Friday, October 20, 2017

Not cutting tax rates is boosting the deficit

It's pandering season again, with politicians and journalists wringing their hands about how cutting taxes will be a windfall to the rich and result in higher deficits. The truth, however, is that by NOT cutting taxes the federal government is losing money and the economy is suffering from sluggish growth. Cutting taxes would almost surely result in a significant boost in revenues and stronger growth. How do I know this? Since early last year (February 2016, to be exact), when talk of tax cuts began to spread and politicians on both sides of the aisle began to agree that our corporate tax rate—the highest in the developing world—should be cut, revenues from corporate and individual income taxes have flatlined, despite the fact that personal incomes have increased by almost 5%, trailing earnings per share have increased 8%, and the stock market has jumped some 30%.

It's amazing: rising incomes, rising profits, and soaring asset prices have resulted in no increase in revenues to the federal government, even though tax rates weren't cut. How could that possibly happen? Simple: people are rational, and they respond to incentives. Given the incentive that tax rates may be reduced in the future, individuals and corporations have apparently taken steps to reduce their current tax liabilities by delaying income, accelerating deductions, postponing investments, and postponing the realization of profits.

Consider these simple facts: S&P 500 trading volume has plunged over 40% since early last year. One reason stocks are up is that people are increasingly reluctant to sell; on the margin they would rather postpone the realization of their gains in order to minimize their current income tax liability. I can assure you that has been a powerful motivator for me, and I'll wager that there are millions of investors who would agree. It's no wonder that NYSE member firms report a 25% increase in margin balances since Feb. '16 (from $436 billion to $551 billion) after no increase over the previous two years. Need income but don't want to pay capital gains taxes? Just don't sell anything and instead add to your margin balance.

Here are some charts which fill out the story:


The chart above shows the rolling 12-month totals of federal spending and federal revenues. Spending has been increasing steadily for the past several years, roughly in line with the growth of the economy. Revenues, however, stopped growing early last year. As a result, the 12-month deficit has increased from $405 billion in February 2016 to $665 billion in September 2017. That's a whopping increase of over 60%!



The chart above shows the major sources of federal revenues (it excludes things such as excise and customs taxes, and miscellaneous revenues, all of which are down somewhat). The only revenue category that has been increasing steadily for the past few years is Payroll Taxes (i.e., income tax withholding), by about 5% per year. That's very much in line with the growth of wages and salaries, which have been increasing at a 3.8% annual rate since Feb. '16. The thing that is unique with payroll taxes is that individuals don't have much discretion over their reported income. If their salary goes up, their withholding is going to go up as well. But individual income taxes are different. They are impacted by deductions, which can be shifted in time, as well as capital gains taxes, which can be legally postponed indefinitely, simply by not selling an appreciated asset. The rich can employ a variety of strategies to postpone or defer their income.

As it turns out, revenues from individual income taxes have experienced zero growth since Feb. '16, despite ongoing growth in personal income and sharply rising stock prices. Corporate income tax revenues have actually declined by about 10% since Feb. '16, despite an 8% rise in trailing, after-tax EPS over the same period. If you were the head of a large corporation and you thought there was a good chance of a meaningful cut in corporate income taxes, wouldn't you take all available steps to postpone income and accelerate deductions? Is it any wonder that US corporations have refused to repatriate trillions of overseas profits? 


So, despite ongoing growth in the economy and in incomes, plus surging stock prices, federal revenues have declined by about 1% of GDP since early last year, as the chart above shows. A static model would have projected a significant increase in revenues. No one (especially the OMB, which is still enamored of static forecasting models) expected federal revenues to be flat over the past 18-19 months.  But that's what happened.


As the chart above shows, the rolling 12-month federal budget deficit has increased from $405 billion in  Feb. '16 to $666 billion in Sep. '17. Relative to GDP, the federal deficit has increased from 2.4% to 3.4%. And it's ALL due to zero growth in tax receipts, which occurred despite no reduction in tax rates and sizable increases in incomes and capital gains. 

