Tax Reform: Restoring Booming Economic Growth, and the American Dream
This column by ACRU General Counsel Peter Ferrara was published on July 7, 2014 on Forbes.com.
Before America dropped off the gold standard in 1971, long term real economic growth averaged nearly 4%. At that long term growth rate, our economic production would more than double after 20 years. After 30 years, GDP would more than triple. After 40 years, a generation, total U.S. economic output would nearly quadruple.
Nothing could be more important for the middle class, working people, and the poor, then reestablishing that long term rate of economic growth. Yet, Obama and his economic policies have America limping along at barely half that. That is because all of Obama’s economic policies are consistently anti-growth, or the opposite of everything that would be pro-growth, as discussed below.
But Obama and his economic policies have been even worse for America than that. That is because the history of the American economy is, the worse the recession, the stronger the recovery, as the economy has to grow faster than average for a while, to catch up to the long term economic growth trendline. President Reagan’s recession ended in November, 1982. By 1984, real economic growth was booming by 6.8%, the highest in 50 years. Over the next 7 years after the end of Reagan’s recession in 1982, the huge American economy, the largest in the world by far at the time, grew by almost one-third, the equivalent of adding the entire economy of West Germany, the third largest in the world at the time, to the U.S. economy. Nearly 20 million new jobs were created during those 7 years, increasing U.S. civilian employment by almost 20%.
Moreover, since the Great Depression, America suffered 11 previous recessions before this last one, which started in December, 2007. Those 11 previous recessions lasted an average of 10 months, with the longest previously lasting 16 months. Obama was sworn into office in the 13th month of the recession, in January, 2009. That means based on the historical record the recession was about to end in a few months, followed by a booming recovery, with faster than average growth to restore the American economy to the long term economic growth trendline. Consequently, Obama was poised upon entering office to get the political credit for the booming economy recovering from the steepest recession since the Great Depression, just based on the historical record of the American economy going back almost three quarters of a century.
Indeed, the recession did end just a few months after that, in June, 2009, according to the National Bureau of Economic Research. But Obama had already by then begun his fundamental transformation of America. So there never was any booming economic recovery. Instead, what America got was the worst recovery from a recession since the Great Depression, based on economic growth, jobs, wages, income, poverty, even inequality, which of course has actually gotten worse under Obama, with no sustained economic growth sufficient to raise the wages and incomes of the middle class, the working class, and the poor. No wonder polls now show Americans identifying Obama as the worst President since World War II.
That is the only valid way of measuring the performance of the American economy under Obama, by comparing it to other recoveries from other recessions under prior Presidents. Not by comparing the recovery to the worst depths of the recession, as the Obama apology cult does. Of course the recovery is better than the recession. It always is, by definition. Nor is there any good excuse for claiming that this recession was somehow different from all previous recessions. Recessions and recoveries have been going on for centuries, and are well defined.
We know how to restore booming economic growth to the American economy, based on the historical record and what has worked before, and the timeless principles and logic of economics, which provided the foundation for Reaganomics. I noted last week how the authors of the book Room to Grow had overlooked the central issue on which conservatives and Republicans need to campaign in upcoming elections: a promising agenda to restore traditional, booming, American economic growth. I promised to fill that gap in following columns, which I start below.
Marginal Tax Rates
The first component of a comprehensive plan to restore booming economic growth is tax reform. The key to understanding the impact of taxes on the economy is to focus on tax rates, particularly marginal tax rates, which is the tax rate that applies to the last dollar earned. The tax rate determines how much the producer is allowed to keep out of what he or she produces. For example, at a 25% tax rate, the producer keeps three-fourths of his production. If that rate is increased to 50%, the producer keeps only half of what he produces, reducing his reward for production and output by one-third. Incentives are consequently slashed for productive activity, such as savings, investment, work, business expansion, business creation, job creation, and entrepreneurship. The result is fewer jobs, lower wages, and slower economic growth, or even economic downturn.
In contrast, if the tax rate is reduced from 50% to 25%, what producers are allowed to keep from their production increases from one-half to three-fourths, increasing the reward for production and output by one-half. That sharply increases incentives for all of the above productive activities, resulting in more of them, and more jobs, higher wages, and faster economic growth.
Moreover, these incentives do not just expand or contract the economy by the amount of any tax cut or tax increase. For example, a tax cut of $100 billion involving reduced tax rates does not just affect the economy by $100 billion. The lower tax rates affect every dollar and every economic decision throughout the economy. That is because every economic decision is based on the new lower tax rates. Indeed, the new lower tax rates affect every dollar, or unit of currency, and every economic decision throughout the whole world regarding whether to invest in America, start or expand businesses here, create jobs here, even work here, because all these decisions will be based on the new lower tax rates. Tax rate increases have just the opposite effect on every dollar and economic decision throughout the economy and the world.
In addition, marginal tax rates do not just affect the incentives of those to which the rates currently apply. They also affect those to which the rates may apply in the future. For example, consider a small business owner. If he invests more capital in the business to expand production, or hires more workers to increase output, that may result in higher net taxable income. It is the tax rate at that higher income level, not at his current income level, that will determine whether he undertakes the capital investment, or hires more workers.
