Overhauling the tax code is a wonky fixation of the D.C. policymaking elite, for good reason — it’s an area loaded with policy nuance, lobbying intrigue and major ramifications for long-term fiscal sustainability.
Senate Finance Committee Chairman Max Baucus (D-MT) and House Ways and Means Committee Chairman Dave Camp (R-MI) have been barnstorming the Midwest promoting their version of bipartisan tax reform. But the dominant paradigm being peddled underscores Washington’s all-too-prevalent complacency about the jobs crisis, and suffers from misguidedly insular perceptions of what promotes long-term economic growth.
The “Dear Colleague” letter circulated by Baucus and Camp in support of their plan proposes a “blank slate” — specifically, that all tax expenditures would be repealed, unless they were demonstrated to advance one of the following goals: “(1) help grow the economy, (2) make the tax code fairer, or (3) effectively promote other important policy objectives.” A high bar that sounds promising in theory, but these vague criteria require some unpacking to be understood fully. For starters, Thomas Hungerford of the Economic Policy Institute rightfully adds the unstated but immutable Congressional prerogative, “(4) effectively promote important political objectives such as reelection.”
Before we get to the flaws in Baucus and Camp’s approach, let’s get a sense for what’s at stake. Collectively, tax expenditures – those deductions, exclusions, credits, exemptions, deferrals of tax liability and preferential treatment of investment income that often get lumped together under the term “loopholes” — reduce federal revenue by roughly $1.1 trillion annually. There are real political barriers to recouping much of this revenue: costly tax expenditures tend to have vested or broad constituencies (see Hungerford’s post, or this Congressional Research Service paper).
The impact of any tax reform on economic growth and progressivity – not to mention considerations too taboo for bipartisan acknowledgement (namely, revenue adequacy and income inequality) – will depend on which tax expenditures are eliminated, and how the resulting revenue increase is used. And with the economy far from fully recovered, reviewing tax and budget policy with an eye toward promoting growth is laudable.
Yet the Baucus-Camp approach is colored, or even tainted, by the presupposition that government spending is anathema and thus fails to properly weigh whether tax expenditures “help grow the economy.” The real test to determine that is whether the revenue loss associated with the expenditures could better promote near- or long-term growth if repurposed as increased revenue, decreased marginal tax rates, reformed tax expenditures or increased government spending. In other words, those expenditures all come with an opportunity cost. To see if they are really worth keeping, we must look at what else could be done with that money.
Instead, much of the current drive for tax reform is falsely premised on the belief that tax expenditures should be repealed to finance lowering rates, since, the argument goes, lower top marginal tax rates are a powerful spur to growth. This was the basic framework of the 1986 overhaul, which is still the dominant paradigm for reform largely because it succeeded politically (never mind how drastically the fiscal and economic context have shifted in a quarter century). Broadening the tax base to lower top rates is almost certainly what Baucus has in mind, and it’s the lodestar of Camp’s proposal: cutting the top corporate and individual rates to 25 percent.
But the premise that lower corporate and individual income tax rates are necessary to promote growth goes against empirical evidence. Recent research on behavioral responses to taxation, as well as historical and cross-country regression analyses of top tax rates and macroeconomic performance, strongly suggest that these growth effects are substantially overstated.
A recent paper by Hungerford, for example, finds that neither the statutory corporate tax rate nor the effective marginal tax rate on capital income (a better reflection of average rates accounting for tax expenditures) have had a statistically significant correlation with economic growth between 1947 and 2010. And a broad array of research, summarized in this paper, suggests lowering top income tax rates will increase unproductive economic behavior (by increasing payoffs to tax avoidance) without meaningfully boosting economic growth or any of its driving factors.
Moreover, to the extent that lowering top marginal tax rates might boost growth by, for example, increasing the supply of labor or savings, these promised long-term term effects cannot hold traction until the economy has already recovered. The U.S. economy is now constrained by a lack of aggregate demand, not by labor supply or the supply of savings (e.g., interest rates are historically low, financed by a huge glut of domestic savings that is constraining demand). Supply-side elixirs cannot fix a demand-side jobs crisis.
In this environment, boosting near-term growth requires policy tradeoffs that would increase present consumption or investment. Over the longer-term, boosting potential output requires reallocating resources to induce greater labor supply, capital accumulation (public plus private net savings), population growth or technological innovation. And in a saner political climate, tax reform could simultaneously boost near-term demand and long-term growth prospects by reversing some of the damaging and fiscally counterproductive austerity enacted.
So how should tax reform be structured? Replacing poorly targeted tax expenditures with direct government spending would help address the drastic shortfall in aggregate demand. Public investment is a key driver of innovation and productivity growth, demonstrating much higher rates of return than most private capital and tending to crowd–in private investment, too.
The long-run growth from increasing core public investments is less ambiguous and certainly greater than that of throwing revenue at marginal rate reductions. (There is zero credible evidence that too-high tax rates or excessive public debt are constraining U.S. economic growth today.) Problematically, the current trajectory for public investment, lowered by sequestration and discretionary spending cuts, is inadequate and imprudent for a competitive 21st century U.S. economy; the Obama administration, House Republican, and Senate Democrat budget proposals for fiscal 2014 all proposed federal nondefense public investment falling within a decade to its lowest levels since 1947.
The nexus of tax expenditures, investment, and innovation is the politically popular research and experimentation (R&E) credit, estimated to reduce revenue by $41 billion over the next five fiscal years. All businesses eligible to take the R&E credit will do so, but many will not set their research and development expenditures based on the credit.
That means some subsidized research spending would take place regardless of tax policy. A dollar repurposed from the R&E credit to direct funding for the National Laboratories or the National Institutes of Health (NIH) would, on the margin, almost certainly produce more national investment. A dollar of direct investment to the National Laboratories or NIH would also likely produce four times the boost to near-term gross domestic product (or jobs) as a dollar spent cutting the corporate tax rate or repealing many corporate tax expenditures, if not considerably more.
There are other potential benefits to be reaped by replacing R&E credits with direct funding for research. Historically, direct public investment in the United States has driven major breakthroughs in technological innovation, as Robert Kuttner documents in his now-classic book, Everything for Sale. And the gains of public investment tend to be shared more equally than research gains owned by shareholders, particularly when innovation or intellectual property subsidized by the R&E credit is subsequently transferred to overseas tax havens.
If they’re truly interested in boosting economic growth, the champions of tax reform should carefully weigh tax expenditures’ opportunity costs without bias about government spending. In many cases, direct government spending could more efficiently promote policy objectives and meet public investment needs than tax expenditures, while increased public investment would almost certainly do more for long-run growth than further marginal rate cuts.
Spurring recovery from the Great Recession and laying the foundation for an innovative, competitive economy requires something far different than “pro-growth” stamped approval from industry and the high priests of voodoo economics. Sadly, that’s not what Baucus and Camp seem to have in mind.