Achieving Permanent, Revenue Neutral, Pro-Growth Tax Reform

 

As Congress turns its attention to tax reform, there is a clear bipartisan consensus on the fundamental principles to employ, see here, herehere, and here.


For example:

  • Promote growth and increase wages for working families
  • Modernize our outdated business and international tax system.
  • Rely on reasonable economic assumptions
  • Make sure that any rewrite of the tax code is revenue neutral

The Tax Foundation has outlined several different approaches to tax reform which meet the above guidelines.  Their Option A is especially attractive:

  • The corporate tax is reduced to 22.5% and full expensing for business investment is allowed.
  • GDP increases by 7.1% long term which translates to a .7% increase per year for ten years, which is substantial economic growth.
  • All income groups, except for the top 1%, will see an after-tax increase in income.
  • Individual Tax brackets are consolidated into the three rates of 12%, 20.5% and 37% and the standard deduction is nearly doubled (from $6350 to $12,000).
  • All itemized deductions are eliminated except for home mortgage interest (limited to $500,000) and charitable contributions.
  • Capital gains and dividends are taxed as ordinary income with individuals being allowed to deduct 40% of qualified dividends and long-term capital gains.
  • The estate tax is eliminated.
  • This tax plan is revenue neutral on a static basis.

Conclusion. There are many attractive features in this plan. Being revenue neutral, with strong economic growth, means that the increase in tax revenue will shrink our huge current annual deficits.  Only the very wealthy top 1% of taxpayers will see their income (slightly) decreased.  The substantial decrease in the corporate tax rate will incentivize multinational corporations to bring their overseas profits back home for reinvestment.

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How to Achieve Sensible Tax Reform

 

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.

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Responsible Tax Reform III. Avoid Complacency about Debt

 

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.

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What to look for in President Trump’s First Budget

 

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.

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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.

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“A Better Way” for Donald Trump to Make His Case

 

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.
Capture9Here 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.”

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Tax Reform for Faster Economic Growth

 

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.
Capture11House 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.

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The U.S. Middle Class Is Growing, Not Shrinking

 

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.
Capture1As 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.
Capture3The 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.

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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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Tax Reform and Economic Growth

 

In a recent post I pointed out that both Republican and Democratic presidential candidates are being unrealistic with their tax reform proposals:

  • The Republican plans would stimulate the economy but at the cost of huge increases in the national debt, even taking into account the growth effects of these plans.
  • Raising the top tax rate to 50%, a Democratic idea, would bring in an additional $100 billion per year in tax revenue, but this is neither enough to make a big dent on budget deficits or appreciably lower income inequality by redistribution.
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The nonpartisan Tax Foundation has just released a new report, “Options for Broadening the U.S. Tax Base,” describing three different ways to do this:

  • Ending the exclusion of employer-sponsored health insurance
  • Removing the cap on the social security payroll tax
  • Capping itemized deductions at a fixed dollar level

Combined with marginal tax rate cuts, each of these options would lead to substantial economic growth.  However, the first option, ending the exclusion of employer-sponsored health insurance, is unlikely but rather this exclusion could be turned into tax credits as part of further healthcare reform.  Likewise, removing the cap on the social security payroll tax is more likely to be used to raise additional revenue to make social security financially sound for the long run.
However, the single measure of capping itemized deductions at $25,000 per individual could be combined with

  • Lowering the corporate tax rate to 27%
  • Cutting the top three ordinary income brackets by 5%
  • Implementing a top capital gains tax rate of 20%

Such changes would be revenue neutral and would lead to a long term GDP gain of 2.7%, a long term wage rate gain of 2.2% and a ten year dynamic revenue gain of $759 billion.
Conclusion:  it is possible to cut tax rates, broaden the tax base and grow the economy all at the same time and without increasing the deficit.  This is what we should be doing!

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I Am One of Paul Krugman’s “Very Serious People”

 

There is a stark contrast between the fiscal and economic policies being proposed by the presidential candidates from the two different parties. The Democrats want to tax the rich to reduce income inequality while the Republicans want major tax reform in order to speed up economic growth.
CaptureI favor the latter approach as long as it does not increase deficit spending.  The Keynesian economist Paul Krugman mocks deficit hawks like me as “Very Serious People.”  But in my “serious” view we have a choice between two very different paths for our economic future:

  • Slow Growth. Continue on our present path of slow 2% annual growth. The official unemployment rate has dropped to 5% but slack in the economy caused by the low labor participation rate keeps raises low and millions still unemployed or under-employed. The slow economy also keeps inflation and interest rates low. This permits Congress and the President to shrug off deficit spending and debt accumulation because it’s virtually “free money,” being borrowed at very low interest rates.   Our present course not only prolongs income inequality but also allows the debt to keep ramping up indefinitely. The longer this continues, the greater will be the disruption when inflation and interest rates do eventually return to normal historical levels.
  • Faster Economic Growth.   There are many things we can do to speed up economic growth. Tax reform is first and foremost but deregulation (relax Obamacare and Dodd-Frank), trade expansion (pass TPP) and immigration reform (with an adequate guest worker program) would also help. But, contrary to what the Republican presidential candidates say, tax reform must be revenue neutral to be sustainable. That way the economic growth it produces will lower deficit spending rather than increasing it.  This is critical because economic growth will create new jobs and raise pay for existing jobs, thereby creating inflationary pressure. Inflation will lead to higher interest rates which in turn will make our debt much more expensive than it is now.

Conclusion. We can make our economy grow faster if we simply put our mind to it. But then inflation and interest rates will go up and interest payments on the debt will become an increasing burden on society.  This is why it is so important to put our debt on a downward path as a percentage of GDP.  We can make it happen if we want to.