Joy, beautiful spark of the gods, daughter from Elysium. We enter, drunk with fire, Heavenly One, thy sanctuary! Your magic binds again, what convention strictly divides. All people become brothers, where your gentle wing abides. The poem Ode to Joy was written in 1785 by German poet Friedrich Schiller. It was adapted in the final movement of Ludwig van Beethoven’s Ninth Symphony, which he completed in 1824. The powerful movement is one of the most well-known pieces of classical music, and was adopted by the European Union as the Anthem of Europe.
I use this title because today, the United States Congress passed the first major piece of legislation since the Affordable Care Act was enacted in March of 2010. Like Obamacare, The Tax Cuts and Jobs Act was passed on a strictly party-line vote, and like the ACA, it is a mishmash piece of legislation. In both cases the legislation was rushed through Congress and little if any care was given to how the new law would really impact people and the economy.
In 2010, the Democrat controlled legislature and President, made a number of promises about how wonderful the world would be once Obamacare was enacted. More people would have access to health care, prices would plummet, and if you liked your doctor, you could keep your doctor. Unfortunately, the economy does not react in accordance with legislative wishes, but rather according to mathematical and psychological rules. Obamacare for all of its lofty goals was a failure.
Now we have the Tax Cuts and Jobs Act. In this case, the legislation is somewhat true to its title. It will indeed cut taxes – at least over the near term – and will indeed create jobs. Our analysis of the bill as it came out of Conference is that the tax cuts and changes outlined in the plan could create as many as 5.8 million new jobs in the short term. Note that this is just a 3 percent increase, and is much lower than the employment growth that followed the Reagan tax cuts. I have taken a lot of heat in the social media about this forecast, but I stand by it for a number of reasons.
First and foremost, little if any economic benefit will result from the changes in the Personal Income Tax (PIT). There are some modest tax cuts in the first couple of years, but this will quickly be dissipated by bracket creep. Simply put, even in these difficult times, wages tend to rise faster than inflation, and the rates are indexed to inflation. Also, many of the deductions that were removed rise faster than inflation. On net, the changes to the PIT are a disappointment. With the amount of political capital that was spent on this pile of poo, real tax reform could have been easily accomplished but it was not.
The real reform is happening on the corporate side and this is where the economic muscle is. I for one believe that corporate taxes as a whole should be eliminated. Taxes on corporations come from three places: Wages, profits and customers. The shares differ based on the company and the industry, but in the end, all corporate taxes are paid by workers, shareholders and consumers. There are economic distortions caused by this taxation and this distortion harms the economy. Simplifying and reducing the corporate tax (as well as the tax on pass-through entities) will reduce these inefficiencies and add to economic growth.
The tax plan also grants a temporary period of capital expensing rather than depreciation. This is a one-off benefit and only occurs at the point when a company invests. This period where investments can be expensed and removed from income rather than being slowly depreciated over time will have beneficial short-term effects on the economy.
The most important factor of the Act, and the only real reform, is a big one. Shifting from what is called a national tax base to a territorial one. This will have huge short-term effects, and they will be lasting. Our current tax system imposes a levy on all corporate income of US based forms no matter where it is derived. This means that a sale made in India by say General Electric would be subject to US tax. This has encouraged a purported $2.6 trillion in unremitted income to have piled up abroad (where it is not taxed). By moving to a territorial system and allowing remittances of capital at a low one-time rate, the Act should encourage a huge amount of money to return to the US to be “de-taxed.” Much of this will flow back out to be invested elsewhere, but much will come home and be distributed to shareholders or reinvested into new plant, equipment, and wages here in the US.
Based on our models, the move to a territorial system will have a very large effect on both capital creation and consumer spending. We spread this out over a few years, but believe that the bulk will come back quickly. This influx of (we believe) about $720 billion in the next two years, along with the expensing provisions, lower corporate tax rate and other modest PIT reforms, will have a tremendous impact on tax revenues, economic growth, job creation, wages and inflation. Our model forecasts that real GDP will grow by an average of about 5 percent a year over the next two years – well above the Congressional Budget Office forecast of about 1.6 percent but well below the 7.25 percent growth that followed the Reagan tax reforms. We believe that wage growth will accelerate from an average of 2.3 percent to about 3.3 percent, and inflation will rise to the 3 percent range. In effect the tax bill will likely stave off a recession for at least the next two and maybe three years.
Our job forecasts are based on these changes.
We have taken some heat that the forecast is unrealistic. As I mentioned before, the growth is not all that huge in percentage terms, and is well below the job growth that occurred in the mid-1980s. It is also conceptual. While it does appear that there is huge slack in the economy, even with a headline unemployment rate of just 4.1 percent, it is also likely that there are not as many workers, or workers with appropriate skills, in some of the regions where we have forecast growth. This is because our models are necessarily based on where jobs are today not necessarily where they will be in the future. If there are opportunities to grow jobs in upstate New York under a lower tax scenario, then the jobs would be created there, not in Wisconsin or Texas where we are assigning jobs now. It’s a model, and models are never exact replicas of reality. The bottom line is that this new money and investment will flow to labor, either through additional jobs, or even larger wage increases. That is how supply and demand works.
Ode to Joy may be a bit of a lofty title to give to this particular Act. I believe that it will have positive effects on net, and in some cases the benefits, while short lived, will be fairly large. So we probably should not be drunk with fire about the Act as a measure of tax reform. But when one considers that there has not really been a significant piece of legislation passed in Washington in almost a decade, this bill is a real spark of the gods.