A Unified Theory of Some of the Misconceptions in the Tax Reform Debate

August 21, 2017

I.

Last week, The Hill published an article titled, “GOP debates retroactive tax cuts.” The article describes how some Republicans have been calling for a tax package that would reduce taxes on income that Americans have already earned, going back to the beginning of 2017:

“We need to make it retroactive so that we unleash the cash and the capital that is sitting there that’s ready to be invested,” [House Freedom Caucus Chairman Mark] Meadows said.

Publishing executive Steve Forbes, who backed President Trump during the 2016 presidential election, said Tuesday in an op-ed for his magazine that it’s crucial for tax cuts to be retroactive.

“Very important, the GOP must make these reductions retroactive to the beginning of 2017,” he wrote. “We want this tax bill to kick up the economy ASAP. And it wouldn’t hurt if people got big tax refunds next April.”

While some claim that a retroactive tax cut is more likely to lead to economic growth, it is not clear how this is supposed to work. After all, if lawmakers reduce tax rates on income earned in January 2017, households would not be able to go back to January 2017 and choose to work more hours in that month; businesses would not be able to travel back in time and choose to make more investments.

Indeed, most economists agree that making a tax change retroactive has little economic benefit, at least in the long run. There are other reasons why lawmakers might choose to make a tax change retroactive: to provide immediate tax relief to U.S. households, for instance, or to align the effective date of a tax change with the beginning of a tax year. But if these considerations lead lawmakers to enact a retroactive tax change, they should not expect the retroactive portion of such a change to contribute to the long-run growth of the U.S. economy.

II.

Back in April, The New York Times published a guest op-ed titled, “Why Are Republicans Making Tax Reform So Hard?” Among other things, the article called for a tax holiday on offshore profits of U.S. companies, claiming that allowing companies to bring their money back from overseas would cause a boost to investment in the United States:

Third, impose a low tax on the repatriation of foreign profits brought back to the United States. This could attract more than $2 trillion to these shores, raising billions for the Treasury while creating new jobs and adding to the United States’ gross domestic product.

The problem with this argument is that there is little evidence that allowing companies to bring back money from overseas leads to higher investment in the United States in the long run. This makes sense: even though a repatriation holiday would put more money in the bank accounts of U.S. companies, it wouldn’t change the underlying profitability of making new investments in the United States. In addition, companies would not necessarily use repatriated money to invest domestically; they could just as easily decide to distribute the money to their shareholders, to be used for consumption.

There may be other good reasons to enact policies that allow companies to repatriate their currently deferred foreign profits to the United States at a reduced rate – for instance, as a transition tax, accompanying a move to a territorial tax system. However, claims that repatriation will lead to substantial investment and economic growth are probably overstated.

III.

Earlier this month, Bloomberg published a report that congressional Republicans are considering enacting some tax rate reductions on a temporary basis, rather than making all of their tax changes into permanent law:

Republicans struggling to pass a major tax overhaul that doesn’t add to the federal deficit are discussing a kind of compromise: mixing permanent revisions with temporary rate cuts for individuals and businesses…

Mixing and matching proposals — making some permanent and others temporary — could be a potential workaround for GOP leaders who want to use a budgetary process known as reconciliation to prevent Senate Democrats from blocking tax legislation. That course limits the scope of the overall bill because it requires that any tax changes that add to the nation’s long-term deficit would have to expire.

It is odd that lawmakers are seriously considering temporary tax changes, given that a central argument for passing a tax bill is the need to grow the U.S. economy. After all, temporary tax changes – especially temporary rate cuts on business – have limited economic effects. Businesses make investment decisions over long time horizons, so cutting their statutory tax rates on a temporary basis will not fundamentally change the calculus of whether to undertake new investments.

Of course, the allure of temporary tax changes is understandable, given the legislative constraints under which lawmakers are operating. Republicans hope to pass a tax bill through the reconciliation process, which prohibits legislation from adding to the federal deficit in the long run. As such, it may be difficult for lawmakers to enact all of their priorities on a permanent basis, and they may resort to passing some of them on a temporary basis instead. However, lawmakers should be fully aware that temporary tax changes come with only limited economic benefits and cannot be the basis of a pro-growth bill.

