Paul Krugman: The Tax Foundation Has Some Explaining To Do

I’m hearing from various sources that the Tax Foundation’s assessment of the Senate plan, which purports to show huge growth effects and lots of revenue gains from this growth, is actually having an impact on debate in Washington. So we need to talk about TF’s model, and what they aren’t telling us.

The basic idea behind TF’s optimism is that the after-tax return on capital is set by global markets, so that if you cut the corporate tax rate, lots of capital comes flooding in, driving wages up and the pre-tax rate of return down, until you’re back at parity. That is indeed a possible outcome if you make the right assumptions.

But there are two necessary side implications of this story. First, during the process of large-scale capital inflow, you must have correspondingly large trade deficits (over and above baseline). And I mean large. If corporate tax cuts raise GDP by 30%, and the rate of return is 10%, this means cumulative current account deficits of 30% of GDP over the adjustment period. Say we’re talking about a decade: then we’re talking about adding an average of 3% of GDP to the trade deficit each year — around $600 billion a year, doubling the current deficit.

Second, all that foreign capital will earn a return — foreigners aren’t investing in America for their health. As I’ve tried to point out, this probably means that most of any gain in GDP accrues to foreigners, not U.S. national income.

So how does the TF model deal with these issues? They have never provided full documentation (which is in itself a bad sign), but the answer appears to be — it doesn’t. Judging from the description here, the current version of the model has no international sector at all — that is, it says nothing about trade balances. They say that they’re working on a model that

tracks the effects of rapidly increasing or decreasing desired capital stocks on international capital markets. The international sector captures the capital payments that leave the domestic economy to the foreign owners of domestic assets and adjusts the growth factors for the tax-return simulator to reflect the actual growth in incomes.

In other words, the model they’re using now doesn’t do any of that.

So while they’re peddling an analysis that implicitly predicts huge trade deficits and a large jump in income payments to foreigners, they’re using a model that has no way to assess these effects or take them into account.

Maybe they’ll eventually do this stuff. But what they appear to be doing now is fundamentally incapable of addressing key issues in the tax policy debate.

NYT