The Economic Impact of the Republican Tax Cuts

The Economic Impact of the Republican Tax Cuts

Over the past few weeks, Republicans in both the House and the Senate have passed major tax overhauls. Those bills are now going to a conference committee, which will craft a compromise bill that will go back to both houses. Both bills include large cuts in both individual and corporate income taxes based on the rationale of stimulating economic growth, so I thought a post evaluating the likely impact on the US economy would be timely.

I’ll also acknowledge that I’m not a macroeconomist, which means there are some tools missing from my toolkit. But I’ll work to be as grounded as I can.

What’s in the bills?

The CBO estimates that the Senate bill would reduce individual income taxes by about $1.1 trillion and business taxes by about $500 billion over the next decade. Within the individual income tax changes, 80% of the benefits go to households making more than $100,000 a year (the highest income 12% of households) and 23% of the benefits go to households making more than $500,000 a year (the top 0.6% of households). In contrast, most households earning less than $40,000 a year (the lowest income 37%) would experience a tax increase. Though the House passed their bill before a full CBO analysis could be completed (here’s what we have), the broad contours are the same. The crux of both bills is about $1 trillion in tax cuts for high income households and $500 billion in tax cuts for businesses.

Though there have been some branding efforts from Republicans to portray this tax cut as focused on the middle class, much of their messaging has focused on presumed economic growth from this legislation. So would these tax cuts significantly improve economic growth? It’s impossible to know the size of the impact with certainty, but there is plenty of data we can evaluate to give us a reasonable sense. I think two approaches are particularly helpful:

1. Looking at historical data on tax changes and economic growth

2. Looking at the assumptions on how tax cuts would fuel economic growth

Historical data

Every tax bill is different, so there’s no true apples to apples comparison. However, I think two historic data reviews are worth looking into:

a) Economic growth right after major tax increases and decreases

b) Long-term trends in GDP[1] growth, corporate profits, and wealth of high income households (since the theory of the bills is that providing companies and high income households with more money will stimulate growth)

I’ve plotted major changes in the tax code since 1980 on top of a graph of GDP growth. The average GDP growth during this period was 2.6%. The highest economic growth was almost 9% back in 1984. The lowest economic growth was about -4% in 2009. I’ve highlighted the year following each tax cut in green (since we’d expect GDP to grow faster) and the year following each tax increase in red (since we would expect it to shrink or grow more slowly).

Chart 1: Real US GDP Growth and Years Following Major Tax Legislation (1980 to 2017)

I want to acknowledge before starting that this is a very rough analysis. Tax legislation varies in terms of type and size, and different elements play out over time. Nonetheless, if we believe tax legislation has a major impact on economic growth, we would expect to see slower economic growth the year after tax increases take effect and higher economic growth the year after tax cuts take effect.

But the chart above doesn’t paint that picture. Of the three tax cuts, two (1981 and 2001) were followed the next year by slower economic growth. Of the five tax increases, three (1982, 1984, and 1993) were followed by higher economic growth. I would view this as a wash, but if you were going to read anything into these data, you’d infer that taxes had the opposite effect on economic growth we would expect.

Another way to look at these data would be to look at the long periods after tax peaks and troughs. The 1993 act was the 4th major tax increase in a row. Theory would say economic growth would slow down after that, but if we look at the following 8 years, growth was actually well above 2.6%. In contrast, if you look at the 8 years following the 2003 tax cut (the second cut in a row), we have the deepest recession since the Great Depression.

The second piece of historical analysis I think is useful is looking at long term trends in the things the recent Republican tax bills are designed to impact. During the tax debate, numerous Republicans have noted that GDP growth has been slower in the past 10 years than in the previous 40.

Chart 2: Real US GDP Growth (1967 to 2017)

If you look closely at the graph above, you’ll see that is the case. Prior to 2007, there were many periods where GDP growth as above 3% a year, sometimes substantially and sometimes for years. However, since 2007, GDP growth has only reached 3% twice, both times barely and briefly.

The theory of the Republican tax cuts is that, by giving more money to businesses and wealthy households, economic growth will be stimulated. However, when we look at the last 50 years, it calls that logic into question.

Chart 3: Corporate Profits and Household Income as a Share of GDP (1967 to 2016)

Over the past 50 years, corporate profits have gone from around 6% of GDP to around 10%. Household income for the top 1% of households has grown from around 6% of GDP to around 11%. If increasing income for corporations and high income households provides substantial stimulus to the economy, we’d expect the past 10 years to be the highest growth decade in the past 50 years. However, what we see is the opposite.

