The Three Choices for Tax Reform

The Three Choices for Tax Reform

September 13, 2017

Trump administration officials and GOP leaders in Congress are still putting together their tax plan. Nevertheless, the early signs point to decisions that could sink the project or produce changes that would jeopardize economic growth.

Congress can approach changing the corporate tax in one of three ways. It can try to simplify the code, it can reform it, or it can cut it back. The GOP’s current approach appears to start with simplification. Simplifying the corporate tax normally means phasing out a package of tax preferences for particular industries or business activities, and using the revenues to bring down the current 35 percent tax rate to 28, 25 or even 20 percent. This model shifts the burden of the tax among industries but not among income groups, since shareholders continue to bear most of the burden. Such simplification can also attract bipartisan support and produce real economic benefits. At a minimum, it lowers tax compliance costs for most businesses; and if it’s done thoughtfully, it can increase economic efficiency. To be sure, any efficiency benefits will be marginal unless the simplifications are fairly broad and sweeping.

The record also shows that serious tax simplification is very hard to achieve. Support from President Obama and congressional GOP leaders wasn’t enough to advance it in 2014, for the simple reason that most companies prefer their tax preferences to a lower tax rate. They’re not wrong economically: The Treasury calculated in 2016 that tax preferences lower the average effective corporate tax rate to 22 percent, and companies in many industries pay substantially less. Why give up those preferences for a 28 or 25 percent rate? A 20 percent rate could solve the problem for most industries, if anyone had a plausible way to pay for it. Of course, financing a deep rate cut was the border adjustment tax promoted by Speaker Paul Ryan, and which the White House and big importers and retailers quickly squashed.

The second option is genuine reform, where Congress changes the structure of the corporate tax. Economically, the most promising reform would give U.S. companies a choice of tax treatments when they invest in equipment. They could deduct the full cost of those investments in the year they make them (“expensing”) while giving up the current deduction for interest on funds borrowed to finance the investments. Or they could stick with the current depreciation system for their investments, including the deduction for interest costs. If enough companies choose the first route, as they likely would, this reform would spur investment and sharply reduce the tax code’s nonsensical bias towards financing business growth with debt rather than equity. Such a structural reform would make sound economic sense. It also seems as unlikely as serious simplification, because it foregoes the pixie dust of marginal tax rate cuts that GOP supply-siders demand.

That leaves the Trump administration and Republican leaders with option three: Cut the corporate tax rate without paying for it. The President seems to favor this approach. He has called repeatedly for slashing the corporate rate to 15 percent, a multi-trillion dollar change, and paying for a small piece of it by limiting a few personal tax deductions for higher-income people. It’s also catnip for GOP supply-siders who continue to proclaim that a deep rate cut will boost economic growth enough to pay for itself. We’ve tried this t several times already, so we now have hard evidence to evaluate those claims. The actual record shows, beyond question, that such turbo-charged dynamic effects do not occur. The most recent example is George W. Bush’s 2001 personal income tax cuts. His “success” enacting them produced huge deficits and ultimately contributed to the financial collapse that closed down his presidency.

A largely-unfunded cut in the corporate tax rate in 2018 would boost corporate profits as well as budget deficits, but it won’t increase business investment, productivity or employment. Prime interest rates in this period have been lower than at any time since the 1950s, so companies have had easy and cheap access to funds for investment for years. At a minimum, this tells us that there’s no real economic basis to expect businesses to use their windfall profits from a big tax cut to expand investment.

Instead, they’re likely to use some of their additional profits to fund stock buy-backs. The rest will flow through as dividends and capital gains, mainly for the top one percent of Americans who hold 49.8 percent of stock in public companies, and the next nine percent who own another 41.2 percent of all shares. Those lucky shareholders will use much of their windfall gains to buy more stock; and coupled with the corporate stock buy-backs, the boost in demand for stocks will pump up the markets. To be sure, those shareholders will also spend some of their unexpected gains, which will modestly stimulate growth. Once that stimulus dissipates, as it will fairly quickly, the ballooning budget deficits will drive up interest rates and slow the economy for everyone else.

The worst scenario is that large, deficit-be-damned cuts in the corporate tax rate could produce a stock market bubble that could take down the economy when it bursts. The good news is that the current Congress would never enact it. The odds of Democrats supporting Donald Trump on a tax plan to make shareholders richer are roughly the same as winning the Powerball; and the certainty of soaring budget deficits should scare off enough conservative Republicans to sink the enterprise.



It’s Still the Economy, Stupid!

July 24, 2017

Republicans know that the terrain for next year’s midterm elections could be treacherous.  Off the record, they bemoan their inability to enact their agenda and mourn President Donald Trump’s unpopularity.  In principle, the GOP still might get its act together and pass a tax reform with new tax breaks for middle class taxpayers.  Events unforeseen and unimagined could offer Trump a platform to renew his poplar appeal.  Even so, they’re ignoring the signs that a sagging economy next year will dominate the 2018 campaigns.

The current expansion is old – it turned eight years old this month – and its fundamentals are weak.  Neither Trump nor Congress has done anything to perk it up.  Only the 1990s expansion lasted longer, and it expired two years after its eighth birthday.  Comparing the two will not cheer Republicans. At a comparable point in the expansion that defined the Clinton era, March 1999, GDP was growing at nearly a 5 percent rate; over the last year, GDP has edged up barely 2 percent.

The most important difference is what was happening then with productivity, and what’s happening now.  In the three years leading up to each expansion’s eighth birthday, productivity had expanded at a 2.4 percent annual rate in the 1990s, compared to 0.7 percent this time.  Without decent productivity gains to lift wages and fuel demand, incomes stall and growth slows.

