President Obama wants to raise revenues by reducing tax deductions and other tax breaks, which the administration calls “spending in the tax code.” Donald Marron of the Tax Policy Center argues that “hundreds of billions of dollars of spending are disguised as tax cuts.”
Don is a very good economist, and he is concerned that special interest tax breaks can misallocate resources the same way that spending subsidies do. I agree. But I’m also concerned that tax breaks and spending subsidies have different implications for the size of government, which is where I part ways with Don and the president.
The following Tax Policy Matrix helps sort out which sorts of tax cuts make economic sense when government size is also a consideration.
The government distorts the economy and reduces GDP through both its taxing and spending actions. One reason is that both taxes and spending cause individuals and businesses to change their behaviors and reallocate resources in suboptimal ways. The table has columns for tax and spending distortions. It also has a column for government debt because running deficits today may translate into higher levels of distortionary taxes tomorrow.
The table includes two Starve-the-Beast scenarios. “With Starve-the-Beast” means that tax cuts will reduce government spending to some extent over time. A narrow tax base shot full of loopholes creates allocation distortions, but if starve-the-beast works that sort of tax base also limits the government’s size creating a counterbalancing benefit to GDP.
In the short run, starve-the-beast may or may not work. Bill Niskanen says that it does not, but I think the effectiveness of it changes over time as political culture changes. In the 1980s and 1990s, policymakers took corrective actions when deficits rose, but the revival of Keynesianism in recent years changed the political culture and, for a while, nullified the fear of deficits for many politicians.
In the long run, it seems obvious that the inflow of tax revenues to the government is a hard check on spending because there are financial market limits to government borrowing.
Let's go through the rows in the table:
Row 1. The government starts off with a balanced budget and with tax and spending systems that cause medium damage.
Row 2. The government cuts taxes $100 by way of a loophole. Tax distortions rise because marginal tax rates are unchanged and we've added a new distortion. Higher debt likely pushes up future tax distortions. This appears to be a poor policy choice.
Row 3. The government cuts taxes $100 by way of marginal rate cut. Tax distortions are reduced, which increases economic growth. The downside is higher debt. This may or may be a good policy depending on the quality of the tax cut. If the cut is to a very distortionary part of the tax code—such as the corporate income tax rate—this policy could make sense. One reason is that the deficit increase might end up being quite small because of the positive economic response to the pro-efficiency tax cut.
Row 4. With starve-the-beast operational, a special interest tax cut becomes a bit of a closer call. Tax distortions and debt rise, but government spending falls somewhat, so the net effect on the economy is unclear. However, I think there are considerations here aside from economics. Special interest tax breaks—such as the ethanol tax break—are troubling because they represent a corruption of the law, an affront to the American ideal of “equal justice under law.” So just on that basis, I’m against special interest breaks, and indeed am in favor replacing the current code with a flat tax.
Row 5. A pro-efficiency tax cut is very likely a winner if you assume that starve-the-beast is operational. Tax and spending distortions both fall, although there is a modest increase in debt.
So far we’ve left out the most important fiscal tool available to policymakers—spending cuts to unneeded and damaging programs to reduce government harm to the economy. The best policy choice would be to combine pro-growth tax cuts with spending cuts to harmful programs. That would reduce government distortions on both sides of the budget, and thus unambiguously increase GDP.
In sum, without matching spending cuts, tax cuts may or may not make sense depending on the type of cut and whether reducing Uncle Sam’s diet will force him to slim down in subsequent years. But it is a fiscal policy win-win to match spending cuts with cuts to the most damaging parts of the tax code.
According to an article in the New York Times, the Obama Administration is seriously examining a proposal to reduce America's anti-competitive 35 percent corporate tax rate.
The Obama administration is preparing to inject an unpredictable new variable into its economic policy clash with Republicans: a plan to overhaul corporate taxes. Economic advisers have nearly completed the process initiated in January by the Treasury secretary, Timothy F. Geithner, at President Obama’s behest. That process, intended to make the United States more competitive internationally, has explored the willingness of business leaders to sacrifice loopholes in return for lowering the top corporate tax rate, currently 35 percent. The approach officials are now discussing would drop the top rate as low as 26 percent, largely by curbing or eliminating tax breaks for depreciation and for domestic manufacturing.
