Topic: Tax and Budget Policy

No, Higher Deficits Don’t Raise Long-Term Interest Rates

According to former Reagan adviser Martin Feldstein, “Higher projected budget deficits could raise long-term interest rates, potentially triggering… a serious economic downturn.”

Has that ever happened?

From 1977 to 1981 10-year bond yields nearly doubled, rising from about 7.4% to 13.9%, but budget deficits were relatively small, around 2.5% of GDP.  Budget deficits were doubled from 1984 to 1993 (about 5% of GDP), yet bond yields were nearly cut in half, falling from 12.4% to 5.9%. Bond yields were no lower from 1997 to 2000 when the budget moved into surplus. But yields fell dramatically in 2008-2012, a period of record budget deficits.

One possible objection is that larger budget deficits were caused by recessions, which is why bond yields did not rise with larger deficits or fall with surpluses.  The graph addresses this concern by using CBO estimates [.xls] of cyclically-adjusted budgets (“with automatic stabilizers,” in CBO vocabulary). Deficits and Bond Yields

Still, there is clearly no correlation between bond yields and any measure of yearly budget deficits and surpluses. And that is also true in other times and places – Japan’s chronic large deficits and debt being an obvious example.

Another possible objection centers on Feldstein’s use of the phrase “projected budget deficits,” as though the CBO’s notoriously inaccurate long-run projections could somehow have an entirely different effect from actual deficits. I criticized the analysis and evidence behind that conjecture in a Treasury Department presentation which was condensed and simplified in a Cato Institute paper. I found the underlying analysis illogical and contradictory and the evidence worthless.

There is no need to make up stories about alleged effects of deficits on bond yields in order to make a strong case for minimizing frivolous government borrowing (e.g., to pay for transfer payments or government employee compensation).

Chronic deficits add to accumulated debt, and that debt will have to be serviced with future taxes even if it is rolled-over indefinitely. That is reason enough for Congress to keep growth of federal spending below the growth of the private economy – a task which requires frugality in spending but also a tax and regulatory climate which minimizes impediments to investment, entrepreneurship, education and work.

Trump’s Tax Reform Proposals

The Trump administration has released proposals to guide the Republican push for major tax reform. The proposals are mainly supply side in nature, meaning cuts to marginal tax rates and other changes designed to increase economic growth. Major tax reforms are needed desperately, so kudos to Trump for taking charge and thinking boldly, particularly on business tax reforms. There are, however, a few misguided parts in his new plan.

Here are thoughts on the proposed business tax reforms:

  • Cutting the corporate tax rate from 35 percent to 15 percent would have a huge positive effect on the U.S. economy over time. It would encourage more capital investment and hiring, and it would reduce the incentive for corporations to avoid and evade taxes. Such a rate cut would cause the income tax base to expand automatically and substantially over time.
  • Cutting the tax rate on “pass-through” businesses to 15 percent, however, is a mistake. Policymakers should aim to equalize the overall rates on income earned by each type of business. So if the corporate rate is 15 percent, corporate income would face a combined tax rate of 15 percent plus the individual dividend rate of, say, 15 percent under tax reform, for a total of about 28 percent (0.15+0.85*0.15). Thus, the top rate on pass-through income should be cut to the same 28 percent.
  • Switching from a worldwide to a territorial system for corporations would encourage multinationals to move their headquarters to the United States. It would reverse the trend toward reincorporating abroad.
  • Ditching the misguided “border adjustment” provision the House proposed is a good move. Paul Ryan and Kevin Brady need to drop it so that tax reform can move ahead.

Here are thoughts on the proposed individual reforms:

  • Reducing the number of tax brackets from 7 to 3 (10, 25, and 35 percent) is a good reform. Cutting marginal rates reduces distortions, increases incentives to engage in productive activities, and reduces avoidance and evasion.
  • Repealing the special 3.8% investment tax is a good reform.
  • Eliminating itemized deductions—such as the state/local tax deduction—is a good reform. But we should also eliminate, or at least cap, the mortgage interest deduction.
  • Expanding child care benefits is a mistake. It would add complexity and distortion to what should be a private area of activity in the economy.
  • Ending the alternative minimum tax and the estate tax are both long overdue reforms.

What about the effects of tax reform on the deficit? Policymakers should put that concern aside for the corporate rate cut portion of Trump’s plan because the automatic expansion of the corporate tax base would mean that the government would lose little if any revenue over the long term. Exhibit A: Canada and Exhibit B: Britain.

However, policymakers should be concerned about the deficit effects of individual tax changes. Optimally, the budget impact of reduced individual tax rates should be offset by eliminating deductions and credits, spending cuts, and dynamic growth effects.

