Key Points
- Our previous analysis showed that President Trump’s campaign tax plan would stimulate the economy in the short run but reduce GDP by about 8.5 percent by 2041 relative to current policy unless cuts were made to spending or additional revenue sources were found that help mitigate the increase in debt.
- More recently, the White House Budget Fiscal Year 2018 proposes to cut federal government spending, excluding Social Security and Medicare, by 16 percent. These spending cuts help reduce the negative debt impact of the proposed tax cuts.
- Nonetheless, when President Trump’s campaign tax plan is paired with President Trump’s budget, the economy is still 2.2 percent smaller by 2041 than under current policy without either change.
President Trump’s Campaign Tax Plan & White House Budget
On May 23rd, 2017, the White House released its budget proposal for fiscal year 2018. The budget proposes changes to many programs for a net federal spending reduction of $3,563 billion over 10 years. This change amounts to a 16 percent spending cut relative to Penn Wharton Budget Model’s (PWBM) projections of federal spending excluding Social Security and Medicare.
President Trump’s Campaign Tax Plan
President Trump’s campaign tax plan reduces taxes on both businesses and individuals. Relative to current policy and after the dynamic impact on growth is accounted for, this tax plan lowers government revenue by 15 percent in 2018. PWBM expects the impact of President Trump’s campaign tax plan and White House tax plan to be similar. However, our analysis will be revised as the White House tax plan gets more specific.
Changes in federal revenues can be offset by changes in outlays. Changes that are not offset affect economic growth through their impact on federal deficits and debt. As government debt increases, more household savings and international capital flows are diverted from private capital formation to financing the debt, dampening economic growth. In the short run, President Trump’s campaign tax plan boosts economic growth. However, Figure 1 shows that in 2041, his tax plan alone reduces the size of the economy by 8.5 percent compared to current policy because his tax plan increases federal debt compared to current policy.
Figure 1: Dynamic Impact of President Trump’s Campaign Tax Plan on GDP with and Without Proposed Budget FY 2018 Changes to Federal Outlays
Note: Federal Outlays, excluding Social Security and Medicare
Source: Penn Wharton Budget Model, 2017
The negative impact of debt on economic growth could be mitigated somewhat if foreign investment flows increased relative to their historical levels. In that case, domestic capital formation need not decline as much. However, more U.S. capital would be owned by foreign investors.
Effect of Spending Cuts
PWBM combines President Trump’s campaign tax plan with a cut of 16 percent to government spending excluding Social Security and Medicare. Figure 1 shows the effect on Gross Domestic Product (GDP) of changes in the level of federal spending on the debt. This tax plan initially boosts the economy both with and without the spending reduction. Nonetheless, even when paired with a spending cut of 16 percent, President Trump’s campaign tax plan results in GDP that is 2.2 percent lower than under current policy in 2041 with no change to taxes or spending. Federal spending, excluding Social Security and Medicare, would need to be cut by about 22 percent for President Trump’s campaign tax plan to meet GDP under current policy in the long run.
Conclusion
Tax cuts in President Trump’s campaign tax plan initially provide incentives for more work and investment. But, in the long run, the impact of federal debt crowds out domestic saving and dampens economic growth. Spending cuts of 16 percent to federal spending, excluding Social Security and Medicare, are not enough to fully offset the impact of the tax cuts proposed by President Trump on the campaign trail. Even deeper cuts, or increasing revenue using taxes that are less distorting than existing taxes, are needed for the President’s tax plan to produce a sustainable positive impact on the economy.