Tax Reform and Economic Growth
Authored By J.D. Foster, U.S. Chamber Senior Vice President, Economic Policy Division, and Chief Economist
Comprehensive tax reform rests foremost on two pillars: middle class tax cuts and reforms to induce stronger economic growth. Other issues such as simplification, transparency, fairness, and permanence are also important, but providing middle class tax relief and improving economic growth are and will likely remain tax reform’s driving motivations.
The exact amounts and allocations of middle class tax cuts will only be known with some confidence once a bill is in hand subjected to analysis by the CBO, the JCT, and outside groups. In contrast, even specific legislative language will generate a range of results regarding expected economic effects. In some cases the expected wide range of results will reflect inherent biases of the analysts, yet in many instances the range of results will reflect fundamental and legitimate disagreements about how tax policy affects the economy, what model types can best capture these influences, and what behavioral assumptions to employ.
Tax Policy and the Economy
Tax policy influences economic outcomes primarily through distortions imposed on prices and incentives individuals and businesses face in making economic decisions such as how many hours to work, how much to save, and when, where, and how much to invest. In almost all cases these tax distortions push decision makers away from those decisions that would otherwise be in their own best interests, the cumulative effect of which is to reduce economic efficiency and the growth of output and incomes.
Correcting tax policy to minimize tax distortions requires care in constructing the tax base and then applying the lowest possible tax rate. Both features are important to pro-growth tax reform: the correct tax base and a low tax rate. For this reason, allowing businesses to deduct in full and immediately the cost of capital purchases, adopting a competitive international tax system, and reducing business tax rates for all forms of businesses anchor pro-growth tax reform.
In recent years the Tax Foundation has analyzed a variety of tax reform plans very similar in outline to the “Big Six” framework, the starting point for comprehensive tax reform. Most economic models used in this arena were originally designed for other purposes and then adapted for tax policy analysis. The Tax Foundation model was designed specifically to analyze the economic effects of major tax policy changes and employs assumptions about specific behavioral responses in line with other models. The Tax Foundation model’s results are not necessarily more accurate than another model’s results, but the Tax Foundation model does provide a credible picture of the order of magnitude of economic effects.
Tax Foundation Estimates
Of the many tax reform plans the Tax Foundation has analyzed in recent years, some differ too much from the Big Six framework to allow a useful comparison. The plans listed below differ from the framework, however all are projected to improve economic performance significantly and all share three key features:
- Reducing business tax rates below 30%
- Expensing of capital purchases
- A territorial tax system
Plan Long-Run Static Cost Long-Run Dynamic Cost Long-Run GDP Gain
Rubio-Lee (2015) -$4.1 trillion +$94 billion + 15%
Jeb Bush (2015) -$3.6 trillion -$1.6 trillion + 10%
House Republican (2016) -$2.4 trillion -$191 billion +9.1%
The Tax Foundation also provides details on how specific provisions contribute to economic growth. Tax reform necessarily involves choices. Competing considerations will limit how far Congress can lower tax rates, for example. Relative economic effects provide key information in making these decisions. Note that combinations of proposals interact and will tend to have a different total effect than appears from adding up the effects of the individual elements.
Key Provision Long-Run Change in GDP
Lower corporate tax rate to 20% Gain of 3.1%
Reduce pass-thru business rate to 25% Gain of 1.1%
Expensing of capital equipment Gain of 4.0%
Eliminate deduction for net interest Loss of 0.3%
Implications of Faster Growth
The mirror image of faster GDP growth is faster household income growth – wages, but also the returns to saving. Real wage growth is ultimately determined by the amount and quality of capital that workers have available, the tightness of labor markets, and the skills and aptitudes of American workers. Pro-growth tax reform directly addresses the first two factors, increasing the rate of capital formation and keeping the economy operating closer to its potential.
Faster economic growth from tax reform would also have important overall fiscal consequences. The Analytical Perspectives volume of the President’s Budget provides useful and broadly accepted rules of thumb relating changes in some economic projections and their fiscal consequences. The most recent edition suggests a 5 percentage point increase in GDP spread evenly over the 10-year budget horizon would increase federal receipts by about $1,450 billion and reduce federal outlays by $110 billion, for a deficit improvement of about $1,560 billion.
Further analysis from the Tax Foundation and others will be needed to form a more complete picture. However, these results confirm tax reform’s promise of significant economic gains. Even if the reported estimates are high by a factor of 2, they still suggest about a 5 percentage increase in GDP from reform conforming to the essentials of the framework.