The main reason we’re not in a recession today is the strong job gains of the last three years, and the current 4.4 percent unemployment rate is comparable to the 4.2 percent rate in March 1999.   Full employment normally presages a slowdown in job creation.  We avoided that in the late 1990s, because the strong productivity growth supported more demand by raising wages.    The best measure of that is personal consumption spending, which increased at a 5.9 percent rate in the year leading up to March 1999.  But our current predicament includes such weak productivity gains that personal consumption spending edged up just 2.6 percent over the last year.

It’s the same story with business investment, the other domestic source of new demand. In the year preceding the eighth birthday of the 1990s expansion, fixed business investment rose 8.5 percent; over the past year, it grew 4.2 percent or half that rate.

All of these measures presage a slowdown in the U.S. economy next year – GDP gains of 1.5 percent in 2018 is a fair guess — and we could slip into a recession if some adverse event provides the trigger.

Last October, I cautioned Hillary Clinton that she would face these same conditions if she won, but that three initiatives could breathe new life into this old expansion.  The first order of business is a dose of demand stimulus, preferably through large infrastructure investments paid for down the line.  Trump promised the same thing; but he and the GOP Congress moved quickly beyond it.

The second initiative would focus on energizing productivity growth.  My own recommendations last October started with measures to help average Americans upgrade their skills, by giving them free access to training courses at local community colleges.  The Trump and GOP budget proposals would cut the inadequate training programs already in place.

The third initiative is a companion piece to promote higher productivity: Jumpstart business investment in new technologies and equipment.  That will be harder for Trump than it would have been for Secretary Clinton, because it requires setting aside the supply-siders’ faith in the power of cutting marginal corporate tax rates.  Instead, we should focus for now on lowering businesses’ upfront costs to purchase the new technologies and equipment that make skilled workers even more productive.

The measure would offer businesses a choice: deduct the full cost of those new purchases in the year they buy them – it’s called “expensing” – or stick with the current system where businesses depreciate the cost and deduct the interest on funds borrowed to cover it. Expensing is a feature of the Trump and GOP tax proposals, but both plans offer more sweeping and much more expensive changes that appear headed for the same fate as Trumpcare.

The election of Trump and the GOP Congress buoyed business confidence precisely because investors believed they would follow through quickly with an infrastructure stimulus and business tax reforms.  Neither seems likely today; and even if one or the other somehow passes in some form late this year, it will probably be too little and too late to revive growth and wages by November 2018.  If neither happens, it will take more than tweets to explain to voters why Republican control of both branches of government has failed to improve their lives.



Trump’s Tax Plan is Aimed at the 2018 and 2020 Elections, Not U.S. Competitiveness

April 26, 2017

President Trump wants to cut the tax rate for all American businesses to 15 percent, and damn the deficit. If you believe him, any damage from higher deficits will be minor compared to the benefits for US competitiveness, economic efficiency, and tax fairness. The truth is, those claims are nonsense; and the real agenda here is the 2018 and 2020 elections. Without substantial new stimulus, the GOP will likely face voters in 2018 with a very weak economy – and tax cuts, especially for business, are the only form of stimulus most Republicans will tolerate. Moreover, if everything falls into place, just right, deep tax cuts for businesses could spur enough additional capital spending to help Trump survive the 2020 election.

Let’s review the economic case for major tax relief for American companies. It’s undeniable that the current corporate tax is inefficient – but does it actually make U.S. businesses less competitive? The truth fact is, there’s no evidence of any such effects. In fact, the post-tax returns on business investments are higher in the United States than in any advanced country except Australia, and the productivity of U.S. businesses is also higher here than in any advanced country except Norway and Luxembourg.

The critics are right that the 35 percent marginal tax rate on corporate profits is higher than in most countries. But as the data on comparative post-tax returns suggest, that marginal tax rate has less impact on investment and jobs than the “effective tax rate,” which is the actual percentage of net profits that businesses pay. On that score, the GAO reports that U.S. businesses pay an average effective tax rate of just 14 percent, which tells us that U.S. businesses get to use special provisions that protect 60 percent of their profits from tax (14 percent = 40 percent of 35 percent).

Tax experts are certainly correct that a corporate tax plan that closed special provisions and used the additional revenues to lower the 35 percent tax rate would make the overall economy a little more efficient. But lowering the rate alone while leaving most of those provisions in place would have almost no impact on the economy’s efficiency – and the political point of Trump’s plan depends on not paying to lower the tax rate.

Finally, would a 15 percent tax rate on hundreds of billions of dollars in business profits help most Americans, as the White House insists, since 52 percent of us own stock in U.S. corporations directly or through mutual funds? The data show that most shareholders would gain very little, because with 91 percent of all U.S. stock held by the top 10 percent, most shareholders own very little stock.

Moreover, the proposed 15 percent tax rate would cover not only public corporations but also all privately-held businesses whose profits are currently taxed at the personal tax rate of their owners. So, Trump’s plan would slash taxes not only for public corporations from Goldman Sachs to McDonald’s, but also for every partnership of doctors or lawyers, every hedge fund and private equity fund, and every huge family business from Koch Industries and Bechtel, to the Trump Organization..

There is no doubt that the President’s tax plan would provide enormous windfalls for the richest people in the country. Beyond that, it may or may not sustain growth through the next two elections, since even the best conservative economists commonly overstate the benefits of cutting tax rates. But the truth is, there aren’t many other options that a Republican Congress would accept.