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Congress is perfecting a profoundly pro-growth tax reform. To paraphrase a famous car commercial of years past, “This ain’t your father’s tax reform.” It’s much better. Even so, concerns linger over the legislation’s advertised 10-year $1.5 trillion sticker price. We should think about tax reform’s sticker price the same way we look at a new car’s sticker price – as the starting point toward a much lower drive-away price.
All credible evidence considered, the Tax Cuts and Jobs Act as passed by the House and under consideration in the Senate would be reasonably expected to increase Gross Domestic Product by between 3% and 4%, and likely much more if the expensing provision is extended by future Congresses. This additional growth from tax reform and its consequent revenue effects will negotiate down tax reform’s federal budget sticker price essentially to insignificance. Even better, with a larger economy the total fiscal effect including state and local revenues is almost certainly a substantial gain. For example, for every $100 billion in federal revenue feedback, in the aggregate state and local governments are likely to gain about $60 billion, leaving a clear revenue gain from tax reform when considering all levels of government.
The basics of growth from tax reform
How much more will the economy grow as a result of tax reform? The honest answer is, nobody knows. Nor will we ever know for certain, even in hindsight. We have theory, intuition, the assurances of highly respectable economists, a few credible models, and some not-so-credible. From all this, we have to render a judgment.
The uncertainty surrounding tax reform’s growth effects requires context. Substantial uncertainty already pervades traditional estimates typically accepted at face value. The baseline revenue forecast starts with the Congressional Budget Office’s (CBO) economic forecast. No slight intended, but we know this forecast is wrong, we just don’t know whether it’s too weak or too strong in any given year or over the 10 years total. Likewise, we know the traditional revenue estimates describing deviations from the revenue baseline are wrong, sometimes substantially so, but again we don’t know in which direction. Nor do we know if the errors offset or accumulate. It is unreasonable to expect greater confidence in the economic growth estimates than we now have with the underlying traditional estimates.
Why would well-designed tax reform “grow the economy?” The simplest answer is because prices matter. Individuals and businesses decide how much to work, save, and invest based on the prices they perceive from wages to goods prices to profit margins. Taxes distort such prices after tax and so distort these economic decisions, diminishing economic activity.
An economy grows because it has more resources, or because it uses them more efficiently. In this regard, the combustion engine provides a useful metaphor. Add more oxygen (labor) or more fuel (capital) and you get more horsepower (output). In addition, technological advances improve efficiency in terms of horsepower or mileage, just as technological advances allow businesses to raise their economic efficiency, manifested in new products and higher labor productivity.
Three reforms are especially critical to a stronger economy: business tax rate reduction; expensing; and territoriality. A fourth, reducing tax rates on labor income to encourage work, is for political reasons not materially part of the current debate. Of the three key reforms under discussion, economic models are fairly adept at incorporating the growth effects of rate reductions and expensing, but are less able to estimate the economic gains from territoriality. These models start with the cost of capital or “hurdle rate,” representing what a business considers the minimum expected return on an investment in order to be willing to make an investment. Some investments have higher expected returns than others even after accounting for risk. Lower the cost of capital and more investments become profitable.
The cost of capital reflects the minimum, required after-tax return plus other factors such as risk, the time profile of the returns, and the taxes levied. Common cost of capital formulations readily reflect tax rates, depreciation systems, and financing considerations. Included as part of a standard economic model, one can then relate changes in tax policy to changes in the cost of capital, which then indicates the expected change in the economy’s stock of productive capital, and thus the resulting ultimate increase in output.
Territoriality, or taxing only business income earned at home, is more difficult to reflect in economic models because the current policy of taxing worldwide income raises the cost of capital for U.S. businesses investing abroad. At first blush it would seem worldwide taxation would encourage domestic over foreign investment by U.S. firms. But in a rapidly integrating global economy, the true effect of worldwide taxation is to drive away companies and activities of a global nature. Rather than encourage domestic investment, current policy encourages business activity to flee overseas to escape punitive U.S. tax.
Though territoriality is hard to capture in estimable economic models, it is no less relevant than the policies of rate reduction and expensing if the United States is to have companies competing globally. The inability to reflect territoriality means, however, the actual growth effects arising from tax reform should be substantially greater than even the best models are likely to show.