Multiple Taxation of Capital
These incentive effects are compounded in our tax system through the multiple taxation of capital. Capital income is taxed not once, but several times in federal and state tax codes. For example, consider a saver who invests a dollar in a corporate enterprise. Any dollar that corporation earns is taxed at the corporate income tax rate, totaling roughly 40% in America on average now, counting federal and state corporate income taxes. If the remainder of that dollar is paid to the investor in dividends, then it is taxed again through the individual income tax at the dividends tax rate. With President Obama increasing the dividends tax rate from 15% to 23.4%, applying that 23.4% tax rate to the 60 cents remaining after paying the corporate income tax leaves just 46 cents for the investor out of the original dollar earned.
A third layer of taxation of capital income is represented by the capital gains tax. Consider an asset such as a share of stock. When the price of that asset increases, that is reflecting an increase in the expected value of the future income stream to that asset. That future income will be taxed by both the corporate income tax and the individual income tax when earned. If that asset is sold now, taxing the increased value by the capital gains tax is effectively taxing that future income stream a third time.
The death tax (the popular name for the estate tax) is still another, fourth layer of taxation of capital income. If the investor in our example above saves the 46 cents remaining on that dollar of corporate earnings after paying the corporate and individual income tax, and leaves it to his children at death, applying the death tax to it would take roughly half of what is left, leaving his children just 23 cents out of the original dollar earned.
Also affecting the impact of marginal tax rates are the rates imposed on competing global economies. America’s top marginal corporate tax rate, at around 40% counting state corporate taxes on average, is now the highest in the world. EU countries have slashed their top marginal corporate tax rates in recent years from an average of 38% down to 24%. Communist China has cut its corporate rate down to 25% as well. Germany is now down to 19%. Canada, which has been booming since Obama was elected in the U.S., has cut its corporate rate to 15%. Ireland famously boomed after it adopted its corporate rate of 12.5%. American companies suffer a major disadvantage in the global economy bearing the highest marginal tax rates in the world.
Our tax system further burdens capital income through depreciation rather than immediate expensing. Except for capital investment in plant and equipment, all other business expenses are deducted in the year they are incurred, because the income tax is supposed to be on net income after expenses. But deductions for the expenses of acquiring capital equipment must be spread out over many years under arbitrary depreciation schedules. Capital equipment is what makes American workers the most productive, and hence the most highly paid with the highest standard of living, in the world. With such capital equipment, for example, workers can use mechanized, computerized, modern crane shovels, rather than their bare hands, for digging and building. Or they can use modern computers rather than just computing in their heads. The effective result of extended, arbitrary depreciation schedules instead of immediate deductions or expensing is higher taxes on investment in capital equipment, which means less of such capital equipment, slowing growth in jobs, productivity and wages.
Our tax reform plan would eliminate all special interest tax credits and other crony capitalist tax credits in the current corporate tax code. That includes all the “green energy” tax credits and preferences, which only reduce economic growth through a misallocation of capital to wasteful production of unnecessarily costly energy. The R&D tax credit would be retained, however.
The incentive effects of marginal tax rate reductions can be contrasted sharply with the impact of tax credits. Such tax credits do not work to stimulate economic growth because they do not change the fundamental incentives that govern the economy. A $1000 tax credit involves the government either explicitly or effectively sending you a check for $1000. But after that, you and everyone else still face the same tax rates and same economic incentives as before.
Tax cuts do not expand the economy by “putting more money in people’s pockets,” thereby leading to increased spending. Increased welfare benefits would put more money in people’s pockets as well. But this is an outdated Keynesian rationale from the 1930s, which, again, does not work for two reasons. First, the government has to borrow or tax the money from someone else in the economy to give you the tax credit or increased welfare check. So, if it takes $1000 out of the economy to give you $1000 through the tax credit or increased welfare, it has not added anything to the economy on net. Secondly, again, there is no change in fundamental incentives.
Note also that the most significant tax credits have been refundable, which means if you do not have enough income tax liability for the credit to offset, the government will send you a check for the difference. The tax credit in this case is entirely indistinguishable from welfare, which is never going to be the foundation for a booming economy. Obama’s own budgets documented show that 35% of his supposed income tax cuts in his stimulus package went to people who do not pay income taxes, and therefore are not tax cuts at all, but welfare checks. This is why Obama’s own budget accounted for this portion of his supposed tax cuts as outlays rather than revenue reductions. You can’t cut income taxes for people who do not pay income taxes.
Our tax reform proposal, however, would retain the current Earned Income Tax Credit and Child Tax Credit. That is primarily because these 2 credits are a highly effective means for reducing poverty as supplements for those who work, and so serve as a foundation for further welfare reform, as we will discuss in a later column on entitlement reform. Also, we recognize validity to rewarding continued fertility on which the future of the nation rests, and so don’t want to propose eliminating the Child Tax Credit that already exists. But we do not propose to increase that credit any further. That is because such a credit increase would not be pro-growth. Also, the plan includes virtually doubling the current personal exemption, and sharply reduces rates for the middle class and upper middle class families up to 90% of all workers. The pro-growth effects of the reform would also sharply benefit the middle class, the working class, and the poor.
