Understanding tax reform, debt, and the economy

Last month the White House released guidance on how it would like to reform the federal tax code, and since then reviews have been predictably mixed. Often these evaluations have fallen squarely along party lines, which can make it difficult to form an objective opinion. To make things a little easier, here are some of the most important things to consider when evaluating attempts at tax reform over the months ahead.

There are essentially four criteria across which all tax reform plans should be judged. The first three have to do with how taxes are collected, and the fourth concerns how much are collected. Tax reform should aim to make the tax code simpler, more transparent, and more equitable. President Trump's proposal undoubtedly makes the tax code simpler and more transparent, though the jury is still out on equity until more details can be provided.

Thus the real concern among most critics of the plan comes when we consider the fourth measure, the plan's cost. Based on similar proposals put forward in the past, the plan could cost several trillion dollars when all is said and done.

Different reviews of the tax plan as a whole largely stem from one's viewpoint on this single issue, making it important to understand the arguments on both sides. To some, it's a way to put money back into the pockets of consumers and businesses who will then spend and invest more into our economy. To others, it's a giveaway of money we don't have that will cause us to run up the national debt and/or eliminate important government programs that help our economy grow.

The most confusing thing about this issue is that both groups are right, but how can this be?

First, let's establish the fact that cutting taxes by several trillion dollars would undoubtedly increase economic growth. You'd be hard-pressed to find a reputable economist who would dispute that point. Tax cuts are always a key piece of any economic stimulus package because they very quickly put more money back into people's pockets by not taking it out in the first place.

The only real problem with putting several trillion dollars back into the pockets of individuals and businesses is that the government subsequently has several trillion dollars less in revenue. When the government has several trillion dollars less in revenue, it has two options:

Spend less, or borrow more.

Governments in general, and especially ours, are not very good at spending less money. This is because it often results in very difficult political choices, especially when we decide to take the largest pieces of the budget — health care, Social Security, and other mandatory programs — off the table. On the other hand, governments are very good at borrowing money. Borrowing makes those tough spending decisions a lot easier, but it also comes with a cost.

Anyone who's ever applied for a credit card knows that the higher your debt as a share of your income the less creditworthy you are generally determined to be. The less creditworthy you are, the higher your interest rate. In the government's case this boils down to the national debt as a share of the economy, or GDP. As our government borrows more as a share of the economy, its interest rate, in this case the interest rate on Treasury bonds, will eventually go up.

Higher interest rates have an economic cost for all of us, making everything from credit card bills to business loans more expensive. This negative impact can crowd out the positives from lower taxes. The key to the whole economic debate over the president's tax proposal is whether or not the economic drag from higher debt is large enough to completely crowd out the boost from lowering taxes.

This also makes the timeline for evaluating a tax plan very important. If you look at the economic impact of tax cuts over a few years you'll almost always see a positive return. However, beyond a few years, as the amount of money being borrowed begins to pile up and push interest rates higher, the overall impacts can turn decidedly negative. That's why one group of people can tell you that a tax plan will boost the economy (over three years), and another can tell you that it will harm the economy (over 10 years), and both be correct.

By what degree interest rates will rise because of the tax plan is not clear. Traditional economic theory says that, all else equal, the relationship between interest rates and government debt should be quite strong, but we know that in reality all is not necessarily equal.

Higher interest rates will only occur if investors demand them in response to treasury bonds becoming more risky. It's not clear that investors would do so, even at today's high debt levels. The U.S. government's debt is literally called "risk-free," and so the reaction by investors to a higher level of debt may not be as strong as theory would otherwise indicate.

This is one of the main arguments from proponents of the tax plan, and in fact is an argument that many economists opposed to the tax plan used to advocate for more government spending during the Obama administration. In the last eight years under President Barack Obama, for example, we essentially doubled the national debt, and saw no discernible movement in our borrowing costs as a result.

This argument holds a lot of weight, but comes with a big caveat. Eight years ago we were operating at a much lower overall debt level than we are today. President Trump has been dealt a very bad hand when it comes to the federal fiscal situation. No president has inherited more debt upon taking the oath of office since Harry Truman, and in some ways Trump's predicament is actually worse than Truman's.

Truman's war debt was temporary, Trump's structural debt is not. This is debt that has built up over years of structural imbalances and several presidents, and it is not going to go away on its own. In fact, looking at projections released by the nonpartisan Congressional Budget Office before Trump was even elected, things are only expected to get worse.

If the president were to make no changes to federal fiscal policy, by the end of his first term 92 cents out of every federal tax dollar would be earmarked for mandatory spending programs — Medicaid, Medicare, Social Security, etc. — and interest on the debt. Without borrowing, this leaves only 8 cents for everything else in the budget, from aircraft carriers to Zion National Park.

On that trajectory, within 30 years, our debt will build up to almost 1½ times the size of our entire economy. That would definitely crowd out economic growth whether we pass a major tax cut or not.

In order for our economy to be more efficient and productive in the years ahead, tax reform is an absolute imperative. However, the hand we've dealt ourselves will require that reform not significantly add to the national debt. In the end, as much as the American public may want a big tax cut, the fiscal realities of today demand revenue-neutral tax reform. Fortunately, the White House tax-proposal outline provides a lot of room to maneuver in forthcoming negotiations with Congress to do so.

Dan White is a director at Moody's Analytics in West Chester and an adjunct professor of economics at Villanova University. Daniel.White@moodys.com