It's only reasonable to conclude that the reason federal revenues have failed to materialize as would have been expected is that people and corporations have taken meaningful steps to postpone income, accelerate deductions, and postpone the realization of capital gains. And they have done all that because they have been thinking there was a decent chance of significant tax reform. 

It's a safe bet that if the tax code is reformed, and marginal tax rates on incomes, capital gains, and corporate profits are reduced, Treasury will see an almost immediate surge in revenue. Tax reform would unleash a wave of profit-taking, a surge of capital gains realizations, a massive redeployment of capital to more productive uses, more investment (reducing taxes increases the after-tax returns to investment, thus prompting more investment), more risk-taking, more work, more growth, and ultimately reduced budget deficits. I'm not talking ideology, I'm just talking basic common sense.

But won't the rich get the bulk of the benefit from lower tax rates? Sure, because the top 10% of income earners pay about 70% of all income taxes, and half the working population pays zero income tax. Anyway, wouldn't you rather let a rich person keep more of his money, instead of giving it to the politicians in Washington? Who do you think would spend a million dollars more productively: a rich person who is already consuming as much as he or she wants, or a politician, who would love to buy votes? When the rich keep more of their hard-earned money, they almost certainly will invest most or all of it, and that's what creates jobs and prosperity. When politicians get a windfall of revenues, they will spend it, and don't forget that over 70% of every dollar that Congress spends goes out in the form of transfer payments (i.e., money given to people who haven't worked for it). 

Congress needs to cut taxes in order to boost revenues and stimulate the economy. Quickly! We can't afford to wait.

UPDATE: Art Laffer has made this same point repeatedly over the years when explaining the mistake that Reagan made in phasing in his tax cuts. If you promise that tax rates will fall in the future, you only weaken the economy today. When lower tax rates make sense, as they do today (especially corporate tax rates) rates need to be cut ASAP, otherwise capital will go dormant, awaiting the lower rates.

25 comments:

Joesph Palmer said...

Interesting. So the day tax cuts pass the bear market begins?

Scott Grannis said...

Joesph: Not necessarily, and I'm glad you've brought this up.

I look at my own portfolio and I see there are lots of things I would like to sell, if only to diversify my risk. But I find it hard to do so given the huge captains taxes that would trigger. If taxes were cut meaningfully I would happily sell things that I have been holding for a long time, but I would almost certainly reinvest nearly everything in other securities. That's why I say that tax reform would trigger a massive redeployment of capital to more productive uses.

In order to get a bear market you would need something to happen that would cause people to want to reduce their overall holdings of stocks in favor of something safer. Tax reform is not going to do that. If anything, lower corporate tax rates would make stocks more attractive (the value of a stock is the discounted present value of future after-tax earnings—cut tax rates and the present value of those future earnings goes up).

Our current system, coupled with the expectation of future reform, has caused a lot of money to be "frozen." Lower taxes would unfreeze a lot of money that would most likely be reinvested in other things. Lower taxes would also attract money that today is reluctant to enter the market, by making the after-tax returns on investments more attractive. Lower corporate taxes would also make the US a much more attractive place to do business, and that in turn would attract a lot of foreign capital.

Joesph Palmer said...

Thanks Scott, appreciate the explanation.

Benjamin Cole said...

Great post.

Interesting is Grannis' third chart (I wish Grannis would number his excellent charts) which shows federal revenues declining as percent of GDP. Great news!

The mid-term goal should be to get federal revenues down to 15% of GDP, by cutting taxes and outlays.

The establishment GOP, and Trump, continue to disappoint. I was hoping that Trump would bring in a more-realistic world view and less outlay-eating yet counterproductive foreign entanglements. A spartan military.

And no one is talking about simply sunsetting the VA, HUD, USDA or Labor, and they should be.

Tax cuts?

If the GOP had brains (yes, a political party with brains is an oxymoron) they would this year cut marginal income tax rates, but from the bottom, leave the top rates alone. They would cement the middle-class vote. Just one year!

