Deficit-ballooning tax cut is a singularly bad idea

As the U.S. tax cut debate gets into high gear, lawmakers should be asking themselves three basic questions:

Does the U.S. economy really need a fiscal stimulus at this juncture when it is very close to full employment? If the government’s debt mounting is not put on a declining path now during the good economic times, when will it be a good time to do so?

{mosads}Might not an increase in the budget deficit contribute to an unwelcome rise in the U.S. trade deficit and thereby lead to more calls for harmful trade protection?

If lawmakers were to answer these three questions honestly, they would conclude how big a mistake it is for the Trump administration to be proposing unfunded tax cuts at this particular moment.

No serious economist would challenge the notion that the U.S. economy would benefit from a significant cut in tax rates that was fully funded by the closing of the all-too-many tax deductions in our unduly complicated tax system.

However, they would take issue with the idea that President Trump’s proposed net tax cut of some $2.2 trillion over the next 10 years, as estimated by the Committee for a Responsible Federal Budget, would somehow be financed by the U.S. getting itself onto a very much faster economic growth path than it is on at present.

It is for this reason that the basic question must be asked as to whether a budget deficit increase at this juncture makes any sense.

Increasing the budget deficit might make sense when the economy is weak and in need of a fiscal stimulus. That was certainly the case in 1981 when President Reagan cut taxes in the wake of the 1979 oil price shock-induced recession. However, this is hardly how one would characterize today’s U.S. economy.

After the second-longest economic recovery on record, U.S. unemployment is now down to less than 4.5 percent — a level most economists would consider to be at or close to full employment. At the same time, the U.S. economy is showing no signs of faltering with the economy adding jobs month after month.

An unfunded tax cut today would almost certainly complicate the Federal Reserve’s difficult task of normalizing monetary policy by raising the prospect of a return of inflation. The Fed is already under considerable pressure to raise interest rates by a tightening labor market, a falling dollar and booming asset market prices. The last thing that it now needs is a fiscal stimulus to the economy.

Responsible management of a country’s public finances demands that in good economic times, the government should seek to reduce its debt-to-GDP ratio. Otherwise the country will find its debt-to-GDP ratio on an ever increasing path, and it will lose its room for fiscal policy maneuvers in the next economic downturn.

This is why it would seem to be singularly bad policy to add to the budget deficit now during the good times. According to the nonpartisan Congressional Budget Office, even before the proposed tax cut, the U.S. government debt-to-GDP ratio is already set to rise over the next few years to an uncomfortably high 89 percent. 

Yet another reason why the Trump administration’s proposed unfunded tax cut would seem to make no economic sense is that it is in direct conflict with the administration’s stated objective of reducing the trade deficit.

If the administration was serious about reducing the U.S. trade deficit, it would pursue policies that would raise the country’s savings level and reduce the dollar’s value to make U.S. exports more competitive. Increasing the budget deficit now by having an unfunded tax cut would go in precisely the wrong direction.

Not only would it contribute to a decline in the country’s savings rate, it would also contribute to a stronger-than-desired level for the U.S. dollar by putting added pressure on the Federal Reserve to raise interest rates.

One has to hope that when Congress comes to review President Trump’s tax proposal, it is guided by concern for what is in the country’s long-term economic interest. If it does not and it accepts the idea of an unfunded tax cut now, our children and our grandchildren are likely to pay a heavy economic price.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.