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Progress on tax reform, ignorance on spending

Progress on tax reform, ignorance on spending
© Greg Nash

The early details of the president's tax reform plan were revealed today, and it appears Washington is at last attempting to take action in reforming our heavily destructive tax code.

The Tax Cuts and Jobs Act goes some way in lowering individual income tax rates for low- and middle-income Americans, while almost doubling the standard deduction for single and married tax filers. The bill is clearly targeted at the average American.

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The bill also takes small steps toward simplifying the tax code by reducing the number of tax brackets and eliminating special interest deductions. As a point of much controversy and debate within the ranks of the GOP, the bill compromises on eliminating the state and local tax deduction (SALT), but instead caps the deduction at $10,000.

 

The Alternative Minimum Tax (AMT) and the Death Tax will be both be repealed, the latter by 2024.

The tax reform bill makes no changes to pretax contribution levels to 401(k) retirement plans, nor does it make any attempt to repeal the ACA individual mandate, as was previously rumored. Additionally, child tax credits will be increased to $1,600 from $1,000, with an additional $300 for each parent.

On the business front, corporate tax will be reduced from 35 percent to 20 percent, without the phase-in period. Companies identifying as pass-through entities will pay a reduced tax rate of 25 percent. The bill also eases a company’s ability to write off interest on loans and the full cost of new equipment, and the repatriation rate on overseas assets for U.S. companies is fixed at 12 percent.

Projected effects of tax reform

Two estimates of the dynamic effects of the general tax framework have been produced in the last week. A report by University of Pennsylvania's Wharton School estimated that the tax reform plan will result in increased rates of economic growth of 1.3-1.5 percent over a decade. The report also revealed that federal revenues would lose between $1-3.5 trillion over the same decade.

The second study by the Tax Policy Center predicts that economic growth will experience a boost from 2018-2022, but shrink after 2022, with a loss in federal revenues of between $2.4-2.5 trillion over a decade.

However, the TPC study does not gauge the positive economic effects of tax cuts with regards to capital flows and foreign capital inflows.

In past articles, I have written about the importance of corporate tax reform, so I am particularly glad with plans to lower the corporate tax rate (and a move to a territorial system) giving us a more competitive edge, growing the economy and in the long-term, raising workers’ wages.

Depending on foreign capital inflows, a comprehensive study using the Global Gaidar Model (GGM) predicts that the proposed tax reforms will boost GDP by 3-5 percent and raise real wages by 5-7 percent, or $3,500 annually, per working American household.

What’s more, the main source of these increases in output and wages is the tax plan's reduction in the marginal effective corporate tax rate, expanding U.S. capital stock by 12-20 percent. Surprisingly, it may not be the government middle-class tax cuts that actually benefit the middle class, but instead corporate tax cuts could be of far greater benefit to workers by raising their wages.

It is important to note, however, that these studies were made prior to the official release of the reform outline. Therefore, we should take the aforementioned projections and economic assumptions with a pinch of salt — the economic effects of the tax reform bill released today are still largely unknown.

Failure to address the spending problem

Republican commentators have repeatedly claimed that the proposed tax reforms will be revenue neutral. Even if the growth-inducing effects of tax cuts pay for themselves (which seems highly unlikely), the true problem is still being ignored — ceaseless spending.

The budget resolution adopted last week allows for tax cuts without the offsets of cutting costly entitlement programs. The final budget resolution rejected an initial House plan to cut at least $203 billion from entitlement programs over 10 years as part of the reconciliation procedure that would let Republicans pass tax cuts without any Democratic votes.

Historically, federal government revenues have hovered around 17 percent of GDP, changing very little with fluctuations in economic growth. Changes in the level of taxation since 1965 have had little influence on the level of revenues collected by government.

Federal spending has also tended to remain fairly constant since 1965 at around 20 percent of GDP, also with minor fluctuations depending on the level of economic growth. Looking forward, however, these historical patterns are set to change drastically.

Federal revenues are expected to grow moderately from around 17 percent to little more than 19 percent of GDP over the next 30 years. Meanwhile federal spending is projected to experience an explosion in growth from around 20 percent of GDP today to almost 30 percent over the same 30-year period.

The dilemma of widening deficits and mounting debt is not a problem rooted in government revenue shortfalls. Driven by the ceaseless growth in entitlement programs, this is a spending problem.

While the proposed tax reforms offer positive moves toward greater dynamism, prospects of robust growth and potential for increased wages, the real solution to this dilemma is found in restoring both discretion and sustainability to the federal budget.

The longer the federal government avoids entitlement reform and remains ignorant of our spending problem, the larger the fiscal burden will be for future taxpayers to pick up the bill.

Jack Salmon is a Washington, D.C.-based researcher focused on federal fiscal policy. Salmon holds an M.A. in political economy with specializations in macroeconomics and comparative economic analysis from King's College London.