Experts across the political spectrum agree that the U.S. tax code is a huge mess and needs to be reformed as well as simplified. It is also generally accepted that lower tax rates will lead to faster economic growth.
As Congress turns its attention to tax reform, Senate Democrats have stated the basic principles which they would like to see included in any changes which are made:
Increase the wages of working families. This could be accomplished by lowering tax rates for all individuals across the board, paid for by eliminating (or at least shrinking) many of the personal deductions in the tax code. The approximately two thirds of all taxpayers who do not itemize deductions would then receive a tax cut, equivalent to a wage increase.
Promote domestic investment and improve middle class job growth. Lower tax rates will give businesses and entrepreneurs a bigger incentive to invest in business expansion and therefore grow the economy faster and create more new jobs.
Modernize our outdated business and international tax system. Our corporate tax rate at 35% is the highest in the developed world and, at the same time, produces below average revenue (see chart). Another reform would be to adopt business expensing (immediate tax write-off for new investment). Again, all such changes should be paid for by eliminating loopholes and shrinking deductions.
Any rewrite of the tax code must be deficit neutral. As important and valuable as tax reform is, it has to take into account our country’s most fundamental problem: our huge and rapidly growing national debt and therefore end up being deficit neutral overall.
Conclusion. The above principles, stated by the Senate Democrats, represent a sound approach to reforming the U.S. tax system. I hope that the Republicans are willing to recognize the validity of these proposals and include the Democrats in developing a bipartisan tax reform plan.
The Trump Administration has proposed a tax reform plan, with both good and bad features, and it is not yet known how Congress will respond to it. In the meantime we should focus on what tax reform can accomplish if does right:
Lower tax rates. Most observers agree that lower tax rates will increase economic growth by encouraging more business investment. Since the end of the Great Recession in June 2009, GDP has grown at the historically slow rate of 2% per year. Any additional growth will be beneficial by tightening the job market, thereby creating more jobs as well as higher wages for the already employed.
Revenue neutrality. Our public debt (on which we pay interest) is now 77% of GDP, the highest it has been since right after WWII. At the present time interest rates are so low that the debt is almost “free” money. But interest rates will inevitably rise back to more normal levels in the future. When this does happen, whether it be sooner or later, interest payments on our ever increasing debt will skyrocket, and eat up as much as a third of federal tax revenue. A huge fiscal crisis will then occur, far worse than the Financial Crisis of 2008.
Observing historical precedent. There have been five tax rate cuts in the last half century: (Kennedy (1964), Reagan (1981, 1986) and Bush (2001, 2003)). Note that public debt was 40% or less of GDP at the time of each of these tax cuts (see chart). The revenue losses associated with each was temporary and the first three at least strongly stimulated new growth.
Conclusion. Our national debt is much too high at the present time to adopt a tax reform plan with an extravagant disregard for revenue loss. The current debt level is so high (and projected to keep getting steadily worse) that modest tax rate cuts, coupled with significant spending restraint, is clearly called for.
As a new administration prepares to take office in January, one of the key indicators of President Trump’s approach to government will be his first budget. This is especially true since the Republican controlled Congress is likely to take a Republican President’s budget seriously.
One of our nation’s chief fiscal watchdogs, the Concord Coalition, has summarized the most important things to look for:
What is the overall fiscal target? President Obama’s recent budgets have aimed at stabilizing the debt as a share of the economy. House Republicans have aimed for a more ambitious goal of balancing the budget within ten years, gradually reducing the debt as a share of the economy. What path will Mr. Trump recommend?
What specific tax cuts will be proposed and what are the likely revenue effects? During the campaign Mr. Trump proposed tax cuts amounting to $5.9 trillion in revenue loss over ten years. Even with dynamic scoring, taking the stimulatory effects of his tax cuts into effect, the revenue loss is still $3.9 trillion over ten years. Such huge revenue losses will make our debt much worse than it is already and won’t be approved by Congress.
What will the budget recommend for the federal debt limit? Currently the debt limit is suspended until March 16, 2017 when it will return at whatever level it is on that date. Congress will then have several months to reset it. Whatever the President recommends will send a strong signal, positive or negative, to the financial markets.
What economic growth rates will the budget assume? GDP growth has averaged 2.6% for the past 30 years. Any predicted long term growth rate higher than this will lack credibility without strong justification.
Conclusion. Mr. Trump has the opportunity to institute the change in course which so many Americans would like to see. His first budget will set the tone and provide an important clue as to whether or not he is serious about doing this.
