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Not just any kind of tax cut can boost economic growth

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President Donald Trump promised last week he would unveil a “phenomenal” tax reform package in the next few weeks. Although no details were offered, Mr. Trump’s past statements suggest that his proposal will adhere to fairly standard supply-side principles.

The idea behind supply-side policy is to encourage more investment, more labor effort and technological innovation through changes in the tax code and regulatory structure.

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Have these policies been successful in the past? Are some types of policies better than others at spurring economic growth? To answer those questions, it’s useful to put supply-side policies into broad categories:

Lower personal tax rates: The Bush and Reagan tax cuts featured large tax cuts for wealthy households. According to proponents, allowing the wealthy to keep more of their income will increase the returns from taking risks on new business ventures and spur new, innovative businesses activity.

However, as many studies have shown, both presidents’ tax cuts had little, if any, impact on economic growth. For example, a report from the nonpartisan Congressional Research Service concluded that “The reduction in the top tax rates appears to be uncorrelated with saving, investment, and productivity growth. The top tax rates appear to have little or no relation to the size of the economic pie.”

Tax cuts for the wealthy did shift the distribution of income toward the top of the income distribution, and the reductions increased the federal deficit significantly, resulting in pressure to cut social programs, but they produced little in terms of growth. 

Reduce taxes on capital gains and dividends: Lowered taxes on capital gains and dividends have also been a prominent feature of past Republican tax plans. But as with tax cuts for the wealthy, they haven’t done much to generate higher economic growth.

Reduce the corporate income tax rates: The idea behind cutting the corporate tax rate is that it makes new investment more profitable, so investment should increase. Lower taxes for corporations also increase the amount of cash firms have on hand, which should also lead to more investment. 

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Another argument holds that corporate tax cuts make U.S. businesses more competitive with foreign businesses. But it’s not at all clear such cuts are needed because the effective tax rate for U.S. businesses -- the rate they actually pay as opposed to the statutory rate -- is not all that different from the rate in other countries.

Although it isn’t obvious at first, this is essentially what the proposal for a border tax adjustment floated by Republicans would do. In effect, it reduces taxes on businesses that use resources located within the U.S. and shifts the tax burden to consumers. But, importantly, the border adjustment doesn’t change the relative tax rates U.S. and foreign businesses pay. That is, it doesn’t affect competitiveness (although it’s being sold as if it does).

The question then is whether the increase in investment the tax change is supposed to bring about, which would likely be small, is worthwhile, given how the tax burden would shift to consumers. If that shift came with an increase in the generosity of social programs so that consumers are better off overall, it might be worth supporting. (This is essentially how the value added tax works in Europe: It’s very regressive, but redistribution through government spending and transfers makes that system highly progressive overall.)

But if anything, the GOP-controlled Congress has hinted it would instead trim spending on social welfare programs, so this wouldn’t be a good deal for the typical American household.

Policies to encourage saving: Policies aimed at increasing saving are supposed to increase the flow of funds into financial markets, spur additional investment and raise economic growth.

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How successful such policies are depends upon the financial sector’s ability to turn additional saving into growth-enhancing, productive investment. It does the country no good if the savings sit idle within the banking system, or if the funds are channeled into sectors experiencing a bubble that will eventually pop and harm the economy. 

During the Great Recession, the availability of lendable funds wasn’t a problem, so additional savings wouldn’t have helped (in fact, by reducing consumption and hence aggregate demand, more savings would have hurt the economy). But when the economy is at or near full employment, such policies can help if financial markets are having difficulty raising funds.

Policies that encourage households to save more -- like tax breaks for putting money into IRAs for retirement -- are a good idea. But they’re unlikely to make much of a difference for economic growth, because there’s no shortage of savings around the world that can be used to fund investment (another reason to doubt that corporate tax cuts would spur investment). But it will help people get ready for retirement. 

A better option would be for the government to enhance programs such as Social Security, particularly for lower-income households. So anything we can do to help people have a comfortable retirement is useful. 

Tax credits for research and development and support for higher education: Tax credits that encourage corporate R&D, support basic research and foster the formation of new, innovative businesses can have large payoffs for economic growth.

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According to growth theory, the only way for the the standard of living (output per person) in rise continuously in the long-run is through growth in technology. The faster productivity can increase through technological change, the faster the standard of living will rise over time.

Support of basic research -- the discovery of new knowledge with no direct connection to the development of new products, at least initially -- has had a surprisingly large payoff in the past. With productivity falling in recent years, bolstering this type of research is essential. 

In addition, support for higher education (along with improvements in elementary and high school so students are prepared when they get there) is needed so that American has an educated workforce ready to put new discoveries into place.

To the extent that Mr. Trump’s policies lean toward encouraging R&D and investment in education and other things that will spur the development of new technology, it’s possible they’ll be successful. Reversing the fall in productivity the U.S. has experienced in recent years is the best way to raise the country’s long-run rate of economic growth.

However, if the president’s tax policy leans heavily toward cuts for the wealthy, cuts to capital gains and dividends, and a shift in taxes from corporations to households -- as I suspect they will -- the effects on growth will be minimal, if history is any guide. 

The main effects will likely be an even faster increase in inequality, higher government deficits and pressure to cut programs such as Social Security and Medicare that workers and their families increasingly rely on. 

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