Tax Reform: Are These the Droids We’re Looking For?

Republicans in the House and Senate are now hard at work on reconciling their respective versions of a sweeping tax reform. As with most issues these days, opinions of these bills divide sharply along partisan lines. So does this tax reform represent a much-needed unshackling of American enterprise? Or a staggering giveaway to the wealthy donor class? For impartial analysis, you can trust me. I’m a doctor…. or, at least a Ph.D. in economics.

The view from 30,000 feet

Before examining the nuts and bolts of the tax reform bills, we need to look at the macroeconomic context. The U.S. economy is growing at a steady clip, generating around 200,000 jobs per month. Unemployment is nearing all-time lows, and real incomes are rising. At the same time, a persistent mismatch between spending and tax revenue is generating ongoing Federal deficits, which will only grow worse in the future. The current tax reforms generate medium-term stimulus at the cost of larger deficits – exactly the opposite of what the macroeconomy needs.

Some people – including the Treasury Secretary – believe that the growth generated by the tax cuts will boost growth by enough to replace all the lost tax revenue. These people also believe in Santa Claus and the Tooth Fairy. Based on the infamous Laffer Curve, this claim has been made before every tax cut since 1981. Every time, the economy does indeed grow – just nowhere near enough to restore tax revenue to its former level.  Typically, the growth effect returns around 10 to 25 cents on the dollar.  So every time, revenues fall and deficits rise. The only way to claim otherwise is to pick a point 8-10 years after the tax cut, neglect to control for inflation or population growth over that time, and then attribute the revenue trend to the tax cut. If you sincerely believe these claims, please contact me for an exciting opportunity in river-spanning infrastructure ownership.

The mundane truth is that, according to professional macro analysts, the tax reforms will boost economic growth by a few tenths of a percent for a few years, and will inflate Federal deficits by a few tenths of a percent for a few years. The magnitudes are small, but the growth effects aren’t needed in a booming economy, and the deficit effects are pointed in the wrong direction.

Down in the weeds

Let’s start with individual income taxes. Economists believe that low-ish marginal tax rates, applied to a broad, “clean” base, produce the fewest distortions and the most growth. America’s individual tax rates are lower than those in many developed countries, but our tax base is honeycombed with credits, deductions, and exemptions – “loopholes”, in other words. The biggest sinkholes are the mortgage interest tax deduction, the (employer-level) exemption for health insurance premiums, charitable and state & local tax deductions, and preferential tax rates for retirement savings and investment income. At a micro level, the ideal tax reform would shrink or eliminate as many of these loopholes as possible, generating more revenue at the same – or lower – tax rates. In fact, if all these “tax expenditures” were eliminated, the primary Federal budget would be in surplus.

The reform bills cap or nibble directly at some of these deductions, although the costliest loopholes are left largely intact. However, both the House and Senate tax bills reduce the effect of these loopholes in a curious way. Most of these deductions and credits can only be claimed by taxpayers who itemize instead of claiming the standard deduction. By doubling the standard deduction, the reform bills induce many fewer taxpayers to itemize, thereby reducing the footprint of all deductions. This is definitely a step towards simplicity for most taxpayers, although it’s unclear whether the combination of a larger standard deduction and less itemizing yields a larger or smaller tax base.

In terms of income tax rates and brackets, there is some difference between the House and Senate bills, with larger rate cuts in the House version. Most journalists, looking at changes in absolute dollar amounts of tax owed, love to play a “who wins, who loses” game with these rate changes. Allow me to spoil that game by pointing out that a small number of people earn a huge proportion of all income. If we look at raw dollar amounts, any tax hikes will gain most of their revenue from this group, and any tax cut will overwhelmingly flow back to this group. Since it would be difficult to write any tax change that did not have these effects, economists would rather examine tax cuts as a percentage of a given group’s income. For example, a reform that gives a household making $50,000 a $5,000 tax cut (10% of their income) while returning $20,000 to a household making $500,000 (4% of their income) might be said to favor the middle class. However, the House and Senate bill fail even on this accounting: low-income groups see their after-tax incomes rise by between 0.3% and 1.4%, while the top income quintile sees their income rise by 2%. This skew actually grows over the ten-year horizon of the bills.

Turning to corporate taxes, there is an even stronger argument for a “broad base, low rate” reform. In contrast to individual income taxes, the U.S. corporate tax rate is well above the worldwide average. Like the individual income tax base, the corporate tax is riddled with arcane loopholes, which simultaneously reduce revenue and distort economic decision-making. Moreover, economists argue that the burden of the corporate tax is actually borne by some combination of corporate employees, consumers, and shareholders – after all, a corporation’s money belongs to, comes from, or goes to actual human beings. The House and Senate tax bills make admirable progress in reducing the U.S. corporate tax rate, but then somewhat lose the script when it comes to closing loopholes. The result is great for lobbyists and tax accountants, modestly positive for workers, consumers, and shareholders, and bad for federal tax revenue. The bills also lower the tax rate on “pass-through” income that flows to the owners/proprietors of smaller businesses. These people are simultaneously plucky entrepreneurs and inhabitants of the top income categories, so this change is great or terrible depending on your point of view.

Collateral Damage

And then there are the provisions that have little bearing on tax policy, but large impacts on many Americans. First, the Senate bill eliminates the individual health insurance mandate created by ObamaCare. In the short run, this means that people can avoid paying into an insurance plan, then sign up for coverage as soon as they get sick. In the medium run, this means either skyrocketing insurance premiums, or the bankruptcy of any insurance company that does not immediately flee the ObamaCare exchanges. An uncharitable observer might note that this will be brought about by a party that has long lambasted ObamaCare for “giving away free stuff” to patients, for skyrocketing premiums, and for dwindling insurer participation. The Senate bill also opens the Alaska National Wildlife Refuge for oil drilling, a move that is purely symbolic to everyone except oil companies and Alaskan wildlife.

Finally, the political context of these changes can’t be ignored. While they are in the process of cutting taxes, Republican lawmakers are talking about how entitlement programs like Medicare, Medicaid, and Social Security are unaffordable in their current forms. At the very least, this represents a clear choice to prioritize tax cuts over these programs. More mendaciously, it suggests that the deficits generated by the tax cuts will be used as a reason to cut these entitlement programs. While it is true that healthcare programs contribute significantly to the government’s long-run fiscal imbalance, an artificial deficit crisis precipitated by tax cuts is not the responsible way to debate a solution.

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