The media’s favorite analysis of the Big Six tax reform framework comes from the Urban-Brookings Tax Policy Center (TPC), which purports to estimate that the plan would increase individual income taxes by $471 billion over a decade (by slashing exemptions and deductions), while cutting business taxes by $2.6 trillion.  Predictably, this generated a tidal wave of outraged editorials and TV ads claiming the plan would do nothing for economic growth and benefit only “big corporations and the top 1%” (which is redundant, because individual taxes aren’t cut and the TPC wrongly attributes nearly all corporate tax cuts to the top 1%).

The Wall Street Journal has offered a powerful corrective to the TPC’s concealed analysis in “Where Critics of Tax Reform Go Wrong”, by Larry Kotlikoff of Boston University. It draws on his working paper with Seth Benzell of MIT and Guillermo Lagarda of the Inter-American Development Bank, which found “The [corporate] tax reform produces enough additional revenues to permit a reduction in personal income tax rates.”

The Tax Policy Center opines there will be “little macroeconomic feedback effect on revenues,” Kotlikoff explains, because they rely on an antique closed-economy model in which (1) investment can only be financed from some domestic “pool” of savings, and (2) higher taxes are equivalent to more savings because they supposedly reduce government deficits without reducing private savings. If government borrows more, this supposedly raises interest rates and “crowds out” private investment.

In reality, U.S. interest rates do not rise and fall with budget deficits, partly because arbitrage ensures the global bond yields move in tandem. Japan ran large chronic budget deficits for decades with super-low interest rates.  

The TPC nevertheless claims that lower corporate tax rates must add to the deficit because they will not raise investment and economic growth. And the reason lower corporate tax rates will not raise economic growth is because they will add to the deficit. Run those two sentences back and forth a few times to appreciate the magnificent circularity of this rhetorical trap for the unwary.

Unfortunately, Kotlikoff’s policy advice is not quite as careful as his analysis. He and his co-authors apparently “share critics concerns that [some unspecified aspect of] the plan would disproportionately benefit the top 1%. One way to rectify the fairness problem and address the country’s long-term fiscal gap would be to add, as the framework foresees, a fourth personal tax bracket for those with very high incomes.”   

Congress might take a clue from the Clinton-Gore campaign, for example, and add a 10% surtax on taxable income above $1 million. That would leave us with a 38.5% tax rate on income reported on individual income tax returns and a 20% tax rate on income reported on corporate tax returns. Contrary to Kotlikoff, that would not raise more revenue (to “address the fiscal gap”) for reasons explained by Kotlikoff himself: “If corporate tax rates are lower than personal income tax rates, people have an incentive to shelter their self-employment income (lower their personal tax bill) by incorporating.”  

In the 1980s, as the top tax rate on individual income fell from 70% to 28%, professionals and owners of closely-held businesses shifted en masse from reporting most of their income on corporate tax forms to reporting it on individual tax returns, as pass-through partnerships, proprietorships, Subchapter S corporations and LLCs.

A 2015 study by five Treasury economists and two Chicago scholars finds, “’Pass-through’ businesses like partnerships and S-corporations now generate over half of U.S. business income and account for [41%] of the post-1980 rise in the top- 1% income share.” If we now slam that process into reverse – by cutting corporate tax rate to 20% while leaving top individual rates of 35-40% – that would soon result in massive income-shifting out of pass-through entities back into C-corporations that pay no dividends and compensate owners with tax-free perks, company cars and condos, and lavish expense accounts rather than large salaries.  

In short, the wider the gap between top tax rates on individual and business income (including self-defined pass-through income on Schedule C) the more futile it would become to raise top tax rates on income reported on individual tax returns above 30% much less 38-40%. The fourth tax bracket is a really bad idea based on really bad estimates of who wins and loses from a lower corporate tax rate.

Kotlikoff, Benzell and Lagarda have no basis for evaluating the “fairness” of proposed tax changes for individuals because they explicitly “do not model” such changes – they are exclusively concerned with the corporate tax. But, their model estimates that cutting the corporate tax raises tax revenue and also raises real wages by about 8 percent.

Kotlikoff’s endorsement of a fourth individual tax rate higher than 35% is not because he believes the GOP Framework adds much to budget deficits, but because he apparently accepts the Tax Policy Commission’s static estimates that the top 1% benefits most, as shown in the Table.

TPC Estimated Static Change in Federal Taxes by Income Group from Republican Framework Tax Plan

The reason the top 1% appears to get the largest tax cut is not because of the plan’s trivial rejiggering of individual deductions and taxes (which go up rather than down), but because the Tax Policy Center arbitrarily “assumes” that owners of capital bear 80% of the corporate tax, and most capital is owned by people with high incomes.

The trouble is, the TPC assumption that labor bears only 20% of the burden of the corporate tax is totally inconsistent with Kotlikoff’s model predicting an 8% rise in real wages from cutting the corporate tax.  It is also totally inconsistent with all recent empirical studies on that issue. Congressional Budget Office economist William C. Randolph, for example, estimated U.S. labor bears 70% of the corporate tax, once we drop the TPC closed-economy fiction and allow capital to gravitate to countries with lower marginal tax rates. For tax-friendly countries attracting U.S. business and investment, Randolph explains, “Foreign workers benefit because an increased foreign stock of capital raises their productivity and their wages. Domestic workers lose because their productivity falls and they cannot emigrate to take advantage of higher foreign wages.”

A Tax Policy Center survey of the evidence likewise concluded that “Recent empirical studies… all conclude that wage earners bear most of the ultimate burden of the corporate tax.”  That means everything you have been reading about “Trump Plan Delivers Massive Tax Cuts to the 1%” is just made-up fiction – based on a key assumption the source (the Tax Policy Center) knows to be false.