The Republican Party Is Putting its Reputation for Fiscal Responsibility at Great Risk

 

The final Republican tax bill has now been passed by both the House and the Senate and awaits the President’s signature which is expected soon. It dramatically lowers the federal corporate tax rate from 35% to 21%.  This is highly beneficial as it will provide a big incentive for U.S. multinational companies to bring their foreign profits back home for spending and reinvestment.


The huge problem, of course, is that the tax rate cuts are not paid for by other offsets and will add $1 trillion over ten years to our already exploding national debt. In fact, we are likely to see trillion dollar deficits again as soon as FY 2019.


Here is a cogent analysis of the bill’s weaknesses by the Wall Street Journal’s Greg Ip:

  • Distortionary business tax breaks still remain such as for oil and gas drilling, electric cars and renewable energy. Also the “carried interest” loophole largely remains intact.
  • New breaks are created, most importantly a 20% deduction for businesses which pay taxes as individuals (pass throughs). This introduces “grave complexity” and creates huge incentives for tax avoidance.
  • The challenge of constraining entitlement growth has become much more difficult. The soaring cost of Social Security, Medicare and Medicaid is the main driver of our debt problem. The Democrats, having been excluded from developing the tax plan, will be far less likely to cooperate on entitlement reform.

Conclusion. Corporate tax rate reform, as desirable as it is, as been badly handled by the Republicans. The new tax law not only makes the debt much worse by itself but poisons the atmosphere for actually figuring out a way to effectively address entitlement reform, the key to getting debt under control.

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The GOP Tax Plan: Bad Economic Policy and Bad Fiscal Policy

 

It is a very good idea to cut the top corporate tax rate to 20% or so from its current 35% level. This will make the U.S. competitive with other developed countries and encourage our multinational companies to bring their foreign profits back home for reinvestment in the U.S.  It will also encourage other foreign companies to set up shop in the U.S.
My last post, however, strongly criticizes the current GOP tax plan, now in Conference Committee, because it will add $1 trillion to our already huge debt:

  • Current national debt, at 77% of GDP (for the public part on which we pay interest) is the highest it has been since right after WWII, and is already predicted by CBO to keep getting worse, without major changes in current policy. When interest rates eventually return to more normal and higher levels, interest payments on the debt will skyrocket. And this will continue indefinitely, eventually leading to a new fiscal crisis, much worse than the Financial Crisis of 2008.

This means that the GOP tax plan, by adding an additional $1 trillion to our debt, is terrible fiscal policy. But the situation is even worse than this.  It is also bad economic policy:

  • Economic growth is finally becoming robust.  We now have had two quarters in a row of 3% growth. In 2015 median household income grew by 5.2% with another 3.2% added in 2016. Blue collar wages are beginning to take off (see chart).  The overall unemployment rate has dropped to 4.1%. Even the unemployment rate for Americans age 25 and older, without a high school diploma, has dropped to 5.2% (see second chart).

Conclusion. The last thing our economy needs right now is the artificial stimulus caused by a deficit-financed tax cut. It is likely to overheat an already hot economy and thereby ignite inflation which will force the Federal Reserve to raise interest rates much faster than would otherwise be necessary.

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Ignoring Massive Public Debt Is Morally Unacceptable

 

The House and Senate have now each passed their own versions of tax reform and a conference will come up with a single version acceptable to both legislative chambers. Each of the individual bills has been scored to add $1 trillion to the national debt over a ten year period and so the final bill will probably have the same feature.  This is a badge of dishonor on the controlling Republican Congress for the following reasons:

  • Yes, economic growth at 2.1% of GDP since the end of the Great Recession is too slow and has caused stagnant wages for millions of middle- and lower-income workers. Even though the unemployment rate has now dropped to 4.1% and the economy has grown at a rate of 3% for the past two quarters, there is still much labor slack to make up for.
  • Yes, the corporate tax rate is too high and encourages multinational companies to invest overseas. Immediate expensing for new business investment would also speed up growth and thereby create new jobs and higher wages.
  • Revenue neutral tax reform is “easily” accomplished by “simply” offsetting all tax rate cuts by closing loopholes and shrinking deductions by an equal amount. Since two thirds of taxpayers do not itemize deductions, it is primarily the higher income taxpayers who benefit from tax deductions and they can afford to pay higher taxes.