But they can't. Not even one year can they exclusively cut taxes on middle-class people. The people who voted in Trump are turning on the GOP establishment (to put it mildly).

You know what? Mitch McConnell may not have a job soon. The Alabama election tells me we will see a new GOP in a few more years.

The GOP is seen as linking arms with wealthy globalists. Is that picture incorrect btw?

Interesting times,

Bryon Severns said...

The Federal Reserve pays an ever increasing portion of America's bills.

Politicians either promise more benefits or lower taxes, so we get both. Eventually, the Federal Reserve will pay most of America's bills and taxes will be replaced with subsidies.

Matthew Grech said...

Excellent points by SG. As a country, we've been far too hostile to investment. Immediate expensing of capital expenditures should be obvious, and in every generation. The goal should be a capital gains tax rate of zero.

But why isn't there more discussion of reducing the payroll tax? Higher payroll taxes retard the pace of hiring; they also disproportionately harm the non-rich. Very roughly: Cut the payroll tax in half - for both employee and employer - while cutting what we spend on "defense" in half. (Estimates for the all-in cost of defense/military/intel run about $1 trillion.) Revenues from the payroll tax, currently about $1.15 trillion, would decline by about the decline in defense spending. The hiring boom, as well as the wage boom, would be incredible. And talk about a better allocation of capital!

In addition to the financial effects, such a change would have the added benefits of: improving the rich/non-rich relationship, and reducing the overall size of government.

Of course, this will never happen.

naive investor said...
This comment has been removed by the author.
steve said...

I remain unconvinced that we will get significant tax cuts. That said, IF we do I think you'll finally start to see rates climb. Bond market is betwixt and between now and correctly is concerned about economic growth picking up from sub 2% to 2.5-3%. Would be a good thing for the economy but def NOT bonds.

Munil Shah said...

Scott, where do you see trading volume down 40%? The ycharts shows the volume is up. https://ycharts.com/indicators/cboe_spx_volume. Can you elaborate?

Scott Grannis said...

Munir: re volume. I got my info from Bloomberg, but what Bloomberg and what you reference are not guaranteed to be the same thing. I’ll have to take this with a grain of salt until I can confirm one way or another. One could be cash, the other futures/futures-related volume. Hmmm

Ed R said...

Yes, the world would be a much better place if MY taxes were reduced.

Scott Grannis said...

Re trading volume: I've double-checked two measures of trading volume available on Bloomberg (NYSE composite volume, SP500 composite volume index). Both show a distinct decline in trading volume compared to early last year, with SP500's decline being the largest.

WealthMony said...

So on today's Yahoo! page Moody's argues that the current tax plan is all wet, it won't work and its greatest failure is it WILL NOT boost economic growth enough to provide the government its lost revenue.

"Clearly, nothing like the plan Republicans recently put forward will become law. The plan does not just fail to lift economic growth meaningfully, it adds significantly to the nation’s fiscal problems. It also is politically unpalatable. The brouhaha over eliminating the state and local income tax deduction, the principal source of additional tax revenue in the plan, has even forced some of the authors of the legislation to step back from it.

If a tax bill makes it into law, and odds appear no better than even that one will, then it will be significantly scaled back. The Senate already put some limits around the tax legislation when it recently passed a budget resolution, necessary for the use of the reconciliation process, which limits the total cost of tax reform to $1.5 trillion over the 10-year horizon. Even this seems a political stretch."

It seems to me that conventional establishment thinking is that somehow the Kennedy/Reagan-implemented lower tax rates did zero to raise government revenue and boost the economy. On a TV panel show over the weekend, one professional guest was asked his opinion about tax cuts and the revenue benefits that resulted from the Kennedy/Reagan tax cuts and he responded, "I'd much rather see something like the Clinton era where policy produced a robust economy and revenue surpluses that enabled government to pay down debt."

Completely ignored about the Clinton era was the emergence of a new internet economy and personal computer that lay behind that robust growth, as well as the advance towards Y2K.

