President Trump and his top economic advisers often argue that a major tax reform would permanently boost the nation’s economic growth rate to 3 percent per year or higher, a significant increase from the roughly 2 percent annual growth rate of recent years. But this argument misstates a subtle but important point: Tax reform is more likely to have an effect on the level of economic activity than its rate of growth.
In other words, even the most optimal version of tax reform is likely to result in a one-time increase in output rather than an ongoing year-after-year hike in the pace of growth of economic activity.
To understand why, imagine an ideal reform that lowers marginal tax rates, taxes different types of economic activity similarly, and reduces deductions and credits--all while raising roughly the same amount of revenue as current law.
Such a reform could benefit the economy in multiple ways. Lower marginal rates on wages could encourage work and expand the labor supply. Lower marginal rates on profits and investment income could encourage saving, boost investment, and expand the stock of productive capital. And equalizing tax rates on different types of economic activity would allow market forces to allocate capital more efficiently, increasing the level of labor productivity.
These changes all may raise the level of output in the long run. And, for a while, the path to the new, higher level of output does imply a higher growth rate. But once economic activity reaches its new level, the growth rate will revert to its pre-reform long-term trend.
This is true for each of the three major ways that tax reform can boost the economy.
Suppose that reform reduced marginal tax rates while broadening the income tax base. Lower marginal rates on labor income would increase after-tax wages, encouraging some workers to put in longer hours and inspiring others to enter the labor force. Because it takes time for people to adjust the amount of work they do, it would take a few years for the economy to feel the full impact of the change. During that time the growth rate would be temporarily higher, but once the labor market adjusts to the new level of labor supply, economic growth would revert to its long-term potential rate.
Similarly, equalizing treatment of different economic activities by eliminating industry-specific incentives in the tax code can result in a more efficient allocation of capital investment. Here’s an example: Because investment in residential housing currently is taxed more favorably than physical capital in many other industries, investment in housing is higher than the level that would maximize economic output. If reform limits the mortgage interest deduction and lowers corporate tax rates, investment in factories, machinery, and information systems should rise and investment in residential housing should fall.
As the mix of capital becomes more productive, the rate of economic growth would rise. However, once the allocation of capital reaches its new equilibrium, the pace of economic growth would fall to its potential rate, as if the policy change had never been made.
The story would be similar if Congress reduced marginal tax rates on capital income such as interest, profits, dividends, and capital gains while eliminating tax expenditures elsewhere in the tax code. This would increase the after-tax returns that households earn on their savings. In response, households would save more and make more funds available for investment. With higher investment, the capital stock—and therefore output—would grow faster for a period of time
But, even in this case, the higher economic growth rate would not persist indefinitely. As the capital stock expands, so does depreciation—the normal wear and tear on machinery and other capital goods—because there is more capital experiencing the rate of decline. That means that over time, a greater and greater portion of total capital investment goes to replacing worn out equipment rather than further expanding the stock of plant and equipment.
Eventually, the capital stock reaches a new equilibrium level relative to output, with the increased amount of investment offset by additional depreciation. Output will be permanently higher than its baseline level, but the rate of economic growth will be the same as if Congress had never cut tax rates on investment income.
It is true that technological progress can boost the long-term rate of economic growth. New inventions and production processes—which economists call total factor productivity or TFP—make it possible for a given amount of labor and capital to produce greater output.
Tax policy could encourage this innovation, but because the sources of TFP growth are not well understood, it is hard to know which policies to reform. Since we know so little about this relationship, few economic models try to incorporate a permanent impact of policy on the rate of TFP growth.
So, when you hear advocates claim that tax reform will result in an increase in the rate of economic growth, remember that they really mean it could raise the level. It is important to keep in mind that these two concepts are not the same.
