Could Trump’s Corporate Rate Cut to 15 Percent be Self-Financing?
April 25, 2017
Spurred by some recent remarks from the Treasury Secretary, many tax policy analysts have been talking once again about how much economic growth can offset revenues lost from tax cuts. If a policy improves economic growth substantially, then it should increase tax revenue collections by increasing the incomes of individuals and corporations.
One question I’ve answered a number of times since this discussion began has been, what kind of growth would be necessary for a tax cut to be completely self-financing? So let’s take President Trump’s stated goal of a 15 percent corporate income tax cut as an example and run some quick back-of-the-envelope math with round numbers to illustrate the basics of how this might work.
How Much Growth is Needed?
The short answer is you’d need about 0.9 percent additional growth over the 10-year budget window that is commonly used in Washington D.C. for budget bills. By “additional growth,” I mean over and beyond what forecasters typically predict. The Congressional Budget Office’s baseline projections are that growth will average about 1.9 percent over the next ten years. In order for a corporate income tax cut to 15 percent to be self-financing, it would have to raise the level of growth to 2.8 percent on average.
The federal government raises about $40 trillion in revenue over the 10-year budget window, according to the Congressional Budget Office’s projections. A corporate income tax rate cut to 15 percent would reduce federal revenues by about $2 trillion over the same time period, according to the Tax Foundation model. In other words, it would reduce federal revenue by about 5 percent.
One way to make up for this loss of revenue would be by having an economy about 5 percent larger. A 5 percent larger economy would have 5 percent more income, which would be taxed and increase tax revenues approximately proportionally. (This isn’t precisely true, but it’s true enough for our purposes. More on this later.)
None of this is particularly complex so far: if an economy is 5 percent larger, it can reduce its tax-to-GDP ratio by 5 percent and raise the same amount of revenue. Simple.
However, a scenario in which the economy immediately becomes 5 percent larger is probably not the right idea to be discussing. Most developments that generate growth do so in a more gradual way. For the sake of keeping the example simple, let’s consider the case of straight-line growth throughout the budget window, an amount we add to the baseline growth projection each year.
To get an economy 5 percent larger, on average, throughout the budget window, you need additional growth of about 1 percentage point per year. This means the economy will be 1 percent larger in the first year, 4 percent larger in the fourth year, 8 percent larger in the eighth year, 10 percent larger in the 10th year, and so on. While the GDP won’t reach the “5 percent larger” target in the early years, it will exceed it in the later years, and on the whole that will balance out. Bear in mind that even though the economy is 10 percent larger in the 10th year in this hypothetical, this does not imply 10 percent GDP growth; it’s accumulated slowly over time.
In short, the basic back-of-the-envelope math tells you that the corporate income tax cut would need to add about 1 percentage point to growth for 10 years to be self-financing during the 10-year budget window. However, there are a few caveats and adjustments that need to be made. The first of these is something called “real bracket creep.” If people’s incomes go up, they get pushed into higher tax brackets, so taxes as a percentage of national income go up. The other caveat here is that we didn’t consider compound growth in the simple example. Both of these reduce the amount of growth needed, and collectively they mean you don’t actually need 1 percent, you need something more like 0.9 percent.
Is That Growth Target Realistic?
Tax Foundation’s Taxes and Growth model would not predict 0.9 percent added growth over the budget window from a corporate rate cut to 15 percent. We’ve run this particular scenario before as Option #51 in our book, Options for Reforming America’s Tax Code. The model predicts something more like 0.4 percent over the budget window: a sustained period of 2.3 percent growth instead of 1.9 percent growth, until the economy is eventually about 4 percent larger.
Other macroeconomic models used for tax policy, such as those used at Tax Policy Center or at the Joint Committee on Taxation, would also not likely predict that much growth from that 15 percent tax cut. Here’s why most models are likely to show more modest results from that policy.
The country is reasonably close to full employment. Most Americans who want to be working currently are working. There’s some potential for adding more workers to the economy, to be sure, but most of the people who aren’t working right now are retired, or in school, or otherwise not interested in joining the labor force.
Growth, instead, would mostly have to come from finding better jobs for the workers we have. Imagine businesses, spurred by their lower tax rate, start ordering new expensive buildings with new expensive equipment in them. These would generate higher revenues on a per-worker basis, increasing incomes across the board. This is an ordinary concept called “productivity growth,” and it certainly could be the result of well-crafted policy.
Unfortunately, productivity growth has relatively low variance, historically. It usually grows between 1 and 2 percent per year. Policy can probably help us stay towards the higher end of that range, but a single policy is unlikely to move productivity growth for the whole economy by a whole percentage point. The Committee for a Responsible Federal Budget, among others, have discussed how both population and productivity are limiting factors on what kind of growth is possible.
This largely explains why most models of U.S. labor and productivity would not expect any single policy change to boost growth by 0.9 percent. In order to make a deficit-neutral cut in the corporate income tax rate, other deficit-reducing policies would be necessary.