This may be a worthwhile proposal, but this is an example where it would be wise to "look before you leap." Or, for fans of Let's Make a Deal, let's see what's behind Door Number 2.
To judge Obama's plan, it is important to have the right benchmark. An ideal corporate tax system obviously should have a low tax rate. And it also should have no double taxation (tax corporate income at the business level or tax it at the individual level, but don't tax it at both levels).
But it's also important to have a simple and neutral system. The right definition of corporate income for any given year is (or should be) total revenue minus total costs. What's left is income.
This may seem to be a statement of the obvious, but it's not the way the corporate tax code works. The system has thousands of complicated provisions, some of which provide special loopholes (such as the corrupt ethanol credit) that allow firms to understate their income, and some of which impose discriminatory penalties by forcing companies to overstate their income.
Consider the case of depreciation. The vast majority of people understandably have no idea what this term means, but it sounds like a special tax break. After all, who wants big corporations to lower their tax bills by taking advantage of something that sounds so indecipherable.
In reality, though, depreciation simply refers to the tax treatment of investment costs. Let's say a company buys a new machine (which would increase productivity and thus boost wages) for $10 million. Under a sensible and simple tax system, that company would include that $10 million when adding up all their costs, which then would be subtracted from total revenue to determine income.
But the corporate tax code doesn't let companies properly recognize the cost of new investments. Instead, they are only allowed to deduct (depreciate) a fraction of the cost the first year, followed by more the next year, and so on and so on depending on the specific depreciation rules for different types of investments.
To keep the example simple, let's say there is "10-year straight line depreciation" for the new machine. That means a company can only deduct $1 million each year and they have to wait an entire decade before getting to fully deduct the cost of the new machine.
Ultimately, the firm does deduct the full $10 million, but the delay (in some cases, about 40 years) means that a company, for all intents and purposes, is being taxed on a portion of its investment expenditures. This is because they lose the use of their money, and also because even low levels of inflation mean that deductions are worth significantly less in future years than they are today.
To put it in terms that are easy to understand, imagine if the government suddenly told you that you had to wait 10 years to deduct your personal exemption!
Let's now circle back to President Obama's proposal. With the information we now have, there is no way of determining whether this proposal is a net plus or a net minus. A lower rate is great, of course, but perhaps not if the government doesn't let you accurately measure your expenses and therefore forces you to overstate your income.
I'll hope for the best and prepare for the worst.
P.S. It's also important to understand that a "deduction" in the business tax code does not imply loophole. If you remember the correct definition of business income (total revenue minus total costs), this means a business gets to "deduct" its expenses (such as wages paid to workers) from total revenue to determine taxable income. Some deductions are loopholes, of course, which is why a simple, fair, and honest system should be based on cash flow. Which is how business are treated under the flat tax.
Here's a video arguing for the abolition of the corporate income tax. The visuals are good and it touches on key issues such as competitiveness.
I do have one complaint about the video, though it is merely a sin of omission. There is not enough attention paid to the issue of double taxation. Yes, America's corporate tax rate is very high, but that is just one of the layers of taxation imposed by the internal revenue code. Both the capital gains tax and the tax on dividends result in corporate income being taxed at least two times.
These are points I made in my very first video, which is a good companion to the other video.
There is a good argument, by the way, for keeping the corporate tax and instead getting rid of the extra layers of tax on dividends and capital gains. Either approach would get rid of double taxation, so the economic benefits would be identical. But the compliance costs of taxing income at the corporate level (requiring a relatively small number of tax returns) are much lower than the compliance costs of taxing income at the individual level (requiring the IRS to track down tens of millions of shareholders).
Indeed, this desire for administrative simplicity is why the flat tax adopts the latter approach (this choice does not exist with a national sales tax since the government collects money when income is spent rather than when it is earned).
But that's a secondary issue. If there's a chance to get rid of the corporate income tax, lawmakers should jump at the opportunity.
The Obama administration is showing interest in reforming the U.S. corporate income tax. That’s good news because a lower corporate rate would boost domestic investment, which in turn would generate more jobs and higher wages and incomes.
A lower corporate rate would also attract more inflows of direct investment from abroad—foreign-based businesses expanding their plants and building new plants in the United States.
