Should We Hope For Tax Reform?

Headlines in coming weeks will likely focus on the details of the Republican plan for reducing taxes and reforming the tax code.  The logic behind the tax cuts is pretty straight-forward: reducing taxes will give Americans more money to spend, thereby increasing consumption and economic growth.  Most Americans tend to take that point for granted.  The main debate over tax reform generally shifts to “should the tax breaks go to the rich or the poor?” with various reasons for either side.

Rather than focus on the beneficiaries of tax cuts, let’s examine the idea of tax cuts as a whole.  Do they actually stimulate the economy? Furthermore, does the economy need stimulating?

Will a tax cut stimulate the economy?

In the 1920s tax rates fell from a top bracket of 70% to less than 25%.  Over that time, the economy improved, personal income rose, and the stock market boomed.  In the 1980s, President Reagan enacted dramatic tax cuts and again the economy improved, personal income rose and the stock market boomed. Simple, right?  Not so much.

President George W. Bush enacted tax cuts in 2001 and 2003 with disappointing results.  President Clinton actually increased taxes in 1993 and the economy experienced a tremendous boom.  Upon closer inspection, it appears that tax cuts and tax hikes tend to have to far less of an impact on the long-term economy than many realize.  In fact, from 1870 to 1912 the US had no income tax rate at all.  Contrast that extreme to the 1947-1999 timeframe when the highest marginal tax rate was 66%.  Still, the economic growth rate from 1870-1912 was identical to the growth rate from 1947-1990; 2.2%.

A detailed study titled “Tax Rates and Economic Growth” (by University of Rome professors Padovano and Galli, 2001) found that a 10% reduction in marginal tax rates, i.e. a pretty large tax cut, increased growth on average by 0.11% (minimal increase in economic growth) in the first year.  Another paper “Optimal Taxation of Top Labor Incomes” (Piketty, Saez, and Stantcheva, 2011) examines tax rates and economic growth from 1960-2010 in 18 different countries (mostly Europe, US, and Canada).  In the end, the research finds no direct correlation between tax cuts and economic growth.  In other words, sometimes tax cuts create growth, other times they don’t.

Will a tax cut stimulate the economy? Perhaps, but it’s less of a slam dunk than most want to believe.

Does the economy need stimulating?

Reagan’s tax cut in the early 1980s were very successful.  Why?  The tax cuts came a time when the US was coming out of a recession.  Interest rates were double digit in the US; unemployment was nearly 10%; stocks traded at a P/E ratio in the single digits!!  The tax cuts worked because we needed tax cuts. The same could be said for tax cuts in the early 1920s.  The unemployment rate in 1921 was more than 11%. (economist.com)  

Today, interest rates are near historic lows, the unemployment rate is below 5%, and stocks trade at all-time highs.  It’s tough to make an argument that the economy needs further stimulation.  Tax cuts are an important tool that can be used to help lift an economy from recession.  However, by enacting sweeping tax cuts now, we may not have the weapon to use later when we actually need it.

Finally…

Tax cuts should, by definition, bring in less tax revenue in the near term.  This means that the US government will be forced to run a larger deficit unless they cut spending (unlikely).  Because of the deficits, the government will borrow more money, going deeper into debt. While this likely doesn’t pose an immediate threat, it begs the question – does the government really need to borrow money to try and stimulate a perfectly good economy?