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Trump: Debt or Taxes?

By James H. Nolt

Last week, I considered whether Trump will use an unprecedented degree of trade protectionism, as he promised on the campaign trail. House Speaker Paul Ryan, who is likely to lead the opposition to protectionism, proposed an alternative interpretation of Trump’s “fair trade” promises. He suggested that what Trump and Congress will implement is not old-fashioned protectionism using tariffs, but tax and regulatory reform to reduce the costs of business investment in the U.S. and thereby promote job growth.

Deep cuts in corporate taxes, as Trump proposed during the campaign, might make it more tempting for companies to move investments back to America. However, what is important is not nominal tax rates, but effective ones. Many U.S. companies that invested abroad are already paying little or no corporate taxes. Apple’s recent problems with the European Union over its tax breaks in Ireland is a case in point. Many large companies like Apple are able to win special tax concessions by inducing dozens of potential investment destinations to compete for their business. If a U.S. company is operating at very low tax rates, even reducing U.S. corporate profit tax rates to 15 percent may not bring them home.

If Trump does as he suggested during the campaign, he might try to use both the carrot of tax concessions and the stick of potential tariff increases to induce companies to manufacture in the U.S. rather than abroad. The problem is that tariffs might have perverse effects if they are not deemed by businesses to be permanent and unavoidable. If there is a chance Congress, or a new president in 2020, might reverse any such tariff increases, businesses have an incentive to drag their feet rather than invest. Protectionism will not bring jobs home if businesses believe the U.S. market will open again in the near future.

Tariff threats are counterproductive because many companies now have global supply chains. They depend on efficient production of imports. Most companies also do not sell only in the U.S., but worldwide. Therefore, if Trump were to threaten significant increases in arbitrary and unpredictable protection, rather than return to the U.S., manufacturers will relocate to countries that have more favorable conditions. Companies will be drawn to nations that do not suffer tariffs on imports from third countries or on exports to the U.S., such as Ireland, Singapore, or Israel. In this globalist economy, protectionism risks causing capital flight from the U.S, rather than bringing jobs back home. These protectionist policies could cause a recession rather than job growth.

Selective tariffs punish specific countries, such as China, but as I said last week, this might just induce those countries to retaliate against U.S. exports rather than return jobs. Recently, China has suggested that Apple might be targeted by Chinese tariffs on the iPhone if the U.S. charges anti-dumping tariffs on Chinese exports, such as steel. Such tit-for-tat trade wars would result in further job losses in the U.S.

If, as Paul Ryan would prefer, incentives are focused on tax cuts rather than tariff increases, that creates another set of problems in a world where debt levels are already quite high and growth is sluggish. Governments have two ways to secure revenue: taxing or borrowing. Business usually prefers the government to borrow because whereas taxes reduce their available capital, borrowing allows them to conserve capital and get paid interest for their extra funds. Government borrowing is mostly done using bonds. If a government sells $1 million worth of bonds to a corporation, in lieu of $1 million in taxes, the company has not lost any capital. The bond itself is a valuable asset that can either be retained as part of the company’s capital reserves or sold to another investor to raise cash. Furthermore, the company is paid interest by the government while it holds the bond. On the other hand, it gets no immediate, tangible returns for paying taxes.

While the government gets new funds equally well from borrowing or taxing, debts add an interest payment to the government’s spending obligations. Debts must eventually be either repaid or refinanced, whereas taxes add no such burden to the government. Consequently, governments and the tax-paying public ought to prefer government programs funded by taxes rather than debt.

Traditionally, conservatives believed that governments should balance their budgets, borrowing only during exceptional circumstances, such as major wars, and paying down debt during peacetime. Many state and local governments in the U.S. still have constitutional provisions requiring balanced budgets. Since Ronald Reagan, however, conservatives have succumbed to the amazing political virtues of borrow and spend, practices that they once criticized liberals for indulging. If funds are borrowed, taxpayers enjoy the benefits of the resulting spending without immediately bearing the costs in the form of higher taxes. Meanwhile, government debt balloons upward, even during peacetime.

Borrowing is especially tempting now because worldwide interest rates are near the lowest they have ever been in history. Since the cost of borrowing is so low, there is greater incentive to borrow rather than tax. I expect that the Trump administration will resort to massive borrowing to pay for its generous tax cuts to corporations and the rich while at the same time increasing military and infrastructure spending as promised. Will all this borrowing and spending jump start growth?

The mere replacement of taxes with borrowing does not in itself create growth. Consider a thought experiment: If taxes on the rich are cut by $1 trillion, but the government increases its borrowing by a little more than $1 trillion (to include the cost of interest), who buys these new bonds? Roughly speaking, it is the same rich people who just got the tax cut. There is not necessarily any new spending or job-creating investment if rich people trade taxes for government bonds. There is only a bigger future burden on the taxpayer in the form of rising debt and increased income for rich people in the form of interest payments by the bonds they now own. The rich are better off. The taxpaying public and the government are worse off. This seems to be the likely course of action for Trump and the Republican Congress.

If government spending does increase, this does tend to have a stimulatory effect. For example, increased infrastructure spending to fix roads and bridges will increase jobs for construction workers. Increased spending on the military will add new jobs at shipyards and for other defense contractors, but this could also be paid for by higher taxes on the rich, as Hillary Clinton had proposed, rather than by selling more bonds to the rich, as the Republicans are more likely to do.

Piling up more and more government debt also redistributes power over the budget from the voters and politicians to the bondholders, i.e., the creditors. It makes it increasingly likely that we could have a disastrous debt crisis in the near future as creditors become bearish to uphold the value of their bonds and loans. The impact of debt on private power is a subject economics textbooks neglect. I will discuss more about this next week.

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James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.

[Photo courtesy of Chris Tolworthy]

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