I updated this chart from our book, Global Tax Revolution. It shows that during the 1980s, the United States enjoyed higher inflows of foreign direct investment (FDI) than outflows. But since then, the pattern has reversed—our companies are now investing more abroad than foreign-based companies are investing in the United States. (Data is from the BEA).
There are numerous factors that affect these flows, but there is no doubt that taxation plays an important role. If we cut our corporate tax rate, we would attract more investment (move the black bar upwards), which would be good for the U.S. economy.
There is an important caveat with the data, however. A large portion of FDI involves mergers and acquisitions. If a foreign company takes over a U.S. company, that’s an investment inflow. If such a takeover is a market-driven event that increases efficiency, that’s fine with me. However, there is evidence that foreign companies are taking over U.S. companies because we have anti-competitive “worldwide” corporate tax rules.
So the solution is to move to a “territorial” corporate tax system and substantially reduce the federal corporate tax rate. That way, we wouldn’t artificially encourage the takeover of U.S. firms, while also attracting larger inflows of job-generating greenfield investments.
A final note on the chart: it clearly shows that U.S. international investment has exploded in magnitude over the last couple of decades. That explosion has greatly increased the importance of having a competitive corporate tax code. So good for the Obama administration for looking into possible reforms.
The news is going from bad to worse for Ireland. The Irish Independent is reporting that the Swiss Central Bank no longer will accept Irish government bonds as collateral. The story also notes that one of the world's largest bond firms, PIMCO, is no longer purchasing debt issued by the Irish government.
And this is happening even though (or perhaps because?) Ireland received a big bailout from the European Union and the International Monetary Fund (and the IMF's involvement means American taxpayers are picking up part of the tab).
I've already commented on Ireland's woes, and opined about similar problems afflicting the rest of Europe, but the continuing deterioration of the Emerald Isle deserves further analysis so that American policy makers hopefully grasp the right lessons. Here are five things we should learn from the mess in Ireland.
1. Bailouts Don't Work -- When Ireland's government rescued depositors by bailing out the nation's three big banks, they made a big mistake by also bailing out creditors such as bondholders. This dramatically increased the cost of the bank bailout and exacerbated moral hazard since investors are more willing to make inefficient and risky choices if they think governments will cover their losses. And because it required the government to incur a lot of additional debt, it also had the effect of destabilizing the nation's finances, which then resulted in a second mistake -- the bailout of Ireland by the European Union and IMF (a classic case of Mitchell's Law, which occurs when one bad government policy leads to another bad government policy).
American policy makers already have implemented one of the two mistakes mentioned above. The TARP bailout went way beyond protecting depositors and instead gave unnecessary handouts to wealthy and sophisticated companies, executives, and investors. But something good may happen if we learn from the second mistake. Greedy politicians from states such as California and Illinois would welcome a bailout from Uncle Sam, but this would be just as misguided as the EU/IMF bailout of Ireland. The Obama Administration already provided an indirect short-run bailout as part of the so-called stimulus legislation, and this encouraged states to dig themselves deeper in a fiscal hole. Uncle Sam shouldn't be subsidizing bad policy at the state level, and the mess in Europe is a powerful argument that this counter-productive approach should be stopped as soon as possible.
By the way, it's worth noting that politicians and international bureaucracies behave as if government defaults would have catastrophic consequences, but Kevin Hassett of the American Enterprise Institute explains that there have been more than 200 sovereign defaults in the past 200 years and we somehow avoided Armageddon.
2. Excessive Government Spending Is a Path to Fiscal Ruin -- The bailout of the banks obviously played a big role in causing Ireland's fiscal collapse, but the government probably could have weathered that storm if politicians in Dublin hadn't engaged in a 20-year spending spree.
The red line in the chart shows the explosive growth of government spending. Irish politicians got away with this behavior for a long time. Indeed, government spending as a share of GDP (the blue line) actually fell during the 1990s because the private sector was growing even faster than the public sector. This bit of good news (at least relatively speaking) stopped about 10 years ago. Politicians began to increase government spending at roughly the same rate as the private sector was expanding. While this was misguided, tax revenues were booming (in part because of genuine growth and in part because of the bubble) and it seemed like bigger government was a free lunch.
Eventually, however, the house of cards collapsed. Revenues dried up and the banks failed, but because the politicians had spent so much during the good times, there was no reserve during the bad times.
