April 15, 2014
For many Americans, today’s Tax Day thoughts will likely center on how much of a year’s earnings must be surrendered to Uncle Sam to fund the federal government.
But another concern is why we lose so much income and so many jobs because our tax system is so badly designed. For our elected officials, Tax Day also offers the chance to consider the most significant economic policy change they could make to raise growth and incomes: tax reform.
The standard economic arguments for long-term supply-side gains from tax reform are right. But they understate the case for tax reform in yielding short-term demand-side gains in the economy and the extent to which tax reform can improve economic opportunity.
Economic gains from tax reform for investment and incomes animate the push for corporate tax reform by many business leaders (with positive nods from both the president and the Congress) and the more comprehensive plan put out in February by Rep. Dave Camp (R-Mich.), the outgoing chairman of the House Ways and Means Committee.
Corporate tax reformers rightly point out the large amounts of U.S. corporate equity income trapped overseas to avoid significant extra U.S. taxes on top of taxes already paid abroad. That tax approach, in which the United States differs from many other industrial economies, reduces the competitiveness of U.S. firms in global markets while also limiting the stock of funds available for more investment and employment in the United States.
Reducing the U.S. corporate tax rate – currently the highest in the industrial world –would increase, investment, employment and wages, especially if financed in large part by broadening the corporate tax base. Economists once thought the tax burden was borne entirely by owners of capital, but many now see it as generating a significant burden on workers through lower wages. (By reducing investment, the tax reduces productivity and wages.)
But attacking corporate taxes is not enough: Many, if not most, tax reformers argue for even more sweeping tax reform. Partly, this desire acknowledges that corporate tax reform is difficult without broader business income tax reform – that is, reducing tax rates on business income more generally, including individual tax rates, while broadening the tax base. In addition, the gains from overall tax reforms would be very large. Reforms that lower marginal tax rates, broaden the tax base and tax income once (and only once) can increase GDP growth by 0.5 percentage points each year for a decade. It is difficult to imagine a more potent policy tonic for higher output, employment and wages.
Broadening the tax base is not simply about generating revenue to finance rate reduction. Fundamental tax reform reduces government-induced distortions in the allocation of capital across types of investments and wasteful health-care spending. Revenue gains from base broadening can also be used to support economic inclusion by subsidizing work by low-income individuals through an enhanced Earned Income Tax Credit, a pro-work and opportunity alternative to increasing the minimum wage, or an alternative subsidy to wages from work.
For the long run, conservative policymakers are interested in fundamental tax reform because of its connections to improved prospects for growth. But liberals should be interested, too. Federal government spending as a share of GDP has risen to as high as 25 percentin the past few years and is currently still elevated at 22 percent of GDP; a lack of long-term spending restraint in Social Security, Medicare and Medicaid will push this figure up substantially. The current federal tax structure has produced at most 18-19 percent of GDP in years of good economic growth across periods in which marginal tax rates have been high or low. Raising tax rates on the incomes of economically successful individuals and businesses will not raise the revenue needed for a much larger government, and those high rates create economic disincentives that inhibit growth. Higher revenue on a sustained basis would need to come from a reformed tax system, with higher rates of taxation affecting most, not a lucky few, taxpayers. Here the United States can learn from European tax systems, with their greater reliance on broad-based consumption taxation to fund larger social spending. So fundamental tax reform offers something for both sides to love.
And in the short run? Much of the Obama administration’s discussion of fiscal policy in general and tax policy in particular has centered on demand-side effects – mired, for instance, in a discussion over the merits of “stimulus.” As a policy to increase aggregate demand, the mix of policies in the 2009 stimulus package was too focused on the mantra of “targeted, timely and temporary.” These were not the right tools to fight an adverse shift in aggregate demand as a consequence of the global financial crisis.
But there is a larger point. Stemming the fall in investment and employment demand in the crisis would have been aided by a jolt—a positive shift in long-term expectations and confidence. Fundamental tax reform, particularly if business-income tax cuts were front-loaded, might have provided that jolt. And it still could, though the effects would have been even higher during the aftermath of the financial crisis.
On Tax Day, it’s only natural to think about the bite taxes take out of our incomes. But we should be thinking about how to make the system work better, too.
This article originally appeared in Politico.