INSIGHTS: PERSPECTIVES ON THE NEED FOR TAX REFORM
By Guest Columnist Scott Hodge:
President of the Tax Foundation
Last week Scott Hodge appeared before the House Ways and Means Subcommittee on Tax Policy to share his thoughts on tax reform. Following is a summary of his testimony.
There are many reasons to reform our tax code, but the cost of tax complexity to our nation’s economy should be near the top of that list.
In addition to robbing us of 8.9 billion hours and more than $400 billion in lost productivity, tax complexity punishes success and hard work, which robs the economy of its ability to create jobs and better living standards. Over the past few months, Tax Foundation economists have been measuring the cost of complex tax provisions using our Taxes and Growth (TAG) Macroeconomic Tax Model.
In June, we will publish nearly 100 of these case studies in a new book, Options for Reforming America’s Tax Code. I hope these provide you some dos and don’ts as you think about tax reform.
We find that much of the complexity in our individual tax code results from our attempts to make the system progressive, either overtly (with graduated tax brackets) or subtlety (with back-door phase outs and claw-backs).
And we know that high marginal tax rates matter to work incentives, and dampen economic growth. Economists have referred to these high marginal tax rates as “success taxes.”
So, for example, we could make our current seven bracket tax rate system simpler, more pro-growth, and still “progressive” simply by reducing the number of brackets into three of 10, 25, and 35 percent.
Compared to such a system, our model finds that the current tax code reduces the long-run level of GDP by 1.4 percent, lowers after-tax incomes by an average of 3 percent, and costs the economy more than 1.1 million jobs.
Our policies aimed at helping the working poor can also have unintended consequences.
The complex structure of the EITC has the ironic effect of encouraging more work as the subsidy phases-in, but then it discourages work effort as the subsidy phases out, because it penalizes a worker for every dollar they earn above the poverty line.
However, we can reduce those tax penalties with a slower phase-out rate for the EITC. Compared to a fairer EITC, our model finds that current rules lower after-tax incomes by more than 1 percent, and cost 164,000 jobs.
I think we all want to simplify the number of itemized deductions and “loopholes” in the code, but we should use the savings to lower tax rates.
We found that if you were to eliminate most itemized deductions (except for the charitable and home mortgage interest deduction) and used those revenues to lower all tax rates by 10 percent, it would increase GDP by 0.6 percent and create 577,000 jobs.
On the business side, everyone knows by now that the U.S. has THE highest corporate tax rate in the industrialized world, and that we have an outdated worldwide tax system. Cutting the corporate tax rate and moving to a territorial tax system would not only simplify the corporate code, but make the US more competitive.
But, just as important, we should replace our immensely complicated depreciation and cost recovery schedules with a much simpler system of full expensing of capital investments.
Dollar-for-dollar, full expensing is one of the most pro-growth tax simplifications that Congress could enact.
By our estimates, compared to an economy with full expensing, our current depreciation system lowers the level of GDP by 5.4 percent, reduces wages by 4.5 percent, and costs the economy more than 1 million jobs.
Over the past year, Tax Foundation economists have gained special insights into what kind of tax policies boost investment, wages, jobs, and economic growth, and which policies lead to less of those things.
We have scored the tax plans of every presidential candidate, as well as numerous tax plans developed by members of the House and Senate.
During this experience, we have modeled every conceivable tax reform plan one can think of, including the Flat Tax, FairTax, Bradford X-Tax, Value Added Tax (VAT), and numerous plans that incorporate features of each of these.
To one degree or another, the plans that produce the most growth tend to incorporate many of the lessons that I’ve just outlined:
- they simplify the tax code;
- they reduce marginal tax rates;
- they reduce taxes on capital;
- they reduce or eliminate the double-taxation of savings and investment;
- and, move toward a neutral or consumption tax base.
I hope that the members of this committee, as well as your fellow lawmakers, take these lessons to heart and start us down the road to fundamental tax reform soon.