  • Current national debt, at 77% of GDP (for the public debt on which we pay interest), is the highest it has been since right after WWII, and is already predicted by the CBO to steadily keep getting worse. When interest rates eventually return to more normal and higher levels, interest payments on the debt will soar. And this will continue indefinitely, eventually leading to a new fiscal crisis, much worse than the Financial Crisis of 2008.

The GOP tax plan should be killed. Although a revenue-neutral tax plan could be put together and would be beneficial, the current plan makes our debt much worse and should be killed. We simply must make shrinking the debt a very high priority and not be distracted from getting this done.

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Responsible Tax Reform II. The Trump Plan

 

Responsible tax reform will be highly beneficial for the U.S. economy because:

  • Economic growth will be speeded up by lowering tax rates on businesses, thereby encouraging more investment.
  • National debt will shrink because faster growth will produce more tax revenue. But this only works if the revised tax plan is revenue neutral to begin with.

The Trump tax plan, described here and here, has the following features:

  • three tax brackets, reduced from seven. Simplification like this is a good idea.
  • double the standard deduction. This puts more money in the pockets of the average tax payer who does not itemize deductions and is therefore a good idea.
  • repeal of the alternative minimum tax. This only affects wealthy people and should be retained, if necessary, to make sure that overall reform does not increase the deficit.
  • lower capital gains tax. This will encourage more investment but should not be included unless the overall plan is revenue neutral.
  • repeal of inheritance tax. This tax feature should be retained until our annual budget deficits are eliminated, i.e. until we achieve balanced budgets on an annual basis.
  • preserving deductions for mortgage interest and charitable contributions. The mortgage interest deduction should be greatly reduced from its current level of $1 million per residence. Wealthy taxpayers don’t need that much help. Raising the standard deduction will already help middle income taxpayers.
  • cutting the corporate tax rate. This is an excellent idea as long as its revenue loss is made up elsewhere. It will encourage multinational corporations to bring their overseas profits back home for reinvestment in the U.S.

Conclusion. The Trump tax plan has some good features as well as some poor ones. Reducing tax rates is a good idea.  But adding to annual deficits is a very bad idea.  With some effort it is possible to reduce tax rates in a revenue neutral way.

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Corporate Tax Reform and the Border Tax

 

Most informed observers of the U.S. economy agree that the Corporate Income Tax of 35% is too high and should be lowered to a rate which is more competitive with other developed countries. Republican Congressional leaders and the Trump administration have agreed that a 20% rate is about the right level.
Now the question is how to make up the tax revenue lost to the federal government from a lower tax rate.  One idea is to impose a Border Adjustment Tax on imports into the U.S. but exempting exports from such a tax.  Since the U.S. trade deficit is currently running at about $500 billion per year (see chart), a 20% tax on imports offset by a 20% tax credit for exports would raise the necessary $1 billion per year.


This week’s Barron’s points out several disadvantages of a BAT:

  • Economic theory predicts that a 20% BAT would mean that the dollar would rise in value by 20%, offsetting the higher costs of imports. But if this happens, then other industries, such as U.S. tourism, would take a big hit.
  • Other countries could retaliate in ways that would be unfavorable to us and cause a “Trump slump.”
  • If a BAT leads to an increase in exports and a decrease in imports, the $500 billion trade deficit will shrink and so the BAT will bring in less revenue than the predicted $100 billion per year.

