Principles of Taxation III

In this third essay on the basic principles for tax reform we look at how taxes affect economic growth and at how other factors such as the national debt can change how the economy reacts to tax reform.

Tax Cuts and Economic Growth

Economic growth is the Holy Grail of tax policy. However the relationship of tax policy and economic growth is complex and simplistic solutions like merely cutting taxes are unlikely to generate the long-term economic growth this country needs. I am not talking about economic growth in the second or third quarter of 2017. My son just got promoted to management at his company. I want economic growth that will support his career for the next thirty years. My grandkids are in elementary school. They won’t even be joining the workforce for twenty years. We need the kind of economic growth that America experienced in the nineteenth century that propelled our country from an agricultural backwater to an industrial powerhouse.

But what worked back then won’t work now. Alexander Hamilton espoused high tariffs (our principal source of tax revenue at the time) and protectionism of embryonic domestic industries at the dawn of the Industrial Revolution (plus a little industrial espionage). We need new solutions for the 21st century.

The mantra from Washington is tax cuts. Tax cuts will power economic growth. Economic growth will generate more tax revenues. More tax revenues will change the deficit to a surplus that will pay down the national debt of $20 trillion. The tax cuts will be phenomenal. The deficit reduction will be big league. Isn’t life wonderful?

Let’s put a little reality into the tax cut equation. Tax cuts are the flip side of the Keynesian coin’s increased government spending. The idea is that cutting taxes (or increasing government spending) will put more money in the hands of people who will go out and spend it thereby generating economic growth. In the wake of the Great Recession, our government tried both tax cuts and increased spending. Just about all we got was a doubling of the national debt (it is impossible to prove that things would have been worse if they had not taken these steps). We do know that the tax rebates went into savings accounts and the excess cash in banks sat in reserves - unlent and unproductive.

Keynes theorized that if a government cut spending during a recession because of reduced tax revenue, the reduced spending would exacerbate the recession. He therefore recommended deficit spending during a recession but he also recommended surpluses after the recession was over in order avoid increases in the national debt which otherwise would ratchet up on every downturn. Politicians did not pay attention to the second half of Keynes’ recommendation so we have had surpluses in only 5 of the last 50 years (although we have only had about 7 years of recession in the last 50 years according to Wikipedia).

Milton Friedman hypothesized that tax cuts or deficit spending that increased the national debt would not generate much economic growth because people would realize that the debt would have to be repaid at some time in the future and that would require more taxes or reduced spending motivating people to save for the future rather than spend now (the Paradox of Thrift).

Keynes theory seems to work when government accounts are more or less in balance. And since the US economy is generally growing most of the time, the money required to reduce the debt accumulated during downturns would not be that much of a burden. But our politicians in Washington are loath to be seen restraining the economy in any way so long as even one person is unemployed, even if the purpose of this restraint is to reduce the national debt.

And so our national debt has continued to grow inexorably until it has now become a huge threat to our economy. As the national debt grows, Keynes’ theory becomes less relevant and Friedman’s becomes more relevant. As a result tax cuts and deficit spending do not work well when there is a large amount of national debt.

As fiscal policy has less impact when there is a large overhang of debt, so the effectiveness of monetary policy is also reduced. Like government spending and tax cuts, zero interest rates and quantitative easing are designed to put money in people’s hands in order to induce them to spend more and generate economic growth. But all of the money pushed out into the economy has sat idle while the economy bumps along with sub-two percent growth.

The conundrum we face is not a contest between the theories of Keynes and Friedman/Hayek. It is a contest between the theories of Keynes and Kahneman. As the national debt grows the likelihood of a major financial crisis also grows. This was clearly demonstrated by Carmen M. Reinhart and Kenneth S. Rogoff in their book, This Time Is Different: Eight Centuries of Financial Folly. The chance of financial crisis increases as debt increases, especially after the national debt exceeds about 70% of GDP. The impact of such financial crises are much greater than what we experienced during the Great Recession (I know. I lived in Mexico during the Lost Decade after a financial crisis in 1981.). As we learned in our earlier essays on Kahneman’s Prospect Theory, loss aversion means the fear of loss can overwhelm the hope of gain and as the national debt increasingly looms over the economy the fear of loss grows exponentially.

