Tax Cuts are Hardly Ever Self-Financing

US President Donald Trump has pre-announced a “big tax announcement” for Wednesday.

On the campaign trail, Trump talked about reducing the corporate income tax rate to 15%, and this is being touted as an element of the announcement.

Some cuts to household income tax rates, perhaps aimed at middle income earners, might also be forthcoming.

Cynics suggest Trump is pre-empting the “first 100 days” policy progress analysis that will flood the media in coming weeks.

Having failed to make progress on healthcare, and made little substantive progress on trade, he may see fiscal policy as the most promising “policy-flag” to plant before the 100 days is up.

Whatever the case, the US Dollar awaits the call with anticipation, as do stock markets.

"As Trump tells his aides to prepare for a 15% corporation tax, the big announcement tomorrow is being front run by markets, with the Nasdaq hitting 6000 for the first time today," says Joshua Mahony at IG.

Should Trump blow away market expectations expect the Dollar to rise, should be underwhelm then the Dollar could continue its 2017 journey lower.

The US has a Spending Problem

Standing in Donald Trump’s way is something that not even the finest in political spin can blow away - economic reality.

In particular, the fact that the US spends far more than it earns.

The Congressional Budget Office reports that, “at 77 percent of gross domestic product (GDP), federal debt held by the public is now at its highest level since shortly after World War II.”

Above: Are we in World War 3? The US debt pile suggests we are.

The CFO adds, “if current laws generally remained unchanged, the Congressional Budget Office projects, growing budget deficits would boost that debt sharply over the next 30 years; it would reach 150 percent of GDP in 2047. The prospect of such large and growing debt poses substantial risks for the nation and presents policymakers with significant challenges.”

The Tax Policy Center estimates that the proposed tax cuts from the new US administration would lower taxation revenues by USD6.2trn over 10 years which amounts to approximately 32% of current US GDP.

Taking into account added interest costs and macroeconomic effects, this estimate widens to USD7.0trn.

This is a whopping addition to the debt pile and unless it is financed it could bring US economic stability to its knees.

So the glaring questions is how will Donald Trump pay for what are incredibly expensive programmes?

Will the Official Line Work?

Donald Trump’s economic advisers, maintain a line of thinking that Trump’s tax reforms will generate more revenue than they cost and so become self-financing.

The team are using a “dynamic scoring” technique to suggest that tax cuts will largely pay for themselves through an expansion of economic growth.

They draw inspiration from supply-side economist Gerald Laffer, who said Trump’s policies would lead to economic ‘Nirvana’.

The idea is that the tax cuts stimulate so much growth that the economy pays for them itself.

But disagreement on this line of thought is widespread.

"We, and Congress, will most likely see this as wishful thinking. If it were that easy, everyone would do it. Though some positive effect on short-term growth is possible from tax cuts, this is likely to be inadequate to boost revenues to outweigh the costs," says Rob Carnell, Chief International Economist at ING Bank N.V. in London.

Analyst David Bloom at HSBC plc agrees saying it seems unlikely that tax cuts will be self-financing.

“While the market is still waiting in anticipation of fiscal changes, we believe aggressive tax cuts if implemented could lead to an eventual USD switch from cyclically positive to structurally negative," says Bloom in a note to clients dated April 24.

Experience from Ronald Regan’s presidency in which the same belief in tax cuts could be self-financing proves they were not in that case.

The government had to borrow massively to finance those tax cuts in the end creating a massive burden of debt for future generations to bear.

Indeed, many analysts believe the plans won’t get past congress.

“Rising deficits are anathema to large parts of the Republican Party, and unless paid for with some spending cuts elsewhere (closure of some loopholes, tinkering with Medicare etc.) it is hard to see how this will be accepted. In the end, it is Congress, not Trump that sets fiscal policy in concert with the Senate,” says Carnell.

ING reckon a meaningful change in the US tax code is not likely, in our view, before August.

“At best, this announcement will be a road-sign indicating the President’s preferred route of travel for Congress. At worst, it will make it harder for the Trump administration to agree a continuing resolution to keep government working once the current debt ceiling suspension expires on Friday,” says Carnell.

All signs then point to disappointment and a lower Dollar which would gel with the recently published US Dollar forecasts released by HSBC.