Turning a Good Blueprint for Tax Reform into a Great One

By MAX GILLMAN and DAVID C. ROSE

April 2017

Two weeks ago President Trump told House leaders that he liked most of the House Ways and Means Committee’s “Blueprint” for tax reform. The blueprint does indeed significantly improve tax policy in a number of ways. But a careful consideration of what the latest economic theory has to say about economic growth suggests that it could be even better. Republicans should not miss this once in a generation opportunity to significantly improve the US tax code.

Governments tax so they can spend. An important fact about federal spending is that in the US over the last 60 years it has been a rather stable proportion of GDP (we ignore entitlement spending since, for the most part, these programs have dedicated funding). The trend is downward from about 24% (in 1958 and 1967) to about 18% (1998-2000). In 2016 it was a little over 19%.

As a practical matter, then, the ultimate objective of tax policy should be to extract enough resources from the economy to support spending of 18-20% of GDP as efficiently and as fairly as possible. Extracting less, such as what has been the average tax revenue share of GDP over the last 60 years of 17% leads to ever increasing debt. Extracting more reduces consumption for no good reason and weakens incentives that support rapid growth.

The blueprint can be improved by adopting a top rate of 22% on personal income and a 22% rate on all corporate profit coupled with: 1) eliminating taxation on dividends (to avoid double-taxation of dividends and remove the differential treatment of debt and equity), 2) eliminating capital gains taxes on stock holdings, and 3) removing all deductions and loopholes except those that exist to properly define corporate and personal income.

There is a very important finding in macroeconomic theory that has gotten surprisingly little attention. In pioneering work Robert Barro, in an article in the Journal of Political Economy (1990), considered government spending to be a constant share of GDP. Then Stephen Turnovsky, in an article in the Journal of Monetary Economics (2000), showed that under this condition income tax policy should be neutral with respect to rates applied to human capital (personal income) and physical capital (corporate profit).

This type of tax neutrality is an established result that no one we know of has successfully challenged. It makes intuitive sense that policy should not favor one over the other and thereby distort resource allocation.

Moreover, no serious economist we know of supports the double taxation of corporate profit. So the real question is, therefore, how to best insure that all corporate income is actually taxed, but only once. Some favor accomplishing this by not taxing corporate profit because dividends will produce personal income which will ultimately be taxed anyway.

This approach is attractive because it recognizes that it is people, not firms, who ultimately bear the burden of paying taxes. But the problem with this approach is that not all corporate profit is distributed as dividend income that is later subject to the personal income tax. This simple fact is particularly relevant when considering a zero corporate profit tax rate.

A zero corporate profit tax rate will induce firms to hold back on dividends so as to reward shareholders mainly through capital gains appreciation arising from retained earnings. This subsidizes physical capital relative to human capital by inducing more earnings retention at zero cost to the firm. If retaining such amounts for firm reinvestment was the best use of these funds, it would have happened already without the tax code inducing such action.

There is another benefit from taxing corporate profits at the source rather than indirectly through personal income that is increased by dividends. The latter approach requires monitoring over 100 million payers to minimize avoidance. Our society makes it hard for government to know much about each household’s finances. Taxing corporate profits at the source, however, requires the monitoring of far fewer firms. And with corporate firms especially, their financial situations are very transparent. This means the effective rate – after accounting for avoidance – is more likely to be close to the official marginal rate when corporate profits are taxed at the source.

Achieving neutrality in how human capital and physical capital is taxed also affects how capital gains should be treated. If we choose to tax corporate profits at the source, then capital gains realized through the appreciation of the value of stock holdings should not be taxed. This approach also cuts off a means by which the federal government can increase taxes through inflating the value of the currency to drive up the price of stocks.

This problem is often cited as a rationale for having a lower tax rate on capital gains, but our approach renders this issue moot. It also vastly simplifies the filing of tax returns by eliminating at one stroke the vast financial industry of “cost-based” accounting of stocks, needed to determine the size of the reported capital gain.

Most discussions about tax rates involve a false choice between having a flat or progressive tax system. We think the blueprint can be greatly improved by not falling prey to this false choice. For personal income, an approach that is better than a pure flat or a thoroughly progressive tax is a progressive system that reaches its top bracket so quickly that it is effectively flat for the vast majority of income for the majority of tax payers. This is where progressivity is needed most – to have a lower or zero rate for those who earn the least. What matters most is not that the rate be perfectly flat, only that it is flat for the people who will be paying most of the taxes.

A tax blueprint with a top rate of 22% on personal income and a flat rate on all corporate income would be a better blueprint. It would move us much closer to taxing human and physical capital equally, which removes a major inefficiency of the current system and the existing blueprint. Its rate of 22% should be high enough to ensure sufficient revenue yield to cover 18% – 20% of spending out of GDP given there is always some avoidance and given that the lowest income individuals will pay lower rates (some zero). Finally, 22% is just below the corporate rate for a number of large countries. This will give American firms a stronger incentive to stay in the US and foreign firms a powerful incentive to move to the US.

Max Gillman is the F.A. Hayek Professor of Economic History and David C. Rose is a Professor Economics, both at the University of Missouri-St. Louis.


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