All in all, the Trump proposals push tax reform in a good direction. Trump, his advisors, and House leaders seem to understand the urgency of passing major tax reforms. But we need Republican senators to step up to the plate and think boldly as well. Republicans have an opportunity this year to pass reforms that would generate large and lasting benefits in terms income and opportunity for every American family.

New CBO Report on Federal Worker Pay

The Congressional Budget Office has released a report on compensation of federal government workers. It finds that compensation is 17 percent higher, on average, for federal civilian workers than for private sector workers, after adjusting for factors such as education levels.

The CBO found that federal wages were a little elevated, but that federal benefits were substantially higher than benefits in the private sector. Generally, less-skilled and medium-skilled workers do better on both wages and benefits in the government, but the highest-skilled workers do better on wages in the private sector.

Wages are 3 percent higher in the government than the private sector, on average, but the CBO finds substantial variation depending on education level:

  • Federal workers with no more than a high school education earned 34 percent more, on average, than similar workers in the private sector.
  • Federal workers whose highest level of education was a bachelor’s degree earned 5 percent more, on average, in the federal government than in the private sector.
  • Federal workers with a professional degree or doctorate earned 24 percent less, on average, than their private-sector counterparts.

Benefits are 47 percent higher in the government, on average, but there is variation as follows:

  • Average benefits were 93 percent higher for federal employees with no more than a high school education than for their private-sector counterparts.
  • Average benefits were 52 percent higher for federal employees whose highest level of education was a bachelor’s degree than for similar private-sector employees.
  • Among employees with a doctorate or professional degree, by contrast, average benefits were about the same in the two sectors.

The Trump administration and Congress should try to bring federal pay and workplace conditions in line with the rest of the nation. Reforms should include cutting the overly generous federal benefits package and reducing the hurdles to firing poorly performing federal workers.

For further analysis on federal wages, benefits, and firing, see here.

Corporate Tax Cuts: Canada’s Experience

President Donald Trump and congressional Republicans are proposing to cut the corporate tax rate. With any tax cut, members of Congress want to know how much revenue the government may lose from the reform. I do not think that cutting our 35 percent federal corporate tax rate to 20 percent or so would lose the government any money over the long term. U.S. and foreign corporations would invest more in the United States, which would boost our economy, and corporations would avoid and evade taxes less.

Canada provides us with a real-world trial run of corporate tax cuts, and new budget data includes the latest revenue estimates. The nation slashed its federal corporate tax rate from 38 percent in the mid-1980s, to 29 percent by 2000, to 15 percent by 2012, as shown in Chart 1 below. Has the government lost revenue?

You be the judge. Chart 2 shows that corporate tax revenues in Canada have fluctuated with the ups and downs in the economy—revenues fell, for example, during recessions in the early 1990s and 2009. But even with the modest Canadian economic growth of recent years, revenues have held up under a much lower rate. Corporate tax revenues are 2.1 percent of gross domestic product (GDP) today, which is a bit higher than in the mid-1980s when the rate was more than twice as high.

Let’s compare to the United States. While Canada’s 15 percent federal corporate tax will raise 2.1 percent of GDP this year, the 35 percent U.S. federal corporate tax will raise just 1.7 percent. Thus, the Canadian corporate tax raises relatively more than the U.S. tax—even though the rate is less than half the U.S rate.

 

 

Canada historic tax revenues here. New Canadian budget data here.

 

Supporters of BATs and VATs are wrong about trade and taxes

My crusade against the border-adjustable tax (BAT) continues.

In a column co-authored with Veronique de Rugy of Mercatus, I explain in today’s Wall Street Journal why Republicans should drop this prospective source of new tax revenue.

…this should be an opportune time for major tax cuts to boost American growth and competitiveness. But much of the reform energy is being dissipated in a counterproductive fight over the “border adjustment” tax proposed by House Republicans. …Republican tax plans normally receive overwhelming support from the business community. But the border-adjustment tax has created deep divisions. Proponents claim border adjustability is not protectionist because it would automatically push up the value of the dollar, neutralizing the effect on trade. Importers don’t have much faith in this theory and oppose the GOP plan.

Much of the column is designed to debunk the absurd notion that a BAT is needed to offset some mythical advantage that other nations supposedly enjoy because of their value-added taxes.

Here’s what supporters claim.

Proponents of the border-adjustment tax also are using a dodgy sales pitch, saying that their plan will get rid of a “Made in America Tax.” The claim is that VATs give foreign companies an advantage. Say a German company exports a product to the U.S. It doesn’t pay the American corporate income tax, and it receives a rebate on its German VAT payments. But an American company exporting to Germany has to pay both—it’s subject to the U.S. corporate income tax and then pays the German VAT on the product when it is sold.

Sounds persuasive, at least until you look at both sides of the equation.

