By Daniel Lacalle*
The dramatic economic decline due to the COVID-19 crisis and the unprecedented recovery spending plans approved by President Trump will drive the fiscal 2020 United States budget deficit to a record $3.8 trillion, or 18.7 percent of US gross domestic product, according to the Committee for a Responsible Federal Budget (CRFB). According to the same estimates, the fiscal 2021 deficit will reach $2.1 trillion and average $1.3 trillion through 2025 as the economy recovers from the impact of the forced shutdowns.
To finance this staggering fiscal effort, the Democratic Party leader, Joe Biden, is announcing a massive tax hike that will neither help the economy nor reduce the deficit.
The solution to the United States budget deficit is not more taxes. Even in the most optimistic receipt scenario, there is no tax hike program that would even start to address the structural deficit, estimated at $1 trillion a year, let alone the abovementioned estimates.
More taxes will hurt the recovery, damage job improvement potential, and reduce investment in the economy. More taxes mean less growth and no deficit improvement.
The Obama administration learned this lesson quickly and extended the Bush tax cuts in 2020, adding a new tax cut in 2013. Other misguided tax hikes in 2013 did nothing to reduce the debt and kept economic and job growth below potential.
A wealth tax, often pushed by the most extreme politicians in America, would not only provide exceedingly small revenues for the Treasury, it would generate more negatives than any improvement in tax receipts. There is a reason why almost every European nation has abandoned the wealth tax. The receipts are negligible and the negative impact on investment, attraction of capital, and job creation outweigh any revenue increase. The wealth tax revenue relative to GDP in the countries where it exists ranges between 0.07 percent in Finland to 0.22 percent in France. There is no way that a wealth tax would collect 1.4 percent of GDP as Senator Elizabeth Warren has estimated. A wealth tax in the United States would make no visible reduction in the existing deficit, let alone finance the trillions in entitlement spending that Biden has announced.
So, how can the United States reduce the deficit?
The US deficit is rising due to excessive spending increases, despite periods of rising tax receipts. The federal government’s revenue went up by 4 percent, to $3.46 trillion, in the 2019 fiscal year, according to the Congressional Budget Office (CBO) report. However, spending went up by more than 8 percent, to $4.45 trillion.
The rise in the 2019 deficit was not due to the “tax cuts.” If anything, the tax cuts helped the economy stay in expansion, creating jobs and increasing receipts at the same time. Corporate income taxes increased by $25 billion (+12 percent), while individual income and payroll taxes together rose by $107 billion (+4 percent). Overall, total receipts rose by 4 percent ($3.462 trillion in the 2019 fiscal year). Total receipts remained at 16.15 percent of GDP, which is the long-term trend figure and consistent with an economy that remained in expansion, with moderate growth.
The main problem is that total outlays rose by 8 percent (to $4.446 trillion), driven mostly by mandatory expenses in Social Security, Medicare, and Medicaid.
Those who say that the deficit would have been solved by eliminating the Trump tax cuts have a problem with mathematics. There is no way in which any form of revenue measure would have covered a $338 billion spending increase.
No serious economist can believe that keeping uncompetitive tax rates well above the OECD (Organisation for Economic Co-operation and Development) average would have generated more receipts. Furthermore, no serious economist can believe that eliminating the Trump tax cuts would have generated more than $300 billion of new and additional revenues.
Remember that corporate tax receipts had already fallen 1 percent in 2017 and 13 percent in 2016, before the Trump tax cuts. The operating profit recession was already evident. If anything, reducing the corporate rate helped companies recover, which in turn made total fiscal revenues rise by $13 billion to $3,328 billion in the 2018 fiscal year, according to the CBO.
The problem of the United States budget is mandatory spending.
Mandatory spending was $2 trillion out of $4.45 trillion in total outlays in fiscal year 2019, but it is projected to increase to $3.3 trillion. Even if discretionary spending stays flat, total outlays are estimated to increase significantly beyond any advance in tax revenues.
Printing money has not reduced deficits or debt. The Federal Reserve has increased its balance sheet to record highs, on its way to $10 trillion, and purchasing Treasurys has only driven governments to continue to spend above budget and the trend of receipts.
Furthermore, if proponents of massive money printing tell us that deficits do not matter and that the United States government should spend all it needs because the Fed will acquire all the debt, then there is no need for higher taxes, is there? In fact, if modern monetary theory (MMT) proponents are right, taxes should be cut and deficits monetized to drive the recovery.
The problem is that the magic money tree does not exist. Monetary policy is only disguising a structural and dangerous spending problem, and this reckless behavior can only be maintained if the US dollar remains the world reserve currency. Therefore, not only is there a limit to how much can the Fed print, there is also a risk that if governments do not reduce spending the US may lose its world reserve currency status.
Consequently, the only solution for America to reduce debt is to cut spending and entitlements.
Any politician should understand that it is simply impossible to collect an additional $3 trillion per year over and above the existing receipts. They should also understand that the trust in the US dollar may collapse if deficits continue to balloon.
It is completely impossible to double the receipts of a growth year like 2019 with higher taxes. Higher taxes will only wreck an already weak economy and delay the recovery. And it is completely impossible to reduce deficits by printing money. Governments will only increase spending if they can monetize it at the expense of real wages and savings.
Believing that the deficit can be reduced by massively hiking taxes is not understanding the US economy and the global situation. It would lead to job destruction, corporate relocation to other countries, and lower investment. Believing that the deficit will be reduced by printing money is not understanding the perverse incentives of governments.
The proof that the US problem is a spending one is that even those who propose massive tax hikes are not expecting to meaningfully cut the deficit, even less so to reduce the debt. That is why they add massive money printing to their magic solutions. It will not work either. And this reckless policy may destroy the US dollar’s reserve status.
Debt matters, even if interest rates are low. Increasing debt and spending means lower growth and weaker real wages in the future.
Originally published at dlacalle.com.
*About the author: Daniel Lacalle, PhD, economist and fund manager, is the author of the bestselling books Freedom or Equality (2020), Escape from the Central Bank Trap (2017), The Energy World Is Flat (2015), and Life in the Financial Markets (2014). He is a professor of global economy at IE Business School in Madrid.