American politicians are repeating these mistakes. Spending has skyrocketed during the Bush-Obama year. We also had our version of a financial system bailout, though fortunately not as large as Ireland's when measured as a share of economic output, so our crisis is likely to occur when the baby boom generation has retired and the time comes to make good on the empty promises to fund Social Security, Medicare, and Medicaid.
3. Low Corporate Tax Rates Are Good, but They Don't Guarantee Economic Success if other Policies Are Bad -- Ireland used to be a success story. They went from being the "Sick Man of Europe" in the early 1980s to being the "Celtic Tiger" earlier this century in large part because policy makers dramatically reformed fiscal policy. Government spending was capped in the late 1980 and tax rates were reduced during the 1990s. The reform of the corporate income tax was especially dramatic. Irish lawmakers reduced the tax rate from 50 percent all the way down to 12.5 percent.
This policy was enormously successful in attracting new investment, and Ireland's government actually wound up collecting more corporate tax revenue at the lower rate. This was remarkable since it is only in very rare cases that the Laffer Curve means a tax cut generates more revenue for government (in the vast majority of cases, the Laffer Curve simply means that changes in taxable income will have revenue effects that offset only a portion of the revenue effects caused by the change in tax rates).
Unfortunately, good corporate tax policy does not guarantee good economic performance if the government is making a lot of mistakes in other areas. This is an apt description of what happened to Ireland. The silver lining to this sad story is that Irish politicians have resisted pressure from France and Germany and are keeping the corporate tax rate at 12.5 percent. The lesson for American policy makers, of course, is that low corporate tax rates are a very good idea, but don't assume they protect the economy from other policy mistakes.
4. Artificially Low Interest Rates Encourage Bubbles -- No discussion of Ireland's economic problems would be complete without looking at the decision to join the common European currency. Adopting the euro had some advantages, such as not having to worry about changing money when traveling to many other European nations. But being part of Europe's monetary union also meant that Ireland did not have flexible interest rates.
Normally, an economic boom drives up interest rates because the plethora of profitable opportunities leads investors demand more credit. But Ireland's interest rates, for all intents and purposes, were governed by what was happening elsewhere in Europe, where growth was generally anemic. The resulting artificially low interest rates in Ireland helped cause a bubble, much as artificially low interest rates in America last decade led to a bubble.
But if America already had a bubble, what lesson can we learn from Ireland? The simple answer is that we should learn to avoid making the same mistake over and over again. Easy money is a recipe for inflation and/or bubbles. Simply stated, excess money has to go someplace and the long-run results are never pleasant. Yet Ben Bernanke and the Federal Reserve have launched QE2, a policy explicitly designed to lower interest rates in hopes of artificially juicing the economy.
5. Housing Subsidies Reduce Prosperity -- Last but not least, Ireland's bubble was worsened in part because politicians created an extensive system of preferences that tilted the playing field in the direction of real estate. The combination of these subsidies and the artificially low interest rates caused widespread malinvestment and Ireland is paying the price today.
Since we just endured a financial crisis caused in large part by a corrupt system of housing subsidies for Fannie Mae and Freddie Mac, American policy makers should have learned this lesson already. But as Thomas Sowell sagely observes, politicians are still fixated on somehow re-inflating the housing bubble. The lesson they should have learned is that markets should determine value, not politics.
The mid-term elections were a rejection of President Obama's big-government agenda, but those results don't necessarily mean better policy. We should not forget, after all, that Democrats rammed through Obamacare even after losing the special election to replace Ted Kennedy in Massachusetts (much to my dismay, my prediction from last January was correct).
Similarly, GOP control of the House of Representatives does not automatically mean less government and more freedom. Heck, it doesn't even guarantee that things won't continue to move in the wrong direction. Here are three possible bad policies for 2011, most of which the Obama White House can implement by using executive power.
1. A back-door bailout of the states from the Federal Reserve -- The new GOP Congress presumably wouldn't be foolish enough to bail out profligate states such as California and Illinois, but that does not mean the battle is won. Ben Bernanke already has demonstrated that he is willing to curry favor with the White House by debasing the value of the dollar, so what's to stop him from engineering a back-door bailout by having the Federal Reserve buy state bonds? The European Central Bank already is using this tactic to bail out Europe's welfare states, so a precedent already exists for this type of misguided policy. To make matters worse, there's nothing Congress can do -- barring legislation that Obama presumably would veto -- to stop the Fed from this awful policy.
