INSIGHTS: HOW CONGRESS CAN MAKE TAX CUTS PERMANENT WITHOUT WORSENING THE DEBT
Guest Columnist: Rachel Greszler, Research Fellow in economics, budget, and taxation in the Gorver M. Hermann Center for the Federal Budget, of the Institute of Economic Freedom, at the Heritage Foundation. Reprinted with permission from The Daily Caller.
The economy is thriving under the Tax Cuts and Jobs Act. Wages are up, scores of jobs are being created, and small businesses are more optimistic than ever about the future.
Making those tax cuts permanent and passing additional pro-growth tax reforms would help sustain higher economic growth, creating long-term benefits for all Americans.
Even so, those benefits would be limited if policymakers fail to address the unsustainable mountain of debt we have already taken on. This part is critical because left unaddressed, the debt will inevitably lead to either an economic crash or decades of economic malaise.
The root problem is not low taxes. After all, the IRS collected record revenue in fiscal year 2018. The problem is excessive government spending, and no amount of tax increases can fix that.
Without restraining spending, further tax cuts today will only mean higher taxes in the future. To achieve fiscal sanity while respecting individual liberty, Congress should pursue tax reform 2.0 by eliminating tax credit spending in the tax code and reducing federal spending.
The Heritage Foundation’s Blueprint for Balance shows how this can be done. The blueprint would achieve an extra $735 billion in additional tax revenues by eliminating narrowly targeted and inappropriate tax credits, or disguised spending, in the tax code.
Getting rid of these credits would more than cover the estimated $657 billion drop in revenues over 10 years that would result from Tax Reform 2.0. Other measures would also help with this, like fully eliminating the state and local tax deduction so that people earning the same incomes across America pay the same in federal taxes.
The state and local tax deduction is deeply inefficient, as it mainly benefits the wealthy and does little for the poor. It also encourages fiscal mismanagement by subsidizing state and local tax increases and discouraging tax cuts.
Replacing this deduction and other narrow and inefficient tax credits with broad-based, pro-growth measures contained in Tax Reform 2.0 would achieve all the benefits of tax cuts without incurring the consequences and risks of higher debt.
An even better proposal would be to simply cut spending and use the tax savings described above to lower taxes even further.
Tax Reform 2.0 would solidify our economic growth and give a boost to working Americans. But regardless of whether or not Congress enacts it, and regardless of the revenue impact, one thing remains certain: Our current deficits are unsustainable.
Without significant cuts in federal spending, no amount of tax cuts can grow the economy out of its debt, and no amount of tax hikes can cover federal spending without crashing the economy.
If lawmakers want to prevent an eventual economic crash or a long period of meager or negative economic growth, they will need to reassess the size and scope of the federal government.
The Heritage Foundation’s Blueprint for Balance gives Congress specific ways that it can reduce spending by $12.3 trillion over the next decade, balance the budget by 2025, and cut the projected debt by 23 percent in 2028.
Tax Reform 2.0 has the potential to give our economy a significant long-term boost. To realize this full potential without future tax increases, lawmakers should couple Tax Reform 2.0 with commonsense tax policies that would get rid of narrow, perverse, and detrimental subsidies and credits in the tax code, as well as instituting structural spending reforms to reduce the size and scope of the federal government.
ON THE ECONOMY: MADE OF MARBLE
John Dunham, Managing Partner, John Dunham & Associates
I saw the weary farmer, plowing sod and loam. I heard the auction hammer, a knocking down his home. But the banks are made of marble, with a guard at every door. And the vaults are stuffed with silver, that the farmer sweated for. This is a verse from the Les Rice song The Banks are Made of Marble. Mr. Rice was an apple farmer and one-time president of the Ulster County chapter of the Farmers Union. He wrote this song in 1948, and it was later popularized by both the Weavers and Pete Seeger.
This week the Federal Reserve raised its benchmark Federal Funds rate by 0.25 percent, to a range of 2-2.25 percent. Even though the media often reports that the Federal Reserve either raises or lowers interest rates, they really do not. The Federal Funds rate is the interest rate that banks charge each other for overnight loans. These loans are generally used to meet reserve requirements. If bank do not have enough reserves at the end of each day, they will borrow from each other. The banks actually determine the rates at which they are willing to loan money, so in effect, the Fed is simply announcing their expected target rate.
The Federal Reserve does have some control over the target in that they set the discount rate, which is the overnight rate charged to banks that borrow directly from it. This basically sets the upper limit for what banks can charge each other.
The media, and many bank economists suggest that the Federal Reserve has tremendous power over the economy through its manipulation of these overnight interest rates; however, historically this is not really the case. In fact, Fed announcements virtually always trail the market – though anticipation of increases do have a feedback loop to market interest rates.
Looking at recent history, one would need to go back to the early 1980’s when the Volker Fed nearly doubled the federal funds rate in an effort to curb runaway inflation. The high discount rate caused an immediate drop in investment in the real economy, as banks had to offer loans at rates about 20 percent just to match discount rates offered by the Federal Reserve. The major recession that resulted from this action put an end to explosive inflation growth.
Since that time, Fed actions have consistently trailed market interest rate changes, even during the last financial crisis, when short term market rates (the rate on the one-year Treasury Note) fell well in advance of changes in the Federal Funds Rate.
Short-term interest rates are up by about 40 percent this year, compared to just 35 percent for the target Federal Funds Rate. The 25 basis-point increase this week, brings the Federal Funds rate in line with the London Inter-bank Offered Rate (LIBOR), which is a market version of the Federal Reserve’s rate. The last time this happened was in late 2017, and still suggests that the Fed is trailing the market.
This means that all of the speculation about the Fed raising interest rates is misplaced. The real question is: What is causing market interest rates to rise?
For starters, the economy has been growing and interest rates tend to generally rise and fall along with economic activity. More activity, more investment, more consumer spending all of which drive up the demand for money.
Interest rates also reflect inflation, since rising prices eat into the return received on money being loaned. Inflation has been picking up, particularly producer level inflation, and that has led to higher financing costs.
Finally, the level of risk involved in making loans has risen sharply, particularly on the corporate side. A recent Wall Street Journal headline says it all: There Have Never Been So Many Bonds That Are Almost Junk. With the risk of default rising, investors are demanding more interest on their loans, and this is driving up both long- and short-term rates.
It is unlikely that these three factors will change much in the next few quarters, so it is safe to assume that market interest rates will continue to rise, and that the Fed will continue to follow them. The banks may bemade of marble, but interest rates are much more fluid. They will follow market conditions no matter what the boffins in the Federal Reserve do.