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The recent joint statement on U.S. tax reforms by Republicans in Congress and the Trump administration is clear about its goals of protecting American families, jobs and businesses, but brings little clarity to how those could be achieved. Its authors want lower taxes for households and businesses, but don’t explain how the government would recoup the revenue losses those would entail. They are clear in rejecting two proposals doing the rounds — a border adjustment tax and a consumption-based tax.
Trump’s campaign assurance that lower taxes would spur economic growth sufficiently to recoup the lost tax revenues doesn’t add up, according to Kent Smetters, Wharton professor of business economics and public policy. He is also faculty director of the Penn Wharton Budget Model, an interactive analytical tool that allows users to weigh the potential impact of individual policy proposals. Proposals to raise revenues by eliminating deductions and exemptions for individuals are tantamount to tax increases, said James Hines, Jr., professor of law and economics at the University of Michigan, and research director of the Office of Tax Policy Research at the university’s Stephen M. Ross School of Business.
Smetters and Hines dissected the various proposals to determine who will benefit the most from them on the Knowledge@Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)
Here are key takeaways from their discussion:
Some Knowns, Many Unknowns
According to Smetters, Trump’s campaign pronouncements contained many specifics on corporate and individual tax reforms, but the new White House plan backed by Republicans in Congress is largely opaque. He noted that the latest White House proposal on expanding tax deductions for capital expenditure is significant, but pointed out that another proposal on individual tax brackets doesn’t specify the thresholds.
The statement’s authors are clear about the final outcomes they want. “The goal is a plan that reduces tax rates as much as possible, allows unprecedented capital expensing, places a priority on permanence, and creates a system that encourages American companies to bring back jobs and profits trapped overseas,” they wrote. They also want “a lower tax rate for small businesses so they can compete with larger ones, and lower rates for all American businesses so they can compete with foreign ones.” On the individual side, they want to “make taxes simpler, fairer, and lower for hard-working American families.”
Sadly, the math doesn’t quite work, according to Hines. “[The proposals] … lead to a huge deficit of a type that Congress would never countenance,” he said. “The more recent pronouncements are long on whose taxes are being reduced and offer virtually nothing on the side of where the money will be made up. Everybody likes tax cuts, but the problem is, you have to pay for government.”
Making the Math Work
According to Smetters, assumptions of “revenue raisers” by the Trump administration offer little respite. Those revenue raisers include the elimination of certain deductions or exemptions such as on health care premiums and select state and local tax deductions. But even with the elimination of those deductions, the government would see a 10% drop in revenue. That gap would double to 20% without the elimination of the deductions, he said, citing analysis using the Penn Wharton Budget Model.
At the same time, both Democrats and Republicans recognize that U.S. corporate taxes have to be lowered to help American companies compete more efficiently in international trade, Hines noted. But that is easier said than done. “The problem is, if you lighten the burden on business, you have to make it back somewhere,” he added. “That’s where Congress is stymied.” He noted that if corporate taxes are lowered, politicians will demand lower taxes for individuals as well.
That situation then trains the sights on government spending, which again brings little hope. “The only thing you can do is to cut government spending, but Congress has proven to be incapable of that,” said Hines. Smetters pointed out that “under the most optimistic scenario of still cutting a lot of deductions,” the government would have to find ways to cut another 20% of federal outlays excluding Social Security and Medicare, which the Trump administration has said will not face cuts.
Will the ‘Positive Dynamic Effect’ Occur?
Smetters noted that the Trump administration’s broader argument is that its proposals will have a “positive dynamic effect” on economic growth and that will grow the tax base sufficiently enough to compensate for the revenue losses from tax cuts. “But the problem is to get that effect, you can’t build up a budget debt at the same time, because that works in the opposite direction of lowering marginal tax rates,” he said.
According to Smetters, the proposal to grant more tax breaks for capital expenditure will have a salutary effect on economic growth. One proposal doing the rounds is to allow companies to elect whether or not they go through a capital expensing where they could write off their capital investments immediately. He said many economists like that proposal since it can stimulate investments and raise tax revenues progressively.
“Everybody likes tax cuts, but the problem is, you have to pay for government.” –James Hines, Jr.
Even as the latest proposals reject the introduction of a “border adjustment tax,” Smetters said it would help. “It will create more parity between the U.S. and the worldwide tax system and help U.S. businesses compete better globally,” he said. Opponents of that tax – such as Wal-Mart — have said that it would make imports costlier. The border adjustment tax proposal aims to exempt exporters’ profits from taxes and remove existing tax deductions for what importers purchase from foreign countries.
If the government chooses to eliminate some tax exemptions and deductions such as for state and local taxes or for employer-provided health benefits, such moves could prove counterproductive, Hines warned. “Those are tax increases and they discourage economic activity in the way that tax increases do,” he said, and Smetters agreed.
