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

Border adjustability will affect imports and exports

Border adjustability in the House Ways and Means Republicans’ destination-based cash-flow tax reform proposal will not result in an immediate and full offsetting exchange rate change as recently claimed by Martin Feldstein, significantly increasing the value of the US dollar relative to foreign currencies.  As noted in the January 6, 2017 blog, Feldstein made a different argument in 1990. 

Alan Viard has made a persuasive case that border adjustability will not permanently change the trade balance, given the assumption that the present value of imports and exports must balance over the life of a country!  However, in the near term, Alan notes that a new and/or non-comprehensive border-adjusted tax can cause sectorial changes discouraging some imports and encouraging some exports.  The magnitude and distribution of those changes need more analysis rather than assuming they won't happen. 

Alan also emphasizes that an increase in the US dollar will have a significant transition effect reducing the value of Americans’ holdings of foreign assets.  That wealth effect would reduce the well-being of American households and should also be subject to additional analysis. Both the trade and wealth effects may be offset by other advantages of the proposed tax reform, but should be explicitly considered by our policymakers.

Tom Neubig

Fiscal federalism affects multinational decisions: new approach to winners & losers?

The recent news of Carrier Corporation’s choice of locating jobs in Indiana vs. Mexico highlights that state taxes also matter in multinational corporations’ investment decisions. As noted in our January 6th blog, origin-based US state and local businesses taxes, such as property taxes and sales taxes on business inputs, are greater than the US federal corporate income tax.  Those origin-based taxes affect business location decisions.

What is newsworthy about the Carrier decision is that it may signal a growing recognition by the U.S. federal government of the importance of state and local business taxes in U.S. business location decisions (“competitiveness”).  The Carrier decision was significantly based on additional state tax incentives.  The negotiations were the result of the Twitter-pulpit of President-elect Trump and his Vice-President Elect and then-current Indiana Governor Pence.

From the perspective of state government policymakers the Carrier negotiations may be seen as a mixed blessing.  States have always strongly defended their "independence" from federal involvement in state tax policy. The new federal Administration may result in the federal government attempting to have more influence on which states benefit from new business jobs and investment.  In addition to choosing winners or losers among businesses, the federal government may exercise more influence in choosing which states are winners or losers.  States may be understandably concerned if this happens. 

Multistate corporations' extensive domestic tax legislative activities highlight the importance of state and local taxes to business.  These have included on-going challenges to assessed values of taxable business property at the local level, support for reduced sales taxation at business input at the state level, and advocacy for lower rates and more generous general as well as targeted tax credits or incentives.  Individual negotiated "deals" already common in many states may occur more often as a result of a presidential Twitter blast.   

The new federal Administration may signal a more proactive policy of encouraging particular business behaviors, such as locating economic activity in the U.S.  It may also signal a stronger federal role in the U.S. fiscal federalism, contrary to Republicans’ conventional backing of greater states’ rights, at least in the area of tax and business incentives.

Robert Cline and Tom Neubig