Monday, November 13, 2017

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.


amritsari said...

how did those tax cuts in Kansas work out :) ??

Why are they trying to get rid of the state and local tax deductions ? Why do republicans think that double taxation is OK ????!!!!

I see dozens of weird and extraordinary deduction possibilities whenever I do my taxes. None apply to ordinary individuals like me. Yet republicans want to get rid of the deductions that benefit most middle class folks. These people are not serious. They just want to help out the rich.

Kman said...

hmmm, I'm not sure about your thesis there that lowering tax rates will increase govt rev, and thus reduce the deficit. Does the bond mkt agree with you on that ??

How about telegraphing that taxes are about to go up (similar to commercials that encourage to buy now bfore prices rise ). This should bring fwd the investment, selling etc that you claim will come, casue now you've cemented in investors minds that this is the "floor" it aint going lower. Let the stampede to take advantage of the low rates begin.

p.s either way we can use some cuts in govt spending.

steve said...

Amritsari, and yet the "rich" (top 1% of income earners) pay nearly 40% of all fed tax. How much would you suggest they pay?

steve said...

BTW, given that deficits are rising-and let's be honest, it's not going to stop AND given that inflation is starting to rise a bit from a moribund 1-2% to a still low 2-3% AND given that virtually all world economies are doing well...I think we'll finally start to see the long bond yield rise from the dead. I know! Many have called for it! Still, being an investor in 10-30 year govt bonds may be the dumbest move in a long time. I'm most certainly not short just not invested in this trade. Moreover, high yield (junk) bonds are also starting to show some weakness. Buyers Beware!

Scott Grannis said...

konrad: There is ample evidence to support your claim that announcing tax increases would result in a surge of government revenue. Of course it would. The point is that people respond to incentives: the anticipation of lower taxes results in a loss of revenue, while the anticipation of higher taxes results in an increase in revenue to Treasury. Since people respond to incentives, a significant reduction in the tax on business income should result in more investment (the reduction in tax rates results in an increase in the after tax return to investment). More investment in turn results in more employment, higher wages, and this in turn broadens the tax base and leads to increased revenues over time.

Scott Grannis said...

amritsari: the current practice of allowing the deduction on federal tax returns for state income taxes is arguably unfair to all those taxpayers who live in low-tax states, since they are effectively subsidizing those who live in high-tax states. In any event, our incomes are taxed several times under current law: at the federal, state and local level. I pay sales tax on the things I buy. I pay state and federal taxes on the dividends I receive from investments I have made with after-tax income. The business that I paid for with after-tax income gets taxed on its profits, and I get a share of those after-tax profits, and when I sell that share I am taxed again on any gains. It would be good to eliminate the double- and triple-taxation of income; I'm all for it. But it is not fair to low-tax states to give residents of high-tax states a subsidy.

The Cliff Claven of Finance said...

Tax cuts do not reduce deficits.

The national debt tripled under Reagan and his tax cuts!

That is a fact -- and Reagan made huge cuts in marginal rates,
which are the best kind of tax cuts for stimulating growth --
we don't have 70% rates today that could be cut in half
that could only happen once.

If tax cuts really reduced deficits,
cutting all tax rates to 10% or lower
would end deficit spending?

If a small (1.5 trillion) tax cut really reduced the deficit,
wouldn't a large tax cut (15 trillion) reduce the deficit even more?

Tax rate cuts for corporations will mainly benefit shareholders via buybacks
-- the top 10% --
haven't they made enough money in the long bull market?

Corporate tax rates in total are not high relative to other developed nations
when you count their value added taxes ... that US corporations don't pay.

That claim that corp. taxes are too high is a consistent self-serving lie among shareholders
who are now buying bigger wallets to hold their profits
when (they hope) corporate tax rates taxes are slashed.

With 4.1% unemployment, our economy does not need a boost.

Corporations will not ramp up capital investments because demographics / aging
in the US, Europe, Russia, China, Japan etc.
don't require the same quantity of capital investments
as when baby boomers were in their prime earnings & spending ages.

amritsari said...

Scott - and how many of those "low tax states" get more back in federal expenditures than they pay in taxes ??? States like CA and NY pay more in taxes to the feds than they get back. So lets be careful before making generalized statements that low tax states subsidize high tax states.

amritsari said...

Steve - we as a society already decided that progressive taxation is ok ... higher incomes pay more in taxes both in absolute and percentage terms. What is a fair rate for the richest is almost academic at that point.

amritsari said...

Scott - "our incomes are taxed several times under current law: at the federal, state and local level." No they are not. State and local property taxes are deductible at the federal level. Your other items might be getting double taxed but I don't have the experience to know. In any case you are arguing that we SHOULD start double taxing income by eliminating the state and property tax deduction ??? I don't get it.

Scott Grannis said...

Re our progressive taxation regime. As a society it appears we have decided that tax rates should be highly progressive, but that doesn’t mean it’s the optimal strategy. Art Laffer argues very convincingly that the optimal tax system is one that taxes everyone at the same rate (e.g, a flat tax system), with the exception that those on the bottom rungs of the income ladder pay nothing. The optimal system should also have no deductions, since that enables the tax rate that all pay to be as low as possible. He makes this point because of incentives; everyone should have the same incentive to work harder and invest more. The after tax rewards to working harder and saving more should be the same for everyone, otherwise you are (as we are now) punishing success. That is like cutting off your nose to spite your face.

Progressive taxation is popular because people on the bottom think they are getting something for free, since the “rich” effectively pay most of the taxes. Envy and greed are not good reasons to have a progressive taxation system.

We now face the “tyranny of the majority” that our Founding Fathers worried about so much. The majority of those who work pay little or no income taxes. Naturally they want to raise taxes on the rich even more. But what then happens is that as they begin moving up the income ladder they find that their marginal tax rate begins to soar. Working twice as hard only nets them 50% more. This serves to trap many in the middle class. We should be rewarding success and hard work, not punishing it.

Steve said...

Term Limits for Congress - These guys continue to under-perform.