ON THE ECONOMY: UP UP AND AWAY
By John Dunham:
Managing Partner, John Dunham & Associates
Would you like to ride in my beautiful balloon? Would you like to glide in my beautiful balloon? We could flow among the stars, together you and I, for we can fly, up, up and away. For we can fly, in my beautiful, my beautiful balloon. The world’s a nicer place in my beautiful balloon. It wears a nicer face in my beautiful balloon. We can sing a song and sail along the silver sky, for we can fly, up, up and away. For we can fly in my beautiful, my beautiful balloon, Ok so the Fifth Dimension was not singing about inflation in this 1967 song written by Jimmy Webb, that reached number 7 on the charts and won the Grammy for best pop single.
Over the years, my best single has not been inflation forecasts. I have consistently been on the high end of the Bloomberg survey of forecasters, and have obstinately stuck to my guns in suggesting that the US inflation rate had to rise in response to the huge increase in the money supply, glibly labeled as Quantitative Easing or QE.
If one considers money to be a token used as a means of exchange then a large increase in the number of tokens should lower their value in real terms. In other words, if a goat costs $10 in an economy with $100 dollars in circulation, then it should cost $100 in an economy with $1000 in circulation, all things being equal.
From a Keynesian perspective there is an equation that says:
For normal people this means that the quantity of money (M) in an economy multiplied by the times it is spent in a year (V) is equal to the Q which is the amount of stuff that is purchased (or GDP) times prices or P. In other words, all things being equal, as the amount of money in an economy grows so do prices. Now according to data from the Federal Reserve of St. Louis, the amount of money in the US economy grew by 356 percent between January of 2008 and the beginning of April of this year. This is an unprecedented rate of growth in the money supply. At the same time PQ or what we would call nominal GDP grew by just 24 percent with inflation accounting for about half of that.
So what happened? In a Keynesian sense only V could have changed, meaning that the amount of time money circulated through the system collapsed. As we have reported before this is exactly what has happened. We noticed it in all of the economic impact models that we were producing. The multiplier effects of spending (what we call induced impacts) were simply collapsing. So the mathematical tautology is in fact working, and the huge growth in the money supply was not leading to inflation because that money was not flowing around the economy very quickly.
What this equation does not explain is why. Why did the velocity of money collapse and why did inflation not occur?
Here the story gets to be a bit more interesting. The Federal Reserve created money out of thin air (as it does) and used that money to purchase bonds from banks and brokerage firms. If we think back to the time, these bonds were being called toxic assets, and were basically represented as non-performing loan portfolios on banks’ balance sheets. So the Federal Reserve created money (think Hamiltons, Franklins and Tubmans) and placed them in banks’ accounts with the Fed and assumed control of the toxic assets. This helped with an immediate problem of boosting balance sheets in the financial sector and helped ensure that the banking system did not crumble. Probably a good thing.
But this also created assets out of liabilities for the banks, and created offsetting liabilities for the Federal Reserve. If we look at data on the actual amount of money in circulation during this period it only grew by 77 percent, so only about one-fifth of the new money created actually entered the economy. Now here’s the rub. The remaining four-fifths sat on account at the Federal Reserve, and the government pays banks interest of one-half of a percent on these assets. Let’s stop for a moment and think about what this means. The Federal Reserve System (which is controlled by banks) printed about $3 trillion, of which about $2.4 trillion is sitting on banks’ accounts. The Federal Reserve is paying the banks $12.2 billion in interest on the money that it gave them. Since the profits from the Federal Reserve go to the US government, in effect taxpayers are paying banks $12.2 billion each year to hold on to Hamiltons that the Federal Reserve printed and gave to them.
In some ways this is probably a blessing because if the banks had actually loaned this money out there would be massive inflation. In effect, the Federal Reserve stopped the money supply from contracting by protecting bank’s balance sheets. This would have led to lower prices or deflation. While most borrowers (like the Federal government) fear deflation, it is actually what was needed to clear the excesses out of the economy that led to the steep recession in 2007 and 2008. By preventing the deflation the Federal Reserve protected borrowers at the expense of lenders and the tax payments to the banks is part of the penance for this. However, these actions have also stopped the economy from growing and have led to the very weak recovery over the past 8 years. Remember our equation MV=PQ. As the velocity of money falls it effects not just prices but output as well.
So in the end the Federal Reserve created a balloon by massively inflating the money supply. This has helped lead to a stagnant economic recovery, reduced the potential for a necessary deflation, but at the same time protected borrowers and the banking system. Only time will tell if the Fed can find a way to wind down this beautiful balloon, or if the world will be a nicer place because of it.
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