IV.

Recently, former Speaker of the House Newt Gingrich wrote a column titled, “Tax Cuts – Not Tax Reform – Are Key to the GOP’s Success.” In the column, Gingrich argued that unless a tax bill reduces the level of federal tax revenue, it will not grow the U.S. economy. Specifically, Gingrich argues against “revenue-neutral” tax reform, or any tax bill that leaves federal revenue the same:

Revenue neutrality, on paper, means the bill must bring in the same amount of revenue as current law. So, if you cut taxes in one place, you must raise them elsewhere. A revenue neutral bill would be a tax shuffle rather than a tax cut – and would do nothing to grow the economy.

The argument that revenue-neutral tax reform cannot grow the economy is very flawed. For a simple illustration why, start with the assumption that some taxes are more economically harmful than others. Then imagine a tax bill that would do two things: it would lower a very harmful tax by $100 billion, and it would raise a less harmful tax by $100 billion. Overall, the bill would be revenue-neutral – it would leave the level of federal revenue more or less the same. But even so, the bill would grow the U.S. economy, because it would make the tax system less harmful overall.

In fact, the entire premise of tax reform is that it is possible to make the federal tax code more economically efficient without substantially changing how much revenue the government raises. The approach of “broaden the base and lower the rates” is designed to make the structure of the federal tax code more conducive to economic growth, even if the level of federal revenue remains the same.

V.

I’ve highlighted four instances in which lawmakers and other public figures have (in my opinion) gotten the economics of tax reform wrong. This is not surprising: tax policy is complicated, and people are bound to make incorrect statements from time to time. However, I think that these four examples exemplify a common pattern – one that I’ve noted frequently throughout the tax reform debate so far.

All four of these questionable tax policy positions seem to share a common premise: the primary channel through which tax policy grows the economy is by putting more money in the pockets of households and businesses.

Let’s call this the “Folk Theory of Taxes and the Economy.” The theory goes something like this:

  1. The size of the U.S. economy is determined by spending: how much households spend on consumer goods and how much businesses spend on new investments.
  2. When the government collects taxes, it reduces the amount of money households and businesses have available to spend. This causes them to spend less than they otherwise would, which leads to a smaller U.S. economy.
  3. Federal tax policy can grow the economy by lowering the level of tax collections, which would make more money available for households and businesses to spend. If a federal tax bill doesn’t reduce the level of tax collections, it will do little to help the economy, because households and businesses will not spend any more.

According to the “Folk Theory,” retroactive tax cuts, repatriation holidays, and temporary tax breaks would all be sensible pro-growth policies, because they put more money into the pockets of households and businesses.

VI.

When economists discuss how tax policy affects the U.S. economy, they often rely on a different theory. We might call it the “Neoclassical Theory of Taxes and the Economy,” and it goes something like this:

  1. The size of the U.S. economy is determined by the amount of labor, capital, and technology. “Labor” is the number of hours people work. “Capital” is how much equipment, buildings, software, and such is available to work with. “Technology” is how efficiently businesses can combine labor and capital to make things people want.
  2. There is evidence that tax policy can have a substantial effect on decisions about how much people work and how much capital is created.[1] All existing tax systems contain some features that discourage work and investment, which lead to a smaller economy.
  3. Federal tax policy can grow the economy by lowering marginal tax rates on work and investment, which would encourage people to work more and businesses to invest more. If a federal tax change does not affect marginal tax rates, it will do little to help the economy, because households and businesses will not change their decision-making.

Under the “Neoclassical Theory,” the economic effects of a tax change are independent of whether the level of tax collections goes up or down. For instance, even though retroactive tax cuts would lower federal revenue, they would not affect marginal tax rates going forward, so the “Neoclassical Theory” would expect them to have little economic effect. Conversely, one could imagine tax changes that do not lower federal revenue but still grow the economy.

