How The Right Kind of Tax Reform Can Expand Economic Opportunity
Republicans’ tax legislation should be judged on its success in expanding jobs and increasing wages for lower-income Americans.
The debate over tax reform in 2017 has, regrettably, been highly partisan. But there has been curious agreement between Republicans and Democrats about one thing: the importance of the income bracket distribution table.
That is to say, both parties have emphasized the direct impact of the bill on the taxes owed by people in various brackets. Republicans emphasize that Americans of every bracket will receive a tax cut; Democrats complain that the majority of the reduced revenue, in dollar terms, affects those who pay the most taxes: high earners.
But this carving-the-spoils mentality ignores the chief virtue of well-designed tax reform: inclusive economic growth that increases the wages and job prospects for Americans on the lower half of the economic ladder.
Put another way: someone who is unemployed today and employed tomorrow may pay higher taxes in the future. Someone who gets a pay raise or gets a better job offer somewhere else could also pay more in taxes. But these individuals will be paying higher taxes because they’re earning more money.
So the question we need to ask is: how can tax reform increase job and wage growth?
The U.S. has the most progressive tax code in the industrialized world
Americans argue often about the wealthy paying their “fair share” of the taxes that the federal government assesses. But what’s rarely understood is that the U.S. has the most progressive tax code in the industrialized world: that is, high earners pay a far greater share of overall tax revenue in the U.S. than they do elsewhere.
A 2005 study from the Organization for Economic Co-operation and Development (OECD) found that the wealthiest decile in the U.S. paid 45 percent of the taxes. That compares to 36 percent in Canada, 39 percent in the U.K., 28 percent in France, and 27 percent in Sweden. The OECD average was 32 percent.
In these other countries, the middle class pays a much greater share of the taxes because all of them have a version of the value added tax, a kind of national sales or consumption tax. The U.S. has state and local sales taxes, but not a federal one.
The end result is a federal tax code in which those with below-median incomes have no net income tax liability, in the aggregate. As you can see in the above chart (all similar-looking charts in this post come from Scott Hodge at the Tax Foundation), Americans earning more than $100,000 pay four-fifths of all income taxes paid in the United States.
The federal tax code has become even more progressive over time. In 1985, the top decile paid 54.7 percent of all taxes. By 2010, it was 70.6 percent.
Hence, when looking at direct effects of income tax cuts on various income brackets, any reduction in federal income tax rates will appear to benefit high earners. That’s because high earners pay virtually all of the income taxes collected by the federal government.
Nonetheless, the Joint Committee on Taxation — the congressional agency charged with issuing the official score of fiscal legislation — estimates that every income bracket will see a tax cut under the Republican bill. In effect, the bill makes the tax code even more progressive than it already is. Under current law, in 2025, those making under $50,000 a year pay 4.2 percent of all federal taxes. Under the Senate bill, they would pay 4.0 percent.
These distributional analyses, however, only make sense if you believe that the only purpose of tax policy is wealth redistribution — that tax rates have no impact on economic growth — that high earners would be just as economically productive under high tax rates as they would be under low tax rates. That is view is not justified by the evidence.
Driving job & income growth through the tax code
All else being equal, lower tax rates lead to increased economic growth. That’s because, in part, businesses use the extra cash to expand — either by hiring more workers, investing in growing their products and services, or returning the additional money to shareholders, which they then spend or invest in other businesses.
As the above chart shows, reducing the top individual and corporate income tax rates to 25 percent would increase the United States’ economic output by nearly 5 percent, and increase wages by nearly 3 percent. Median household income in the U.S. was $57,617; 3 percent of that is about $1,750 a year.
What’s notable about the above chart is that reducing the corporate tax rate to 25 percent has substantially more impact on growth than reducing the individual rate to 25 percent. It’s notable for two reasons: first, corporate taxes only account for about a tenth of federal revenues; individual income taxes and payroll taxes comprise nearly all of the rest. In other words, reducing the corporate rate is fiscally cheaper than reducing the individual rate.
