Policy changes have been a key theme for markets this year. Aside from the tariffs (which dominated the conversations in April), investors have shifted their focus to the proposed tax bill that’s on its way to the Senate.
For decades, politicians and pundits have debated the economic impact of tax cuts. Proponents of tax cuts typically point to the theory of supply-side economics, also associated with the phrase trickle-down economics, which argues that a lower tax burden encourages businesses and individuals to invest more, save more, create jobs, and ultimately grow the economy. The theory is that tax cuts (even those given to the wealthy) will trickle down and benefit all.
The flip side of the argument centers around concern for government deficits and debt, which typically increase due to the lower tax revenue. Without an offset in government spending, tax cuts reduce government revenue in the short term and increase government deficits, which ultimately increase the amount of government borrowing.
Let’s take a quick walk down memory lane and look back at how US tax policy changes impacted the economy.
Congress created the first income tax in 1862, during the Civil War, to finance the war with a graduated tax rate of 3% to 5%. This tax ended in 1872, and later attempts to bring it back were struck down by the Supreme Court.
Over the next thirty years, there was no income tax. The main source of government revenue came from tariffs (which made up roughly half of the government revenue) and taxes on specific goods such as alcohol and tobacco (which made up roughly 40% of the revenue).
In 1913, the Sixteenth Amendment officially gave Congress the power to collect income taxes. Rates began at 1% on income over $3,000, and increased to 6% for those making over $500,000.
Taxes rose considerably during World War I, with the top tax rate hitting 77%. Tax rates fell during the 1920s but rose again during the Great Depression and under FDR’s New Deal. By World War II, the top rate hit a whopping 94% for the highest bracket.
In 1964, President Lyndon B. Johnson cut taxes significantly. A period of economic growth followed, though experts still debate how much credit should be attributed to the tax cuts. Interestingly, overall tax revenue actually increased in the following years due to an increase in economic activity, despite the lower rates. The 1964 tax reduction laid the framework for the belief that tax reductions (rather than increased government spending alone) could be used to stimulate the economy.
Tax rates fell again in the late 1970s under Jimmy Carter, and again, economic activity responded accordingly. Ronald Reagan followed the same playbook and reduced the top tax rate from 50% to 28% and embraced the idea of trickle-down economics, believing that tax benefits to corporations and the wealthiest Americans would have a trickle-down effect on the economy.
George W. Bush enacted additional tax incentives in the early 2000s, including rebates, child tax credits, and lower rates on dividends and capital gains. The tax changes were extended in 2010 under President Obama.
In 2017, President Trump signed tax reform, reducing the corporate tax rate from 35% to 21% while also increasing the standard deduction.
Historically, tax reductions appear to impact economic activity positively, although tax rates are merely one input into a very complex system that impacts economic activity, and it’s difficult to draw a direct correlation between the specifics of tax policy and the subsequent economic impact.
I view Johnson and Carter’s tax cuts in the 60’s and 70’s as benchmarks for successful tax reform, with the following commonalities shared by both. (1) Tax cuts that are spread relatively evenly across all income brackets, (2) the cuts were large enough to impact consumer spending (this works best when tax rates are relatively high prior to the cuts), and (3) tax reform is done during times of economic strain. It’s a bonus if the country happens to have a relatively low debt burden if/when the tax revenue declines and borrowing increases.
While taxpayers in higher income tax brackets typically see the largest gross dollar benefit from tax reductions, individuals with a lower income have a higher propensity to spend any increase in take-home pay. Thus, lower-income groups tend to have a higher fiscal multiplier, meaning each dollar of tax relief generates more than a dollar in economic activity.
Prior to the Johnson tax reform, rates were so high that they were constraining economic activity and encouraging more off-the-books transactions for businesses and individuals alike. By reducing the burdensome tax rates (a 40% tax rate for income for $20,000 of income before 1964), individuals not only kept more of every dollar earned, but were also more likely to report income rather than risk hiding it illegally.
