Lots for Economists to Like in the House GOP Tax Plan

Debating the implications of the GOP tax plan, most analysts speak past each other. That’s because there are 3 prisms through which changes can be assessed: the implications for efficiency and growth, the impact on the public finances, and the distributional impact across income groups.

The media tends to focus on the latter, but this is the least interesting. Distributional analysis tends to put the status quo on a pedestal (see how “progressive” sources now defend the state and local income tax deduction), tends to be static in its thinking, and in the case of this tax reform, ignores the potential for significant corporate income tax rate cuts to raise wages. Added to that, a lot of the results are simply not surprising. Given a large proportion of people do not pay income taxes, it is hardly shocking that their after-tax income doesn't increase following income tax rate cuts, though this can be influenced of course by credits.

As my colleague Chris Edwards has written before, the GOP open themselves up to these distributional critiques by talking about how their changes represent a “middle class tax cut” rather than focusing on the supply-side case for lowering marginal rates. As a result, this morning’s tax discussions on Twitter have been dominated by the sharing of blogs saying, in essence, that “the tax cut is actually a tax increase for much of the middle-class because the new credit is set to expire in 2022.” I am struggling to find blogs or comment pieces which used the same logic to explain why George W Bush’s temporary tax cuts weren’t really tax cuts at all, but hey, who expects consistency in politics!

On the efficiency and growth front, there is in fact lots to like in the House GOP plan. The changes to the income tax code stripped away a whole host of small deductions and made significant inroads into some big ones too (curtailing the mortgage interest deduction and eliminating the state and local income tax deduction), as well as abolishing the AMT. Of course, to make this politically palatable, the GOP near-doubled the standard deduction, expanded the child credit and added a new personal credit too. These will do little for growth, especially compared with purely lowering marginal rates, but they do help compensate losers from other changes.

The long-term consequence of the package of these reforms though (assuming they pass Congress without being further diluted) will be a combination of lower rates, fewer deductions and fewer people itemizing. This will significantly reduce deadweight costs associated with taxation. A key variable to watch out for to assess the broader economic impact of the income tax changes is the proportion of people who will face lower or higher marginal rates as a result of all the changes. One reason why this must be seen in the round is that linking tax thresholds to chained CPI rather than CPI will see slower threshold increases, meaning people being dragged into higher bands more quickly as nominal wages rise over time.

The most important policy goal was of course a large permanent cut in the corporate income tax rate, and this plan (if it passes) would achieve that. There is good reason to think this will raise the level of GDP and wages. Even though non-corporate businesses were already favored in the tax code once you include taxes on dividends, the GOP wanted to cut all business tax rates and broadly maintain differentials. They therefore introduced a new pass-through business tax rate at 25 percent. But this necessitates complex anti-avoidance rules to stop people restructuring their affairs to earn less wages and more business income.

The other, final change of note is the welcome planned repeal of the estate tax. This will not set be fully implemented until 2024, however, by which time the political landscape may have changed significantly.

Overall then, critics of the plan were wrong to say this was just about tax cuts without reform. In fact, the plan was a lot bolder on making changes to deductions and the structure of the code than many expected. Sure, other less growth-oriented measures were included to compensate some of the losers from broader reform, but overall the tax code is made more coherent.

The real debate for conservative economists should be weighing these efficiency gains against the consequences for the public finances. The plan is projected to add $1.5 trillion to the debt over 10 years, but even this is predicated on full expensing and the new income tax credits expiring after 5 years, which is debatable to say the least. The problem is that absent spending cuts, net tax cuts ultimately become tax shifting, leading to higher taxes in future.

A few weeks ago, I wrote that tax cuts which raised borrowing were worth it if they were used to grease the wheels of pro-growth tax reform or if they were a precursor to restraining spending. The latter looks unlikely. Whether the specific tax changes the GOP have planned got enough “bang for the buck” from the extra borrowing is an open question. Certainly, the priorities as this develops into legislation must be to keep the most economically beneficial measures: the corporate rate cut, the marginal income tax rate cuts, and the elimination and constriction of deductions.