Originally posted at Forbes, February 2017.
As I’ve written, the House Republican tax bill has a lot to recommend it, including to Democrats. It needs some tweaks and proper transition rules to ensure it’s at least revenue neutral and as progressive as the current system (which, as you can read here, is far more progressive than commonly believed). But, if enacted, it will produce a major increase in U.S. net domestic investment, which has shrunk from roughly 15 percent of national income in the 1950s to 5 percent today.
The reason we’d get an investment boom, which would, over time, significantly and permanently raise real (inflation-adjusted) wages (my estimate is 10 percent), involves the impact of the reform on the effective marginal tax on investing in the U.S. Today, the U.S. has, it appears, the highest effective marginal corporate tax rate of any developed country. This is true despite the fact that our corporate income tax collects precious little revenue, i.e., the average corporate tax rate is very low (thanks to loopholes and corporate tax shelters) whereas the marginal corporate tax rate is very high. As a result, we have the worst of both worlds — a corporate tax that drives away investment, yet collects meager amounts of revenue.
Under the House tax bill, the U.S. nominal corporate tax rate is reduced from 35 percent to 20 percent, but the effective marginal corporate income tax goes to zero. The reason involves the bill’s provision that businesses can expense (immediately write off) all new investment. The value of this write off to a new investment offsets, in present value, the future taxes that will be paid on the investment. Hence, a new investment is made, on balance, free of tax.
Democrats may think this is a tax sop to the rich who own corporations. It’s not. First, much of the corporate income tax (Twenty five percent according to the CBO, but close to 100 percent based on my recent co-authored simulation study) falls on workers. The rich can pick up their capital and move it to a lower-tax country and that’s just what they do. Workers generally can’t pick up their lives and start their careers from scratch in a foreign country whose language they may not speak. But when the rich take their capital abroad, they leave behind those immobile workers, who end up with less capital with which to work. This makes workers less productive and reduces their wages. There are plenty of bad policy explanations for the last half century of American wage stagnation. But low U.S. domestic investment is high on the list.
If the Democrats think, as I think, of the corporate income tax as a tax on U.S. labor, they should be keen on eliminating it. The House tax reform plan does this. Yes, it retains a 20 percent nominal corporate income tax rate, but the provision of immediate expensing of new investment really means, as indicated, a zero percent effective marginal corporate income tax.
In going from taxing corporate income tax to taxing business cash flow (and new investment is negative cash flow, which is why it gets an immediate write off), the House tax plan moves us from what I believe is a significant tax on labor to business tax structure that is, apart from its title, the combination of two tax systems — a 20 percent destination-based value added tax (VAT) and a 20 percent wage subsidy. The VAT part of the tax represents a tax on consumption. To see this note that national (household plus government) consumption, C, equals the sum of national income, Y, produced plus imports, M, (Y + M is the maximum amount we could consume) less the amount not consumed because it is allocated to domestic investment, I, or exported, X. This is why our national income accounting satisfies C = Y – I – (X – M).
Now many people, particularly politicians, are very confused about what consumption taxes (whether imposed directly via, for example, a retail sales taxes or indirectly via, for example, a VAT) really tax. Here’s the answer. They tax what’s used to pay for consumption. This boils down to current and future labor earnings (wages) plus wealth. If the House Republicans were simply advocating moving from our current corporate income tax (which, again, in my view is just a disguised tax on labor) to a VAT, they’d be eliminating one tax on wages and replacing it with a different tax, but on wages plus wealth. Since this reform is meant to be revenue neutral, getting a share of the new tax’s revenue from taxing wealth means you need to collect less tax on wages. So simply replacing the corporate income tax with a VAT would be a great thing for workers. But the House plan goes farther. It also provides a wage subsidy. I.e., it represents, as stated, a VAT plus a wage subsidy. This means that the House plan ends up taxing one thing and one thing only — wealth. The Republicans are, thus, handing the Democrats what they, in their heart of hearts, are surely dying to do, namely tax wealth. The Republicans are just doing this in a very subtle and opaque, except to economists, manner.
Unfortunately, most members of Congress don’t have a clue how to think about the tax system and how to fix it. You can’t blame them. None of them have a PhD in economics, let alone specialize in public finance. So we now have some Republicans and Democrats in Congress pointing to the House tax plan and saying it’s regressive because it taxes consumption. This is more #stupideconomics emanating from Washington. I’ve started a series of columns on this topic, all of which are posted at my website. Yes, the word “stupid” is crass, but I’m really talking about economic views, not people.
The latest conveyer of #stupideconomics is Georgia Senator David Perdue (a Republican) who is opposing the border adjustment (the subsidy to exports, X, and tax on imports, M, implicit in the above formula). Senator Perdue stated yesterday that “This 20-percent tax on all imports is regressive, hammers consumers, and shuts down economic growth.”
I’d like to lock up Senator Perdue in my office, which has a nice white board, for a day to explain why everything he said is totally off base. If he doesn’t want to hear this from me, I can come up with any number of former Republican heads of the Council of Economic Advisers who could set him straight. But here, in a snapshot, is what I’d tell Senator Perdue. Consumption taxes don’t hammer consumers. They hammer workers and wealth holders. But they reduce the tax burden on workers if they are imposed in a revenue-neutral way and replace a tax that exclusively or primarily hammers workers.
Second, the House tax plan is not a consumption tax. It’s a pure wealth tax since it comes with a 20 percent wage subsidy. Stated differently, it’s a consumption tax on consumption not paid out of wages, but paid out of wealth. When Senator Perdue says the House tax plan “hammers consumers,” he surely is not worried about the Donald Trumps of the world. But they are the ones who will get hammered, not someone working as a janitor at Trump’s Mar-a-Lago Palm Beach club. Third, Perdue seems to think that the price of imports will rise due to their taxation as part of the border adjustment. This too is #stupideconomics. Economic theory and general experience from every other developed country tell us that the exchange rate will appreciate to leave the price to U.S. consumers of buying imports unchanged. Thus, if we are importing avocados from Mexico and the border adjustment places a 20 percent tax on those imports, but the exchange rate changes and makes the dollar cost of buying, in pesos, avocados from Mexico 20 percent cheaper, the U.S. purchaser of avocados will see no change in price.
Now, yes, this adjustment may not happen instantly if there are enough traders in the exchange market who have Senator Perdue’s background in economics. But there is a simple way to ensure an immediate 20 percent appreciation of the dollar, which will leave the dollar prices of imports unchanged as well as the dollar receipts from exports (whose subsidy will be offset by the loss in the dollar value of their foreign currency sales receipts). The way is to have Congress pass a resolution calling on the Federal Reserve to ensure a 20 percent appreciation of the dollar upon the enactment into law of the House tax plan. The resolution would be non-binding as the Fed is an independent agency and needs to remain independent. But the Fed is chock full of excellent economists, starting with its marvelous Chair, Janet Yellen. So I see no reason why the Fed would be unwilling to assist the economy in adjusting to this new tax system. And, yes, the Fed does have the wherewithal to effect a 25 percent appreciation (25 percent, not 20 percent, is needed given the algebra of the problem) if the market forces that will naturally be unleashed to make this happen on their own need a quick nudge.
This article was originally published at Forbes on February 10, 2017. (http://bit.ly/2ht476W)