Will tax cuts favoring the wealthy cause an increase in economic growth?

Depending on the state of the economy, tax cuts that further concentrate income and wealth by primarily benefiting the affluent could either promote or inhibit an increase in economic activity.

To determine which path is most likely to transpire, one would need to understand the answers to the following three questions.

1.  Is desired investment greater than actual investment?  In other words, is a lack of funding specifically preventing the private sector on aggregate from boosting capital expenditure to their desired levels?

2.  Will tax cuts for the (super) wealthy be funded via higher taxes or spending cuts that predominately fall on the middle class and poor or will they be funded by greater treasury issuance?

3.  Will monetary policy seek to offset the effects of fiscal expansion?  How would financial markets react in response to the Fed?

1.) Has capital expenditure disappointed because of a lack of funding?

Michael Pettis puts it best (emphasis mine):

In order to understand the conditions under which supply-side tax cuts for the wealthy will lead to more growth or greater unemployment, we must make a distinction between actual investment and desired investment. Actual investment, as its name implies, consists simply of the current investment level, that is, all the investment projects that are being funded. 

By contrast, desired investment consists of investment projects that have not been funded because capital is not available to fund them. The key here is the availability of funding, and whether or not savings are scarce. There are many potential projects in the world for which injections of investment capital would benefit these economies. This would raise productivity levels by more than the cost of funding such investment, in which case these projects would be wealth-creating and net positive ventures for these economies 

If these projects have not been implemented because savings are scarce and capital is not available to fund them at a reasonable cost, they form part of desired investment.

If firms expect to have difficulty meeting an increase in demand from their customers, after considering possible forecast errors,  boosting capital expenditure is one way for corporations on aggregate to capture greater future revenues.  As business investment must be financed, firms do so via bank loans, by issuing debt or equity into the capital markets, or by retaining earnings.  Even pools of financial assets that are perceived to be "trapped" in lower tax countries can be leveraged partially through the derivatives market to finance domestic investment.

It has been widely observed that private sector investment has been subdued following the Great Recession.  Despite rebounding after the worst of the downturn, gross private domestic investment spending relative to the size of the economy is still below levels found in prior expansions.  In fact, as a percentage of GDP, gross investment remains at levels consistent with the lows of the 2000-2002 recession.

With that said, given near record high pre- and post-tax corporate earnings, elevated equity valuations, and cyclically low corporate credit spreads, it is far from obvious that a lack of funding is causing anemic gross private investment.

Moreover, a scenario where firms aggressively competing for funding/credit would be more consist with rising long-term treasury bond yields and a widening treasury yield curve as growth and/or inflation expectations improve.  On the contrary, in the post-crisis period firms have been unable to satiate the drive by global financial participants to accumulate financial securities.  Their inability to do so has in part led economic observers to wonder whether the developed world is exhibiting symptoms of secular stagnation, the condition where the propensity to save is chronically in excess of planned investment ("search for yield").  Therefore if businesses are easily able to meet their funding needs, what is causing deficient investment?

As is evident from total industry capacity utilization rates, an ongoing lack of inflationary pressures, and weak wage growth, their still appears to be room for firms to expand production to satisfy expected aggregate demand without having to resort to spending on capital.  Simply put, firms are meeting the needs of their customers with the economy's existing productive capacity. This suggests that the lack of gross investment is a byproduct of deficient aggregate demand (total sales), not supply side or funding constraints.  On this count, tax cuts skewed toward corporations and their shareholders are unlikely to produce a large enough ongoing response in private investment to justify them in the first place.  A better way to force firms to invest to a much greater degree is to overwhelm them with sales (revenues) by augment the after-tax incomes and wealth of their customers.

Also see You’re the Real Job Creator, An interview with Stephanie Kelton:

Remember a few weeks ago when John Bussey from the Wall Street Journal asked that room full of CEOs how many of them intended to create new jobs with money they’d save from the tax cuts, and only a handful raised their hands? Gary Cohn, Trump’s economic adviser, was embarrassed. He said, “Why aren’t the other hands up?” Well, the answer is that businesses don’t hire when profits go up, they hire when sales go up. That’s what drives hiring and investment. Businesses do not want to hire; the last thing they want to do is put another employee on payroll, train them, and provide them with health care. You have to make them hire. You have to swamp them with customers and create such strong demand for their product that they have no choice but to add staff.

2.) Treasury issuance (larger deficits) or spending cuts/taxes elsewhere?