The chart below compares how the “Folk Theory” and the “Neoclassical Theory” approach the four issues mentioned above: retroactive tax cuts, repatriation holidays, temporary tax cuts, and revenue-neutral tax reform:

Comparing Two Approaches to the Economics of Tax Reform
  Folk Theory of Taxes and the Economy Neoclassical Theory of Taxes and the Economy

Retroactive tax cuts

Leads to economic growth by putting money in the pockets of households and businesses Does not lead to long-run growth, because taxpayers cannot change past decisions about work and investment

Repatriation

Leads to economic growth by allowing companies to “bring money home” that can then be invested in the U.S. Does not lead to long-run growth, because it does not change the underlying profitability of investing in the U.S.

Temporary tax cuts

Leads to economic growth by putting money in the pockets of households and businesses Does not lead to long-run growth, because decisions about investment are made on long time horizons

Revenue-neutral tax reform

Does not lead to economic growth, because it simply increases taxes on some taxpayers and decreases taxes on others, without lowering the overall level of taxes Can lead to economic growth by removing or lessening structural biases in the federal tax code, and by lowering marginal tax rates on work and investment

VII.

I should note that the “Folk Theory of Taxes and the Economy” is not meant to be a pejorative label. I’ve termed it such because I think that it’s the primary lens that most ordinary people use when thinking about the relationship between taxes and the economy. I think this holds true on both sides of the political aisle. One sometimes hears dialogues like this one:

CONSERVATIVE: We need to lower taxes in order to put more money in the pockets of successful businesses, so that they can grow the economy.

LIBERAL: No, we need to lower taxes for the middle class, who are more likely to spend their money right away. That’s how we can grow the economy.

Both participants in this hypothetical dialogue are implicitly relying on the “Folk Theory”: they both agree that the path to economic growth is putting more money in somebody’s pockets. They simply disagree about whose pockets.

VIII.

From an economic point of view, the “Folk Theory” is not necessarily wrong. In fact, it may be a good description of how federal tax policy should operate during recessions and other periods of low aggregate demand. When the economy is operating below potential, it may be imperative to get consumers and businesses spending money as quickly as possible, and cutting taxes is one way to do that.

But when the U.S. economy is operating close to potential, the case for the “Folk Theory” becomes weaker.[2] One reason is that the theory fundamentally relies on a claim about an income effect: it posits that, if households and businesses have more income, they will engage in more economically productive activities. But income effects do not always point in a positive direction: for instance, as a household becomes wealthier, it might choose to work less and enjoy more leisure time.

On the other hand, the “Neoclassical Theory” is based on claim about a substitution effect: if you make work cheaper relative to leisure, households will work more; if you make investment cheaper relative to consumption, businesses will invest more. These substitution effects are unambiguously positive for the economy, which puts the “Neoclassical Theory” on a firmer grounding.

One more point in favor of the “Neoclassical Theory” is that it seems to hold up well empirically. As mentioned above, several studies confirm that labor and investment do indeed respond to marginal tax rates, which puts the building blocks of the theory on solid ground. In addition, neoclassical models seem to do a pretty good job of interpreting the history of recent federal tax changes.

IX.

The debate about tax policy and the U.S. economy is complex, heated, and difficult to resolve. There are dozens of relevant studies, historical examples, and economic models, the vast majority of which I haven’t mentioned at all in this piece.

Here, I’d simply like to suggest one small way that we could improve the debate about taxes and the economy. When someone makes a claim that a particular tax change will lead to economic growth, we should ask, “What is the mechanism by which this would happen?” Perhaps our interlocutor is arguing that a tax change will put more money in the pockets of businesses; maybe the claim is that a tax change will lower the marginal tax rate on investment. In any case, our discussions about tax policy would be enriched if we pointed to specific causes and effects.


[1] The question of how tax policy affects technological innovation – or, indeed, what causes higher “total factor productivity” in general – is quite difficult to answer.

[2] The question of whether the U.S. economy is currently operating at potential (or even whether “potential GDP” is a coherent term) is hotly debated and hard to answer.

 


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