The House has passed its tax bill, and it's based on one organizing principle: that people with more money can do the most for the economy.
Of the $1.5 trillion in deficit financed tax cuts in this bill, the overwhelming majority of the benefits accrue to corporations and the top one percent of income-earning households. Exact numbers vary, but some reviews suggest that as much as 80% of the benefits will accrue to America's wealthiest households. A recent analysis from the Tax Policy Center concluded that the after-tax income of the richest 0.1% will grow by 3% due to this bill, more than double the gains of the middle class.
This is not an accident. It is a critical element of supply side economics.
Supply side economics, a major plank of the conservative movement since at least the early 1980's, argues that production and capacity drive economic growth. As a result, policies which increase investment in and development of business will spur economic growth overall. On this basis conservative policymakers have put together a tax bill which grants the overwhelming majority of its benefits to the already wealthy. Here are five reasons why proponents argue that will work on everyone's behalf, and five reasons why most economists say it won't.
Think about these tax strategies.
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If economic growth is spurred by business investment, one of the best things that the government can do is get out of the way of that investment. As a close second, the government should encourage and reward that investment as aggressively as reasonably possible. This is much of the basis behind the White House's famous prediction that tax cuts will boost incomes by $4,000 to $9,000 per household.
Based on this logic the tax cuts passed by House Republicans and those under consideration in the Senate will slash the corporate tax rate and, by restructuring pass-through income, will make it easier to profit as a private investor. The goal in both cases is to encourage companies and individuals to invest their money by increasing the rewards for doing so. Entrepreneurs will, proponents argue, spend more money developing new businesses if they can keep more of the money from doing so.
Investors are more likely to give those entrepreneurs and businesses money if they will get to keep more of the profits.
As a downstream result, workers across the country will benefit from the jobs and prosperity that come from new firms, studios, factories and other forms of productive enterprise built by this new business activity.
For the same reasons that investors will sink new money into the market, existing businesses are more likely to expand if they can keep more of the profits. The key notion here is elasticity of markets.
Reducing the corporate tax rate will make it far more lucrative to launch a successful business venture, because the company will get to keep more of its own profits. This creates a corresponding incentive, then, for companies to create more business ventures. Companies will expand elastically in response to new profits.
They will do so, in part, because the greater profit margins offset greater risks.
Although any company could today take out a loan or spend some of its own capital launching a new product or opening a new branch, every venture comes with a certain degree of risk. A company decides to act based on a calculation of capital, risk and reward. By raising the reward through lower taxes, Congress hopes to influence that calculation.
One of the great debates of our time is why wages aren't rising as much as they should in response to a near-historically tight labor market. Economists have a lot of theories, but proponents of the current tax cuts argue that reducing high-end taxes will help prod that process along.
By increasing the capitalization of businesses, tax cut proponents believe that companies will have more freedom to compete for talent. In addition, they will have the resources to improve training and skill development, raising employees' skills and general competitiveness in the marketplace. Finally, increased activity in the business environment will make the hiring market even tighter than it is right now.
All of these forces will work to push average pay up.
This is what's known as trickle-down economics.
When someone makes a small purchase its impact on the economy is limited. Buying a $1 product only moves that single dollar into and through the system. Therefore, rather than trying to encourage a million people to make single-dollar purchases, it's often more efficient to encourage a single person to make a million dollar purchase.
This pushes a large amount of money into the economy at a single time, and typically in a manner that touches many disparate parts. When someone buys a house or a boat, that purchase price hides all of the small purchases that go into building and transferring that product. A single house involves not only the construction crew which builds it, but also the realtors that sell the property, the electricians who wire the house, the manufacturers who make materials used to build the house, the companies which make the products someone fills that house with.
The list goes on, populated with workers and industries all enriched by single purchases.
American companies hold over $2.6 trillion in assets overseas that they could spend in the U.S. They are also eager for foreign investment as a source of potential new money. Reducing domestic taxes on corporate profits makes all of that more likely.
By making it cheaper to bring money back into the country ("repatriation"), Washington will encourage companies to do so. With that money, as discussed above, they can increase domestic investment, building new facilities and products on American shores, with American jobs. The same holds true for foreign investment. By making the United States a more lucrative business environment, foreign investors will be more likely to buy into domestic corporations and foreign businesses will be more likely to build here.