2. A front-door bailout of Europe by the United States -- Welfare states in Europe are teetering on the edge of insolvency. Decades of big government have crippled economic growth and generated mountains of debt. Ireland and Greece already have been bailed out, and Portugal and Spain are probably next on the list, to be followed by countries such as Italy and Belgium. So why should American taxpayers worry about European bailouts? The unfortunate answer is that American taxpayers will pick up a big chunk of the tab if the International Monetary Fund is involved. Indeed, this horse already has escaped the barn. The United States provides the largest amount of subsidies to the International Monetary Fund, and the IMF took part in the bailouts of Greece and Ireland. The Senate did vote against having American taxpayers take part in the bailout of Greece, but that turned out to be a symbolic exercise. Sadly, that's probably what we can expect if and when there are bailouts of the bigger European welfare states.
3. Republicans getting duped by Obama and supporting a VAT -- The Wall Street Journal is reporting that the Obama Administration is contemplating a reduction in the corporate income tax. This sounds like a great idea, particularly since America's punitive corporate tax rate is undermining competitiveness and hindering job creation. But what happens if Obama demands that Congress approve a value-added tax to "pay for" the lower corporate tax rate? This would be a terrible deal, sort of like a football team trading a great young quarterback for a 35-year old lineman. The VAT would give statists a money machine that they need to turn the United States into a French-style welfare state. This type of national sales tax would only be acceptable if the personal and corporate income taxes were abolished - and the Constitution was amended to make sure the federal government never again could tax what we earn and produce. But that's not the deal Obama would offer. My fingers are crossed that Obama doesn't offer to swap a lower corporate income tax for a VAT, particularly since we already know that some Republicans are susceptible to the VAT.
Sometimes it's not a good idea to be at the top of a list. And now that Japan has announced a five-percentage point reduction in its corporate tax rate, the United States will have the dubious honor of imposing the developed world's highest corporate tax rate. Here's an excerpt from the report in the New York Times.
Japan will cut its corporate income tax rate by 5 percentage points in a bid to shore up its sluggish economy, Prime Minister Naoto Kan said here Monday evening. Companies have urged the government to lower the country’s effective corporate tax rate — which now stands at 40 percent, around the same rate as that in the United States — to stimulate investment in Japan and to encourage businesses to create more jobs. Lowering the corporate tax burden by 5 percentage points could increase Japan’s gross domestic product by 2.6 percentage points, or 14.4 trillion yen ($172 billion), over the next three years, according to estimates by Japan’s Trade Ministry. ... In a survey of nearly 23,000 companies published this month by the credit research firm Teikoku Data Bank, more than 44 percent of respondents cited lower corporate taxes as a prerequisite to stronger economic growth in Japan. ... A 5 percentage-point tax rate cut is unlikely to do much to solve Japan’s woes, however. An effective corporate tax rate of 35 percent would still be higher than South Korea’s 24 percent or Germany’s 29 percent, for example. ... Meanwhile, the government is trying to offset lost tax revenue with tax increases elsewhere, which could blunt the effect of reduced corporate tax burdens.
I suspect the Japanese government's estimate of $172 billion of additional output is overly generous. After all, the corporate tax rate in Japan will still be very high (the government originally was considering a bigger cut). And foolish Japanese politicians will probably raise taxes elsewhere. But there will be some additional growth since the corporate tax rate is an especially damaging way to collect revenue.
But I'm not losing sleep about Japan's economic future. I hope they do well, of course, but my bigger concern is the American economy. The U.S. corporate tax rate of nearly 40 percent (including state corporate burdens) already is far too high, particularly since America adds to the competitive disadvantage of U.S.-domiciled firms by being one of the few nations to impose an extra layer of tax on foreign-source income. Japan's proposed rate reduction, however, means the high tax rate in America will be an even bigger hindrance to job creation.
It's also worth noting that the average corporate tax rate in Europe has now dropped to less than 24 percent, so even welfare states have figured out that a high tax burden on business doesn't make sense in a competitive global economy.
Sometimes you can fall farther behind if you stand still and everyone else moves forward. That's a good description of what's happening in the battle for a pro-growth corporate tax system. By doing nothing, America's self-destructive corporate tax system is becoming, well, even more destructive.