Seeing as global financial market conditions have enabled the US corporate private sector to finance the existing pace of private investment with very little issue, tax cuts favoring them and their shareholders are only likely to produce modest gains in economic growth over time.  However, should the Trump administration seek to balance tax cuts by raising taxes or cutting government spending on households with the highest marginal propensities to consume (the middle class and poor), this could easily undermine any growth effects.

To understand why, let's return to Pettis:

If desired investment is in line with actual investment, however, the higher ex ante savings of the wealthy does not lead to greater productivity, more growth, or increased wealth eventually trickling down to all households. It can temporarily lead to no change in GDP as long as nonproductive investment rises (mainly in the form of inventory) or increases in debt-fueled consumption keeps total consumption unchanged. But either way, GDP can only be maintained with an unsustainable rise in the debt burden and, over the longer term, GDP growth must drop.

It goes without saying that raising taxes or cutting spending on middle class and poor households reduces their post-tax incomes after government transfers.  Since these households predominantly spend a greater percentage of their marginal income/wealth, to avoid a drop in overall consumption spending that dampens GDP growth, the following must occur:

1. Households must finance a greater portion of their spending by using credit (issuing debt). 
2. Firms must raise the pre-tax pay of such households to cancel out their higher tax burden and fall in transfer income.
3. Corporations must increase productive capital expenditure enough to counteract any drop in aggregate consumption spending.  Should this investment become nonproductive in the form of unplanned inventories, firms must refrain from firing redundant workers.

Option #1 implies a rising household debt burden as debt-to-income ratios climb.  Options #2 and #3 are consistent with trickle down theory where greater private investment results in lower unemployment and higher wages.  Option #1 and a potential rise in unplanned inventories in option #3 are both temporary.  When financial institutions and markets begin to question whether the household sector can meet their obligations, households are forced to cut their consumption spending once credit becomes scarce.  This easily can become a reflexive scenario where households are unable to negate cuts to their after-tax and transfer incomes by using credit.  As households on aggregate are forced to cut their spending, businesses begin to experience sales disappointments that lead to unplanned inventories.  A prolonged period of elevated inventories incentivize firms to fire workers.  Deteriorating employment, weak wage growth, disappointing corporate sales, elevated inventory levels, cause the risk-adjusted returns on potential investments to fall and with it both desired and actual gross investment to decline.

Therefore, it's imperative that the government finance a tax cut favoring the upper-class by issuing treasuries or firms must increase spending on investment, wages, and hiring.  Ironically, should the government attempt to aggressively raise revenue by cutting government spending or raising taxes elsewhere and firms are unwilling to boost investment, then slower growth and higher unemployment would likely cause government ex-post debt/GDP ratios to soar.  Therefore, either private investment must balance any decline in household consumption or household/public debt ratios must rise.*

In the current economic backdrop where the corporate private sector is easily able to meet their investment needs, rather than redistribute income from poor and middle class households to the wealthy, it would arguably be preferable to do the opposite.

Back to Pettis:

In that case, rather than implement tax cuts for the wealthy or other policies that increase income inequality, the economy is better off with the reverse. If wealth is transferred from wealthy households to ordinary and poor ones, either consumption will rise without a corresponding reduction in investment because unemployed workers will be put back to work, or consumption will remain constant but it will no longer be fueled by a rise in the debt burden. Either GDP growth rises and wealth actually trickles up, in other words, or it is maintained without a corresponding rise in the debt burden. 

By the way, it is important not to ignore the impact of higher consumption on investment. As consumption rises, it turns out that desired investment will rise too, as businesses must produce more goods and services to satisfy higher demand for their products. In that case, GDP growth will rise even more as the increase in GDP is not wholly driven by an increase in consumption. As the income of ordinary and poor households rises, in other words, part of this will be diverted to more consumption, but part of it also will be diverted to more investment, which in turn will increase productivity.

Again, if the goal is to force private corporations to increase investment, hire workers, and raise wages, the solution is to improve their customers after-tax incomes by reducing their tax burden.

3.)  Monetary Offset?

