Why Trump's best idea for economic growth won't work

Myles Udland
Markets Reporter

If there’s an economic idea President Donald Trump and his economic team have emphasized most often it is that slashing taxes will boost growth.

Except this might not work at all.

“After a decade when GDP growth averaged only 2%, Treasury Secretary Steven Mnuchin has suggested that the proposed tax cuts will raise the economy’s sustainable growth rate to 3%,” writes Paul Ashworth, an economist at Capital Economics.

However, Ashworth writes, “there is little obvious correlation between lower tax rates and faster economic growth.”

Ashworth looks at the economy after the two most recent tax cuts, those enacted by the President Regan in the 1980s and Bush in the 2000s.

“Isolating the impact of tax changes is notoriously difficult,” Ashworth writes.

“Furthermore, previous fiscal packages focused on reducing individual tax rates rather than corporate taxes, so aren’t necessarily a good guide to the current proposals for reform. Nevertheless, as Chart 3 shows, labour force growth actually slowed in the aftermath of both the Reagan and Bush tax cuts. Productivity growth also slowed following the Reagan tax cuts, although it did briefly accelerate following the Bush tax cuts.”

Labor force growth actually slowed following the most recent U.S. tax cuts. (Source: Capital Economics)

Ashworth also writes that there is little obvious correlation between lower taxes and faster GDP growth, despite the, “suggestion that the reduction in tax rates in the early 1980s was followed by faster economic growth in the second half of the 1980s.”

“Economic growth actually accelerated further in the 1990s, against a backdrop of rising tax rates,” Ashworth notes.

Taxes were rising as GDP grew in the late-90s. (Source: Capital Economics)

The concerns raised by Ashworth about the overstated benefits of lower tax rates are not the first we’ve heard. Back in February, we highlighted work from Ben Inker, head of GMO’s asset allocation team, which showed that U.S. corporate profits tend to fall when tax rates rise.

“While tax rates are currently at about their lowest levels and corporate profits just off of their highest, tax rates did their falling in the 1980s and the profit spike was a good 20 years later,” Inker wrote.

“Given that lag, it strains credibility to argue that the tax rate fall was an important driver of the rising profitability.” An increase in corporate profitability, and in turn business investment, is seen as the main driver of higher economic growth following tax cuts.

Others, including Warren Buffett and strategist Tom Lee, have both cast doubt on the idea that lower tax rates would necessarily provide a competitive advantage to either corporations or investors.

At the Berkshire Hathaway (BRK-A, BRK-B) annual meeting this year, Buffett said that “it’s certain that some of a lower corporate rate would be competed away.” Lee said at the Yahoo Finance All Markets Summit in February that at the single-stock level, lower tax rates are “very quickly discounted” by investors.

In an interview with The Economist this week, President Trump said he thinks the 3% growth the administration expects to follow a tax cut is “low.”

Myles Udland is a writer at Yahoo Finance. Follow him on Twitter @MylesUdland

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