EIB #12 - The No-Growth, Deficit-Financed Tax Cut
The House reconciliation bill would dramatically accelerate the spiral of federal debt-to-GDP. In turn, it risks reigniting inflation. Conservatives promised fiscal responsibility and should deliver.
All,
In today’s EIB, please find:
Why Are the GDP Growth and Primary Deficit Numbers Out of Whack?
Some Options for Raising GDP Growth and Lowering the Primary Deficit
Email chris@russoecon.com with questions, suggestions, or to request a briefing or testimony. Feel free to forward or subscribe (it’s free). Thanks for your support!
Best,
Chris
P.S. This EIB was written on Sunday evening while waiting for the reconvening of the Budget Cmte’s markup. Around 10:28pm ET, Chairman Arrington suggested that there will be a future manager’s amendment to modify the House bill to reflect any outcome of ongoing negotiations. He did not announce any such details tonight. My comments reflect the bill as voted on tonight. The bill was favorably reported.
The No-Growth, Deficit-Financed Tax Cut
I support Pres. Trump’s goals of permanent, pro-growth tax reform and reducing the federal deficit. However, the House reconciliation bill will not meaningfully raise growth, will dramatically raise the deficit, and risks reigniting high inflation.1
Tax Foundation estimates that the bill will raise real GDP by 0.6% in the long run.2 Amortizing that over the 10-year window, this suggests an increase to real GDP growth of only 0.06% per year.3 This estimated increase to growth is minuscule.4
Meanwhile, current scoring suggests that the bill will raise the 10-year primary deficit by $2.7 trillion, or 0.7% of 10-year GDP.5 This is a massive increase to the primary deficit, which would (under current law) average about 2.1% over the next 10 years.
The increase to the primary deficit as a percent of GDP is ten times larger than the increase to real GDP growth. Mathematically, this implies a dramatic acceleration of the growth rate of federal debt to GDP, which is a key metric of debt sustainability.6
Why Are the GDP Growth and Primary Deficit Numbers Out of Whack?
These numbers are out of whack because of the Ways and Means Cmte’s portion of the bill, which includes several extremely expensive, no-growth provisions.
Changes to the Alternative Minimum Tax. Costs $1.4 trillion for no growth.7
Expanded/Extended Standard Deduction. Costs $1.3 trillion for no growth.
Expanded/Extended Child Tax Credit. Costs $0.8 trillion for no growth.8
There are also a host of gimmicky, base-narrowing provisions with artificial sunsets.
No tax on tips through 2028. Costs $40 billion ($120 billion if permanent).
No tax on overtime through 2028. Costs $128 billion ($380 billion if permanent).
Senior standard deduction. Costs $72 billion ($180 billion if permanent).
No tax on car loans through 2028. Costs $58 billion ($180 billion if permanent).
Clean Fuel Tax Credit through 2031. Costs $45 billion ($60 billion if permanent).
MAGA savings accounts. Costs $17 billion ($35 billion if permanent).
Yet, the bill does not make permanent several key pro-growth provisions.
Capital expensing (“bonus depreciation”) is only extended through 2029.
Research and development (R&D) expensing is only extended through 2029.
Limit on EBITDA-based interest deductibility is only extended through 2029.
Expensing of qualifying manufacturing, extraction, and agriculture structures only covers construction beginning before 2029 and ending before 2033.
Tax Foundation estimates that making these provisions permanent could cost an additional $500 billion, and would raise long-run real GDP by an additional 0.4%.9
Republicans are presumably banking on a Republican president and a Republican Congress extending these provisions again in 2029. However, this political outcome far from assured, and the policy uncertainty dramatically undermines the pro-growth economic benefit. Hence the drive to make tax reform permanent in the first place!
Some Options for Raising GDP Growth and Lowering the Primary Deficit
The following options available to the W&M Cmte are not mutually exclusive.
Nix the changes to the AMT and standard deduction. This alone saves $2.7 trillion and makes the bill deficit neutral, with no impact on real GDP growth.
Nix the base-narrowing gimmicks to pay for making the key pro-growth provisions permanent, raising the bill’s impact on long-run real GDP to 1%.
Nix other tax expenditures as additional offsets. W&M has jurisdiction over $50 trillion of tax expenditures over 10 years. Jack Salmon offers suggestions, e.g.:
Cap corporate SALT deduction at $10,000 (saves $793 billion).
Cap the ESI exclusion at the 50th percentile of premiums (saves $661 billion).
Reduce mortgage interest rate deduction to $500,000 (saves $260 billion).
Eliminate “head of household” filing status (saves $209 billion).
Repeal SALT deduction pass-through workarounds (saves $200 billion).
Eliminate tax credits for college expenses (saves $130 billion).
Required valid SSN for CTC and EITC (saves $28 billion).
A Cautionary Tale: The $1.9 Trillion American Rescue Plan
When Democrats have the House majority, they can pass almost anything on a party-line vote. Speaker Pelosi could have had a one-seat majority and the Devil in her caucus, and she would still never lose a vote on the floor. This conformity is a tactical strength but a strategic weakness. It is how Democrats passed trillions of dollars in deficit spending, caused a four-decade high inflation rate, and lost their trifecta.
By contrast, whipping Republican votes is like herding cats. This nonconformity is a tactical weakness but a strategic strength. Internal disagreement makes our policies stronger and messaging sharper. While I do not always agree with their rationales, the courage of individual members to vote “no” helps Republicans over the long run.
