U.S. Can Afford Trump's Radical Tax Cut

What are the problems with the Trump proposal? First, we do not know whether it can pass various congressional rules, and second, there is a danger that too much personal income will be reconverted into business forms, to reap the new, lower tax rates.

The Trump administration announced Wednesday its intent to proceed with a radical cut to the corporate income tax, lowering it to 15 percent. We haven’t been presented with enough details to conclude whether such a plan can work, but I’ve been seeing some of my fellow economists claim -- incorrectly -- that we can’t afford those changes. There are some potential problems with President Donald Trump’s proposal, but there is no fiscal reason such a tax plan ought be ruled out.

It seems the administration is willing to consider a tax cut that increases the budget deficit, rather than finding alternative revenue elsewhere. And indeed the new plan is likely to increase budget deficits by hundreds of billions of dollars. But still, less money for the government is not the same as an economic cost. Most versions of the plan, if executed properly on the details, would most likely boost economic output and create new jobs.

The simplest way to think of an unfunded corporate tax cut is that the federal government has to borrow more money, say at rates in the range of 1 percent to 2 percent, while corporations have more money to invest. Estimates vary for the rate of return on private capital, but 5 percent to 10 percent is one plausible estimate. So in essence, society is borrowing money at 1 to 2 percent and may be receiving 5 to 10 percent in return. That is a net gain, not an economic cost.

In terms of distribution, the deal is more favorable than it might appear at first. The increase in borrowing will eventually be paid for, and the top 20 percent of Americans pay about 84 percent of all income taxes. The future payback therefore is likely to come from the well-off, not the poor. The new corporate investments will also create jobs and some valuable products as well, and that benefits more people than just the wealthy.

The pessimist might wonder whether companies would take their windfall and invest it at all. Many companies might simply hold the gain in money management accounts. In this scenario, the tax plan probably won’t be worth passing, as American companies would have nothing useful to do with the free resources, even when given a nudge to invest. That should induce a fairly panicky response, including radical deregulation of business and fiscal austerity on entitlements, but I don’t see critics of the tax plan following up on this view consistently.

This argument for a corporate tax cut -- “let’s borrow more now while rates are relatively low” -- is remarkably like the argument that Keynesians have been using for more government infrastructure spending for years. The main difference is that here the spending would be done by private corporations rather than the federal government. You may or may not believe the private expenditures will be more socially valuable than the government expenditures, but if you think we can afford one kind of stimulus we probably can afford the other. And as I said, the private rate of return on investment probably is higher than the government’s borrowing rate, even if you think that government spending would yield higher returns yet.

To put it bluntly, I am suspicious of ideological motives when anyone says we can afford a big dose of government stimulus but we cannot afford a corresponding private stimulus. The more consistent view is that we probably need more investment on both fronts, and thus cuts in the corporate tax rate are a welcome start, at least if we put aside the pessimistic scenario mentioned above. It’s still legitimate to consider whether a plan should include more government stimulus (Trump himself would probably agree, though Congress may not), but that’s a very different point from claiming the U.S. cannot afford a corporate tax cut. In addition, you also might think that some other taxes should go up, such as consumption taxes, but even if true it does not mean the corporate rate cut is unaffordable.

So what then are the problems with the Trump proposal? First, we do not know whether it can pass various congressional rules, and there is a disturbing and repeated tendency for the Trump administration to lurch ahead with plans that are not properly vetted.

Second, there is a danger that too much personal income will be reconverted into business forms, to reap the new, lower tax rates. It is essential to have greater and more detailed assurances that the tax reform will embody sufficient regulations to limit these kinds of arbitrage.

Those problems may or may not be surmountable, but in the meantime we should view the proposal as a possible economic boost, not a burden we cannot afford.