Setting the Record Straight on Tax Reform by David Montgomery

Share

Though I share Rob Ketcham’s concern about the risks of a last minute effort at tax reform, I do so for almost exactly opposite reasons.  My greatest fear is that a tax reform bill will pass with just 50 votes in the Senate, but that it will be so far from the original Brady-Ryan plan to be Tax Reform In Name Only.  If that happens, we will have missed a once-in-a-generation opportunity to complete the process that Ronald Reagan started, of fundamentally changing our tax code into one that encourages Americans to save and invest at home.

This does not seem to be Mr. Ketcham’s concern.  He seems to think that President Trump invented tax reform last Wednesday, when in fact Speaker Ryan spent two years developing the Blueprint for Tax Reform he released even before President Trump won the election.   The President’s message on Wednesday rested on a massive effort by the country’s greatest experts on taxation.

Having read these misrepresentations of tax reform, it appears that I need to try once again to explain the Brady-Ryan plan and why it would lead to substantial increases in investment, wages and economic growth.

The principles that guided Speaker Ryan and Chairman Brady were that tax reform must encourage investment, eliminate incentives for American companies to move overseas, and keep the deficit from increasing.  For personal taxes the goal was to simplify and lower taxes on the middle class.  Every aspect of tax reform in original Brady–Ryan plan that I described earlier this year was carefully designed to serve at least one of those objectives.  

Mr. Ketcham ignores this and singles out two provisions of that plan, elimination of the AMT and the death-tax, as examples of the President Trump’s selfish interest in tax reform.  Contrary to Mr. Ketcham’s allegations, the AMT has unintentionally become a paperwork and financial burden on the middle class and the death tax closes family farms and businesses. And despite the impression Mr. Ketcham creates, these are minor components of tax reform with little revenue effect.

The major parts of the Brady-Ryan plan address the shortfall of investment since the Great Recession.  According to the Bureau of Labor Statistics, growth in labor productivity and output from 2008 to 2016 was lower than for any comparable period of time since 1948.   There are many factors that affect productivity and growth, but investment in new plant and equipment and in R&D are most important.  

In 2010 net private investment had fallen to 1% of GDP, and by 2015 it had struggled back to about 4%.  From 1960 to 2008 net private investment never fell below 5% of GDP, despite Vietnam, oil embargoes, stagflation, and more oil price shocks.   The current lack of investment holds back wage growth as well, because wages cannot increase without productivity growth.  Past cycles in investment and the current low are clearly correlated with increases and decreases in the tax burden on investment.

Jobs and investment have also moved overseas as U.S. companies have moved their headquarters, invested in new factories and R&D centers, and sold themselves to other countries where they pay lower taxes.  This “base erosion” has also moved taxable income out of the U.S. and contributed to growing deficits.

Business pages report on the ballooning Federal deficit nearly every day, so that designing tax reform to avoid contributing to the deficit is an obvious policy goal.  But that is not the only reason it is central to tax reform in the Trump administration.  As long as Democrats make obstruction of President Trump’s initiatives their highest priority, the only way to pass legislation is by using the budget process to move tax reform without their help.

There is nothing underhanded about using the budget process in this way, but it is not a slam dunk.  The process starts with a Budget Resolution, which sets targets for revenues and spending and contains instructions for the committees that flesh it out.  Once those committees have acted, each House of Congress must pass a reconciliation bill to put the committee actions together into a package consistent with the original budget resolution.  That reconciliation bill requires only a simple majority to pass in each house, and it may contain new legislation if it is germane to the budget.   The Congressional Budget Act was designed from the start to make sure that a budget could not be held up by a minority.

The plan this year was to use reconciliation to pass tax reform.  This is where avoiding increases in the deficit comes in.  First, the House Budget Committee instructed the House Ways and Means Committee, which originates tax legislation, to make tax reform “deficit neutral.”  Second, the Senate budget process is constrained by the so-called “Byrd rule” which prohibits any tax cuts that would increase the deficit after 10 years.   That means that to pass the Senate, tax cuts must either expire after 10 years, as happened with President Bush’s tax cuts, or be designed to maintain or lower the deficit thereafter.

So now we see that tax reform must be deficit neutral over the next 10 years as a goal of budget policy and thereafter as a precondition for passage.  But who decides?