Ideally, reducing corporate and individual tax rates (net of cuts to government transfers or higher taxes elsewhere) works to spur investment and consumption spending thereby result in lower unemployment and higher wages as the economy produces near its full potential.  As this occurs, market participants begin to price in improving future corporate cash flows due to a higher expected growth path of nominal and real GDP.  Elevating risky asset prices and narrower credit spreads would not only confirm the optimistic beliefs of market participants but also shape the course of events (See Farmer and Soros).  In short, a lower private sector tax burden sets off a positive feedback loop where higher anticipated aggregate growth and employment are a cause and consequence of advancing asset prices that raise the value of after-tax wealth.  Insofar as the latter brings stability to collateral values, this feedback loop also fortifies household balance sheets which in turn adds fuel to economic activity.

On the other hand, tax cuts that successfully boost aggregate demand and employment will also likely lead to higher expected inflation.  This will provoke market participants to anticipate a tighter monetary stance than they previously priced in.  Therefore, a less accommodative monetary stance may counterattack looser fiscal policy unless the central bank communicates an adjustment to their perceived reaction function.  Rather than set off a positive feedback loop, tax cuts may cause short-term rates to rise and asset price appreciation to be less than what would have been the case absent a monetary offset.  Unlike the rosier scenario, the positives associated with a lower private sector tax burden are blunted by collateral values, net worth, and borrowing costs that may not be substantially affected (or worse) due to monetary policy expectations.

Seeing as the Fed has been less accommodative despite routinely missing their inflation target throughout the bulk of the recovery, it's unlikely that the Fed would react favorably to growth-induced tax cuts that produce "too low" unemployment or push inflation toward their 2% objective.  Without a much faster pace of nominal GDP pushing up the long end of the treasury yield curve, the curve is much more likely to continue flattening.  Although it would be preferable for the Fed to resist additional policy rate hikes until long-term treasury rates price in further improvement in growth and inflation trends by moving higher, it does not appear as if the Fed will waver from their current pace of tightening.  At this point, it would presumably take a financial market shock to force the Fed to deviate too far from their current plan.

Either way tax cuts are likely to produce at best only a modestly positive economic effect.  At worst, should the yield curve invert due to the Fed's actions and market participants begin to fear the possibility of an impending slowdown, the Trump tax cuts may actually precede slower economic growth in the years to come even if they are not the cause  (post hoc ergo propter hoc fallacy).  Thus even in the best case, the Fed must comply in order for the Trump tax cuts to have their intended consequence.  Ironically, the Republican mantra especially since 2008 has been that fiscal deficits, a looser Fed, and a depreciation in the dollar exchange value are to be avoided.  Yet this combination is precisely what is required for the Trump tax plan to have its biggest chance of success.

To summarize:

1.  Rather than favor tax cuts that specifically bolster the fortunes of the already (super) wealthy, reducing the tax burden of middle class and poor households would much more likely cause nominal and real economic activity to be greater than it otherwise would be.

2.  Financing tax rate reductions that overwhelmingly benefit the highest income earners that own most of the net wealth by cutting spending on programs that favor the middle class and poor is a form of upward redistribution that may result in slower economic growth than what would have been.  In order for the tax reductions to have a positive effect, such spending cuts should be avoided at all costs.

3. Given the Fed's current reaction function, it is more probably than not that the central bank will seek to offset a looser fiscal stance that leads to "too low" unemployment and inflation nearing their 2% target (ceiling).  Should monetary policy become too tight where employment gains and wage growth disappoint (disproportionally affecting labor income dependent households), this combined with tax cuts favoring the rich is more likely to upwardly redistribute wealth and income in a way that does not materially improve economic activity.*

4.  On the other hand if the Fed communicates that they are willing to accommodate a looser fiscal stance, the Trump tax cuts should be positive for nominal growth.  Under such a scenario, employment and labor force participation rates (especially for prime age workers) may very well rise to levels once thought of as unrealistic/unsustainable.  Although the tax plan could have been constructed in a more evenly distributed manner by not being so skewed towards the wealthy, lower unemployment would unquestionably benefit the middle and lower classes. 



*The FT Alphaville post, Is “growing the pie” overrated, and does that explain why everything is terrible?, makes the hugely important point that shifts in fiscal policy seem to minimally improve the growth rate of the overall economy but have outsized distributional impacts.

In advanced economies a lexicographic framework that focuses exclusively on distributional analysis and then only to growth when the distribution of different policies is the same is generally likely to be appropriate under a broad range of social welfare functions. This is because the distributional effects of many policies are orders of magnitudes larger than the growth effects.

Should this prove to be the case with the Trump tax cuts, it's far more likely that the policy will increase the share of aggregate income flowing to the wealthy while only marginally influencing the overall size of the economy.