I’ve included household income from the bottom 80% of households — that is household income for all US residents when you exclude the highest income fifth, so the vast majority. Here, income as a share of GDP has gone down from about 45% to about 41%. Again, I’m not a macroeconomist, but to me this explains why our economy has grown so slowly in the past 10 years — our economy grows fast when money is going to the middle class, but recently money has increasingly gone to corporations and the wealthy.

So, in conclusion there’s not clear historical evidence that tax cuts meaningfully stimulate economic growth. Let’s turn our attention to the mechanisms by which the tax cuts could stimulate growth.

How Would Corporate Tax Cuts Stimulate Growth?

Any time a person or entity spends money, that contributes to economic growth. And depending on how that money is spent, there can be substantial indirect effects. The Republican tax plans put about $1.5 trillion back into the economy. So what economic impact would we anticipate from that?

I’ll start with the corporate tax cuts. Though the bills include numerous changes, the big change was decreasing the tax rate from 35% of profits to 20% of profits. Here, the logic is fairly straightforward — if you lower corporate tax rates in the US, potential projects that were previously unprofitable (or less profitable than other countries) become profitable. As a result, companies will make greater investments in the US.

However, when we move this from theory to practice, that logic breaks down. Let me give you a couple of examples. As some of you know, I recently created a board game, and I’m now producing copies of it. I had the option of producing the game in the US or in China. If I produced the game in China, I could sell it for $50 and make around $10 per game. If I produced it in the US, I could sell it for $50 and I would lose around $10 per game. So I’m producing the game in China. I literally can’t make any profit if I produce the game in the US because it’s not realistic to sell my game for more than $50. And if I can’t make profit, it doesn’t matter what the tax rate on profits is — it could be 0% and I still wouldn’t choose to produce the game here.

As another example, think of an Amazon distribution center to serve the Southeastern United States. Amazon currently has four distribution centers around Atlanta. They do this because lots of people live around Atlanta, and you want distribution centers close to major airports, rail lines, and your customers to minimize shipping costs. It would never make sense for Amazon to put its distribution hub for the Southeast in China. They’d need thousands of small amphibious boats sailing across the globe and driving to people’s homes, which would be incredibly expensive! Amazon’s distribution centers are already in the United States and there’s no threat of them moving overseas, so the tax cut will just result in higher Amazon profits.

These are obviously just two illustrative examples, but other evidence leads to a similar conclusion that the proposed tax cuts won’t significantly increase business investment. At the recent Wall Street Journal CEO Council, the moderator asked the CEOs present how many of them planned to increase investment of the Republican tax cuts are enacted. Only around 10% said they would. A recent survey by the Atlanta Federal Reserve found similar numbers. And CEOs from companies such as Pfizer, Cisco, and Coca Cola have told their investors they plan to use the windfall to issue dividends and buy back shares rather than hiring more people. Dividends and share buybacks reward people who own shares of those companies.

We also have a historic analogue for this. In 2004, companies were allowed to repatriate earnings from overseas at a 5.25% tax rate rather than the normal 35% rate. Fifteen companies accounted for roughly half of the money repatriated, and those companies increased share buybacks by 38% while cutting 20,000 jobs.

Taken as a whole, it seems unlikely that the business tax cuts will lead to big increases in companies launching new ventures and hiring more workers. Instead, the tax cuts will just make businesses more profitable, which benefits those who have invested in them. So who are those investors? There are numerous types of businesses, and accounting for ownership for most types is challenging. However, for one type, it’s fairly straightforward — companies listed in the US stock market. We know that foreigners own about 26% of the US stock market. When we break down US ownership (the remaining 74%), including stocks in pension funds, mutual funds, 401(k) plans, etc., the wealthiest 10% of Americans owns 90% of that value, and the wealthiest 1% owns 50% of that value. So, indirectly, tax cuts for business in the US are another way of steering money to wealthy individuals. Which leads naturally to the question — what happens to the US economy when wealthy Americans are given more money?

How Would Tax Cuts for Wealthy Americans Stimulate Growth?

There are two potential mechanisms by which giving wealthy Americans more money would stimulate the economy. First, they could invest in new businesses and projects that will generate profits. Second, they could buy lots of goods and services produced in America.

On the first count — investments — individuals are caught in the same trap as businesses. To the degree that there are good investments available, those investments are already getting made. For the past 8 years, the prime interest rate (the benchmark used as the basis for most business loans) has been lower than at any point since the 1950s, and living in Silicon Valley I can attest that not only are good business ideas already getting money but cockamamie ideas are as well. So it’s safe to say reduced taxes won’t lead to funding a significantly higher number of good business ventures.

