Tax Cuts: What Could be Salvaged from President Trumps Promises?

In the last couple of weeks markets have been thrown into a tailspin by presidential tweets, rumors of political resignations, and general discontent. It is becoming harder to figure out what is actually-happening in Washington and how that will impact markets and the economy. Right after the November election, markets fell in love with President Trump. Since then, Markets have continued to be disappointed:

After the transitory outperformance, the Trump theme industries – financials, industrial, consumer discretionary, energy sectors – lost the advantages and started to underperform the market since May.

In an attempt, to understand what economic reform remains possible and likely during the Trump administration, I had a conversation with leading economist and political advisor Dr. Laffer. Aptly named, the father of supply-side economics, Dr. Laffer represents the thinkers that are proponents of lower taxes and less government involvement.

Stefanova: Dr. Laffer, you are closely connected to the current administration providing advice on economic policy. After last year’s Presidential Election, markets were euphoric about the possibility of meaningful economic reform and stimulus. The so-called Trump trade since has very much fizzled out. The Trump administration has lost most if not all of their battles and has largely not been effective to deliver major reforms. The Health Care reform so far has failed and we are yet to see meaningful progress on the tax reform or infrastructure deal. At this point, what remains feasible in terms of reform and when should investors expect to see results?

Laffer: What remains feasible is a cut in the corporate income tax rate down to 15% as we see bi-partisan support. We can expect that if it does happen, and it certainly needs to, it could be before the end of the year. To make corporate tax cuts more feasible, we have been recommending to the administration that we remove these from politicians become exponentially more risk averse in an election year. Additionally, the cuts need to be passed this year in order for the growth effects to be felt by Americans by the time November 2018 comes around.

Stefanova: How do you think the economy will react to such reform and why?

Laffer: It would be incredibly simulative for the economy:

• Increased Profit Incentive

Well for one, the incentive corporations have to make a profit will increase dramatically, and those sectors of the market that are able to expand labor and capital the quickest will reap the most benefits out of the gate.

A basic measure of the incentive effects on work, output and employment of government tax and other policies is the pace of increases in overall productivity (real output per hour of all persons). Larry Summers and others call this most recent period of extremely low productivity gains “the new normal.” It’s not a new normal at all! Low productivity gains are exactly what happens when economic incentives are muted and dimmed. I believe that the President’s tax proposal, combined with deregulation efforts that have already begun, will increase annual productivity growth by something like 1 to 2 percentage points per year over the coming decade. This productivity growth will generate more tax revenues in addition to more jobs, output and employment. With productivity increases in the 1.7 to 2.7 percentage point range, 3% GDP growth over the coming decade should be a “slam dunk.” And with this type of GDP growth, tax revenues won’t be a problem. 

• Decreased Sheltering

One consideration in assessing the effects of a corporate tax rate change on tax revenues that is especially overlooked by most analysts is the sheltering of income from taxation. These analysts just assume that people pay the tax rates that Congress legislates. Yet when those analysts see sheltering in a specific company, they harshly criticize the company in question for the practice. GE is often held up as the classic example of tax sheltering. However, even when companies cannot shelter all of their income, many will at the very least report the non-sheltered income in preferred (i.e. lower tax rate) categories such as employee/owner compensation and other expense-able benefits, pass-through entities such as partnerships, LLCs and Chapter S corporations, capital gains, dividends, future expense deductions (especially for insurance companies) and other such items. This sheltering aspect is by no means small. For example, if GE doesn’t pay any corporate taxes at 35%, surely they won’t pay any less taxes at 15%. They can’t pay less. And some of those lawyers, accountants, and lobbyists that GE employed because they needed to shelter income at a 35% rate will no longer be worth the cost at a 15% rate and therefore they will be let go in exchange for paying some tax. Businesses will pay for tax sheltering services right up to their marginal cost (the tax rate). A lower tax rate decreases that marginal cost and thus lowers the amount of sheltering services businesses are willing to pay for. Lower tax rates mean less sheltered income and, more importantly, higher tax revenues. 

The effective taxes would fall by much, much less than the reduction in the highest tax rates. It is altogether possible and even reasonable to expect a very large offset to the negative arithmetic effect of lower tax collections if not even a revenue reversal (i.e. higher tax revenues) at 15% than at 35%.

• Location Effects

One of the most basic principles of economics is that taxes don’t redistribute income; they redistribute people and businesses. Among the 50 states of the United States, net in-migration into the low tax states way exceeds net in-migration into the high tax states (which in fact have a larger out-migration). 

For companies on a global scale, the effects are even more pronounced. Just look at the inversions of U.S. companies in Figure 1, which enumerates companies leaving the U.S. tax jurisdiction versus the highest U.S. corporate tax rate and the average of the highest OECD corporate tax rates. It’s amazing and it looks like an ever-increasing stampede out of the U.S.