The Barron’s article suggests much better ways to make up the $100 billion in tax revenue (on a static basis) which would be lost to a corporate tax rate cut to 20%. For example:

  • A corporate tax rate cut of this magnitude would be revenue enhancing (on a dynamic basis), easily raising an additional $50 billion in tax revenue.
  • The CATO Institute recently compiled a list of corporate welfare programs in the federal budget totaling $100 billion. Eliminating just half of this would save an additional $50 billion.

Conclusion. Cutting the corporate tax rate to 20% from its current level of 35% will contribute significantly to faster economic growth. It should be quite possible to keep such a tax rate cut revenue neutral by cutting back on crony capitalism.

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What Might Fundamental Tax Reform Look Like?

 

All four of the major presidential candidates have tax plans. Hillary Clinton would make small tweaks in our current tax system.  Bernie Sanders would raise current taxes substantially.  Both Donald Trump and Ted Cruz would both radically reduce the size of the federal income tax but would also greatly add to the national debt over the next ten years.
I have been trying to make the case on this blog that fundamental tax reform is the best thing we can do to get the economy growing faster in order to create more and better paying jobs.  I have also discussed a specific way to accomplish fundamental reform, namely the so-called Competitive Tax Plan proposed by the tax law expert, Michael Graetz.  It is a progressive consumption tax, a so-called Value Added Tax.
Capture2As reviewed in yesterday’s Wall Street Journal by Reihan Salam, the editor of the National Review, the Graetz Plan has these features:

  • A broad-based VAT of about 14% on goods and services.
  • Families earning less than $100,000 per year are exempt from the income tax. The tax rate would be 15% for incomes between $100,000 and $250,000 and 25% above this level.
  • The payroll tax (supporting Social Security and Medicare) would be greatly reduced for all workers earning less than $40,000 per year.
  • The corporate tax rate would be lowered to 15%, making it among the lowest in the world.
  • The Graetz Plan is revenue neutral as verified by the Tax Policy Center.

Think of the incredible advantages of such a tax plan. Of the expected 145 million tax returns for this year, 120 million would no longer be necessary.  Extravagant deductions such as for mortgage interest would have much less political support. The low corporate tax rate would bring jobs back to the U.S. instead of sending them overseas.  The rampant cronyism involved in tax breaks being handed out by Congress would be greatly reduced.
What is not to like about the Graetz Plan?

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How to Lower Income Inequality

 

My last post provides evidence that income inequality has increased more under recent Democratic presidents than under Republican presidents.  Here is a brief summary of the argument:

  • Cheap money is of greatest value to those who have access to it.
  • The effects of the Bush housing bubble (in the 2000s) were more evenly distributed than for the Clinton stock market bubble (in the 1990s) or the Obama credit bubble.
  • Two earner households are the backbone of the American middle class.
  • During the first six years of the Obama presidency, the number of two-earner households declined, the number of single-earner households rose by 2.6 million and the number of no-earner households rose by 5 million. In other words, two-thirds of the increase in the number of households under Obama is accounted for by households with no-one working. This largely accounts for the shrinking middle class and the increase in inequality.
    Capture

Another way to consider this situation is to look at the labor force participation rate which has been steadily decreasing since the year 2000.  As the above chart shows, this trend is expected to continue indefinitely in the same downward direction.  Along with a slowing increase in the productivity rate, this constrains the U.S. economy’s capacity to expand. Clearly what is needed is faster economic growth in order to create more jobs and better paying jobs.  The way to accomplish this is with:

  • Tax Reform. Lower individual and corporate tax rates for all paid for by shrinking deductions and closing loopholes. More money in the hands of the middle class will stimulate demand. More money in the hands of small business will stimulate supply.
  • Expanded Earned Income Tax Credit. Putting more money in the pockets of low-income and marginally employed workers will encourage more of them to find work and stay in the workforce.

With all the headwinds holding the economy back, our national leaders (and would be leaders!) ought to be focusing much more attention on taking specific actions which would speed up economic growth.

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