I expect I fall in well with Benjamin who calls for a significant reduction in the size of the federal government as well as revenue reductions. I doubt we see either over the next few decades.

If you can stomach it and are interested, you can read the article here:
https://finance.yahoo.com/news/moodys-chief-economist-republican-tax-plan-set-fail-170334541.html

Scott Grannis said...

WealthMony: the article you reference was by Mark Zandi, a committed Keynesian, anti-Supply Sider, and reliable spokesman for mainstream thinking. He never saw a tax cut he didn't like. It's no surprise he's not impressed with any Republican plan. Yes, the Clinton years were great in many respects. Unfortunately a lot of the reduction in government spending came from the defense budget, and that in turn left us with a weak military at a critical moment in time. But the tax reductions under Clinton (made possible by the Republicans in Congress) did wonders for growth, as did the Reagan tax cuts. I suggest reading "The Seven Fat Years" by Robert Bartley for the whole story.

I remain persuaded, by two facts, that tax cuts and tax reform would prove very beneficial: 1) the massive amount of un-repatriated corporate profits held overseas, and 2) the significant reduction in federal revenues evidenced since Feb. '16. When taxes are high enough to effect big changes in behavior (and in particular the negative changes we are seeing), then reducing tax rates can make a big positive difference.

steve said...

Scott, how do you feel about the idea the the GOP is siding with a 4th bracket to keep taxes high on the top end? Seems to me to achieve serious economic growth we need the upper end to have taxes cut also and certainly NOT raised!

Moreover, I can practically guarantee that the state tax deduction will NOT be eliminated and without this provision you have very little. Only reducing corp tax is not enough to alter growth. I suspect very few businesses pay anywhere near the top rate of 35% now anyways.

Johnny Bee Dawg said...

This is just plain old common sense. Its amazing how its lost on so many these days.
Outstanding post!
GDP and the stock market are both well below historic trends. Lots of catching up to do.

Just imagine if the government has our backs, instead of creating Marxist headwinds like the previous period since DEMs took over Congress in 2007??

God Bless Trump! Its like somebody finally turned on the light switch on election day.
America dodged a bullet.

Scott Grannis said...

steve: re top bracket. Adding a fourth bracket for high income earners would be very stupid, but not impossible given the current state of the GOP. The economy needs lower tax rates—because it needs more investment, but not granting lower rates to the folks who control most of the capital is like cutting off your nose to spite your face. As a country we've GOT to stop labeling people (rich, poor, white, black, male, female, etc) and trying to redistribute income. Anytime government attempts to alter the natural order of things in a free market it almost always results in unintended, and perverse, consequences.

Let the rich get richer, who cares? They only get richer if they are doing something productive and valuable to the rest of us. The rich can't spend much more than they already are spending. Any additional riches they acquire will almost certainly be reinvested, and that benefits everyone. By getting rich and investing more they are doing us all a favor.

Unknown said...

Well yes indeed, stockholders might in fact postpone selling

-IF-

They think a tax cut is coming.

-IF-

There is not a tax cut, I postulate they will then... sell their stocks.

Scott Grannis said...

It’s hard to know at this point whether a tax reform failure would result in a big stock market crash. I know most observers believe that the market is way overbought and very expensive, but I struggle to find hard evidence that would support that belief. Yes, PE ratios are high, but not high considering the extremely low level of yields. And in any event, PE ratios have been in the 20-21 range for almost two years now, since way before Trump and tax cuts became an item. Also, corporate profits are up 10% in the past year and forward earnings expect more of the same. The global economy is on the upswing. Politics in most countries are becoming more business-friendly. Most importantly, real interest rates are still very, very low, which strongly suggests the market is not pricing in any pickup in economic activity. Trump and the Republicans in Congress have not exactly inspired a lot of confidence in anyone these days, and so I suspect the market doesn’t really expect them to deliver much in the way of tax reform. Meanwhile Trump is making real progress towards rollling back regulatory burdens, and this at the very least is acting as a tail wind for the economy.