Both changes would lead to more jobs and a better labor market for workers.
Bringing money into the United States doesn't work the way tax cut proponents claim.
First, increasing foreign investment will create an enormous trade deficit. More than a third of the benefits from a corporate rate cut will accrue to foreign investors, leading billions of dollars to flow out of the economy. To the extent that this rate cut encourages additional foreign investment, the profits from that money will also flow back out of the U.S. economy to the original investors. This will help drive up the value of the dollar (as people need more dollars to invest in the U.S. market, our currency will get more expensive), creating a wider trade gap and hurting exports.
Meanwhile, taxes have not historically had much impact on repatriation. Companies have rarely responded to repatriation incentives, and when they have, they historically have used that money to issue dividends and stock buybacks rather than funding new investment.
The "end of repatriation taxes is not likely to boost investment much," wrote William Gale, Co-Director of the Tax Policy Center, in an e-mail. "Companies with a lot of funds abroad also have a lot of funds here and are already not investing those funds."
Rich people don't tend to spend new money.
Trickle down consumer economics is, at its heart, a form of economic stimulus. It argues that tax cuts can be used to drive spending which, in turn, will drive economic activity. In a consumer driven economy like the United States', this is not an inherently bad idea. However there is no observable evidence that it works.
To the extent that tax cuts do create new spending, they generally do so at the low end of the spectrum. The less money a household has, the more likely it is to immediately spend new income. By contrast, wealthy households tend to already have all the money they need. They're much less likely to spend new money because their wealth already exceeds their purchasing patterns. As a result, new income tends to go into savings. This can help investment (since banks will use that saved money to fund loans and make investments), but it does not substantially drive new consumer activity.
It isn't realistic to expect corporations to spend new money because they're not spending the money they already have.
U.S. corporations currently have nearly $2 trillion in assets, more than the GDP of Canada or Italy. They're not spending this money. It's sitting in bank accounts and portfolios waiting for business opportunities worth spending on, because companies don't invest or expand until there's a reason to do so.
That's the problem with increasingly liquidity in a vacuum, and supply side economics in general. Businesses build capacity to meet demand, but consumers don't necessarily increase demand to meet new capacity. Just because a factory exists doesn't mean that customers will show up to buy its products. Corporate tax cuts won't create opportunities or increase the demand that drives business expansion, it will only add to the existing pool of held assets.
"Much of the corporate rate cut will benefit old investment -- it will provide windfall gains without commensurate increases in investment," wrote Gale. "Interest rates are already low and the effective tax rate on capital is already fairly low."
Overall, these tax cuts probably won't drive new investment because the market already has plenty of incentives for private investment.
Then there's the danger of crowding out.
The government will have to borrow an estimated $1.5 trillion to pay for this tax cut. The Treasury will issue bonds to raise that money, which operate as an investment vehicle competing in the marketplace.
Investors generally like Treasury Bonds because of their security, so the more of them that are available the more money they siphon away from private sector investments. Investors looking for a better store of their money than cash will buy Treasury Bonds when they would otherwise have found a safe mutual fund or something similar. This is "crowding out." Even to the extent that tax reform will create real, new investment activity, any of those gains will likely be offset by this phenomenon.
The chief argument that tax reform advocates make is that this plan will cause America's economy to grow faster. They're right that for years now GDP growth has been sluggish in the United States. They are wrong that tax cuts will change this.
Tax policy has no substantial relationship with economic growth.
Although there is some small amount of data relating low-end tax cuts with increased consumer demand, the bigger picture is that individual and corporate tax rates have never strongly correlated with GDP growth rates. Ronald Reagan cut taxes in the 80's, and the economy grew sluggishly. Bill Clinton and George Bush Sr. famously raised them, and the 1990's posted booming economic growth. George Bush Jr. cut them again, and his presidency was marked by multiple downturns.
That's not to say tax cuts are irrelevant as far as good policy goes. However they're only one part of a very complicated system of incentives and demands in our economy. Real, enduring economic policy is far more complicated.