The second option is consumption, and the wealthy certainly consume more than the average household. However, they consume at a lower proportion than the average household. We know that the wealthiest 1% of Americans save around 40% of their income compared to less than 4% for the average American.

So where are they putting those savings? Largely in existing assets that just raise the prices of those assets. One example is the stock market, and the best way to think about stock prices is p/e ratios (price to earnings ratios). Here’s an example of how they work. Suppose there’s a company that made $1,000,000 earnings (profits) last year that has 1,000,000 shares of stock. In that case, each share would have $1 of earnings. If the share price was $18, that would be a p/e ratio of 18/1 (or just 18).

The p/e ratio is a good measure of how cheap or expensive stocks are. The blue line on the chart below shows the trailing p/e ratio for the S&P 500 stock index for the past 70 years. The average over this period is 17.6. I’ve added recessions in gray. Recessions tend to make p/e ratios artificially high right after the recession. That’s because corporate profits decrease during recessions while share prices recover as we exit recessions, and trailing p/e ratios are based on the price today and the earnings for the previous year. You can really see this in late 2001 and early 2010, where p/e ratios spiked exiting the last two recessions.

Chart 4: Trailing S&P 500 P/E Ratio and Recessions (1947 to 2017)

Taking that lens to the chart above, p/e ratios today are incredibly high. In fact, the only time in the past 70 years we’ve seen p/e ratios this high other than right after recessions was during the stock market bubble of the late 1990s. Why is the p/e ratio so high right now? Because stock shares are like any other good, abiding by the laws of supply and demand. And because wealthy Americans have so much money now (see Chart 3), demand is high. We can infer from this that a main reason stock prices are higher than almost any time in the past 70 years is that wealthy Americans are looking for places to put their money. But buying shares of stock doesn’t really help the real economy, particularly in a time when corporations are already holding a record $1.9 trillion in cash and liquid assets.

In Conclusion — The Real Bad News

As we’ve seen, both the House and Senate Republican tax proposals are designed to give large tax cuts to businesses and the wealthy. Though it’s impossible to predict the economic future, the evidence we have suggests that those tax cuts would have only a small positive effect on economic growth. However, they would almost certainly increase the deficit over $1 trillion over the next decade.

That raises the question of whether future Congresses will allow that to persist or try to close that gap. And Republicans in Congress have already started messaging they plan to pursue cuts in Social Security, Medicare, and Medicaid. Senator Marco Rubio said last week, “You also have to bring spending under control. And not discretionary spending. That isn’t the driver of our debt. The driver of our debt is the structure of Social Security and Medicare for future beneficiaries.” And Senator Orrin Hatch, Chair of the Senate Finance Committee, stated, “We’re spending ourselves into bankruptcy. Now, let’s just be honest about it: We’re in trouble. This country is in deep debt.” Both Senators are ignoring the impact of tax cuts on the debt while saying that the debt is such a problem we need to make large spending cuts.

And that’s the core issue. Even if we only cut spending by the same amount as we cut taxes, that would almost certainly have a negative impact on the economy. Why? As we’ve already seen, tax cuts for businesses and the wealthy have only a small positive impact on the economy. In contrast, spending on Medicare and Medicaid is largely on healthcare services consumed in the US, which has a strong positive impact. And spending on Social Security also has a strong positive impact, as seniors generally spend a large portion of their checks on goods and services produced in the US.

Economists use the term “multiplier effect” to refer to the economic stimulus impact of government decisions. These are difficult to calculate, and it isn’t an exact science, but we can feel reasonably confident in what moves have larger or smaller effects. Mark Zandi, Chief Economist at Moody’s Analytics, estimates that tax cuts like those in the Republican bills have a multiplier effect of around 0.3. That is, if we cut $1.00 in taxes, that will increase GDP by $0.30. Not huge, but not nothing.

The problem is cuts to Medicare, Medicaid, and Social Security all have multipliers that are probably between 1.0 and 1.5. Let’s assume 1.0 to be conservative. A $1 tax cut increases GDP by $0.30, but then a $1 spending cut decreases GDP by $1.00. So we’re left with no change to the federal budget, but the economy has actually shrunk by $0.70 rather than increasing.

And that’s the ultimate economic issue with the tax cuts making their way through Congress. If there are no spending cuts to accompany them, they will increase the deficit by over $1 trillion. If there are spending cuts to offset that deficit, those cuts will shrink the economy by more than the tax cuts will grow it.

[1] GDP stands for Gross Domestic Product and is the total value of all goods and services produced in a country. Throughout this document, I’ll use GDP as shorthand for the size of the US economy.