Democrats publicly excoriated liberal economist Larry Summers for warning that the $1.9 trillion American Rescue Plan risked causing high inflation. But he was right! Democrats fell in line anyway. I bet Democrats who narrowly lost re-election wish they had listened. Offsets might have saved their seats and their House majority.
Similarly, I bet House Democrats who narrowly won their re-election campaigns are privately thankful to Sens. Sinema and Manchin for scaling down Build Back Better into the Inflation Reduction Act.10 Otherwise, inflation might have reached 10%.11
Concluding, Conciliatory Thoughts
There are many good provisions in the bill, which include but are not limited to:
Permanent reductions to individual marginal tax rates which, while expensive, provide direct and broad-based tax relief to working American families, raises economic growth, and can be fully paid for with offsets already in the bill.
Permanent 199A pass-through deduction at 23%, permanent increase to the death tax exemption, and permanent low rates for GILTI, FDII, and BEAT.
Reforms to various federal benefit programs, including Medicaid and SNAP, to strengthen their financial positions while focusing benefits on the truly needy.
Additional spending on key priorities, including national security and the border.
Authorizing FCC spectrum auctions and more permitting for American energy.
A debt limit increase, which allows Treasury to continue to borrow to meet its lawful payment obligations (including interest payments, Social Security, SNAP, Medicare, Medicaid, military salaries, retirement benefits, veterans programs, etc.)
I also understand the political realities that come with slim majorities in the House and Senate. E.g., blue state Republicans are going to demand their pound of SALT. The bill does not need to be perfect. It just needs to be a step forward, not backward.
Nevertheless, the bill as written will dramatically increase the deficit, do little for economic growth, and therefore accelerate the debt spiral. Economically, this will risk reigniting inflation. Conservatives promised fiscal responsibility and should deliver.
Estimating the inflationary impact of this deficit-financed tax cut is difficult. In part, this is because the public has (to some degree) expected expiring TCJA provisions to be extended or expanded. To the degree the resulting deficits have been anticipated, some of the inflationary effect has been baked into inflation between 2017 and today. Consequentially, fulfilling that expectation will have a more muted impact on inflation vs. a surprise policy.
Of course, there is no free lunch. To the degree the resulting deficits have already been anticipated, not fulfilling that expectation will have an even stronger disinflationary effect.
Of course, you can quibble with the Tax Foundation’s estimates, which are imperfect. Nonetheless, their general equilibrium model provides an objective, consistent benchmark for dynamically evaluating the economic and fiscal effects of reconciliation proposals.
Importantly, though, the Tax Foundation model seems to omit channels through which tax reform can raise the long-run growth rate of real GDP as opposed to just its long-run level. Improvements to the long-run growth rate of real GDP are tremendously more impactful that one-time changes in the level of real GDP because they compound over time. And in terms of the debt-to-GDP math, it is the growth rate of real GDP that matters. To put the reconciliation bill on the fairest footing that I can, I will assume that the 10-year amortized growth rate is a permanent increase in real GDP growth rather than a temporary increase.
This is approximately equal to 0.6% (the percentage increase in the level of real GDP) divided by 10 years. (I write “approximately” because this ignores compounding, which in this case is reasonable because the overall increase in the level of real GDP is small.)
An old joke: “How do you know economists have a sense of humor? We use decimal points.”
For context, the median participant on the Federal Open Market Committee (the group of Federal Reserve governors and presidents who set interest rates) estimates the long-run growth rate of real GDP is 1.8% per year. This would only raise that to… 1.86% per year.
Calculated as the 10-year increase in the primary deficit divided by the sum of nominal GDP over the next 10 fiscal years (as projected by CBO in its Jan 2025 economic projections.)
Here, I am implicitly assuming that the real interest rate on federal debt is not affected by the bill. This is a “cautious” assumption insofar as I do not want to overstate the potential impact of the reconciliation bill on the U.S. debt-to-GDP ratio. In reality, higher levels of U.S. debt-to-GDP will raise interest rates to some degree, which worsens the deficit impact. (As the U.S. rolls over its debt at a higher interest rate, interest payments will also increase.)
If so inclined, feel free to mentally replace the word “costs $X” with “reduces federal revenues by $X.” The philosophical point does not affect the underlying mathematics.
I am surprised by this estimate. I assume that the Tax Foundation’s model does not include a fertility channel, or assumes that the sensitivity of fertility with respect to tax incentives is small. I am not an expert on this issue, but this research summary suggests that the fertility effects might be significant, which would raise long-run population growth and revenue.
While still small, these changes about double the impact of the bill on long-run real GDP.
CBO originally scored the IRA as reducing the 10-year deficit by $238 billion. As Republicans argued at the time, this was a bad score. The energy subsidies alone cost roughly $250 billion more than originally scored, according to estimates from JCT. This suggests that the IRA was deficit neutral, at best, and therefore did not lower inflation. Yet, the deficit and inflation were still better than they would have been under BBB.
CBO’s original score of BBB is within that range ($367 billion over 10 years). Moreover, as above, this original score reflects bad estimates for the cost of the energy subsidies. The 12-month inflation rate hit 9.0% in June 2022. Based on the size of the national debt at the time, the likely deficit impact of BBB would have been enough to push inflation above 10%.
