The Trump tax cut will not turbocharge the economy.

by | Mar 28, 2018 | Markets, Economy, & Government | 0 comments

Fans of the Trump tax (TTC) cut believe it will stimulate economic growth. Their belief is not supported by arithmetic and history.

According to David Stockman, who was Reagan’s Budget Director, The impact of the Trump cuts is trivial when compared to that of the Reagan tax cuts (RTC):

  • Relative to GDP, the Trump cut over a ten-year projection period averages out to 1/10 of the size of the Reagan cut: 0.4% versus 4.4%.
  • The peak year TTC is ~1.4% of GDP versus 6.2% for the RTC.
  • The Trump tax cuts for individuals net out at 0.7% of GDP and disappear after 2025. Marginal tax rate cuts under Reagan rose from an initial 1.8% of GDP to 3.0% when fully implemented.
  • The TTC does, however, cut the corporate tax rate to 21%, which foots to about $1.4 trillion over ten years. If corporate profits remained constant over the next ten years, this cut would amount to ~7.6% of total profits over the period.

The Trump tax cuts will have to be financed by additional US Treasury borrowing. No one knows how this additional demand will affect interest rates, but unless the Federal Reserve reneges on its commitment to shrink its balance sheet, it is hard to see how interest rates remain at current historically low levels.

Tax cut advocates overstate the stimulative effect of the Reagan cuts. Over the three year period, 1983 through 1985, GDP did grow at an annual rate of 4.5%, as the US recovered from the recession that Fed Chairman Paul Volcker had to induce in order to rid the country of double-digit inflation. But, there was no permanent uplift in growth from the Reagan tax cuts; rather, what mainly drove GDP growth from 1983-85 was the normal process of recovery. The Reagan era economic performance was not exceptional by post-World War II standards; over the period 1983-1990, the US economy grew at a compound annual rate (CAGR) of 3.55%; the its CAGR during the Reagan years was almost identical at 3.58%.

Furthermore, TTC enthusiasts forget what happened subsequent to the RTC. The combination of the tax cut and the defense build-up caused the federal deficit to rise to 6% of GDP. Worried that the surge in the deficit would crowd out private investment, Reagan signed bills authorizing three tax increases in 1982, 1983, and 1984. The cumulative effect was to roll back about 40% of the 1981 tax bill. Parenthetically, although David Stockman was famously “taken to the woodshed” by Reagan for opining that the tax cuts would create deficits “as far as the eye can see”, he turned out to be absolutely correct over the long term.

In 1987, the interest rate on US treasuries rose 40% in ten months. Had Alan Greenspan not ridden to the “rescue” after the October, 1987 stock market crash of over 22%, the deficits of the Reagan era would have triggered a painful, but necessary recession. Since then, however, successive Fed Chairpersons have engaged in “free-lunch economics” by engaging in massive bond buying programs to prevent interest rates from rising. The funds to finance these purchases came not from private savings, but from money backed by nothing other than entries on the Fed’s computer. All our central bank has done is delay and make worse the ultimate reckoning [more on this in future posts]. The lesson here is that tax cuts are not a magic elixir.

 

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Sam Mitchell is a researcher by trade. For almost four decades, Sam's job has been to invest other people’s money as well as his own. The total amounts involved have been in the billions of dollars.

Sam lives or dies economically according to whether the findings and conclusions from his research are correct.

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