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In principle, well designed tax cuts can increase US investment and lending by foreigners which can, in turn, increase the aggregate US capital stock and, as a result, domestic output by US firms. That’s a positive for the US economy, but it may not boost the pre-tax incomes of Americans as much as tax cut supporters claim.
Here’s why: While those foreign capital inflows may boost domestic production, they also require firms to use some of that output to distribute profits and/or pay interest to foreign investors. Thus, the effects of tax cuts on domestic output may exaggerate their effects on pretax incomes of US entities.
Cutting taxes can drive foreign investment in two ways. First, lower tax rates may increase after-tax returns to investors, including some foreign investors. For example, if the corporate tax rate is cut the after-tax profits of U.S. affiliates of foreign corporations on the factories they build in the US will increase, encouraging more such investment. Second, unless tax cuts are offset by other policy changes, they will increase the federal budget deficit. That tends to raise domestic interest rates and other rates of return, which makes US financial assets more attractive to foreigners and attracts an inflow of savings to finance domestic investment generally and offsets the “crowd-out” effect of higher deficits.
But those foreign investors need to earn and be paid returns. The US government and US-based corporations must pay interest to foreign holders of their debt. Firms must also distribute a share of their profits to foreign shareholders. Those payments reduce the amount of profit available to pay out to US residents. For that reason the effect of tax cuts on domestic incomes will be smaller than their effect on domestic output.
A better way to measure the effect on domestic income when foreign capital inflows change is gross national product, or GNP, which subtracts net income to foreigners from domestic output.
Here is an example of how this might work: In July, the Tax Policy Center estimated the revenue and macroeconomic effects of tax plans consistent with the Trump administration’s April tax outline. We projected that a plan just comprised of tax cuts would reduce Gross Domestic Product (GDP) by about 0.5 percent in 2027. The main reason is that higher deficits would crowd out private investment and offset increased incentives to work and save. By contrast, TPC estimates that the plan would decrease GNP by twice as much--1.0 percent in 2027.
Similarly, the same type of plan but now including revenue raisers would barely change GDP after a decade, but reduce GNP by 0.2 percent. The difference between the two measures is smaller when revenue raising provisions are included because the overall tax plan would generate smaller federal budget deficits, raise US rates of return less, and attract a smaller amount of foreign capital than the “tax cuts only” version.
These days, most estimates of the dynamic effects of tax policy are presented in terms of the impact on GDP. But when it comes to issues like the effects of increased foreign investment on US incomes, it pays to be careful—the dynamic effect on Americans’ incomes may well be smaller than is shown by the projected change in GDP.
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