Delaying tax cuts is ballooning the deficit

Trust politicians to do the opposite of what they should do. The overriding problem that is keeping Congress from achieving true, growth-friendly tax reform is concern that lower tax rates would mean a larger budget deficit. Consequently, politicians are trying to "pay for" lowering some taxes by raising others and/or reducing allowable deductions. Instead, they should be focusing on the urgent need to cut taxes in order to reduce the deficit and strengthen the economy.

I discussed this in greater detail in a post last month (Not cutting tax rates is boosting the deficit). Here's the short version of the story: Since February 2016, when there first emerged a growing consensus that the corporate income tax rate was too high and needed to be cut, revenues from corporate and individual income taxes have flatlined, while federal spending has continued to increase. As a result, the deficit has jumped from $405 billion to $683 billion. The logical explanation for the huge shortfall in revenues (despite the fact that tax rates have not fallen and income and profits have continued to increase at healthy rates) is that people and companies have been actively engaged in minimizing their tax liabilities by deferring income, not realizing capital gains, postponing investments, and accelerating deductions. Why? Because there is a reasonable chance that by doing so they will be able to take advantage of lower tax rates in the future. By inference, this strongly suggests that if Congress manages to cut tax rates, then federal revenues will surge and the deficit will decline, and the economy will benefit from increased investment, spurred by lower corporate income tax rates and increased business investment.

Here are some updated charts which fill in the story:

Chart #1

Spending has been rising at a 4-5% annual rate for the past several years. Revenues, however, have gone flat since Feb. 2016. This is notable, because since then, personal incomes and corporate profits have continued to rise, and there has been no cut in anyone's tax rate. A static forecasting model would have projected continued increases in income tax revenues.

Chart #2

The revenue shortfall can be traced to the individual and corporate income taxes. Together, these two important sources of federal revenue have been flat to slightly down since Feb. 2016. Meanwhile, payroll taxes have been increasing at a steady 5% annual rate, which is exactly in line with wages, incomes, and higher contribution limits. Payroll taxes are very difficult to avoid or postpone.

Chart #3

Chart #4

As a percent of GDP, federal spending and revenues are not terribly out of line with historical norms, as Chart #3 suggests. As Chart #4 shows, the federal budget deficit is not out of the range of what we experienced from the mid-70s to the mid-80s.

Chart #5 

In nominal dollar terms, today's budget deficit has grown from $405 billion in the 12 months ended Feb. 2016 to $683 billion in the 12 months ended Oct. 2017. That's an increase of $278 billion, or 68%. At this rate it is going to be a problem fairly soon. Bear in mind, however, that the main driver of the increase in the deficit is the unusually slow growth (especially given that the economy has been growing) in corporate and individual income tax revenues. This could improve quite rapidly if tax rates on corporate and individual incomes are reduced in a meaningful fashion.

People and businesses respond to incentives; that is at the heart of all economic analysis (or at least it should be, but the CBO unfortunately refuses to believe it). Since the chances of lower tax rates are appreciably greater than zero, people and businesses have an incentive to minimize their tax liabilities, and the unusually slow growth of federal revenues supports this thesis. If Congress keeps dragging its feet on this issue, or if a cut in corporate taxes is postponed until 2019 (as the Senate is stupidly proposing), then the deficit is going to get worse, investments are going to be postponed, and the economy is likely to weaken.

The weakness in federal revenues is also a good indication that tax rates on businesses and individuals are too high. The fact that US corporations have avoided repatriating as much as $3 trillion in overseas profits is very strong evidence that corporate income taxes are too high. As my mentor Art Laffer taught me, tax rates that affect behavior in inefficient and uneconomic ways are by definition too high. The best tax rate is the one that people are content to pay, and are least likely to avoid paying. We all know that taxes are a fact of life. But when the marginal rate on corporate profits is 35-40%, and the marginal rate on individual income is 50-65% (as is the case today, including state taxes), taxes are obviously too high, because evasion is high (because the rewards to tax evasion are huge), and revenues are low.