In my last post, “Donald Trump’s Best Chance to Win in November,” I said that the best way for Mr. Trump to broaden his appeal beyond working-class whites and to have any chance of winning the presidential election is for him to endorse the reform plan, “A Better Way,” recently developed by the Republican House of Representatives. Here is a brief and positive summary of the Trump platform so far:
His tax plan is highly pro-growth and will not cost nearly as much as the previously advertised $10 trillion over a decade.
He supports legal immigration and simply wants to solve the illegal immigration problem, one way or another.
He is not opposed to foreign trade per se but wants to negotiate, from a position of strength, with countries that manipulate their currencies, steal intellectual property or compel companies to disclose trade secrets as a condition of entering their markets.
His policy proposals so described are completely compatible with the House’s “A Better Way” reform plan whose planks are:
Poverty. Reward work. Tailor benefits to people’s needs. Improve skills and schools. Demand results.
National Security. Defeat the terrorists. Protect the homeland. Defend freedom.
The economy. Regulate smarter. End bailouts and cronyism. Put students and workers first.
The constitution. Make government more accountable and more representative. Restore constitutional checks on spending.
Health Care. More choices and lower costs. Real protections and peace of mind. Cutting edge cures and treatments. A stronger Medicare.
Tax reform. Simplicity and fairness. Jobs and growth.
These guiding principles are being fleshed out into complete policy documents. They do indeed represent a better way forward for our national government. Donald Trump could do far worse than to endorse this comprehensive reform plan developed by the House Republicans. It would show that he is serious about “Making America Great Again.”
Several of my recent posts have been devoted to the topic of faster economic growth, see, for example, here. One way to do this is by making it easier to start and grow a small business. Another way is with broad-based tax reform. House Republicans have just released the outline of a plan for fundamental tax reform, “A Better Way: A Pro-Growth Tax Code for All Americans.” It has the following main features:
The current seven tax brackets for individuals are condensed to just three: 12%, 25% and 33%.
The standard deduction of $12,600 (for joint returns) is raised to $24,000 and the $4,050 personal exemption is eliminated. This feature means that fewer filers will need to itemize deductions.
In fact, all itemized deductions for individuals are eliminated except for mortgage interest and charitable contributions.
To encourage business creation and expansion, the pass through tax rate for small business will be 25%. Full and immediate expensing for investments in new equipment and technology will be allowed.
The corporate tax rate will drop from 35% to 20%, paid for by eliminating dozens of tax carve-outs and deductions, including net interest expensing. A territorial system will be established whereby multinational firms will no longer be taxed both abroad and at home for the same dollar of income. This will encourage the multinationals to keep production facilities in the U.S. and to bring home foreign profits for reinvestment here.
The purpose of this plan, according to Kevin Brady, Chair of the House Ways and Means Committee, is “to rev up the economy, cut taxes on business, simplify the code and let American families file on a postcard.” The authors of the report claim that this tax proposal is revenue neutral, i.e. will not lower tax revenue, on a dynamic scoring basis, taking resulting economic growth into account. If this assertion holds up under nonpartisan analysis, then this is an excellent proposal which deserves broad support.
One of the topics I discuss on this blog is income inequality (here,here, and here). An interesting article in yesterday’s Wall Street Journal, “Upper Middle Class Sees Big Gains, Research Finds,” is highly pertinent to the inequality issue. As can be seen in the above chart, the percentage of people in the middle class or above has greatly expanded between 1979 and 2014. Furthermore, the basic research on this issue,by Stephen Rose at the Urban Institute, shows very clearly (in the chart below) what is happening: the higher is a family income, the faster it is increasing. The best policy response to this phenomenon should be clear. Rather than trying to decrease inequality with higher taxes on the wealthy, we should be trying to boost the less wealthy into higher income classes. The way to accomplish this is to:
Grow the economy faster with broad-based tax reform (lower tax rates paid for by shrinking deductions), immigration (guest worker) reform, (fair) trade expansion, and regulation reform (to help more small businesses get started). This will create more jobs and better paying jobs.
Improve education with early childhood education (to get minorities off to a better start in school), boosting high school graduation rates above the current 80% average (with better career and vocational education) and making college more affordable by putting more resources into community colleges and scholarships for low-income students.
Combat social inequality. The fraction of children with a single parent is the best predictor of upward economic mobility. The lower-income class marriage rate has dropped from 84% in 1960 to 48% in 2010. Policy should therefore focus on removing the marriage penalty in all government programs.
The basic forces of globalization and growing technology use are driving this societal change. The best way to respond is to enable more people to benefit from these basic trends.
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. There 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?