The real issues in Federal Tax Reform

Republicans in the house of representatives have introduced their tax bill, and congress and the president intend to pass some version of tax reform promptly.  As folks consider the details and try to craft a package that will pass, let’s first remind ourselves what are the main principles, goals and problems facing tax reform.

The key goal is always economic growth.  Growing the economy at a sustainably fast clip means on average everyone is better off and each person or family has more opportunity to improve their lot.  It also allows us to afford more of the public goods that government can supply, including caring for the needy.

Moreover, generally the policies that promote growth are also those that are fair among individuals.  Thus, lowering the overall burden of taxes allows people to retain more of the fruits of their labor and savings and investment, which is inherently fair.  For all these reasons, economic growth is the lodestar for public policy.

The general principles that should guide growth-oriented income tax reform are use of broad tax bases with low rates, especially the “marginal” rates that apply to one’s last dollar earned.  Also, special provisions (exemptions, credits, etc.) for businesses and personal taxpayers distort their decisions away from choices that promote growth and are fair.

Counter-intuitively to some folks, levying taxes directly more on natural people and less on business corporations is also growth inducing.  Martin Feldstein, the eminent Harvard economist, wrote in the Wall Street Journal this week that corporate tax reform is the key to growth, as students of tax policy know.  He said the most important reform is to cut the corporate from our present 35 percent, which is the highest among major industrial nations, to 20 percent or less.

Further, a paper last month by the non-partisan Tax Foundation reviewed the theoretical and empirical studies over many years and concluded that labor bears much more of the burden of corporate taxes via reduced wages and increased unemployment than does capital (investors) via reduced profits.  To the extent corporate taxes raise costs of production, consumers also bear part of the burden and economic growth suffers.

So, getting the corporate marginal tax rate down to 20 percent or lower is the most important thing in this reform.  Among other things, doing so will greatly reduce the problems of U.S. businesses leaving profits they earn in other countries there or in tax havens.  When these earnings are repatriated, we will enjoy a permanent growth surge due to increased investment.

While reform reduces marginal corporate rates and tax revenues, it is important to stop the growth of deficits and national debt, which have gotten quite out of hand.  Deficits and debt themselves are not the problem, but rather the very high levels they’ve reached in recent years.

To a great extent, reduced taxes will themselves accelerate growth and thus replace some tax revenues lost to lower rates.  However, the bulk of the deficit and debt problem must be solved via slowed spending growth because government spending at all levels is so high it substantially slows economic growth.

Why is tax reform so difficult that we’ve been unable to make any meaningful progress on it over the last 30 years?  Public choice theory explains this quite well.

The special interests that benefit from exemptions, deductions and credits available only to some parties are few in number, but each member of the group has a large stake in keeping these provisions.  On the other hand, the beneficiaries of tax reform that replaces them with lower rates and broader bases are many in number with each beneficiary having generally a small average stake in the outcome.

Hence, the defenders of the provisions that need reform are easily able to organize into industry and other interest groups because they are few and their large individual stakes make it worth their while to hire consultants, lawyers and lobbyists to press their case.  The large number of people supporting the public-interest reforms and their small individual stakes means they generally can’t even get meaningfully represented.

Reform will succeed if republicans stand up to the special interests and for the public interest by cutting marginal corporate tax rates.

Ron Knecht is Nevada Controller.  James Smack is Deputy Controller.