Benjamin Cole said...

Re corporate profits:

Corporate profits, by any measure, relatively and absolutely, are at record highs, and much, much higher (like double) than the Ronald Reagan days, for example. Good news, I say. I prefer prosperity.

Yet aggregate demand, in the US and globally, is only so-so, and has been weak after 2008. Every industry, from autos to steel, to shipping to smartphones even food and commodities, has overcapacity. The supply-side is fine.

Maybe corporate tax cuts are the right move. I would prefer tax cuts that boost consumer demand, and also a growth-oriented monetary policy.

I think the establishment GOP is slating its own doom. The latest is Sen.s Corker and Flake, bowing out. No one seems to remember Trump completely flattened the establishment GOP field in the primaries. I mean Jeb! got 2% of the vote.

So the establishment GOP response to this voter rebellion in their own ranks is to tout corporate tax curs and globalism (including counterproductive military expeditions of infinite duration and cost).

The GOP should cut middle-class taxes only, as a statement and probably as good economic policy.

I am pretty sure the GOP in four to six years will not be the GOP (what is left of it) you see today. That's a bit spooky, no?



Scott Grannis said...

Benjamin: using tax cuts to stimulate demand and not supply (i.e., more investment) is a prescription for disaster. You assert that every industry has over-capacity, yet we know that business investment has been extremely weak in the current expansion. Wages have grown at very modest rates. The best way to stimulate demand is to boost investment, which creates more capital that can make workers more productive and more valuable. Cutting corporate taxes would do the trick, boosting middle class wages significantly. If wages are weak, it is an excellent sign that business investment has been weak. Keep in mind this basic maxim: there are two major factors of production, labor and capital. When labor is abundant, labor’s wages are weak. When capital is abundant, the demand for labor is strong and labor’s wages rise. Pump capital (investment) into an economy and watch real wages rise. Starve an economy for capital and you will find unhappy workers. It’s that simple.

Benjamin Cole said...

Scott:

Theoretically, you are probably correct. I am just an econo-junkie.

But egads, sometimes one has to do what is expedient (if no principles are involved).

The GOP is putting a target on its back, and seems to be living in a bubble. They will not be there in four to six years, unless they do something to re-win their invigorated rank-and-file.

On some macro-levels, perhaps investment is weak. Others point out weak real estate investment, due to small housing starts, is skewing the data.

I can tell you, no good idea in venture capital goes unfunded, no good commercial real estate deal is unfunded, corporations can sell bonds easily for small interest etc. And corporate profits at record highs.

Corporate profits skyrocketing and capital is cheap and abundant. If investment is weak…well, that puzzles me. Maybe labor is so cheap it makes sense to cut back on capital outlays.

Hey, I am not against tax cuts. If I had my way, there would no taxes on productive behavior, whether working or investing. But that is another oboe dream.

Scott Grannis said...

Re cost of capital. Benjamin asserts that "capital is cheap and abundant." I believe the truth is exactly the opposite—that the cost of capital is very expensive and therefore in short supply. John Cochrane's post today, "Hall Graphs," adds some meat to this argument.

http://johnhcochrane.blogspot.com/2017/10/hall-graphs.html

Briefly, he argues that the cost of capital is very high these days, with burdensome regulations, taxes, and excess risk being the main culprits. Capital is very expensive, and that is why businesses have not invested hardly any new capital in their existing workforce in recent years. Without new capital investment, wages have stagnated. All this could be reversed with a reduction in the burdens on capital (e.g., with reduced regulatory and tax burdens).

Think of the "cost of capital" as the return on capital that is required in order to offset risk, regulatory, and tax burdens. The higher the burdens, the more expensive capital becomes. We know that the corporate tax rate is exceedingly high, compared to that of most other countries. We know that regulatory burdens increased significantly during the Obama years (and yes, they increased during the Bush years as well, but by much less). Increased burdens on capital made it harder to find and deploy capital; that resulted in less capital investment, less productivity (productivity has been exceptionally low during the current recovery), and relatively stagnant wages.

