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Tax Reform and the Deficit

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James Kleckly

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By James W. Kleckley

Sunday, October 22, 2017

Much of the current debate about the proposed tax reform legislation has centered on the distributional effect of this tax law. Whose taxes will be cut the most? The wealthy? The middle class? Corporations?

We really do not have an adequate answer, as the devil is in the details and the details have not been developed.

Most people would like to see their taxes go down, but most of us demand the benefits of taxation — from roads and bridges to national defense. In reality taxes are necessary to pay for current services or to make payments on debt.

The debate should center on determining our collective level of need and the level of funds necessary to finance these demands (plus repayments for borrowing). History shows that the United States has not done a good job at making this balanced decision. After all, our national debt is more than 20 trillion dollars and climbing.

Tax reform is a fiscal tool that can be used to grow or contract the economy. Tax law changes also affect the nation’s deficit when expenditures exceed revenues.

Most economists think that the proposed tax cuts would stimulate growth, but are unsure about how much.

The effect on the deficit is not clear. The “supply-side” proponents of the proposed legislation argue that economic growth will accelerate, tax revenues will increase, and the deficit will fall. Others argue that the effect on the economy from lower tax rates will be positive, but not positive enough to stop the deficit from climbing. Still others worry that the deficit will increase dramatically, regardless of the effect on the economy.

If the economy is close to full employment we should probably question the necessity of a tax change. If we stimulate too much, inflation will rise. If inflation rises too much, interest rate increases will follow. Higher interest rates would help savers (i.e., more interest for your savings account), but borrowers would pay more (i.e., mortgage rates and credit card interest would rise).

In late 2016 the Peterson Foundation showed how interest costs on the U.S. debt will become the third largest category in the federal budget by 2028 behind Social Security and Medicare. One can only imagine this relative ranking if tax changes allowed the deficit to haphazardly increase during a time of rising interest rates.

In fact we are close to full employment. The most recent number of continuing claims for unemployment insurance was lower than any time in the past 30 years. The three month average for total job openings is the highest ever recorded and the unemployment rate for September stood at 4.2 percent. This level of unemployment is the lowest monthly rate in nearly 17 years.

The economy also has been growing steadily since the end of the 2007-09 recession. The number of non-farm jobs, which stood at 146.7 million in September, was at an all-time high in August. While the September total dropped slightly from the August record, largely due to the impact of Hurricanes Harvey and Irma, employment growth should resume in October. The nation should gain approximately 2 million jobs in 2017, thereby realizing positive job growth for the eighth straight year.

Let us hope that the legislators in DC are careful about changing tax policy. It is not just about lowering taxes. If they get it wrong the long term effect on the U.S. economy could be damaging and the negative effect on our nation’s debt could be dramatic.

James W. Kleckley, is the director of the Bureau of Business Research in the College of Business at East Carolina University.

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