An Objective Look At Issues Without Idol-Worship

Friday, August 5, 2011

Tax Cuts Can Improve U.S. Credit Rating

Yesterday, S&P downgraded U.S. government debt from AAA to AA+. This move has been precipitated by Egan-Jones, an independent credit-rating agency which downgraded US debt in July.

So why did the US debt get downgraded?

Well, Egan-Jones downgraded US debt because of an increasingly unfavorable debt-to-GDP ratio. The downgrade probably would not have occurred had the US government made some credible plan to cut spending, balance the budget, and reduce the debt while pursuing pro-growth policies.

S&P downgraded the US debt for basically the same reasons. You can read those reasons here. You can listen to David Beers, a top dog at S&P, explain their decision here. To summarize, their reasons are the following:

1. The US government didn't cut the deficit enough over a 10-year period in the recent debt ceiling showdown.

2. There's political uncertainty as to whether the US government will be able to cut the deficit/debt enough, due to the Republican's unwillingness to raise taxes and the Democrat's unwillingness to cut spending, especially entitlement spending.

3. The debt-to-GDP ratio is too high.

4. The prospects for US economic growth remain weak and the US couldn't possibly "grow" its way out of its debt problem.

Of course, there's huge controversy over this debt downgrade. The White House is claiming that the S&P made a serious math error that led them to this downgrade... Which is a downright laughable claim, assuming that all of the fundamental reasons why the debt was downgraded are still there: high debt-to-GDP, poor political environment mainly due to strong political uncertainty, and weak economic growth.

And, obviously, political mudslinging is going on over this. Republicans, the Tea Party, and others are blaming the left and establishment Republicans for spending like drunken sailors under Bush and Obama. Federal spending, after all, has more than doubled since 1999. Democrats and the left-wing media (including the supposedly "independent" Anderson Cooper of CNN) are blaming the Republicans for not agreeing to taxes on "the rich," "Big Oil," and "Big Corporations."

Well then, allow me to completely disprove that notion. In fact, allow me to show how CUTTING taxes would have created a better economic outlook and more tax revenues over the long-run, and how such a move could possibly have avoided a downgrade of the US debt.

This study shows that a cut in the US corporate tax rate of 10 percent would increase economic growth by 1.1%. The average US corporate tax is roughly 35% (the highest tax bracket is 39% though). So an elimination of the US corporate income tax would increase economic growth by about 3.85% per year. See where I'm going with this? The US economy is more-or-less $14.6 trillion large. Assuming no other economic growth, an elimination of the corporate tax rate would grow the US economy by $562bn in one year and from $14.6 trillion to $21.3 trillion in ten years. That's a total increase of $6.7 trillion or 45.89%. In twenty years, no corporate tax rate would grow the US economy from $14.6 trillion to $31.1 trillion, for a total increase of $16.5 trillion or 113%.

Now, in 2009, the US government collected $339.3bn in tax revenues from the corporate income tax. I'm not quite sure what the figure is for 2011, but I'll eyeball it and say it's $350bn, which will more than allow for the very weak economic growth that has occurred between 2009 and now. Over ten years, not having this tax would result in $3.5 trillion in lost tax revenues. Over twenty, it would result in $7 trillion in lost tax revenues.

Now, remember that a major reason why the US government's debt was downgraded was that the debt-to-GDP ratio was too large. What we see above is that eliminating the corporate tax rate would increase government debt by $350bn in one year, $3.5 trillion in ten years, and $7 trillion in twenty years. HOWEVER, we also see that eliminating the corporate tax would increase the size of the economy by $562bn in one year, $6.7 trillion in ten years, and $16.5 trillion in twenty years. Thus, eliminating the corporate income tax would result in a loss of revenue (at least over the near term), but the resultant increase in economic growth would offset that revenue loss and actually reduce the debt-to-GDP ratio, thus placing the US government on a better financial footing.

And this isn't only true regarding corporate taxes. Studies conducted by the Harvard economist Robert Barro have shown that tax cuts have a multiplier greater than 1.0. Basically, what this means is that each dollar cut in taxes (and thus added to the debt) creates more than one dollar in economic growth, thus decreasing the debt-to-GDP ratio. Barro's studies have also shown that spending increases have a multiplier less than 1.0, meaning that each dollar increase in spending creates less than $1 in economic growth, therefore increasing the debt-to-GDP ratio.

Barro's studies have also been backed up by studies conducted by two other Harvard economists, Silvia Ardagna and Alberto Alesina. These studies are even more important for our purposes here, as they not only show that tax cuts have a positive effect on economic growth, but that spending cuts are a better tool for reducing deficit spending than tax increases.

But wait! There's more! There's also the fact that, in the very long-run, tax cuts will not only reduce debt-to-GDP, but also increase overall tax revenues.

Going back to our corporate income tax example, an elimination of the corporate tax would result in a revenue loss of $350bn per year or $3.5 trillion every ten years. But that doesn't account for two things: (1) How increased economic growth from eliminating corporate taxes will increase revenues from other taxes; and (2) How some of the lost revenue from eliminating the corporate income tax will be regained through other taxes (e.g. eliminating the corporate tax will inevitably increase capital gains, thus increase tax revenues from the capital gains tax).

Unfortunately, this second factor cannot be readily quantified for - I've seen estimates everywhere from 50% to 100% of lost tax revenue from corporate income taxes would be recouped through other taxes. Because we cannot quantify this number, I do not think it's fair to use it in our analysis.

However, we can do rough "back of the napkin" calculations to determine how much increased economic growth will increase tax revenues. Again, going back to the 2009 figures posted above, the federal government collected $2,331.6 billion or $2.3 trillion in all tax revenues minus corporate tax revenues. Since, in our analysis above, we increased 2009 corporate tax revenues by about 3% to account for the minimal economic growth that has occurred between 2009-2011, we'll also increase the revenues from other taxes by 3%, which puts those revenues at $2.4 trillion.

When we account for the increase in economic growth over ten years from eliminating the corporate income tax, I think it is totally fair to assume that tax revenues from other taxes will increase by the same amount as the size of the economy. After all, tax revenue is proportionate to national income, especially since the majority of tax revenue in the United States come from taxes which tax incomes (e.g. individual, payroll, and capital gains taxes). So taking this assumption into account, tax revenue from other taxes would increase from $2.4 trillion to $3.5 trillion in ten years; from $2.4 trillion to $5.11 trillion in twenty years, and so on.

Of course, because the elimination of the corporate income tax would mean would reduce revenues by $3.5 trillion every ten years, these tax cuts wouldn't pay off in the first ten or twenty years. But when I did a little more math, I discovered that they would pay off between 60-70 years, as tax revenues would increase to $23.15 trillion in 60 years and $33.78 trillion in 70 years... Which would more than pay off the $3.5 trillion loss every ten years. (You do the math: $3.5 trillion x 7 decades = $24.5 trillion in lost revenue, while an increase from $2.4 trillion in tax revenues to $33.78 trillion means an increase of $31.38 trillion, which more than makes up for the $24.5 trillion loss.)

The above analysis can also be used to determine how long it would take other tax cuts to pay off.

So how's that for a debunking of left-wing rhetoric? Three Harvard economists have conclusively shown that tax cuts reduce debt-to-GDP while spending cuts are a better method for balancing the budget than tax hikes. I've also shown how corporate income tax cuts boost economic growth, reduce debt-to-GDP, and eventually pay off in the form of overall higher tax revenues.

So, next time you hear someone say it's time to tax the rich more, you know how to answer.