In our April commentary we discussed how markets may have been driven higher in part because of the potential for tax reform. Since then, markets have continued to drift higher with no formal tax reform plan in place. While we wait for the details lets discuss "tax breaks" and the impact on the economy in general.
Currently the national debt exceeds $20 trillion and the 2017 fiscal year ended with a buget deficit of $666 billion. The national debt has been climbing as many government sponsored programs continue to experience higher outlays. Social Security and Medicare combine for about 40% of federal spending and this is only expected to increase. These are alarming numbers and it's estimated that President Trump's proposed tax cuts would add an additional $1.5 trillion to the deficit over the next 10 years.
Will economic expansion accelerate enough to offset the additional deficit?
Here is how a reduction in taxes is suppose to work...The cuts unleash investment and innovation which leads to more jobs, higher income and rapid economic expansion which help lower the deficit. There are many factors to measure the effectiveness of tax cuts but research done by Robert J. Barro and Charles J. Redlick found that historically cutting the average marginal tax rate on Americans by 1 percentage point raised the next year’s per-person economic output by about 0.5 percent. While positive, the concern is it's not enough to offset the additional deficit and could end up bloating the deficit even further. Others state that tax reform disproportionately benefits the wealthy and corporations, not the average taxpayer. In 2012, Kansas enacted tax reform and significantly cut rates with the hopes of economic expansion. Unfortunately the results showed that job growth, small business formation and overall economic growth lagged. This is not to say that tax cuts were the sole root of the problem, but it does show that a positive correlation of lower taxes and higher economic growth isn't always the case. In fact, we have experienced increased job growth in periods of both tax increases (Clinton, Obama) and tax cuts (Kennedy,Reagan). Factors such as age demographics, technology and normal economic cycles play a large role in shaping an economy. It should be stated that lowering taxes itself does not guarantee economic expansion as people could choose to work less to earn the same income.
Proponents of tax cuts argue that new business creation, which is considered to be the lifeblood of the U.S. economy is faltering in part because of high taxes and increased regulation. The numbers show new business creation is at a 40 year low. Starting a business is a risky and costly venture and proponents argue that without incentives such as lower taxes, write-offs on new capital purchases and less regulation, individuals are less inclined to take the steps necessary to start companies. It is argued that "wealthy" taxpayers pay more tax when marginal tax rates are slashed which means lower income earners bear a smaller share of the tax burden. It is also argued that private businesses use capital more efficiently than the government and tax revenues could rise even in the face of tax cuts as experienced in the 1920's. You can even point to a recent example where Indiana lowered state income taxes and corporate rates in 2013 and experienced a significant drop in unemployment (3.5%) and boost in GDP to 4%.
As you can see, tax reform is not an exact science and several factors shape an economy. The answer (as we often remind you) is probably somewhere in the middle but finding the right balance proves to be difficult. We think the government should look into alternate options with Social Security and Medicare benefits to help balance the budget but those are touchy subjects and would take time to hash out. While much of the attention is on tax reform, the bigger issue in our opinion is the Fed and ECB which are going to be attempting an unwinding of their balance sheets while raising rates. Financing a growing deficit with an increase in rates is a risky proposition unless economic expansion quickly follows. One thing is for sure, the economy will not thrive or collapse on tax reform alone.