Something very interesting is going to happen in the realm of economic policy making and budgetary practice if US President-elect Donald Trump makes good on his electoral promise about bringing about changes in the American economy. This may see the resurrection of President Reagan's supply-side economics along with pressing into service Keynesian demand management. The two policy strategies have rarely, if ever, joined hands in macro-economic management, the two being considered as antithetical to each other. To the economist it would be like blowing hot and cold, in the same breath. Yet America appears to be poised to witness, nay experience, the seemingly implausible economic phenomenon under the leadership of a man who knows little about economics but has proved to be an astute entrepreneur with deep experience of high finance and taxation.
It may be recalled that the supply-side economics became the darling of the conservative politicians after President Reagan introduced it in the Eighties to jumpstart job creation and stimulate growth. Known under the rubric of Reaganomics, his economic policy focused on cutting taxes on individual income and corporate profit. Tax cut was expected to increase supply of factors of production (capital for investment, labour for employment). According to proponents of supply-side economics, the resulting increase in aggregate supply would achieve happy outcome of expanding real GDP and reducing the price level. In 1981 President Reagan and the Republican-dominated Congress cut personal income tax rate by an average of 25 per cent to increase economic incentive for increasing aggregate supply. The hope was that aggregate supply would increase output and employment to extents that would be enough to increase tax revenue in the medium term. But before the tax cut took effect recession hit the economy, contracting output in 1982. So the new policy had to be delayed. Once the recession ended, the economy began what at the time was to be the longest peace time expansion on record vindicating the supply-side economics. But it had its downside: the growth in Federal spending exceeded the growth in Federal tax revenue afterwards. So the expectation of increased tax revenue resulting from investment on the back of tax cut did not materialise and Federal budget deficits continued to swell. Annual deficits accumulated in the succeeding years giving rise to huge Federal debt.
To reduce Federal deficits President George Bush Sr. had to increase taxes in 1990 and President Clinton continued the trend of increasing tax rate in the higher income bracket. In 1995 a newly-elected Republican Congress put the brakes on Federal spending. Higher tax rates and a slower growth in Federal spending combined with a growing economy to cut Federal deficits. The supply-side economics, therefore, had a pyrrhic victory and was more like a flash in the pan.
The above summary on the practice and effects of supply-side economics holds lessons for anyone re-inventing the same policy. President-elect Trump seems to have taken a leaf from the past and has re-packaged the macro-economic policy combining supply-side with demand-side management to stimulate growth and employment. If he succeeds it would be a masterstroke that has not been dared before. Much, however, depends on the packaging of the policies, dovetailing one with the other. The President-elect has promised to reform the taxation of corporate profits by reducing domestic corporate profit to 15 per cent from the present 35 per cent and taxing foreign profits of US companies at 15 per cent each year. The former cut, according to the think tank Tax Policy Center, would mean lower tax revenues of almost $ 2.4 trillion over the next 10 years. Closing business loopholes in the Internal Revenue Code, could raise $ 500 billion in tax revenue. But this will be offset by allowing companies to deduct most of their expenses for new business investments from taxable income. Even more dramatically, the proposal to lower tax rate for business income distributed to owners of so-called 'pass through' entities such as partnerships on limited liability companies would lose more than $ 1.5 trillion in tax revenue. This will bring the total loss of potential tax revenue from the corporate sector over the next 10 years to $ 3.9 trillion. At present US corporations operating abroad are taxed at 35 per cent when their profits are brought back to the US. To avoid paying this tax US companies generally squirrel away their profits overseas. The result from the proposed tax reform relating to overseas US companies is, therefore, uncertain. President-elect Trump has proposed to impose 10 per cent on past profits of US companies earning abroad as well as 4.0 per cent on other past foreign profits. Supposing that this will work out, the resultant increase in tax revenue under this head will amount to only $ 150 billion which is way below the loss of $ 3.9 trillion of tax revenue from the corporate sector. President-elect Trump will, therefore, be taking a huge gamble in proposed tax-cut reform adhering to the supply-side economics.
Apart from the consideration of budgetary deficits, the implications of Trump's tax-cut proposals raise issues of equity. Personal tax-cuts proposed by him will be of far more benefit to millionaires than to the working class. Research by Tax Policy Center shows that top 0.1 per cent of earners, those making more than $ 3.7 million a year would get a tax cut of nearly $ 1.1 million which is equal to 14 per cent of their after-tax income on average. The poorest fifth of Americans would get a tax break just $ 110 a year or 0.8 per cent of their income. In his tax-cut proposal, Trump is evidently guided by supply-side considerations but the eventual increase in tax is not likely to materialise because the beneficiaries will be more prone to save rather than make new investments. His tax reform policy, as it is packaged, is destined to increase budgetary deficit.
Where Trump departs from Reaganomics is in respect of Federal spending. Realising that his tax-cut proposals may not be enough of a stimulus to spur growth, at least in the medium term, he has chosen the path of higher Federal spending, particularly on infrastructures. The goal of enhancing growth and employment hinges as much on demand management as on supply-side stimulus. But in the absence of budget surplus (due to tax cuts and expected private sector investment), public investments to stimulate growth and increase employment will almost entirely depend on debt-financing ballooning the debt-GDP ratio. If a dollar that is borrowed and spent by the government pushes up the bond yield, it will make it more expensive for the private sector to borrow and spend. As a result, the private sector will scale back its borrowing by a dollar which will cancel out the impact of government spending on gross domestic product (GDP). The reliance of public sector investment can be sustained only if return on it covers the cost of borrowing and generates income in such magnitude that ensures gradually increased tax revenue. This will, however, depend on the type of public sector investment made. Investing on roads, bridges and airports is not likely to kick in revenue in the medium term because they have long gestation period. The budget deficit from tax reform will thus be aggravated by public debt.
Trump's approach to macro-economic management is not dismissed out of hand by economists such as Larry Summers and Paul Krugman who have long argued that a fiscal stimulus is needed to lift the economy out of its post-financial crisis torpor. But even they are sceptical about the outcome of Trump's demand-side management policy. President-elect Trump can yet prove critics of his unconventional macro-economic policy, combining supply-side with demand-side management, as wrong if it is repackaged on the basis of past experience. So far he has taken note of the past, but does not seem to have been convinced to eschew the mistakes of the past.
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