reagan’s and Bush II’s tax cuts – a massive increase in deficit spending and debt. The difference this time around is that the debt was much smaller under Reagan and everyone wanted to buy US bonds. Today, the world is tired of them. The only one buying today is the Federal Reserve. We depended on China buying our debt for decades but they’re switching to gold. Interest rates will have to rise in order to entice buyers other than the Fed.

Economists know that tax cuts for businesses will reduce their costs, increase profits and expand investment. But the caveat is that nothing else is hindering business. That's not true today. Yes, taxes are a drag on business, but so are regulations that cost businesses $2 trillion per year in compliance costs, the high cost of health insurance for workers and high minimum wages.

Reagan was lucky to have his recession in the first years of his first term, so he didn’t have to take credit for it. Everyone one blamed the peanut farmer from Georgia. Trump will have his recession in his first term as well, but it appears that it will happen too late for him to blame Obama so he’ll have to eat this one by himself. But what happens when he has to sell massive amounts of bonds or treasuries to pay for much greater spending on unemployment insurance and aid to the poor while tax revenues plummet? Who will buy?

Governments at all levels already take about 45% of GDP in the US. The optimum for growing the economy according to some studies is 25%. That's a bridge too far. Not even Republicans would accept the spending cuts necessary to achieve such a goal. It would require squeezing the military to a degree that would terrify them.

Growing the economy so that real wages rise and real unemployment falls requires investment by businesses in new or expanding plants. If we energize consumer spending as mainstream economists preach, we will only get price inflation. That will help reduce the real value of federal debt but it’s also the same as defaulting on that debt; it makes the holders of debt poorer. But the US doesn't have the wealth to spend on new investment because 45% of income goes to governments, most of which spend it on the military and payments to the poor.

Those are good things to spend money on, but we have to keep in mind that they are pure consumption and a one-for-one trade off exists between increased consumption and investment: every dollar spent on consumption is one less available for investment. Production possibility frontiers in every introduction to economics textbook explain the concept well. That’s one reason we have suffered such a slow recovery from the last recession. Businesses don’t have the wealth to invest because so much is going to consumption.

The only helpful change is taxes will come with massively reduced federal, state and local government spending so that tax shuffling doesn’t cause deficits to explode. But no one, least of all Republicans, are thinking about it. In politics, the Preacher was right: there is nothing new under this sun.
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