If the U.S. were to cut its corporate tax rate à la President Trump’s plan to 15% from 35%, inversions from the U.S. into foreign tax jurisdictions would not only disappear as they did after the 1986 tax cut (see Figure 3 above), bringing back gobs and gobs of U.S. companies’ profits and jobs, but we would also attract lots and lots of foreign companies to seek U.S. domicile for tax purposes (reverse inversions), thereby adding hugely to our corporate tax base. In Table 1, you can see just how much the rest of the world has cut their corporate income tax rate.  The effects are astonishing. According to a recently updated Bloomberg article , Tracking Tax Runaways, 1 in 4 tax inversions from the U.S. go to Ireland, which has the lowest corporate income tax rate in the OECD at 12.5%.  At present, there are estimates of $2 to $3 trillion of funds (10% to 15% of U.S. GDP) held abroad and poised to return if only tax conditions were more favorable.

• Historical Perspective

Higher output, employment, and production would also increase corporate profits and stock prices and thus investments. The unfunded liabilities of pension funds would drop for state, local and the federal government and private businesses. Individual savings would appreciate in value and so would the returns to investors in either “fixed” income or equity assets. Government spending items such as welfare and supplemental income would fall, tax revenues would rise. What’s wrong with that? 

To show my point, I have plotted two versions of de-trended real GDP per adult and de-trended real federal tax receipts per adult from the 1st quarter of 1950 to the present in the next two figures: The reason for two identical charts save for the scale of each series is to show i.) just how closely the series are correlated (Figure 2) and ii.) the hypersensitivity of tax revenues to economic growth—the magnification effect of growth on tax revenues (Figure 3). The bottom line is that economic growth is the key driver of magnified tax revenues, and low tax rates, deregulation, sound money and freer trade are the key drivers of growth. High and rising tax rates smother economic growth and drive tax revenues down. Now what’s so hard to understand about that?

Stefanova: What are the biggest roadblocks to these reforms?

Laffer: The biggest roadblock on the path to tax reform right now is the inability for many on Capitol Hill to trust in the dynamic effects of a tax cut. Legislators today have a hard time believing that the economic growth that comes with a tax cut can more than make up for the static revenue loss.  There seems to be a deficit-neutral obsession among politicians; they think a tax cut must be paid for with a tax increase somewhere else. One of the greatest offenders in this area is the Congressional Budget Office, whose forecasts have been consistently ignorant of the dynamic effects of a tax cut on the economy.

Stefanova: Dr Laffer you are the author of the Laffer curve concept. Can you please explain the concept and share if you believe this concept remains relevant today. 

Laffer: The central idea of the Laffer Curve is that there are always two tax rates that produce zero revenue.  This is obvious when one thinks about it. It is clear that 0% taxes produce zero percent revenues.  No surprise there!  But there is another tax rate that produces zero revenues, and that’s a tax rate of 100%.  If the government takes everything you earn, you don’t work (actually, people would work to sustain themselves, but they would not report the income to the tax collector and thus the government would get nothing). 

The other important idea is that there are two tax rates that produce the same amount of revenue: a high tax rate on a small tax base and a low tax rate on a large tax base. At some point along the range, the tax rate becomes so high that it is a disincentive to earn money. This is the “prohibitive” range. 

Now the Laffer Curve does not say whether a tax cut will raise or lower tax revenues. Revenue responses to a tax rate change will depend upon the tax system in place, the time period being considered, the ease of moving into underground activities, and the prevalence of legal loopholes.

The curve concept really plays out when we examine the 11 states that adopted the income tax post-1960. When we examine the tax revenues of those states as a share of the revenues from the other 39, we see an average drop of 23% from the time before each tax was implemented through 2014. If we were considering only the static effects of a tax, we would expect these states to be topping the charts in revenues. Instead, every single one of these eleven states experienced a decrease in its tax revenue as a share of the other 39 (Table 2).

Stefanova: Dr. Laffer, you have been an economic advisor for many presidents both Republican and Democrat. What do you believe are the biggest mistakes administrations make regardless of their political affiliations and how do you think these can be avoided?

Laffer: Sticking with economics, there are three mistakes that come to mind.

• The first mistake is believing tax cuts should be phased in. If you want the growth that comes with tax reform, why would you not implement it in its entirety from the start?
• Another mistake is believing that if you tax people who work and pay people who don’t work, you’ll get more people working.  An economy can’t be taxed into prosperity, nor can a poor person spend himself into wealth.
• Political economists rebut arguments they know to be true in order to curry favor with their political benefactors.  One of the biggest mistakes any politician can make is to believe these economists whose incentives are such that it is more beneficial to put forth complex error and disregard simple truth.