Tuesday, December 12, 2017

What Happens if the Tax Bill Is a Revenue Disaster?



CreditAl Drago for The New York Times

Jonathan Chait raises a good point, which many of us were already thinking about: for all the debate about whether the tax bill will partially pay for itself, it’s actually more likely that it will end up worsening the deficit by far more than most estimates suggest. The reason is simple: the bill is junk, hastily drafted and full of exploitable loopholes. Once the tax lawyers and accountants get to work, they will probably find ways for their clients to avoid hundreds of billions in taxes that even the JCT estimates still assume will be paid.
Suppose this is indeed what happens. I’ve been trying to think through the next step: What effect will a ballooning deficit have on markets and the political climate?
When it comes to markets, my conclusion is, not much. The tax bill might lead to somewhat higher interest rates, but probably not to an interest rate spike. Why not?
You might think that I’m making the same argument I was making during the aftermath of the financial crisis, when I argued repeatedly – and correctly – against predictions that budget deficits would lead to soaring rates. But my reasoning now is different, because both the underlying economic situation and the source of the deficits is different.
Back in 2009-10, we had a deeply depressed economy with monetary policy at the zero lower bound, which meant basically that desired saving exceeded desired investment. So government borrowing wasn’t competing with the private sector for a limited supply of funds, it was giving idle potential saving a place to go.
These days we’re much closer to full employment, and the Fed is gradually raising rates, so it’s an entirely different situation. But if you want to claim that deficits will drastically raise rates, you need to spell out the channel; and I think that channel would be largely blocked.
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First of all, the U.S. isn’t going to go bankrupt; it can’t run out of money to pay its bills (except for political holdups), because it can print money. And we’re a long way from the kind of situation in which America would become so dependent on the printing press that we’re looking at potential hyperinflation.
What this means is that monetary policy – basically, short-term interest rates — will be set by the Fed based on economic conditions. And long-term interest rates will, to a first approximation, be the average of expected future short rates, so they too will reflect expected economic conditions.
So the only way big deficits could drive up rates would be if they gave a big boost to demand, threatening to overheat the economy, and causing the Fed to raise rates to avert that overheating.
Which means that the market impact of deficits depends on how much we think these deficits will raise demand. And the answer is, probably not all that much – if you think of the tax bill as a form of demand stimulus, it’s a very ineffective one, and the piece of the deficit that comes from gaming incompetent legislation will be especially ineffective.
For one thing, the bulk of the gains will go to the rich, who probably spend less of a marginal dollar. And this will be especially true for rich people receiving what they suspect will be transient income gains.
So, imagine yourself as a wealthy, liquid taxpayer experiencing a surge in after-tax income because your accountant has found clever ways to exploit the idiocy of new legislation. It will be fun and lucrative, but you’d have to suspect that the fun will end eventually – that even this GOP, with this leadership, will eventually close the most outrageous loopholes. So we might see big deficits that have relatively little real effect, because the winners from system-gaming save most of their gains.
Notice, by the way, that this isn’t the conclusion I’d like to reach on political grounds. Given how terrible this bill is, I’d like to claim that it will lead to immediate market disaster. But I try not to engage in motivated reasoning (although sometimes I give in to temptation, then apologize); and I just don’t see a market disaster even if we see the expected epidemic of tax avoidance.
What about the politics? OK, here I don’t have a clear model, so this is much more speculative. Still, what happens if the deficit balloons, and it’s clear that gaming of the tax bill is a major factor?
We know what Ryan and McConnell will try to do: they’ll try to use deficits as an excuse to cut safety-net programs. But will they be able to get away with this with the memory of the tax scam still fresh in everyone’s memory? I’m pretty cynical about centrists and the propensity of the media to be taken in by charlatans, but I think this would probably be a bait and switch too far.
Put it this way: Republicans would surely use big deficits as an excuse to propose big cuts in social programs, but they’d face a barrage of hostile media coverage, plus lots of public demonstrations as in the case of health care, all reminding everyone that these deficits were created by their own dishonest promises just a few months earlier.
And imagine, as we should, that all of this would go along with many front-page stories about dubious business types abusing the new loopholes. Doesn’t this sound like a political disaster for the GOP?
They could, of course, simply ignore the deficit and leave Medicare alone. But my guess is that they won’t be able to help themselves, that they’ll be prisoners of their own rhetoric even as the most unpopular legislation in history becomes pure political poison.
So that’s my prediction: minor market impact, but quite probably a political disaster for the GOP as it becomes even clearer that their tax policies reward scammers.
Of course, all this may be overshadowed by constitutional crisis. But that’s for another essay.
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