Of course, the size and scale of the tax cuts matter as well. Take Reagan’s 1982 tax cuts, which are widely viewed as the gold standard for boosting economic activity. Not only did the Economic Recovery Tax Act of 1981 spread the tax cuts rather evenly across each bracket, but the tax cuts reduced federal revenues by about 2.9% of the total size of the US economy, according to the Committee for a Responsible Federal Budget. Proportionally, this was the largest tax cut in American History. For comparison, the Trump tax cuts in 2017 reduced government revenues by 0.6% of GDP.
Reagan’s tax cuts were implemented at a critical time. Unemployment rates were high, inflation was still elevated following oil and gas embargos, and the S&P 500 had provided no return since peaking in 1968 (an almost unthinkable scenario today).
The tax cuts spurred economic activity, but they also added to the national debt considerably during Reagan’s time in office. Government debt nearly tripled from $908 billion to $2.6 trillion during his eight years in office, the largest proportional increase in modern political history. While that sounds staggering, President Reagan had plenty of room for debt expansion when he entered office. In 1981, the US government had a debt-to-GDP ratio of only 28%. By the time Reagan left office in 1989, the ratio stood at a mere 52%. In other words, we could afford to stimulate the economy with tax cuts and additional government debt.
One thing is generally true when it comes to tax cuts: reductions in income taxes have historically increased the annual budget deficit and added to the national debt. Government debt currently stands at $37 trillion, or 122% of GDP, higher than our previous peak of 106% during World War II.
Which brings us to today. Let’s examine the current proposed tax bill in light of the checklist of successful historic tax reform.
The Tax Policy Center (a nonpartisan organization) calculates that the lowest quintile of taxpayers will receive almost no net benefit from the proposed tax package (in fact, they estimate a slight decrease in after-tax income). Meanwhile, the top quintile will receive a 3-5% increase in after-tax income. So, that’s not a great start.
The size of the tax breaks is relatively large. According to the Tax Foundation, the bill is estimated to reduce tax revenue by $4.1 trillion over the next decade, which equates to an average annual tax deficit of about 1.3% of the economy.
The third pillar of my arbitrary list of factors that determine the economic success of tax cuts is that tax rates are being reduced from reasonably high levels. Is that currently the case? Not really. A quick comparison of other developed economies shows the US tax rates are near the low end of global tax rates and absolutely lower than decades past. It’s difficult to argue that tax rates are high and that they should be reduced at all.
The final pillar of successful tax reform is that it takes place during challenging economic times. While there have been some relatively concerning headlines, it’s difficult to argue that the economy is under stress at the moment. The stock market is within 3% of an all-time high. The unemployment rate is still near a record low, the corporate earnings are at a record high. Which raises the question, why do we need a tax cut at all? … and I’m not sure that we do. However, we never really know if the economy is strong or weak until some time has passed and economic data is received. The US economy may be in the process of a slowdown from the tariffs after recording negative economic growth in the first quarter of the year.
While it’s hard to say how much positive economic impact the proposed tax reform will have, one underlying concern remains: how will the decrease in tax revenue impact our growing level of national debt?
On May 16, Moody’s (a debt rating agency) downgraded the credit rating of the United States, citing concerns over growing national debt and rising interest costs with little progress on spending cuts in Washington. Meanwhile, interest rates on 30-year Treasury bonds surpassed 5%. A level not consistently seen since the 2006-2007 time frame. The increase in rates could be seen through a positive lens as increased future growth expectations, or could be viewed as investor concerns overly the growing risk of inflation. Sprinkle in a growing concern around the ballooning government deficit and debt, and we seem to be building a case for higher interest rates in the coming months, a scenario that may not be fully priced into the markets.
This is not to say that tax reform won’t be successful, but the ultimate goal of cutting tax should be economic growth. It won’t be surprising if consumer confidence improves, the stock market appreciates, and we all keep a little more money in our pockets. None of those are bad things. But if the economy grows at a slower rate than the debt burden, then the tax cuts will have a negative impact over the long term.
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