The Hugest tax cut in US history: Should that be the goal?

The President on June 8th said, "We have also proposed a historic tax cut — biggest in the history of our country, by the way".  Although details about the plan await, an analysis by Jerry Tempalski of the US Treasury provides some indication of the potential size of the tax cut: at least -2.89% of GDP, the prior record from the Economic Recovery Tax Act of 1981.

A record US tax cut would reduce revenues over the next ten years by at least $7.3 trillion, at -2.89% of GDP.  However, the 1981 Tax Act That Act phased in a 23% reduction in individual tax rates, provided extremely accelerated depreciation of capital assets, and indexed individual tax rate brackets by inflation starting four years later.   By the fourth year after enactment, the reduction was -4.15% of GDP and probably still growing.  If the six out-years are at -4.15% of GDP, the President's total tax cut would be over $9.3 trillion over ten years. 

The President’s FY18 budget (Table S-2) claims there will be 10-year $2.1 trillion budget “effect of economic feedback”, some of which will be from tax “reform” as well as from other government initiatives.  Thus, the dynamic macroeconomic effects will only offset a small portion of the huge deficit increase from the tax cut yet to be proposed in sufficient detail to make an actual estimate of its total cost or its economic effects. 

Instead of trying to set a new record on the size of tax reductions, any tax change should focus on the future needs of the American citizens, and establish a tax system that effectively promotes economic growth, is simpler and also fairer. 

Tom Neubig

Cash flow taxation and “excess” (but still marginal) returns

Setting aside the issue of border adjustability, the cash-flow tax on domestic producers would replace the current CIT’s tax on total corporate equity income with a business tax on so-called “excess” returns.  To see this, consider expensing of business investment is similar to a traditional Individual Retirement Account (IRA) deduction.  A traditional IRA provides an immediate tax benefit that is equivalent to exempting the expected “normal” return on the retirement savings.  The present value of the immediate tax savings offsets the expected present value of the future taxes on the payouts of both the principal and expected investment return.  But since all future payouts are subject to tax, any “excess” capital returns would be taxed in the future.  Unlike a Roth IRA that provides no upfront deduction but exempts all future payouts, the traditional IRA (expensing) taxes “excess" returns.  

Expensing eliminates the so-called “normal” return to capital, but a recent US Treasury empirical study found that three-quarters of corporate income was "excess" returns.  (See Nov. 21, 2016 blog on "normal" and "excess" returns.) Businesses and investors aren’t taking risks and exerting significant efforts to earn “normal” returns, which often are equated to government bond rates.  Businesses and investors are still concerned about taxes on "excess" returns.  Taxes on “excess” returns can reduce the expected return below their high hurdles rates that reflect risk and entrepreneurial effort.  

The return may be "excess" but it isn't necessarily "infra-marginal" to investors and entrepreneurs. That is why many corporations were more interested in a lower corporate tax rate than expensing after a similar tax reform proposal was made in 2005.

Tom Neubig