When Treasury Secretary Mnuchin announced the details of the Administration's proposed tax reform package last week, he stated that the tax cuts proposed in the tax reform package would generate economic growth so extreme that it would pay for the tax cuts by itself. In the face of such a significant pronouncement, I wanted to see how the numbers would play out.
The tax plan includes the following proponents:
(a) A cut in the corporate tax rate from 35% to 15%;
(b) Allowing the same tax cut, i.e. 15% to be applied to profits from owners of pass-through entities, such as S-Corporations, partnerships, LLC's;
(c) Increasing the standard deduction from $6,350 to $12,000 for individual filers, and the standard deduction for married couples who filer jointly from $12,700 to $24,000;
(d) Eliminating the alternative minimum tax (AMT);
(e) Eliminating all individual deductions except the mortgage interest deduction and the deduction for charitable giving. This would include eliminating the deduction for the payment of state and local taxes;
(f) Changing the number of tax brackets from seven to three, and lowering the tax rate for the highest bracket to 35% from 39.6%;
(g) Lower the capital gains tax rates from 23.8% to 20% by eliminating the 3.8% tax that funds the Affordable Care Act;
(h) Eliminate the inheritance tax;
There have been a wide range of estimates concerning the costs of the tax cuts. Although the most extreme estimate has been as much as $6 trillion, most estimates have been in the range of $2.6 trillion to $3.9 trillion over a 10 year period. For calculation purposes herein, assume that the cost of the plan over the next decade is $4 trillion. In terms of measuring the economic effect that the tax cuts could have on our economy, I will use Gross Domestic Product (GDP) as a gauge. The current US GDP is $18 trillion, and our present growth rate as a percentage of GDP is 2.1%. Further, the average GDP growth from 1947-2016 has been 3.22%. The Trump Administration believes that it can generate GDP growth exceeding 3%, so I am assuming a GDP growth rate of $3.5%, which is approximately 1.5% above our current average from the past 7 decades. A 1.5% increase in GDP growth would amount to $270.5 billion annually. If you calculate that GDP growth increasing at 1.5% on a compounded basis the most generous calculation of the total economic growth would be $3.96 trillion.
The deduction for payment of state and local taxes, one of the largest breaks for individuals, saves taxpayers about $103 billion this year, according to the congressional Joint Committee on Taxation. That is $38 billion more than the mortgage-interest deduction and $46 billion more than the deduction for charitable contributions.
There are 45 million tax filers that itemize tax deductions. The nonpartisan Tax Policy Center estimates that 27 million of these filers will take the increased standardized deduction. Statistically, the rate of single people vs. married people in the US is evenly split, so applying that ratio to our numbers, the increase in the standard deuction for married filers will cost $156 billion/year, or $1.56 trillion over the next decade, and the increase in the standard deduction for single filers will cost $77 billion/ year, or $0.77 trillion over the next decade.
There is also the one-time tax on cash repriated to the US by multinational corporations that is estimated to be $2 trillion. Assuming that the tax rate on those repatriated sums is 15%, that will add $300 billion to the Treasury as a one-time payment. It's also worth noting that the addition of $2 trillion in cash to our economy will cause economic stimulation amounting to an additional $450 billion over a 10 year period.
Finally, to calculate the cost of increasing the federal deficit, for purposes of this argument, I am using the increased cost of the federal deficit both in increased interest costs and loss of economic activity (as there are people who say that the increase in the deficit could wipe out the economic activity generated by the tax cuts). The cost of the federal deficit for 2017 is projected to be $222 billion and the federal debt is $20 trillion. As calculated below, the tax plan adds about $675 billion to the deficit, but that number is the net calculation over a decade. In the short term, the federal deficit wouldincrease by as much as $2 trillion. For calculation purposes, I am assuming that we borrow to finance our federal deficit at an average rate of approximately 1.1%.
So, to calculate (over a 10-year period):
Cost of tax cuts (corp., indiv., inherit., AMT, cap gains) ($4 trillion)
GDP increase of 1.5% compounded over 10 years $3.96 trillion
Cost of increase in standard deduction (married) ($1.56 trillion)
Cost of increase in standard deduction (single) ($0.77 trillion)
Savings from elimination of state/local tax deduction $1.03 trillion
Tax revenue from repatriation of overseas cash $300 billion
Economic stimulation from $2 trillion repatriated cash $450 billion
Increased interest costs of federal debt ($85 billion)
TOTAL ($675 billion)
As a percentage of the costs of the tax plan, the additional deficit amounts to 16.9%.
Let's try to prove out these numbers using a micro-economic analysis.
Assume a pass-through entity realized a $500,000 profit in 2016 on revenues of $3.125 million, which is a 16% net profit percentage. The company's owner is taxed at the rate of 39.6% on the $500,000 profit, that being $198,000. Under the Trump Tax Plan that $500,000 in profit would be taxed at 15% or $75,000, resulting in tax savings of $123,000. The elimination of the state tax deduction adds $5,000 to the tax bill, so the net savings are $118,000. The company owner uses $80,000 of the tax savings and $40,000 of the additional profit to hire 3 new employees and uses the remaining $38,000 to purchase inventory. The company has been growing revenue by 8% annually, but with the new employees and added inventory, the company achieves a 15% growth in revenue. Company revenue increases to $3.6 million, resulting in profits of $600,000. Taxes at 15% with the lesser deductions would amount to $95,000, which is a $20,000 increase. The creation of 3 new jobs at $120,000 provides an additional $24,000 in tax revenue to the treasury. The multiplier effect on the creation of 3 new jobs, and increased economic activity that the company adds to the economy approximates 0.9 times the added profits or $54,000. So, the added economic growth and tax revenue to the treasury is calculated to be $98,000. The deficit of $20,000, or 16.9% approximates the deficit above on a national level.
Understandably, there are many assumptions being made in these calculations, however, it is surprising and noteworthy that it is possible for the Trump Tax Plan to almost pay for the tax cuts with increased economic growth. I was not expecting that resiult, even with the generous assumptions and leaps that I am making herein. At a growth rate of 2.1%, our economy is certainly sluggish, and given that we have historically achieved a growth rate of 3.22%, for the Trump tax plan to jumpstart the economy and achieve a 3% or better growth rate is possible. However, to achieve a growth rate of 3.5% or more and to sustain that for the next decade is certainly going to be a challenge.