Economic Growth vs. Income Distribution
Which constituency should get the biggest breaks — businesses or individuals? To find answers to that question, the government has to decide which of the two it wants more — economic growth or distribution of income, said Smetters. “Often those things don’t work in the same direction; it is a classic tradeoff.”
Economic growth is typically driven by corporate tax reform, which includes both tax cuts and allowing deductions for expenses, he noted. But if those cuts are to be offset by removal of some other deductions for individuals, individuals would be hurt, said Hines. “Most of the revenue potential is in the middle class and the upper middle class, because that is where the big numbers are; the higher income people are already taxed a lot,” he said. “Taxing medical benefits will hit people hard in tough parts of the income distribution curve.” That dilemma is a tough one to crack, and “everybody is avoiding a discussion on new sources of revenue,” he added.
Slow Road Ahead
According to the joint statement, the decks are clear for the two committees charged with recommending tax reforms– the House Ways and Means Committee and the Senate Finance Committee – to begin their work. Its authors expect the necessary legislation to begin moving through the two committees this fall. However, Hines and Smetters don’t expect significant progress this year. “It’s a fantasy if you think something serious will get done in tax reform in 2017,” said Hines. Smetters agreed: “The timeline doesn’t work for any major tax reform” to see the light of day this year.
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4 Comments So Far
Edward Dodson
Our politicians (and, apparently, their advisers schooled in the economics of taxation) continue to avoid a deep analysis of what sources of public revenue are both just and will contribute to sustainable economic growth. This is not say that the entire economics profession ignores these issues. The problem is that their observations and conclusions rarely, if ever, find their way into the public dialogue.
As an almost life-long proponent of tax reform, I have studied the literature thoroughly going back as far as Richard Cantillon and other political economists of the 17th, 18th and 19th centuries. Their perspectives have been resurrected in modern times by a small number of economists. There was Scott Nearing at Wharton at the dawn of the 20th century, followed by Harry Gunnison Brown (University of Missouri) and John Commons (University of Wisconsin). Many of their insights were further advanced and developed by C. Lowell Harriss (Columbia), William Vickrey (Columbia) and Mason Gaffney (University of California). It seems that former World Bank economist Joseph Stiglitz (Columbia) has joined this list.
What is it that they share? It is their recognition that rent-derived income is unearned and is the most appropriate source of public revenue. There are many sources of unearned rents in our society, imputed and actual streams of income that exist not because of what the owner of an asset does but by aggregate public and private investment in infrastructure and other societal amenities. Yet, our tax codes treat rent-derived income and gains on the sale of the assets involved far more lightly than income earned by producing goods or services. Gains on the sale of land and financial instruments are treated as “capital gains” even though actual capital goods (i.e., buildings, machinery, technologies) depreciate rather than appreciate over time.
Distinguishing between earned income and rent-derived incomes ought to be the basis for reform of our tax system.
Richard Schaefer
I take a more simplistic view.
For many years, everyone has been saying the government is too big. It is time to do something about it. Bureaucrats have been lining their pockets with inflated salaries at the expense of the average taxpayer. Washington,DC and its surrounding areas was the only place that did not suffer at all in “The Great Recession” and was oblivious to what was happening to the rest of the country. Washington, DC was built on a swamp and now is the time to drain it. Sound familar?
The problem is not how to pay for the government, but how to cut back on an ever-growing behemoth that is unwieldy and in charge of out-of-control spending. There was a study done about twenty years ago that revealed many departments had outlived their usefulness and original intent. The recommendations were to eliminate those entities and streamline other departments that overlapped each other with duplication. What happened? Nothing.
What we need is a 5-year plan that starts with laying off 10% of every department, including 10% of the management. In the corporate world, it is called “getting rid of the dead wood”. This needs to continue at the 10% rate per year until it is managable. Identified out-dated departments need to be eliminated and not go on in perpetuity.
It is not the time to try to figure out how to pay for something, but how to manage the spending by cutting back.
Like I said, I take a more simplistic view.
Edward Dodson
Mr. Schaefer, there is no doubt you are correct that the public sector needs to be significantly reduced for all the reasons you state. My response is that by changing the way public revenue is raised we will come closer and closer to a full employment society, dramatically reducing the need for some of the functions government has been called upon to perform. Tax simplification will by itself release a huge number people from the tax compliance service sector.
Anumakonda Jagadeesh
Proposal released yesterday by the White House outlines some bold ideas that have long been tossed around think tanks and academia. Glenn Hubbard, former chair of the Council of Economic advisors under George W. Bush and dean of Columbia Business School, says, “Directionally, I like many elements of it, though I am unclear on many details.”
At first glance it appears regressive: lower top tax rates, repealing the Alternative Minimum Tax, cuts to capital income, and eliminating the estate tax, which, because of its high minimum threshold, applies only to the richest 0.2% of American families(Trump’s tax agenda is exciting and ambitious, but who will pay for it?Allison Schrager,QUARTZ).
Dr.A.Jagadeesh Nellore(AP)