Tax Policy Center’s Flawed $6.2 Trillion Revenue Loss from Trump Tax Plan

A crucial graph in the Wall Street Journal article, “Trump Fiscal Plain Roils the GOP,” relies on estimates from the Tax Policy Center. Unfortunately, the TPC provides only static estimates of revenue effects of House Republican or Trump tax plans.  That is, they assume lower marginal tax rates on families and firms have literally no effect at all on tax avoidance or long-term economic growth. 

The Wall Street Journal graph purports to project budget deficits over the next 10 years under Congressional Budget Office (CBO) baseline, the House Republican tax plan and the Trump tax plan.  This is quite misleading, because all three scenarios treat future federal spending as given, unchangeable.  Federal spending rose from 17.6% of GDP in 2001 to 19.1% by 2007, and is now 20.7% in 2015. The 2017 Budget projects spending to reach to 22.4% by 2021 and keep rising. 

The CBO August baseline projects federal spending to total $50.2 trillion from 2017 to 2026, so a mere 5% reduction in that growth would exceed $2.5 trillion.

Under President-elect Trump’s revised tax proposal, claims the Tax Policy Center, “revenues would fall by $6.2 billion over the first decade before accounting for interest costs and macroeconomic effects. Including those factors, the federal debt would rise by at least $7 trillion over the first decade.” 

Do not confuse these alleged “macroeconomic effects” with dynamic analysis used in Tax Foundation models and academic studies. The Tax Foundation estimates, for example, that the House Republican tax plan “would reduce federal revenue by $2.4 trillion over the first decades on a static basis,” but that figure shrinks to $191 billion once they properly account for improved investment incentives,  greater labor and entrepreneurial effort and therefore faster economic growth. 

By contrast, the Tax Policy Center presents only “macro feedback” estimates for the Trump plan. The TPC Keynesian model and Penn-Wharton models assume that revenue losses are 2.6% of GDP, the same as static estimates.  But interest rates are higher, adding to deficits and debt.

The TPC Keynesian model is all about alleged effects of budget deficits on demand and interest rates -- not about supply-side microeconomic incentives to raise potential output by raising labor force participation, entrepreneurship and investment.  

According to the Tax Policy Center, “The marginal rate cuts would boost incentives to work, save and invest if interest rates do not change [emphasis added] . . . However, increased government borrowing could push up interest rates and crowd out private investment, thereby offsetting some or all of the plan’s positive effects on private investment unless federal spending was sharply reduced to offset the effect of the tax cuts on the deficit.” 

This is confusing or confused.  TPC begins by admitting lower marginal tax rates on labor and capital “would” provide incentive for more and better labor and capital, and therefore faster long-run growth of the economy and taxable income. In the short run, “TPC estimates that the impact on output could be between 0.4 and 3.6 percent in 2017, 0.2 and 2.3 percent in 2018 and smaller amounts in later years.”  Their mid-range estimate is that “the Trump tax plan would boost the level of output by about 1.7 percent in 2017, by 1.1 percent in 2018, and by smaller amounts in later years.”  Despite faster economic growth for 5 years, the net “feedback effect” supposedly reduces the 10-year static revenue loss by a surprisingly trivial 1.9% (from $6.15 trillion to $6.03 trillion) for reasons hidden inside the Keynesian model.

“The TPC’s Keynesian model takes into account how tax and spending policies alter demand for goods and services. . . and how close the economy is to full capacity.”  Despite references to supply-side incentives, the Keynesian model does not allow such incentives to enlarge “full capacity” -- potential GDP: “TPC plans to build a neoclassical model of potential output whose results could be integrated with those the Keynesian model, but that work is still in progress.”  This denial of supply-side effects is a fatal flaw in the model’s revenue estimates. The Trump tax plan is assumed to raise economic growth for only five years before we bump up against “full capacity” because tax rates are assumed to affect only demand, not supply.

For example, the TPC says “allowing businesses to elect to expense investment would create an incentive for businesses to raise investment spending, further increasing demand.  These effects on aggregate demand would raise output relative to its potential for several years . . . [emphasis added].

On the contrary, more investment spending clearly increases supply – increasing capacity and potential GDP.  Lower marginal tax rates on added labor income likewise raise the supply of human capital (participation rates and incentives to invest in education).

If Trump’s tax policy “would boost incentives to work, save and invest” then the future economy and tax base must be larger than otherwise.  It follows that future deficits cannot be nearly as large as the static TPC estimates claim.  It also follows that there will also be more savings with which to finance both public and private borrowing.