The fact that the equity risk premium (the earnings yield on stocks less the yield on 10-yr Treasuries) is still substantially positive is another reflection of the fact that capital is scarce. If capital were abundant, the earnings yield on stocks would be negative, as investors would be very willing to accept a lower yield on stocks vs Treasuries because they would be relatively confident that equity prices could rise in the future with a rapidly growing economy (which would be the result of lots of investment and productivity gains). We saw this happen in the 1980s and 1990s, when tax and regulatory burdens were much lower and productivity was much higher.

Benjamin Cole said...

Scott Grannis:

Interesting arguments. LIke I said, I certainly am for the lowest taxes and least regulatory burdens on productive behavior (investing, working) possible.

Social welfare largely does not work, and military outlays are largely boondoggles.

Here is a thought: You have argued the lowering taxes on capital would increase the demand for labor, and thus boost labor income, and I think that is true.

Is the reverse true also? That is lowering taxes on labor---say a payroll tax holiday---increase the demand for capital and thus returns to capital?

Cochrane is a brilliant writer, IMHO. Cochrane does believe federal deficits are the primary cause of inflation, and the mounting federal debt a crisis. he calls it the "fiscal theory of price inflation" or something to that effect.

I am not sure how Cochrane's assertions square with Japan-o-nomics, but like I said, I am just an econo-junky.

Anyway, we will see what shape the Trump tax cuts take.

I think any tax cut is a good tax cut!

The Cliff Claven of Finance said...

"It's pandering season again, with politicians and journalists wringing their hands about how cutting taxes will be a windfall to the rich and result in higher deficits."

I stopped reading after that first sentence.


It's nonsense to claim cutting taxes is NOT a windfall for the rich, and will NOT result in higher deficits.

The federal debt tripled under Reagan, along with his significant reductions of too high marginal rates.

Are you claiming it's going to be different this time?




A good economist would point out that the bottom 50%, sorted by income, pay a tiny percentage of all federal income taxes, so can't expect to benefit much from a tax reduction.


A good economist would point out Reagan tax cuts coincided with a tripling of the debt,
... and after Obama almost doubled the debt, increasing the debt even more may not be a wise idea.


A good economist would point out that the rich own / manage the businesses and employ the other people,
so there is no benefit for workers, if their bosses are punished with higher taxes "on the rich".



A good economist would point out that In 2004, 9,700 companies were eligible to take part in a tax holiday that would bring the overseas cash back at a rate of 5.25% -- they mainly used the money for share repurchases and bonuses.

About $312 billion was repatriated, and the Congressional Research Service said the program had little effect.


Someone please find a good economist to say those things.



If cutting taxes is always a great idea, according to Republicans, then why not cut them even more than Trump wants?

Perhaps cut taxes to zero, and just borrow all the money needed for government spending?

Isn't that what the voters always want -- more government spending, and less taxes?



Two myths I often read:
(1) US corporate taxes are high
That claim ignores the fact that most other developed nations have value added taxes and the US does not.
Including value added taxes, US corporations pay tax rates similar to other developed nations.

(2) "Overseas" money would benefit the nation if it came "home":
First of all, that didn't happen with the 2004 program described above.

Second, roughly half the money is already in the US, being used by bank customers
other than the company that originally deposited it in a bank,

Third, a company that has a lot of cash in overseas banks (could be just a separate account in a Manhattan bank)
could use it as collateral for a very low interest rate loan in the US from the same bank, and

Fourth, if a US company paid 25% income tax to a foreign nation,
and the US also had a 25% corporate tax rate,
then that company could repatriate overseas profits here with no tax penalty
( .. rather than paying another 10 percentage points of taxes
because our corporate tax rate was 35%)



It is my opinion that tax revenues should pay for 100% of government spending over the business cycle --
deficit spending is a way for politicians to "hide" their spending from the taxpayers -- the government spends more,
but no taxes go up.