The Economy

Tax Cuts: Be Careful What You Wish For

The short-term economic boost that the GOP-proposed tax cuts would generate wouldn't be sustainable without growth in the already-tight labor market.
Joel NaroffNovember 9, 2017
Tax Cuts: Be Careful What You Wish For

The Republicans in Congress are trying desperately to deliver on at least one of their campaign promises. What will come out of the tax bills that have been introduced in the House and Senate, if anything, is unclear. But right now, the proposals offer more risks than benefits.

Joel Naroff

Joel Naroff

First, let’s be clear: there is a difference between tax cuts and tax reform. Tax cuts simply lower payments; they don’t fundamentally change the structure of the code. Tax reform, on the other hand, restructures the code so that business activity is directed toward economic fundamentals rather than tax advantages.

Tax cuts are like sugar highs. They get businesses and households running around like crazy, but eventually things come crashing down. Yes, they can raise the level of economic activity in the short term. However, we are concerned about growth. Once the economy accelerates to the new level, how do you grow from there? Tax cuts just don’t cut it when it comes to generating greater longer-term growth.

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Tax reform, however, removes the incentives or disincentives to do something simply because it is tax advantaged or disadvantaged. The current tax structure distorts economic decision-making and creates inefficient markets. Removing those incentives or disincentives would make businesses and markets work better, producing a more efficient economy.

And a more efficient economy has a greater capacity to grow.

Indeed, it is worth reviewing how an economy expands over time. There are really only two ways to grow. Either a company uses more workers and through brute force expands output, or workers are used more efficiently.

So, potential growth is determined by the growth rates of the labor force and productivity. Labor-force growth is determined by demographics and immigration. The number of people in each age group is given, and normal models can fairly accurately determine the growth in the labor force. The best guess is that over the next decade it will expand somewhere between 0.5% and 0.75%, depending on immigration levels.

What about productivity? It has been pathetic this decade, averaging around 0.5%. Most economists expect it to rise to anywhere between 1.50% and 1.75%.

If you add labor force growth to productivity growth, the potential growth rate for the economy ranges from about 2% to 2.5%. That is pretty much where growth has fallen during this decade. That is, we seem to be growing at potential. That may not feel good, but unless either the labor force or productivity increases faster, it will be hard to do better.

Which gets us back to tax policy. Right now, the proposals center around cutting taxes for businesses and households and finding ways to pay for the cuts so the budget deficit and national debt don’t soar. The bills don’t restructure the code much. They don’t remove the insane elements that drive every businessperson crazy or end the tax breaks or loopholes that have little to do with making the economy more efficient.

The bills may increase corporate profitability, but that doesn’t raise long-term growth potential. And they may give some households more money, but without greater economic growth, incomes don’t necessarily continue to rise.

But the really major problem facing the Republicans, at least politically, is that their bills create huge budget deficits. For decades, Republicans have positioned themselves as the party that’s against raising the national debt. Unless they figure out a way to pay for the tax cuts, they will have trouble passing the legislation.

The concerns with the current bills don’t end with the huge budget deficits, limited reform of the system, almost no closing of loopholes, or changes that fail to increase productivity. What’s worse is that they have the potential to create significant economic problems.

When it comes to economic policy, it is not just what you do that matters, but also when you do it.

Right now the unemployment rate is the lowest in nearly 18 years, and the biggest problem facing businesses is the inability to find qualified workers. Simply put, the labor market is really tight, no matter how you measure the unemployment rate.

So, what would a sugar high (a tax cut) accomplish? Undoubtedly, with a large-enough cut that is concentrated in early 2018, growth could reach 3% or even higher for a period of time. Unfortunately, with the labor force and productivity growing so slowly, that pace would exceed the capacity to grow over the longer term.

What would be the impact on the economy of growing faster than capacity when we already have tight labor markets? To expand output, firms would have to either start hiring unqualified workers or bid workers away from other companies. Either way, labor costs would rise.

Rising worker compensation may support faster growth, but it would also pressure earnings and raise inflation. And that’s where the Fed comes in.

Right now, the Federal Reserve is intent on hiking interest rates toward more normal levels. They are not so much worried about inflation as about their limited capacity to fight the next recession due to the low level of interest rates.

If inflation accelerates, the Fed will be forced to raise rates faster and higher than expected. Most economists currently expect that the Fed will hike rates at least three times in both 2018 and 2019. Accelerating inflation would cause rates to rise — and not just to reload the Fed’s arsenal, but also to stem the rising prices.

There is no doubt that we need a massive change in the tax code so the economy can operate much more efficiently. Sub-1% productivity growth is awful. But given where we are in the business cycle, with the expansion soon to become the second-longest in history and with labor markets tight, a surge in growth is not what the doctor ordered.

A cut, cut, cut tax bill may sound great. It may be wonderful political strategy. But if it causes inflation and interest rates to rise faster, while further tightening the already-limited supply of labor, it creates the likelihood of bubbles forming. And we know what tends to happen when bubbles form: recessions follow.

So be careful what you hope for, because you just may get it.

Joel L. Naroff is president and chief economist at Naroff Economic Advisors and a former chief economist for TD Bank.