As the U.S. economy shows increasing signs of recession, President Donald Trump has begun to toy with the idea of further tax cuts. But for the most part, cutting taxes won’t fix the problem at hand.
So far the idea of a payroll tax cut has garnered the most attention. America’s Social Security system imposes a 6.2% tax on both the employer and the worker. If that tax were lowered, the incentive to hire workers might be greater.
That logic is correct as far as it goes, but it is important to cut payroll taxes in exactly the right way. The inclination in American politics is to cut the payroll tax on the worker side, not the employer side. That is the opposite of what should be done.
In a recession, the usual problem is that too many people are seeking too few jobs. The reluctance lies on the side of the employer, not the worker. So cutting the taxes paid by the worker won’t help much. In contrast, cutting the taxes paid by the employer might at least boost the demand for workers and thus stimulate employment.
In the long run, according to economic theory, it does not matter whether you cut payroll taxes for workers or employers; eventually wages will adjust so that the true, tax-adjusted set of wage offers ends up the same. But for the purposes of fighting a near-term recession, it matters very much whose taxes are cut.
If you doubt the political tendency to cut payroll taxes on the worker side, recall that during the last recession, the federal government reduced workers’ payroll taxes from 6.2% to 4.2%. Today’s Democratic House would probably insist on the same.
An alternative argument for a payroll tax cut for workers is that it would put more spending money in people’s pockets. But if there is a recession soon, it probably won’t be because of inadequate consumer spending, which so far has remained robust. The real pressures are coming from the trade war, the possibility of a spreading international recession, policy uncertainty and weak investment behavior. More consumer spending doesn’t seem to be the priority. Furthermore, the last payroll tax cut did not prevent a slow recovery from that recession.
Note that if a payroll tax cut did stimulate more consumer spending, America’s trade deficit could well rise. That is not a problem from the point of view of this economist, but it would frustrate Trump and make the trade wars harder to win, especially for anyone who sees reducing the trade deficit as their goal.
What about indexing the capital gains tax to inflation, another proposal? That is probably a good idea. Even if you are “anti-capital” in your political orientation, it would be better to have inflation indexing, perhaps with a higher tax rate eventually. Still, it is not obvious this tax cut would help fight off a recession. It’s hard to know why investment has been sluggish in the U.S. economy, but the cut in the corporate tax rate in the 2017 tax reform law — from 35% to 21% — doesn’t seem to have helped, at least not in the short run.
In fact, a cut in the capital gains rate could hurt the economy if it is perceived as temporary and something a Democratic president could reverse. If the capital gains rate is temporarily low, the incentive is to sell stocks now rather than later, which could hurt the stock market and thus the economy.
The general lesson in all this is clear: Recessions are messy, complex phenomena, full of frustrated expectations, and they cannot easily be reversed by pushing on one or two levers. The hard truth is that, if there is a recession, it is probably not the kind of recession where tax cuts are going to make a big difference. Tax cuts should be evaluated on their own merits, and not seen as a solution to the short-term problems of the day.
What, then, can the federal government do to help mitigate or perhaps even avoid a recession? The answer may have more to do with trade than with taxes. Yes, the trade war with China is partly a geopolitical and foreign policy issue, and it needs to be evaluated on those terms. But all other trade wars should cease immediately. Doing so might actually help the U.S. win the trade war with China by bringing more allies to its side.
The best way to bring more certainty to the global economy, and thus reduce the risk of a recession in the U.S. and elsewhere, is for Trump to end all talk of tariffs and trade wars for economic reasons.
— Tyler Cowen is a Bloomberg columnist. He is a professor of economics at George Mason University.