By reducing the tax rate on corporations from 35% to 20%, reducing the effective tax rate on passthrough businesses, and by adopting expensing for at least the first five years, tax reform would substantially reduce the cost of capital, encourage businesses to stay in or migrate to the United States, encourage a rapid expansion of the nation’s capital stock, and generate substantial gains in total output and income. In this the theory is quite clear.
Unfortunately, both the House and the Senate bills include only five years of expensing. If one assumes future Congresses will extend expensing or make it permanent, and reflects this assumption in the analysis, then the growth effects would be significantly greater than those reported.
Available credible estimates
Assessing comprehensive tax reform’s effects on a modern industrial economy is no simple exercise, requiring tremendous judgment and experience. On November 27, nine of the nation’s most accomplished and esteemed economists expert in the field published an open letter to Treasury Secretary Steve Mnuchin in which they concluded, “The Republican [tax reform] bills could boost GDP by 3% to 4% long term by reducing the cost of capital”.
For those preferring their analysis have a mathematical foundation, the Tax Foundation, using its state-of-the-art model, indicates the House version of the Tax Cuts and Jobs Act would increase GDP by 3.9% and the version that passed the Senate Finance Committee would increase GDP by 3.7%. The Heritage Foundation using a much simpler model concludes GDP would be 2.6% or 2.8% greater in the long run under the House and Senate bills, respectively. It bears repeating that if one assumed future Congresses would extend expensing through the entire 10-year period, then the reported growth effects would be substantially greater.
Larry Kotlikoff of Boston University, one of the leading academics in the field, has with his colleagues developed a sophisticated model capable of explicitly reflecting international trade and capital flows. This feature is especially important as tax reform intended to reduce the cost of capital will for some period likely induce a substantial inflow of saving from abroad to finance the expansion in the stock of productive capital. Using his model to analyze the Unified Framework which preceded the House bill but which is identical in its essentials, Kotlikoff found GDP would be between 3% and 5% greater following tax reform.
The revenue feedback effects from additional growth are perhaps the least difficult aspect of the analysis. One can use Table 2-4 of the Analytical Perspectives of the Federal Budget describing how a sustained change in GDP alters the revenue and spending projections. Table 2-4 suggests an increase in GDP of between 3% and 5% translates into between $900 billion and $1.5 trillion in federal budget deficit reduction.
Indebted to distraction
Analyses from Penn Wharton (PW) and the Tax Policy Center (TPC) report less encouraging results, and so it is important to understand why their results differ. For both PW and TPC, the key tax provisions in the House and Senate bills would substantially increase economic growth. However, PW and TPC then claim the increase in budget deficits implied by the traditional estimate for tax reform would push up interest rates and thereby choke off the additional investment and growth the tax cuts would otherwise produce.
The flaws in this analysis are fairly obvious. First, if the growth occurs, then the revenue feedback suggested occurs, the increased deficits about which PW and TPC are concerned fail to materialize, and so the countervailing interest rate effect itself is short-circuited.
However, the concern over interest rates is even more easily assuaged. Federal debt doubled under George W. Bush, and more than doubled under Barack Obama. And interest rates today? The 10-year Treasury bond has traded in recent years in a range of roughly 2% to 2.5%, which given inflation approaching 2% yields a real interest rate well below 1%. If interest rates responded as PW and TPC suggest, then surely interest rates today would be vastly higher. This is simple observation, not theory.
This observation is also history, what about the future? According CBO’s latest, under current policy the federal government projects about $9 trillion in cumulative deficits over the next 10 years, or about six times the static costs of the tax reform bill. If rising debt produces crushingly higher interest rates as PW and TPC claim, then they and all their adherents should be in utter panic over the devastation wrought by the interest rate effects of $9 trillion in already projected additional debt. No such panic is in evidence. Or perhaps for PW and TPC analysts, only pro-growth tax reform’s static deficits are anti-growth.
Current federal government deficit projections are clearly a cause for concern. The U.S. Chamber of Commerce has long warned of these and how they grow in future years under the pressures of rapidly rising entitlement spending. Hence the Chamber has long championed fiscally responsible tax reform. For tax reform to succeed it must have a reasonable prospect of being permanent. A huge tax cut would likely not long survive the cumulative fiscal pressures. When the revenue feedback effects are considered under reasonable expectations for improved economic growth, it is clear tax reform in its current House or Senate forms would ultimately improve state and local finances in the aggregate while having a minimal effect on the federal deficit up or down.