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A Better Plan for Tax Reform

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Message Matt Lykken

It is imperative that the U.S. to boost growth without losing revenues. Interest on federal debt outstanding for 2016 was $433 billion, and when interest rates normalize to 2007 levels that figure would jump to $938 billion on just the debt we owed in 2016. 71% of that debt was incurred in the Bush and Obama administrations. The interest attributable to just those two administrations will equal over 45% of 2016 individual income tax receipts -- almost half the tax you pay. Unless we can BOTH grow the base and avoid losing revenue, the American people will be permanent debt serfs. That is on top of unprecedented amounts of student loan, mortgage, car and consumer debt. Meanwhile, the quality of U.S. jobs continues to decline along the trend that has been evident since the 1970s. With the forthcoming leaps forward in the automation of tasks that lower-skilled professionals currently perform, if we don't address these problems now our economy will be too weak to recover.

This growth cannot be triggered by supplying new capital. Our economy is not limited by capital, but by demand. It is nonsensical for business to invest in new property when American consumers lack the funds to buy new products. The decline in quality of employment has left consumers strapped and in debt, because they lack market power to demand their old share of business profits. Labor's share of total income has fallen substantially since 1973. The government's attempts to provide stimulus through low interest rates have increased consumer debt in an unsustainable manner. The bulk of the American public has few assets beyond their homes and retirement savings (40% have no net assets -- a child with a dollar in his pocket has a higher net worth than 40% of Americans combined). While average retirement saving is itself far too low, the funds that people do have are largely in the form of tax-preferred investments in stocks through IRAs, 401(k)s/403(b)s, insurance annuities, and the like. They also have an indirect interest in the stock market through state and local and corporate pension plans, most of which are funded by stock and many of which are under stress. Because middle-class savings are low and interest rates on bank savings are nearly nonexistent, consumers since 2008 have been shy about spending. Many Baby Boomers who had intended to retire by now are instead continuing to work, bidding down wage rates and keeping their non-IRA savings in the bank at depressingly low interest rates.

Tax cuts to put money in consumers' pockets are unsustainable. Historically much of the revenue loss from cuts would come back as consumers bought products produced by workers who therefore received more pay to buy more products and pay taxes, but today we have significant dampers on that virtuous cycle. Much of the benefit flows abroad to foreign suppliers under our massive trade deficit, as shoppers head to Walmart to buy Chinese merchandise or burn more Saudi oil. Much of the rest concentrates in the hands of the wealthy due to the lack of employee market power, and the wealthy spend only a fraction of their money, breaking the cycle of demand.

Tax cuts that flow to capital income are particularly unhelpful. They are ineffective at providing stimulus in a demand-limited economy. Meanwhile, reducing rates on capital income tends to flow money to the wealthy, so such subsidies stifle aggregate consumer demand. Further, subsidies such as low capital gains rates are not tied to American investment, but rather equally subsidize American dollars flowing to China or France. Small-business expensing and the like stimulates questionable tax reporting and thus the short-term appearance of stimulus, but produces little actual ripple-effect stimulation. To the extent that small businesses do spend more, if they are not met with an actual increase in consumer demand they just lose their investments, again dampening the benefit.

Lowering tax rates on small business is unlikely to stimulate business expansion, since there are relatively few people with a good business idea who chose not to earn money just because they are opposed to the resulting taxes. Small businesses, unlike multinationals, cannot choose to avoid tax by changing their operations or performing them elsewhere. They either earn profits or they don't, and they would rather earn $1.00 and keep 70 cents than earn nothing. However, tax reductions on genuine small business do put money in the middle-class owners' pockets that they will likely spend, and are thus better than subsidies to capital income.

Lowering tax rates on businesses that are of a size and variety that can choose whether to do business in the United States, on the other hand, has a substantial stimulative effect. The benefit has to be stable enough to convince the companies to change their business location, but once that hurdle is overcome real operations that pay real wages will be more likely to remain in or come back to America. That will not be true for low-wage, low-margin operations that are more sensitive to pay scales than to tax rates, but those businesses would not help much anyway. The businesses that respond to tax rates are high-margin businesses of the type that are relatively willing to pay good wages. Those businesses are ideal for the virtuous cycle, bidding up wage rates and putting cash into the hands of consumers. At the same time, bringing operations back to the U.S. helps to ensure that the consumer dollar will be spent on U.S. goods and services, again aiding the virtuous cycle of stimulus.

Against this background, what can we say about the House Blueprint for tax reform? Its subsidies for capital gains are unacceptably inefficient. Corporations do not decide where to place their wage-paying operations on the basis of individual tax rates on capital gains or dividends. Therefore, such subsidies will not encourage investment in U.S. operations. Even if this country was capital constrained, subsidizing capital gains would not cause moneyed individuals to invest in U.S. operations rather than foreign operations.

