Analysis

Why tax cuts won't generate as much economic growth as Trump hopes

President Trump and congressional Republicans talk about their tax overhaul plan as if it’s a sure-fire bet for the economy.

Far from it. There’s little historical evidence that tax cuts actually pay off in boosting economic growth long-term.

And today’s combination of high federal debt and a tight labor market casts even more doubt on whether tax cuts will stimulate growth.

The heart of the GOP strategy is big tax savings for corporations and other businesses. Slashing taxes on companies large and small, the theory goes, will bring massive new investment in plants and equipment, job growth and higher pay for America’s long-suffering middle class.

Specifically, Trump administration officials predict that its tax plan will push U.S. economic growth to 3% per year from the 2% annual average that economists expect for the foreseeable future. The higher growth, officials say, would help create 12 million new jobs over the next decade.

To achieve those goals, however, Trump’s tax scheme will have to succeed where Republican as well as Democratic presidents before him have failed.

To bolster its case, the White House last month cited President Reagan’s massive cuts in 1986 and the effect they had over the following 10 years. Yet U.S. economic growth, as well as gains in jobs and income per person, was actually stronger in the decade before the Reagan tax change.

A corporate tax cut “isn’t by itself enough to make a dent in the growth rate,” said Joel Slemrod, co-author of the book “Taxing Ourselves,” which reviewed linkages between taxes and growth going back to the late 19th century.

What’s more, there are two realities in today’s economy that are likely to weigh against the potential benefits of substantial tax cuts. First, the gross national debt -- nearly $19 trillion — is far larger than when Reagan or his successors tried the strategy. Second, the domestic labor market is much tighter, with unemployment at a 17-year low.

Although details of the GOP tax plan are still being negotiated, the White House framework would likely add significantly to the national debt — about $2.4 trillion over 10 years, according to the nonpartisan think tank Tax Policy Center.

Adding to that debt, most economists agree, would largely negate any growth gains from tax relief.

That is because high federal debt means higher interest payments for the government, and will tend to push up inflation and interest rates. That would likely undercut savings generated from lower taxes and discourage private-sector investment, which is crucial to improving productivity and the long-run prosperity of Americans.

At the same time, when an economy is already near full employment, tax cuts can only do so much to pull in more workers. The resulting pressure to pay higher wages may in fact encourage business executives to spend money on better technology instead of hiring more workers.

As a top Reagan economic advisor, Martin Feldstein fully supported the slash in the corporate tax rate that was part of the 1986 reform. Today the Harvard economist is more circumspect.

Though he sees the need for tax reform, Feldstein said the current climate raises important questions about whether tax cuts today would be “too big of a price to pay” if they result in higher debt. Already the U.S. gross national debt has more than doubled since the mid-1980s, to more than 100% of the nation’s gross domestic product.

In the past, most tax cuts in America have come when the economy was slumping and unemployment was well above what it is today. During recessions in 1981 and 2009, politicians pushed through tax breaks to give a shot in the arm to consumers and businesses. Putting more money into people’s pockets was meant to stimulate spending, to boost demand and sales that would help keep more employees in their jobs.

But the economy now is in a very different place. The recent period of economic growth, while weaker than past recoveries, has been one of the longest in the nation’s history. The unemployment rate this year has consistently hovered below 4.5% — a level that most experts consider to be full employment, in which almost everyone capable and willing to work has a job.

“If you’re at full employment ... you got nowhere to go really, so you’re unlikely to get the same growth impact,” said Douglas Holtz-Eakin, a former Congressional Budget Office director who is president of the conservative-leaning American Action Forum.

Millions of Americans remain out of the labor force for one reason or another, and Trump’s tax strategy does include new tax credits for dependent and child-care expenses, which could encourage some people to participate in the labor force.

But on the whole, the biggest gains from the proposed tax cuts are likely to go to the wealthiest taxpayers. The top tax rate would drop to 35% from the current 39.6%, and the plan would do away with the estate tax and alternative minimum tax.

Taxpayers making less than $150,000 — who account for the bulk of households — will take home about $500 more a year, according to estimates by Moody’s Analytics. That is probably not a big enough payoff to have much effect on a country as large as the United States.

Holtz-Eakin, an economic advisor to President George H.W. Bush in 1989 and 1990, and other economists see more punch coming from the corporate tax side. Business investment and startup activity have been unusually sluggish this last decade. If Trump succeeds in dropping the corporate tax rate to 20% from the current 35%, that would be the lowest since 1940, when the rate started to shoot higher, reaching a peak above 50% in the early 1950s.

No one knows for sure why U.S. business investment has been so lackluster over the last decade. Given that corporations have plenty of cash on hand and borrowing costs have remained unusually low, some economists reckon there must be a shortage of investment opportunities in the U.S. Some say businesses today face greater regulations and market impediments like monopolies.

Eric Zwick, a University of Chicago economist who studies public policy and corporate behavior, thinks it’s a combination of technology, globalization and policy considerations that has made it less attractive for companies to invest in the U.S. than elsewhere. What’s more, he says, the increasing shift in the American economy to services could mean there is just less demand for capital goods than before.

It’s unclear whether Trump’s tax cut would have a sizable effect on such trends.

Manuel Cosme, a partner at Professional Small Business Services, says he would probably hire two full-time employees at his Vacaville, Calif., consulting firm -- instead of one full-time and one part-time, as he plans -- if a tax overhaul is adopted along the lines of what Trump has proposed.

But that decision hinges on many other factors too, he added, not the least of which is that business activity remains robust.

Cosme’s plans point to the difficulty of disentangling the effect of tax cuts from other trends affecting the economy, such as changes in the population, technology, monetary policy or the value of the dollar.

Geopolitics matter too. Economists point out, for example, that America’s fastest economic growth rates recorded in the last century were during 1940-45, a period in which tax rates also happened to rise sharply. Nobody of course would attribute the growth to soaring taxes.

“The U.S. is a really large, really complicated economy, and taxes are a relatively small part of the picture,” said Mark Mazur, who served as assistant Treasury secretary for tax policy during the Obama administration. “They’re important…but they’re not the main driving force.”

don.lee@latimes.com

Follow me at @dleelatimes

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