As the US tax cut debate accelerates, with Congress in the coming weeks likely to pass the first major bill since Donald Trump entered the White House, law-makers should be asking themselves some fundamental questions. If they answered honestly, they would conclude that the president’s proposed unfunded cuts will unduly threaten the US economy both in the near and long term.
No serious economists would challenge the notion that the US would benefit from a significant cut in tax rates that was fully funded by closing the numerous deductions in the country’s overly complicated tax system. However, they would take issue with the idea that Trump’s proposed net cut of around $2.2tn over the next 10 years could be financed through the US getting itself onto a faster economic growth path than it is presently enjoying.
Increasing the budget deficit might make sense when the economy is weak and in need of fiscal stimulus. That was the case in 1981 when President Ronald Reagan cut taxes in the wake of the 1979 oil price shock-induced recession. However, this is hardly how one would characterise the present state of the US economy. After the second longest recovery on record, US unemployment is less than 4.5%, a level most economists would consider to suggest the economy is at or close to full employment. The economy is showing no signs of faltering, with more jobs being added each month.
An unfunded tax cut would almost certainly complicate the Federal Reserve’s difficult task of normalising monetary policy by raising the prospect of a return of inflation.
The Fed is already under considerable pressure to raise interest rates in the light of the tightening labour market, a falling dollar and booming asset market prices.
Responsible management of a country’s public finances demands that in good economic times the government looks to reduce its debt to GDP ratio. Otherwise the country will find its debt to GDP ratio on an ever-increasing path, and it will lose its room for fiscal policy manoeuvre in the next economic downturn. Adding to the budget deficit during the good times is singularly irresponsible. According to the non-partisan Congressional Budget Office the US government debt to GDP ratio, not accounting for the proposed tax cut, is set to rise over the next few years to an uncomfortably high 90%.
Moreover, Trump’s proposed cuts seem to be in direct conflict with the his stated objective of reducing the trade deficit. If the administration were serious about reducing the US trade deficit, it would pursue policies to raise the country’s savings and weaken the dollar to make US exports more competitive. Increasing the budget deficit would take the economy in precisely the wrong direction. This would contribute to a decline in the country’s savings rate as well as a stronger than desired level for the dollar, by putting added pressure on the Fed to raise interest rates.
I hope that when Congress comes to review Trump’s tax proposal, it is guided by concern for the country’s long-term economic interest. If it does not and accepts the idea of an unfunded tax cut, later generations are likely to pay a heavy economic price.
Desmond Lachman is a Resident Fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the Chief Emerging Market Economic Strategist at Salomon Smith Barney.