Today’s High Marginal Tax Rates
In the book Room to Grow, former Treasury official Robert Stein says the above marginal tax rate analysis was all valid during Reagan’s era because marginal tax rates were as high as 70% when Reagan began. But rates were cut so sharply under Reagan, that further rate cuts would not produce nearly the same effects.
That point, however, overlooks how high rates have grown under the Obama Democrats, federal and state. Obama insisted on the expiration of the Bush income tax cuts for the highest income earners, pushing top marginal rates to over 40%. Then Obamacare imposed further rate increases, on both labor and investment income, pushing top marginal rates to around 45%. Counting state income taxes, total marginal income tax rates climb to around 50%, even more in the most wild-eyed Democrat states, like California and New York. Moreover, American businesses today face stiff competition from countries where corporate tax rates have been steeply slashed, as discussed above.
Modern Tax Reform
I have been working with the National Tax Limitation Committee and its President Lew Uhler to develop the most pro-growth tax reform plan that would be politically viable, in consultation with free market tax policy experts, such as Scott Hodge and Steve Entin of the Tax Foundation, Steve Moore of the Heritage Foundation, Chris Edwards and Dan Mitchell of the Cato Institute, former Virginia Governor Jim Gilmore, now running the Free Congress Foundation, Ryan Ellis of Americans for Tax Reform, Dean Clancy formerly of Freedom Works, and others.
The plan we have developed would include just two rates for the personal income tax: 10% on family income up to the maximum taxable income for the Social Security payroll tax, which is $117,000 this year, and 22.4% on income above that. (The earnings of about 90% of workers fall below the Social Security maximum taxable income, so 90% of workers would bear only the 10% rate). This would create essentially a flat rate tax counting the Social Security payroll tax, which is currently 12.4%. The Social Security maximum taxable income is indexed to grow each year at the rate of growth of real wages, therefore the threshold for the 22.4% rate would grow along with that as well. That means that inflation would not result in automatic tax increases over time, pushing more and more people into the higher tax bracket. The current personal exemption of $3,500 would be raised to $6,000, exempting the first $24,000 annually from tax for a family of four.
One insight behind the plan is that the liberal/Left would successfully demagogue any effort to completely eliminate the multiple taxation of capital described above, as would be ideal. So the plan seeks to reduce the rate on all the multiple taxes to just 10%, which we believe would not significantly slash economic growth. Consequently, that rate of 10% would apply to corporate income under the federal corporate income tax, to taxation of capital gains taxes, and to taxation of corporate dividends. The plan would also include immediate expensing of all business investment in plant and equipment, replacing all depreciation.
Also under the plan, all savings and investment would be deductible, effectively an unlimited IRA, but the saved funds could be used for anything, unemployment benefits, college or other education expenses, downpayments for homes and real estate, health care, retirement, though all would be taxable as ordinary income when used for consumption. This would focus the system on taxation of consumption, but not income devoted to the savings and investment that is the foundation of economic growth in a capitalist system.
The plan would retain the deductions for home mortgage interest and for charitable contributions. But it would eliminate the deductions for state and local taxes, which just encourage, if not subsidize, state and local tax increases. It would also eliminate the tax exemption for state and local government bonds, which encourage, and even effectively subsidize, increased state and local debt. But remember, reducing the tax rate to 10% for about 90% of workers itself reduces the value of all deductions to just 10 cents on the dollar.
We expect the tax reform plan to be a substantial tax cut when scored on a static basis, not counting the effects of the reform on economic growth. But we expect the reform to produce booming economic growth, leading to a net gain in revenue when scored on a dynamic basis, taking those pro-growth effects into account. These expectations will be confirmed, we believe, when the reform is scored under the economic models of the Tax Foundation, the Heritage Foundation, the new Tax Policy Center of the National Center for Policy Analysis, and other free market economists. We believe tax reform plans designed to be revenue neutral when scored on a static basis are inevitably doomed to failure, as they effectively increase taxes on some, to reduce taxes on others, creating a storm of opposition from those bearing the higher taxes.
Consider the dramatic pro-growth effects of this reform, against the still born growth effects of the tax reform proposed by Stein in Room to Grow. That plan would increase the Child Tax Credit to $3,500, and help finance that by actually increasing marginal tax rates for upper middle class families from 25% today to 35%. The Child Tax Credit increase would waste major funds for no pro-growth effects, as discussed above, and the rate increase would counterproductively reduce growth. The modern, NTLC tax reform plan would produce sweeping pro-growth effects, by contrast, which would again sharply benefit the middle class, the working class, and the poor. Again, we expect that to be documented by the economic models discussed above.
The NTLC tax reform group is in close consultation with Congressman Paul Ryan, who is slated to be Chairman of the House Ways and Means Committee next year, and his staff. We expect Ryan’s tax reform proposals next year to be similar to what we are proposing. We expect the GOP Presidential candidate in 2016 to campaign on similar tax reform proposals as well, as part of a comprehensive pro-growth plan that would restore booming, world leading, American economic growth, and the American Dream. Further components of that comprehensive plan will be discussed next week.