Tooth-Fairy Economics Triumphs in GOP Tax-Cut Plan

Absent spending reductions, the burden on taxpayers isn’t alleviated

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“The approval process for the biggest Tax Cut & Tax Reform package in the history of our country will soon begin,” President Donald Trump recently announced via Twitter. “Move fast Congress!”

Accordingly, Senate Republicans are planning a 10-year budget that would include $1.5 trillion worth of tax reductions, The Wall Street Journal reported last week.

At the same time, nothing has been said about spending cuts. On the contrary, the president’s Office of Management and Budget anticipates that, over the next five years, federal outlays in constant dollars will rise.

This inspires a question once posed by the late free-market economist Milton Friedman: “When is a tax cut not a tax cut?” His answer: when it is accompanied by a larger rise in government spending. “The real cost of government,” Friedman explained, “is measured by what government spends, not by the receipts labeled taxes. The goods and services it buys are not available for other use.”

Why are taxes only part of the real tax burden? “Suppose,” continued Friedman, “government spends $400 billion and raises $350 billion in funds labeled taxes. Who do you suppose pays for the $50 billion difference? The tooth fairy? Hardly. You do.”

Friedman wrote these words in 1977. Forty years later, Senate Republicans still seem to believe in tooth-fairy economics. One reason is that it’s far more expedient politically to reduce taxes than it is to slash spending. But if such craven behavior by our leaders posed a problem in 1977, when the federal debt accounted for 27.1% of gross domestic product, it poses a much bigger threat in 2017, with the figure at 76.7% and still climbing.

WE CAN, HOWEVER, GIVE GROUND in one respect. A tax cut also isn’t really a tax cut in the rare case in which it won’t lead to a loss of revenue. A plausible argument for such revenue neutrality can be made about one key part of Trump’s plan: a reduction in the top federal rate on corporate profits from the current 35% to around 20%. The need for a decline in spending is still paramount. But if there is revenue neutrality, then there is no reason to object, particularly if the cut might help grow the economy.

The idea of a revenue-neutral reduction requires a nod to economist Arthur Laffer. His “Laffer Curve” made the intuitively obvious point that, say, a 15-percentage-point hike in taxes will likely generate less than 15% more in revenue, while a 15-point reduction will likely lose less than 15%, once all behavioral changes are accounted for. In the special case of the corporate income tax, over 10 years, this cut might even bring a net gain in revenue.

TO BEGIN WITH, if a corporation nets more earnings as a result of a lower tax, the extra profits aren’t completely lost to the tax collector, but become taxable salaries, dividends, and capital gains. Also, U.S. corporate tax rates are among the world’s highest, as was confirmed in a study (“International Comparisons of Corporate Income tax Rates”) released in March by the Congressional Budget Office. Slashing the rate would therefore dramatically reduce corporate flight to low-tax countries.

There would also be windfall revenue from a one-time “amnesty rate” to induce repatriation of the estimated $2 trillion in profits that U.S. corporations are keeping offshore. Then, too, with funds freed up from the tax collector, there could a long-term increase in capital investment, which would generate more for the Treasury.

But other likely features of the Senate Republicans’ tax-reduction plan, especially cuts in individual income taxes, are revenue losers, although politically attractive. The Laffer Curve also applies—lost revenue will be proportionately less than static analysis indicates—but no one can plausibly argue that the reaction will be at all comparable to a cut in the corporate income tax. As outlays climb, the debt will continue to soar, and taxpayers, not the tooth fairy, will bear the cost.

Trump’s recent tweet already makes one nostalgic for the time he was running for office. Speaking of the “waste, fraud, and abuse” in federal spending, the candidate vowed, “We will cut so much, your head will spin.” So far, alas, there’s been more spin than substance in that promise.

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