The Problematic Assumption Underlying 2 Estimates Showing Weak Growth From GOP Tax Reform

COMMENTARY Taxes

The Problematic Assumption Underlying 2 Estimates Showing Weak Growth From GOP Tax Reform

Dec 1st, 2017 6 min read
COMMENTARY BY
Adam Michel

Senior Policy Analyst, Grover M. Hermann Center

Adam N. Michel focuses on tax policy and the federal budget as a Senior Policy Analyst in the Grover M. Hermann Center.
Then-President-elect Donald Trump greets a worker as he tours a factory in Indianapolis, Indiana, in 2016. MIKE SEGAR/REUTERS/Newscom

Key Takeaways

The Council of Economic Advisers, which advise the president, believe that GDP could increase between 3 and 5 percent.

Tax reform would raise the return on investment in the United States relative to the returns in other countries.

Economic studiesshow that the U.S. economy continues to be more open every year.

There’s a key reason two estimates of the economic effects of the GOP tax bill show only small effects: they’re largely ignoring the primary mechanism that will lead to economic growth – the inflow of investment to the United States from other countries.

The Tax Policy Center (TPC) and the Joint Committee on Taxation (JCT) have produced estimates of the economic effects of the GOP tax reform bills. The JCT estimates that the Senate tax reform bill will raise GDP, but only by a modest 0.8 percent in ten years. TPC estimates the House passed version of the bill would grow the economy by 0.6 percent over the same time period.

But those numbers aren’t in line with a growing academic consensus on the growth effects of tax reform. Consider these studies’ findings:

  • A recent Heritage Foundation analysis shows that the Senate tax reform bill could boost the size of the U.S. economy by almost 3 percent over the long-run.
  • The Council of Economic Advisers, which advise the president, believe that GDP could increase between 3 and 5 percent.
  • A growth effect of between 3 and 5 percent was also independently verified by three economists from Boston University.
  • Nine leading economists recently described how the economy could see a boost of up to 4 percent due to tax reform.
  • Independent analysis from the Tax Foundation estimates that the House bill could boost GDP by 5 percent and the Senate bill could raise GDP by 3.7 percent.

All of these estimates find larger increases in the economy because they explicitly or implicitly model additional capital inflow in response to tax reform’s reduction in the user cost of capital. The JCT and TCP numbers follow from assumptions they make that limit the capital inflow.

Tax Reform, the User Cost of Capital, and the Open Economy

The proposed GOP tax reform plans will lower the corporate income tax rate from 35 percent to 20 percent and allow for five years of expensing. Combined, these two policy changes reduce the user cost of capital, which is a price that mangers use when evaluating potential new investment projects.

Firms only invest in new projects when the expected returns are greater than the user cost of capital. By lowering the user cost of capital, the tax reform bill is expected to significantly increase investment, which also leads to increased hiring, greater output, and higher tax revenues.

Ultimately, the funding for new investment must come from additional saving. If the economy is closed, meaning that there is no trade with other nations, then the additional saving has to come from domestic households. Interest rates have to increase in order to entice domestic households to save more. The increase in interest rates raises the user cost of capital, which mutes the effects of tax reform.

However, if the economy is open, as the U.S. economy is, then businesses have access to savings from foreign households through global capital markets. International savers want to place their money where it will get the best return. Tax reform would raise the return on investment in the United States relative to the returns in other countries, so the pool of international savings would fund more investment here and less investment elsewhere. The more global capital markets shift from investment from the rest of the world to the United States, the smaller the increase in the user cost of capital, and the larger the increase in the U.S. capital stock and GDP.

Assumptions in the JCT and TPC Models

Economic models have three options for how to describe international trade. The first is to assume that the economy is closed. This simplifies the task of producing estimates by ignoring the rest of the world. The second is to assume that the economy is small relative to the rest of the world, so that changes in policy have no effect on the world interest rate. This allows the model to capture the effects of international trade without complicating the model too much. The third is to include a complete market for international capital. This is the most realistic, but also the most computationally difficult.

The models used by the JCT and TPC use a blend of the first two options, building in assumptions that the U.S. economy is relatively closed to international investment. For example, TPC follows the government assumptions that only 24 cents of each new dollar of government debt will be financed by foreign investors. These assumptions come from the Congressional Budget Office’s Solow model, which fixes savings rates based on assumptions made by the modeler. Thus, it is little surprise that the TPC model often finds that the static and dynamic scores are “nearly the same.” By modeling the U.S. as a partially closed economy, the models predict that tax reform will only modestly increase the foreign investment that will flow into U.S. markets.

The effects of these assumptions have not gone unnoticed by other economists. In the Wall Street Journal, economists Laurence Kotlikoff and Jack Mintz explain that the TPC and government scorekeepers depend on “closed-economy models that do not simulate the current, let alone the future, global capital market.” Closed economy models ignore salient facts about the world economy. “For all the talk about the Republicans not being an ‘evidence-based’ party, in this particular debate they seem to have the science on their side,” concludes economist Tyler Cowen.

U.S. Economy Is Not Closed to International Capital

Economic studies reviewing the available research conclude that capital is highly mobile and consistently show that the U.S. economy continues to be more open every year.

Other countries have studied the research on capital mobility and become wise to the competitive benefits of tax reform. International corporate tax rates have fallen in recent years, so that the United States has the third-highest marginal tax rate in the world. In a global capital market, Congress cannot set tax rates in a vacuum.  If taxes are relatively higher in the United States than in the rest of the world, then more investment will be made in the rest of the world.

The world has a global capital market where savings will move to find the best return. Models of the economic effects of tax reform should reflect this mobility.

This piece originally appeared in The Daily Signal