Obviously, not all citizens are familiar with these economic and psychological theories but there has been a pervasive feeling of unease in our country. A recent Rasmussen Report stated that 64% of the people in the country believed we are headed in the wrong direction. It is not our rational brain that understands economic theory behind this unease; it is our instinctual brain that raises the hair on the back of our collective necks.

And we must keep in mind the fact that the size of our national debt is dwarfed by the unfunded future obligations of Social Security and Medicare. The net present value of those future obligations has been estimated to be as much as $40-60 trillion. Many of our children and grandchildren don’t believe they will ever see a benefit from these programs. That’s some legacy we are leaving to our offspring.

Competitive Taxation

Many proponents of tax reform believe that the US corporate tax is too high and makes US businesses less competitive than their international competitors. The US corporate tax is near the top of those of developed countries. Further, the US is practically the only country to tax global income rather than only the income earned domestically. This uncompetitive corporate tax and its global scope have distorted how US companies do international business.

As a business grows it begins to export its products to other countries. As these markets grow, it may make good business sense to begin to have some operations located in the overseas markets. There are many reasons why a business may want to have some of its operations overseas. Some businesses have taken advantage of lower wages overseas to relocate their manufacturing plants to other countries and importing their products back into the United States (offshoring).

The profits from these operations are taxed at the rate in the foreign country, which is usually less than that of the US. The US does not levy the global tax on these earnings until the profits are repatriated back to the US. This has caused many companies to keep their foreign profits offshore. The amount of unrepatriated profits is estimated to be around $2 trillion. So instead of this money being reinvested in the United States is sits idle overseas or (worse) is reinvested overseas generating even more foreign profits (and more foreign jobs).

Some companies have even gone so far as to change their domicile from the US to a low-tax foreign country through a reverse merger (these transactions are called inversions) because it is so much more profitable to be a foreign company. The Obama administration concocted a huge penalty to thwart the proposed inversion of US pharmaceutical giant Pfizer but did not address the poorly conceived tax policy that prompted Pfizer to attempt the inversion in the first place.

Because US companies compete internationally they need a tax policy that does not impair their ability to compete. Some progressives may baulk at lowering corporate tax rates but lower rates that help to improve the ability of American companies to compete would help generate more jobs in America and eliminating the global taxation would bring new investment funds back on shore. Corporate taxes only represent about 11% of federal government revenues so the cost of competitive corporate tax rates would not have a large impact (besides, a good case can be made that the cost of taxes is pushed onto us consumers anyway in higher priced products).

Border Adjustment Tax

One of the tax reform proposals being discussed is a border adjustment tax that would levy a tax on imports but not on exports. Because we don’t know if this new tax will actually end up in the proposal let’s not waste a lot of time on it right now. The only thing I would say at this time is that this tax would be perceived by our trading partners as a tariff and they are likely to react accordingly, which could trigger a devastating trade war that could severely damage the US economy.

Tax Stability

Currently, the US tax regimen is horribly complex and, even worse, it changes every year. These changes can be minor or major but compliance costs are exorbitant because not reflecting even a minor change in a tax filing can have major penalties and even jail time. These changes can arise from special deductions or subsidies (those K Street lobbyists have to justify the enormous fees they charge) or they may be ideologically oriented (as are some of the taxes and penalties in the Affordable Care Act).

Businesses facing an uncertain tax (or regulatory) environment will be hesitant to invest in new plant and equipment or to hire new employees. A simplified and stable tax regime would permit US businesses to grow and promote economic growth and jobs (although accountants and lawyers might be negatively affected).

Combined with the other essays on the principles of taxation, I think we now have a framework that can be used to analyze the benefits and drawbacks of President Trump’s forthcoming tax proposal. Based on the principles we have discussed, we can see that tax policy in a vacuum is not likely to be as phenomenal as its promoters predict.