Tax Cuts and Interest Rates: A Closer Look

Opponents of President Trump’s ambitious tax proposal are once again wielding their favorite argument: concerns about increasing deficits.

The renowned Penn Wharton Budget Model (PWBM) predicts that the tax bill could add around $3.3 trillion to the federal debt over the next decade. Critics argue that this would lead to higher interest rates, harm private investment, and ultimately burden future generations.

However, this criticism is based on some important assumptions that seem a bit out of touch with economic realities observed over the past 30 years.

Debt and Economic Interaction

The Penn Wharton model operates on a straightforward premise: if the government borrows more, it competes with the private sector for available capital, which would typically push interest rates up, hinder corporate investments, and negate potential economic growth from tax incentives.

The problematic part is that this scenario hasn’t played out as they assert. Since the 1990s, the U.S. debt-to-GDP ratio has soared—climbing from under 40% to over 120%. Yet, surprisingly, interest rates have continued to drop. Even during periods of significant borrowing, particularly after the 2017 tax cuts, bond yields remained at historic lows. There hasn’t been a notable slowdown in investments or a spike in capital costs.

The PWBM’s projections don’t effectively account for the dynamics at play since the model treats capital as a limited commodity. However, the U.S. serves as the cornerstone of the global financial system, attracting savings from all around the world. This influx is largely due to the dollar’s status, which is bolstered by trade imbalances with other countries. If we export more than we import, dollars from foreign producers return, often finding their way into U.S. financial assets.

This steady capital influx actually puts downward pressure on interest rates, even in the face of rising federal borrowing. While there certainly are consequences associated with deficits, the notion that borrowing will unavoidably cause interest rates to spike doesn’t hold up against economic evidence.

Understanding the Limits

That said, it’s crucial to recognize that the U.S. government can’t just borrow endlessly without implications. Factors beyond public debt levels—such as trade balances, global demand for dollar-denominated assets, domestic savings, and monetary policies—also shape interest rates.

Focusing exclusively on the debt-to-GDP metric misses a vital aspect: whether new debts are being utilized effectively. This is where Trump’s proposal comes into play.

The proposal isn’t merely a political gimmick; it’s an attempt to enhance workforce capacities, stimulate domestic investment, and rejuvenate economically stagnant areas. By offering tax incentives and exempting overtime from income tax, the plan encourages work and reduces costs for small businesses and manufacturers. It also aims to draw investment into rural areas often neglected by modern economic progress.

These are tangible, structural changes—no need for fanciful justifications. If interest rates can persistently remain stable despite rising debt, the conventional debates around growth from tax policies might need reevaluation.

A Misguided Perspective?

Why does PWBM continue to miss the mark? Their model is premised on the idea that financial limitations will inevitably kick in—assessing that all borrowed funds will drive up interest rates, viewing every additional dollar of debt as a hindrance to growth. It’s a neatly packaged theory, albeit one that fails to capture the complexities of capital flow in the global economy.

The Economic Advisors Council during Trump’s administration appears to understand this nuance better. Their assessments of the tax bill model tax cuts without expecting rate hikes, predicting robust outcomes—GDP growth of 4-5%, millions of jobs, and significant wage increases for working families—based on actual experiences following the 2017 tax cuts.

During that period, interest rates didn’t surge dramatically. So, why assume they will this time?

While we should approach federal borrowing cautiously, that doesn’t equate to inaction. The proposed tax plan aligns with the existing economic landscape. The U.S. government remains the most reliable issuer of debt worldwide. As long as global policies favor U.S. trade deficits, demand for American debt from foreign investors will stay strong. (And if Trump’s trade strategy achieves a better balance between imports and exports, domestic revenue could supplant foreign buyers.)

The key factor is whether tax initiatives enhance productivity, reward job creation, and foster growth in the private sector. This tax plan is designed with those objectives in mind.

The real risk isn’t that interest rates will suddenly skyrocket due to theoretical predictions. The actual risk lies in letting abstract fears stifle opportunities to strengthen the U.S. economy.