Mr. Ketcham sees all sorts of chicanery here.  According to the rules of the House and the Senate, the Budget Committees decide.  In the normal course of business, they rely on the Congressional Budget Office and staff of the Joint Committee on Taxation for revenue estimates.  Until recently, these estimates were based on a single macroeconomic forecast that was assumed to be unchanged by the legislation being analyzed.  This “static” approach has worked well for the mass of legislation that is not expected to have a major effect on the economy.

This clearly is not true of major tax legislation, especially when it is designed to increase incentives for and remove obstacles to investment in the United States.  Because of this, the Budget Committees decided that they wanted revenue estimates to take into account how changes in taxation would affect growth of the economy and thereby alter the net effect of tax changes on revenue.  

Adoption of “dynamic revenue estimation” was not popular among many revenue estimators, because it is difficult, requires development of new tools, and strains CBO and JCT’s resources.  I have banged my head on how to do it right myself.  But nobody denied the obvious fact that budget policy will be better informed if some attempt at dynamic revenue estimation is made than if it is not.

Having decided that they want dynamic revenue estimates, it remained up to the Budget Committees whose estimate to accept. Neither the JCT nor CBO have a track record or established role in dynamic revenue estimation, because the entire practice is new. Other independent organizations, like the nonprofit Tax Foundation and the Tax Policy Center, have done dynamic revenue estimates for some time, and the Treasury Department and Office of Management and Budget could also provide them.  

As a matter of law and practice, it is up to the Budget Committees to decide what analysis they want to rely on, and always has been. This is a power and responsibility no different than that of an agency head, member of regulatory commission, or judge who must decide which expert opinion on an economic issue to accept.  Neither CBO nor the staff of the JCT at this point have a monopoly on expertise about the new practice of dynamic revenue estimation.

So now to the merits of the Brady-Ryan blueprint for tax reform and how this week’s announcement by President Trump suggests it might be changed, focusing on stimulus for investment and growth.

The Brady-Ryan plan would stimulate investment in 3 ways – lower tax rates for corporations and pass-through businesses, lower tax rates on investment income, and immediate expensing of all types of investment.  Of these three, analysis by the Tax Foundation shows that immediate expensing is by far the most important.  Their analysis shows that full expensing accounts for about 60% of the increased revenues attributable to accelerated economic growth.

And it is the first provision sacrificed in President Trump’s plan.  Instead of full and permanent expensing, the more recent plan is to allow expensing for a 5-year window and then return to the current rules.  This is just foolish.  Most surveys of businesses I know of find that temporary tax cuts do little to change long-term strategies about where to locate new factories and how much to invest.   

Moreover, the revenue loss associated with expensing is greatest in the first 5 years.  Expensing a large investment can eliminate tax liability in early years compared to depreciating it, but after the deduction of investment expense is fully utilized the company will have no depreciation to claim going forward.  Thus its taxes will increase in later years.   The additional economic growth stimulated by permanent expensing will also offset the early revenue loss, so that the Byrd rule’s requirement for deficit neutrality after 10 years is easier to satisfy.  Giving expensing for only 5 years may limit its revenue loss during the 10-year budget window but just makes the Byrd rule problem worse.

Now I will move to the goal of keeping jobs and investment here at home.  Contrary to what Mr. Ketcham believes, the one-time tax on the retained earnings of foreign affiliates of US companies is not intended to provide a stimulus to investment, but rather to provide revenues to offset the effects of rate reductions and expensing.  His mention of the failure of past “tax holidays” to induce corporations to bring back money they were hoarding overseas is a red herring.   A tax holiday offers a carrot of temporarily lower tax rates on overseas earnings that only means something if there is a stick of much higher taxes in the future.  

The Brady-Ryan plan recognized the futility of that effort.  Instead it and the President’s plan would tax all foreign earnings still held in overseas affiliates of U.S. corporations whether or not they are transferred to the U.S. parent’s books.  This one time tax has the sole purpose of raising revenue.  The second part of both the Brady-Ryan and the President’s plan is to make all future dividends paid from foreign affiliates to US parents tax-free.  The whole idea is to make sure that U.S. taxes don’t keep our corporations from bringing back foreign earnings for dividends or investment in the U.S.   

But these two provisions still don’t address the problem of U.S. companies finding it advantageous to move their factories to foreign countries, so as to avoid U.S. taxes on earnings from manufacturing and R&D done here.

The problem is that other countries generally rebate taxes when a company exports goods produced in that country, and impose their Value Added Taxes or other direct taxes on goods that are imported.   We do not do that – U.S. companies pay income taxes on revenue from exports just the same as they pay taxes on revenue from domestic sales, and foreign companies pay no taxes on income they earn from exporting goods to the United States.

