(This item originally appeared at Forbes.com on October 5, 2017.)
The Republican Party has released its framework for tax reform. I like it a lot.
First, let me congratulate all those, within Congress and throughout the policymaking intelligentsia, who kept their eye on what really matters:
It’s the economy, stupid. A healthy economy helps solve every other problem. It reduces the demand for welfare, at the personal level and the corporate; it creates more tax revenue; with more revenue and less need for spending, it allows a reduction in budget deficits. It makes politicians popular, which then gives them the ability to anger certain interest groups in favor of the general good. Get the economy right, and everything else becomes easier. Get it wrong, and you are soon in the spiral of decline: welfare and other socialist demands increase, and the ability to pay for them declines. Deficits balloon, in part because politicians, whose popularity is waning due to the poor economy, start trying to purchase their political support with handouts to cronies and interest groups. Pretty soon, politicians are raising taxes and relying on destructive “easy money” to fix the economy.
To get the economy right, focus on Taxes and Money. There’s not too much that can be done about Money for now; so that leaves Taxes. We have a lot of other economic problems in the U.S. too, including a regulatory monster that is out of control. But, if anything, our recent experience has shown that the U.S. economy can bear a lot of these burdens, if you get Taxes and Money right. We will have to do something about regulation, too, and many other matters, including healthcare. But, those topics promise to be a lot more troublesome, and also to provide less potential benefit. Get the big stuff right, first.
The plan has a lot of great fixes. It gets rid of the Alternative Minimum Tax, discards the “death tax,” allows immediate expensing of corporate capex, introduces territorial taxation for corporations, includes considerable simplification and increases the basic deduction. All these are big strides toward the Flat Tax model, which is our goal here.
I think the Republicans have come to a bit of a conclusion regarding the debate over “Fair Tax” (unified Federal sales tax) proposals. In the end, whatever its merits, it is too dangerous unless we repeal the Sixteenth Amendment. I’ve argued that the natural target for a “Fair Tax” today is not at the Federal level, but at the State level, where sales taxes already constitute the backbone of tax policy. “Fair Tax” fans: get busy in State politics and show us what you can do.
With this in mind, the present tax plan is good. A Steve Forbes-style 17% Flat Tax is better. Take as much as you can get now, and get ready to do more later. We have some natural steps to follow: the next one can be to eliminate the 33% bracket and make the 25% bracket the highest, combined with further simplification and more increases in the basic deduction. From there, it is an easy step to a 17% rate on both individual and corporate income. Other countries have taken a similar path; now it is our turn.
Don’t be distracted by minor matters, and remember that all estimates of supposed revenue declines are wrong. The Japanese government cut taxes every year, 1950-1970. Every year, static estimates showed that this would result in a decline in tax revenue. Every year, politicians ignored the technocrats, and cut taxes anyway; every year, tax revenues rose. After twenty years of this, the revenue/GDP ratio was unchanged, and tax revenues had risen by sixteen times. The economic boom that took place was so intense that, when GDP growth hit 5.7% in 1965, it was considered a recession.
Also, don’t be distracted by minute calculations of supposed “winners and losers.” History shows that higher income brackets tend to pay a higher percentage of total tax revenue when rates are lower. This was true when the top rate was 28% after the 1986 tax reform, and it would be true again at 33%.
I’m glad to see that Republicans have mostly discarded their past discomfort with the fact that most Americans “don’t pay income taxes.” They pay payroll taxes, which are no small matter, and for most people, are indistinguishable from income taxes. A 10% or 15% income tax rate on low incomes, in addition to the 15.3% FICA taxes, soon adds up to an effective marginal income tax rate in excess of 25%. Income taxes on low incomes don’t generate much revenue, but are felt by a broad swath of people. Raising basic deductions is an easy solution that also builds support for tax rate reductions on higher incomes. By reducing significant marginal tax rates on modest incomes, it might even boost employment.
The Tax Policy Center’s estimates of revenue consequences of the plan were widely watched. The TPC explicitly stated that they use “static” estimates, with no changes assumed to growth or behavior. In other words, they are admitting upfront that they are wrong, because there are always growth and behavior consequences, all of them positive, even if we disagree on the magnitude. By their calculation, they estimated a “ten-year cost of $2.4 trillion.” To the average person, this sounds like it would reduce revenue by $2.4 trillion per year for ten years. But, it means the average revenue decline would be $240 billion per year for the first ten years. Since nominal GDP was $18.6 trillion in 2016, and will be higher than that in the future, we’re talking about a reduction in tax revenue by about 1.3% of GDP or less, according to the TPC’s incorrect assumptions.
I don’t think this reduction in revenue would even appear. Most of the revenue decline is expected to come from the corporate tax reforms – actually, more than 100% of the decline, with some revenue gains expected from all non-corporate tax changes. And yet, we’ve seen already that most of the developed world – the OECD – gets more corporate tax revenue than the U.S., at lower rates. Britain gets more revenue (2.6% of GDP) with a 19% rate (equivalent to a 15% Federal and 4% average State tax rate), than the U.S. gets with a 39% effective rate (2.05%). If U.S. corporate tax revenue fell short for some reason (I don’t think it would), that could easily be remedied later with some reduction in exemptions – which we eventually want to do anyway.
Plus: growth. If nominal GDP grew an additional 1% per year, which is a pretty low hurdle considering that we are whacking 15 percentage points off the corporate tax and also doing a lot of other helpful things, the revenue shortfall would be counterbalanced by growth in six years, even if revenue/GDP did fall by 1.3 percentage points, which I doubt. After six years, you would be getting more tax revenue, even at a lower revenue/GDP ratio – a pretty nice return on investment. The other effect of growth is that it tends to allow spending cuts; there is less need for government support. This could easily allow Federal spending/GDP to fall by 1.3 percentage points. In the (unlikely) worst-case scenario, tax revenues fall by as much as the TPC describes; the result is that the Beast is starved, by a little bit; the private economy is substantially empowered; and Washington’s spending-cutters can get to work. Oh the horror.
The future is hard to predict. But, we can look at the range of possibilities, and see that there really isn’t much risk or downside; and the potential gains are big.
Don’t chicken out. This is a meaningful, but relatively modest, step toward the kind of Flat Tax system that has already been a proven success in dozens of other countries. They often did it in one go, and found, in nearly every case, that tax revenues/GDP were unchanged, total revenue increased (a lot!), and the gains to GDP were a lot more than 1% per year. Positive tax reform is about as close as you can get to “free money” in the world of economic policy. Some economists will claim it doesn’t exist—it offends their philosophies of scarcity. I suggest you pick it up.