The Blueprint is quite correct in seeking to lower the effective corporate tax rate, but a 20% target, even if achievable, would merely make the U.S. competitive; it would not make us the best. Should we settle for less than the best when it comes to our livelihoods? Further, we cannot achieve anything close to a 20% rate by eliminating special-interest deductions. Even getting to 28% via base broadening would require eliminating all subsidies directly aimed at U.S. investment, a poor trade-off for a rate reduction that would be location-neutral. The BAT seeks to make up the difference from consumers, which would only siphon off U.S. consumer demand to the tax man. The proposed one-time tax on foreign earnings has the advantage of being a sneak attack, and thus can be expected to have a relatively small negative effect on behavior, but a one-time tax cannot support a permanently reduced rate. Longer-term or periodic taxation of the profits that U.S. corporations earn abroad will continue to encourage inversions and acquisitions by foreign companies, while U.S. companies would be unable to bid successfully to acquire low-tax foreign operations from others.

Reducing tax rates for business other than corporations is not efficient stimulus. While changes in tax rates drive short-term behavior, with taxpayers postponing income before a reduction and triggering income after it becomes effective, there is little evidence for significant long-term effects with regard to operations that are not mobile. Again, taxpayers who only have a choice of earning income or not earning it tend not to be pushed over the decision boundary by a 15% difference in the tax rate. Further, contrary to the calls for tax simplification and for reducing IRS interference, placing stress on the boundary between "business" income and other income will unavoidably create many controversial issues.

The Blueprint's proposal to lower income tax rates on working Americans makes more sense, subject to the problems discussed above. Lowering rates from the bottom of the working scale rather than the top is the most efficient, since those nearer to the bottom spend more of their incomes. Such reductions would be more efficient if combined with corporate tax reform that really stimulated investment in U.S. operations, since consumer spending would then be more likely to recycle repeatedly within the U.S. economy.

If the drawbacks and inefficiencies in the Blueprint were unavoidable, then we would need to try to learn to live with them, for reform is surely necessary. But they are not unavoidable. The Shared Economic Growth proposal would reduce the rate that a corporation "feels" on its U.S. operations to zero, the best rate in the world. It would do so in a way that was revenue positive today, and would become more so as the Baby Boomers retire. It would provide a wealth effect to working Americans, particularly helping the responsible savers who have borne the brunt of the hidden "80% tax" on interest income under Fed policy. It would remove distortions and inefficiencies from our economy and stimulate the free flow of investment cash. It would place our subsidies where they do the most good and would improve the fairness of our tax system. Shared Economic Growth puts the incentive where it counts, and pays for it by reducing incentives that are obsolete.

The Shared Economic Growth proposal

Shared Economic Growth is based upon a dividends-paid deduction, a mechanism that the Senate Finance Committee has wisely advocated. While the Committee's prior proposal was considering a withholding tax as the offset, however, Shared Economic Growth instead eliminates ineffective and unnecessary subsidies for most capital gains and dividends (recall that President Reagan eliminated special capital gains rates before Congress brought them back), and makes high-income Americans pay the equivalent of the FICA taxes paid by ordinary working people. This still leaves the wealthy with relatively low tax rates by global standards. We don't want such high rates that we make it worthwhile for the rich to give up their citizenship. We do, however, need to rebalance in favor of productive working people rather than those who rig markets and gamble with other people's money.

Corporations would be able to expense their domestic investments, so that they would have a choice between currently investing their earnings in U.S. operations or paying them out for someone else to invest.

Why is this a better offset than a withholding tax? The power of a dividends-paid deduction is that it applies strong pressure on corporations to move their operations to America, away from any foreign tax, in order to boost their P&L and please the stock analysts. Because a large portion of stock holdings are in the hands of mutual funds, pension funds, tax-advantaged retirement savings accounts, charitable foundations and the like, shareholders would pressure companies to reduce their tax rate towards zero by making U.S. investments or paying out dividends. Adding a withholding tax changes that equation, taking the pressure off the companies and permitting corporate management to maintain their practice of doing buy-backs in order to increase the value of their stock options. Further, adding a withholding tax would take away the middle-class wealth effect, maintaining stress on the value of retirement savings and maintaining pressure for the responsible middle class to minimize spending. It would take away the fairness benefit of allowing earnings to be taxed at progressive rates or to benefit from retirement savings incentives. The Shared Economic Growth pay-fors, in contrast, would cause those who derive their income from capital (the speculators who brought us 2008) to be taxed more like working people.

Efficient stimulus that helps the middle class and doesn't bloat federal debt. It's not that difficult.

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Matt Lykken graduated with honors from Harvard Law School in 1985 and has been working as a tax attorney for 27 years. He began his career with the Office of Chief Counsel, I.R.S., and for the last 22 years has worked as an international tax planner (more...)
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