The Brady-Ryan plan had an elegant solution to this problem:  exempt all earnings from exports from income tax and eliminate the deduction from income tax for the cost of imported goods.  All of a sudden, there would be no incentive to move overseas to pay lower taxes on income from goods produced for shipment to the U.S. market or for export to third countries.  In addition, since the U.S. is a net importer, this provision would provide revenues needed to offset the effects of immediate expensing and rate cuts.

Even better, a little thought about how this “border tax adjustment” would affect imports and exports leads to the conclusion that it will be paid for by other countries, not U.S. consumers.  All else being equal, the effect of higher taxes on imports and lower taxes on exports would be an immediate drop in the U.S. trade deficit.  But that cannot happen if tax reform is deficit neutral, because it is also an economic fact of life that our trade deficit mirrors our borrowing from overseas, and that borrowing is driven by budget deficits.  To keep the trade deficit from changing, the dollar will appreciate until the entire burden of the border adjustment is born by our trading partners who will get fewer dollars for what they export and pay more in local currency for what they import.

Unfortunately, our elected representatives have chickened out on the border adjustment.  A coalition of retail interests and big contributors convinced many legislators dependent on their support to declare against the border adjustment before they had any explanation of how it would work.  In its place, the President proposes a minimum tax on all foreign earnings of foreign affiliates of U.S. companies.  This is small beer compared to the border adjustment, fraught with difficulties of defining income to be taxed and preventing companies from avoiding the tax, and will leave U.S. corporations at a disadvantage to foreign corporations that operate in those low-tax jurisdictions.

The proposal to eliminate interest deductions for businesses is a “base broadening” measure intended to raise revenue needed for the rate cuts that will stimulate investment.  It also has benefits of its own, by eliminating a subsidy for debt financing that has made corporations more highly leveraged and prone to bankruptcy, and made it harder for small, dynamic firms that need equity finance to compete.   The President’s plan is to narrow eligibility for the interest deduction rather than eliminating it completely.  This change will weaken its good effects and, more importantly, reduce the amount of lost revenue it can offset.

Thus Mr. Ketcham and I have some areas of agreement.  I do not want to see real tax reform derailed by TRINOs for another generation, and I don’t want contrived budget estimates to conceal the inferiority of the latest incarnation of tax reform to the original Brady-Ryan plan.  I am actually a great deal less worried about the second than the first, because I believe there are plenty of good Republican advocates of tax reform to keep the process honest, if not necessarily going in the best direction.  I think many will share and express my opinion that the most recent proposals are not revenue neutral and that they fall far short of the Brady-Ryan plan in what they would do for investment and growth.  

Finally, to the virtues of bipartisanship in tax reform.  I do not know of anyone in the White House or Republican leadership who would not be delighted to have a bipartisan, permanent, growth-oriented tax bill.  But it takes two to tango.  Singling out Republicans for blame when Democrats show no more willingness to work together for the good of the country is pure partisanship.

To my eyes, the problem is that Democratic leaders have made it very clear that they care only about redistribution in tax reform, no matter what damage that does to incentives and economic growth.  Indeed, President Trump moved toward Democrats’ wish to redistribute income when he indicated willingness to impose a surtax on the highest incomes.  

I tried in my earlier column to add something to attract moderates in both parties by offering an approach to climate change that they should all like.  That was a carbon tax along the lines proposed by George Schultz and other old-time Republicans.  

Their proposal combined a carbon tax that I thought would provide useful revenues in a tax reform package with legislation to remove all the unnecessary regulatory measures that the Obama Administration imposed in its Climate Action Plan.  A double dividend for growth

But readers of this column have had a preview of the likely reaction of the Democratic leadership.  When I made this proposal, our own Senator Van Hollen immediately contacted the Spy to correct the record and make his position clear: more taxes, great, but less regulation, no way.

David Montgomery was formerly Senior Vice President of NERA Economic Consulting. He also served as assistant director of the US Congressional Budget Office and deputy assistant secretary for policy in the US Department of Energy. He taught economics at the California Institute of Technology and Stanford University and was a senior fellow at Resources for the Future.

 

Write a Letter to the Editor on this Article

We encourage readers to offer their point of view on this article by submitting the following form. Editing is sometimes necessary and is done at the discretion of the editorial staff.