The other notable point is that the U.S. has the highest corporate tax rate in the world, especially when taking state and local corporate taxes into account. According to the OECD, the combined federal, state, and local corporate tax rate in the U.S. is 38.9 percent. Canada is at 26.7 percent; France at 34.4 percent; Germany at 30.2 percent; Japan at 30.0 percent. The OECD average is below 25 percent.
The Republican tax reform bill brings the federal corporate rate down to 20 percent, 26 percent inclusive of state and local taxes. This feature of the bill should do the most to drive up employment and wages, especially for those with incomes below the U.S. median who are unemployed or underemployed.
Offsetting the deficit impact of tax rate cuts
The Joint Committee on Taxation projects that two aspects of the Senate bill will do the most to reduce federal revenue: the reduction in the corporate tax rate to 20 percent ($1.3 trillion over ten years), and the reduction in the individual tax rates ($1.2 trillion over ten years). The individual tax rates sunset at the end of 2025; Republicans clearly hope that most of them will be preserved in the same way that the Bush tax cuts of the early 2000s were preserved by President Obama.
To the degree that cutting taxes increases the deficit (i.e., it leads to reduced revenue to the Treasury even after taking into account the benefit of economic growth), it forces the government to borrow more money; interest costs must ultimately be paid for either by tax increases, or by devaluing the U.S. dollar, thereby reducing the value of our debts. Either effect lowers economic growth.
Balancing out the deficit impact of tax cuts can be achieved in two ways: first, by reducing spending; second, by raising taxes elsewhere to offset the corporate and income tax rate cuts. Over the long term, reducing the growth of federal spending is more important, because spending — on health care entitlements in particular — is expected to grow faster than federal revenue will.
Republicans partially offset the impact of the tax rate cuts in four primary ways: first, by replacing many of the personal exemptions in the tax code with a doubled standard deduction; second, repealing the Affordable Care Act’s individual mandate; third, reducing the ability of businesses to deduct their borrowing costs; fourth, moving to a territorial tax system for U.S. corporations’ overseas profits. (This last feature would mean that corporations domiciled in the U.S. would pay taxes in the countries where the profits were achieved, and only there; today, they pay taxes in both that country and the U.S., a huge competitive disadvantage relative to the rest of the industrialized world.)
The Joint Committee on Taxation estimates that, over ten years, the GOP bill will reduce federal revenue by $1 trillion, inclusive of the effects of economic growth. Notably, however, the bill would increase federal revenue in 2027, in part because of economic growth, but also because the individual rate reductions sunset after 2025.
Opportunities missed and seized
The Republican tax bill could have done more for economic growth by reducing tax rates on dividend income and capital gains. These taxes reduce the willingness of Americans and businesses to invest their earnings in economically productive ways.
In addition, the bill could have done more to restructure tax breaks that primarily benefit the wealthy: in particular, the tax deduction for mortgage interest, and the exclusion from taxation of the value of employer-sponsored health insurance.
But the bill does take some important steps in that direction, by capping the property tax deduction at $10,000 a year, and by eliminating the deduction for state and local income taxes: a provision in the tax code that primarily benefits wealthy zip codes in California, Chicago, and the northeast corridor (the dark blue spots in the Tax Foundation map below).
Measuring the success of tax reform
We will have several ways to measure whether or not the Republican tax bill — officially, the “Tax Cut and Jobs Act” — succeeds at expanding economic opportunity.
The most important: how much does reform decrease unemployment relative to projections based on current law? Also: how much does it increase wage growth and economic growth relative to current law?
But for those who focus excessively on the distributional aspects of tax reform, an even better measure to focus on is whether or not the bill increases or decreases the share of income taxes paid by the wealthy. A successful reform — one that leads to more economic growth — will lead to the wealthy paying a greater share.
That’s what happened under George W. Bush. Right before the onset of the Great Recession, the top 1 percent were paying a higher share of federal taxes than they had in generations, despite the fact that Bush had cut capital gains and dividend taxes early in his presidency. The One Percent’s share of taxes paid rapidly declined as the recession took hold.
The ideal reform will increase the dollar amount of taxes that everyone pays — because everyone is earning more.