When the German company sells to customers in the U.S., it is subject to the German corporate income tax. The competing American firm selling domestically pays the U.S. corporate income tax. Neither is hit with a VAT. In other words, a level playing field.

Here’s a visual depiction of how the current system works. I include the possibility that that German products sold in America may also get hit by the US corporate income tax (if the German company have a US subsidiary, for instance). What’s most important, though, is that neither American-produced goods and services nor German-produced goods and services are hit by a VAT.

Cutting the National Endowment for the Arts

Establishment reporters don’t seem to think that anything good happens in society without a stream of federal money attached to it. That sort of tunnel vision was on display in a recent Washington Post story about the Appalachian Regional Commission (ARC). And it was on display again in the Post today in a story about the National Endowment for the Arts (NEA).

The story discusses NEA projects in Indiana, a state presumably chosen for the same reason that the prior story focused on the ARC and Kentucky: the Post wants to sow dissension in a part of the country that voted for Trump.

NEA-Indiana projects described by the Post include $3,000 for a tunnel made of twisted branches and $10,000 for a sound project that “takes place in multiple spaces and includes a hangout where visitors can listen to records, have a coffee or beer, and will eventually include a low-powered FM radio station.” Numerous NEA grants seem to trickle through state and local governments before being dispensed to local artists and nonprofits, thus creating jobs for paper pushers along the way.

The story warns that the NEA is “under attack.” President Trump “has proposed eliminating the agency altogether.” What a heathen! In Indiana, “artists and nonprofit leaders in small towns or underserved communities fear that lawmakers don’t understand how much they depend on the millions of arts dollars distributed each year outside booming metropolises.”

The NEA’s annual budget is $150 million. Indiana has two percent of the U.S. population, so I would guess that it receives about two percent of NEA funding, or $3 million a year.

If NEA spending in Indiana is important, couldn’t Indiana governments and philanthropists support it? State and local governments in Indiana currently spend $43 billion a year from their own revenue sources. Couldn’t they carve out just $3 million—or 0.007 percent—of that to support local quilters, hoop net makers, puppeteers, and other Indiana craftspeople?

For further reading on the NEA, see here.

Mulvaney’s Plan to Reform the Government

President Trump’s Office of Management and Budget (OMB) has released a “Comprehensive Plan for Reforming the Federal Government and Reducing the Federal Civilian Workforce.” The 14-page memo from OMB director Mick Mulvaney creates a process for executive branch leaders to produce a detailed plan to cut the government. The final plan will be included in the fiscal year 2019 budget a year from now.

The core of the process is that the president is requiring federal agencies to prepare Agency Reform Plans by this September, with draft plans due June 30. Agencies must come up with downsizing “proposals in four categories: eliminate activities, restructure or merge, improve organizational efficiency and effectiveness, and workforce management.” Agencies “should focus on fundamental scoping questions (i.e. analyzing whether activities should or should not be performed by the agency).”

Some of the factors that agencies should consider when doing their “fundamental scoping” are whether activities are nonessential, whether they violate federalism, and whether they would flunk a cost-benefit test. Agencies should propose eliminating activities that do not pass muster on these and other criteria.

Director Mulvaney is trying to get federal bureaucracies to reconsider all of their activities in a bottom-up manner. The downsizing process he has launched will include actions that the president and agencies can take administratively, and reforms that will need legislation passed by Congress.

Aside from pushing agencies to identify savings, the OMB will work over the next year to propose and implement crosscutting reforms that affect all agencies. One theme in the memo is the need to cut the federal civilian workforce. The memo encourages agencies to implement near-term cuts and to develop plans to reduce workforces over the next four years. The memo is right that “technology may have changed or eliminated the need for some positions.”

The memo provides a good framework for pursuing federal downsizing. Some agencies will probably drag their heels and try to include just minor-league reforms in their plans. But the OMB will be overseeing the development of the plans, and will hound agencies to think big. It will also be important for the administration to fill top positions in agencies with leaders who have a zeal for cutting.

Support from congressional Republicans is also needed. The reform effort will be undermined if members simply whine and grumble when the administration suggests trims to their favored programs. When Trump’s “skinny budget” was released in March, the response of Senate Majority Leader Mitch McConnell was to announce that he would not allow cuts to an obscure $120 million pork barrel program that favors his state. But if the party leader selfishly rejects such a tiny cut, how does he expect any other member to accept cuts to any of the programs they favor?

If the Trump-Mulvaney budget reform effort is to be successful, we are going to need congressional leaders to act as actual leaders. And that means putting the broad public interest in spending control ahead of narrow parochial interests.

Mick Mulvaney’s press briefing on the new plan is here.  

For comments on previous OMB reform actions, see here, here, here, and here.

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