Can the U.S. Economy Do Better? IV. Let’s Try Tax Reform!

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After seven straight years of anemic, sub-par growth of 2.1% annual growth, one of the most important questions in public policy today is whether or not the U.S. economy can do better. I have devoted my last three posts, here, here, and here, to this question, presenting both positive and negative points of view.
Capture7There are very definitely strong headwinds slowing down growth but there are also specific strategies that are very likely to help speed up growth. One of these is tax reform.  The nonpartisan Tax Foundation (TF) has just issued an excellent report, “Options for Reforming America’s Tax Code” with many good ideas. Here are just three of the many different examples presented.  But they show the powerful effects that would be generated by significant tax reform.

  • Replace the Corporate Income Tax with a Value Added Tax (VAT) of 5%. This would be a huge change but it would also have a hugely positive impact. TF estimates that doing this would boost the economy by 5.5% in the long run as well as boosting tax revenue by a whopping $315 billion per year on average. Furthermore, all income groups from low to high would see equal gains in income.
  • Eliminate All Itemized Deductions Except for Charitable Contributions and Mortgage Interest and Lower the Top Individual Income Tax Rate to 27%. This change would grow the economy 1.1% in the long run and also create 496,000 new jobs. It would also increase tax revenues by $26 billion per year on average. It has the defect of raising incomes more for the affluent than for low- and middle-income groups. But this defect could easily be remedied by, for example, limiting the size of the mortgage interest deduction.
  • Cap the Total Value of Itemized Deductions at $25,000. This popular proposal would not help grow the economy but would bring in almost $200 billion a year in new tax revenue.

What is the better strategy? To be pessimistic and accept the point of view that faster growth is just too difficult or to adopt specific policies which are likely to help?

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“Manana Is Not a Credible Fiscal Plan”

 

Thus spoke George Osborne, Great Britain’s Chancellor of the Exchequer, in a recent speech to the Economic Club of New York.  “By applying a consistent and long-term economic plan, we can ensure that our best days lie ahead.  If we reduce our high debt so we can weather new shocks, and take the difficult decisions to make our economies more productive, we can provide rising living standards for our citizens.”
CaptureAccording to Mr. Osborne, any long term economic plan needs to include three elements:

  • An activist monetary policy to do whatever it takes to sustain sufficient demand in the economy.
  • A credible commitment to sustainable fiscal policy. Some have argued that fiscal consolidation is incompatible with economic recovery. But recent experience, e.g. sequestration in the U.S. and a balanced budget in the U.K., has shown the reverse.
  • An ambitious program of supply-side reform. The U.S. has a booming technology sector and the fracking revolution. The U.K. has cut its corporate tax rate to 20%, welcomes disruptive innovation and is pushing ahead on shale gas.

In the U.S. things are moving in the right direction and so the focus needs to be on keeping the momentum going.  Monetary stimulus has accomplished much but now a sound exit policy is needed.  Sequestration has slowed down the growth of government debt but has not ended it.  Further progress will require entitlement reform, especially for Medicare and Medicaid.  But first, the Affordable Care Act needs to be improved to do a better job of controlling the overall cost of healthcare.  Infrastructure improvement, tax reform and expanding trade are the supply side keys to increasing productivity and shared prosperity.
Activist monetary policy, credible fiscal policy, and ambitious supply side reform: these are the policies which will lead to future progress!

Is It Feasible to Cut Tax Preferences to Pay for Lower Tax Rates?

 

I have been focusing lately on America’s two biggest fiscal and economic problems:

  • How to boost the economy in order to put more people back to work
  • How to either cut spending or raise revenue in order to shrink the deficit.

A few days ago in “The Great Wage Slowdown and How to Fix It,” I laid out a fairly specific proposal to make a substantial reduction in tax preferences in order to cut tax rates across the board and especially for the 64% of taxpayers who do not itemize deductions.  These are the middle- and lower-income workers with stagnant incomes who would likely spend any tax savings they received thereby giving the economy a big boost. Let’s examine whether or not this is a realistic course of action.
CaptureThe above chart from the Congressional Budget Office document, “The Distribution of Major Tax Expenditures in the Individual Income Tax System,” shows that, for example, the upper 10% of households by income receive about 40% of the total $1 trillion in individual tax expenditures per year.  Furthermore, this same top 10% of tax payers have an income of about $140,000 or more (Congressional Research Service). My basic idea is to shrink tax preferences by $250 billion per year and to lower tax rates for middle- and lower-income non-itemizers by this same amount.  If we assume that they would spend 2/3 of this new income, it would boost the economy by $170 billion per year which is 1% of GDP.
A reasonable way to achieve this savings is to expect higher income earners to contribute a greater percentage of their tax preference savings.  For example:

  • top 1% contribute $110 billion (2/3 of their total deductions).
  • top 96th % to 99th % contribute $50 billion (1/2 of their total deductions).
  • top 91st % to 95th % contribute $30 billion (1/3 of their total deductions).
  • top 81st % to 90th % contribute $30 billion (1/4 of their total deductions).
  • top 61st % to 80th % contribute $30 billion (1/5 of their total deductions).
  • this gives a total of $250 billion in tax preference savings.

This back-of-the-envelope calculation is not intended to be definitive but rather to suggest what can be done along these lines.  Those who are more well-off need to make bigger sacrifices in getting our economy back on track.

Economic Expansion Is Not Enough

 

The Washington Post reporter Robert Samuelson gives our economy today a B-, because the unemployment rate has inched down to 6.1%, fulltime employment is up to 105.8 million in 2013 from 99.5 million in 2010, and full-time women’s pay reached a high of 78% of men’s pay in 2013.  The big negative, of course, is that median household income was $51,939 in 2013, down from $56,436 in 2007, just before the financial crisis.
The Bard College economist Pavlina Tcherneva, as summarized by the reporter Neil Irwin in yesterday’s New York Times, shows what has gone wrong with economic and monetary policy since the end of the Great Recession in June 2009. The American Recovery and Reinvestment Act of 2009 (an $850 billion stimulus package) did boost the economy but it primarily aided “the skilled, employable, highly educated, and relatively highly-paid wage and salary workers.”
Capture2On the other hand the Federal Reserve’s quantitative easing policies have kept interest rates remarkably low and have thereby caused investors to buy stocks rather than bonds in order to get higher returns.  This has artificially boosted stock prices and has been especially advantageous to the top 10% and, even more so, the top 1%.
CaptureWhat is needed, according to Ms. Tcherneva, is a targeted, bottom-up approach to fiscal policy, which provides more and better paying jobs directly to middle- and lower-income wage earners.  Her suggestion is for public works jobs, public service employment, green jobs, etc., all of which would require large infusions of federal money thereby worsening the federal deficit.
A much better approach would be broad based tax reform, lowering tax rates across the board, paid for by closing the loopholes and deductions which primarily benefit the rich.  Since the 64% of taxpayers who do not itemize deductions would receive an effective pay boost, this would amount to a tax reform program targeted to exactly the middle- and low-income wage earners who have not yet recovered from the recession.  These folks would most likely spend their extra income, thus further boosting the economy (see my previous post).