Tax Reform and Supercommittee Math

by Douglas Holtz-Eakin

The moment President Reagan’s signature dried on the 1986 tax reform, two things doubtlessly happened. One, the anti-growth lobby started dreaming up credits, deductions, rate changes, and other tweaks to gum up the code. Two, policy wonks and politicos started planning the next grand tax reform. Fast forward 25 years, and it seems both groups are still hard at it. No deficit panel, commission, or any defensible set of fiscal policy recommendations would be complete without proposing fundamental tax reform. Everyone seems to agree that what we have is bad and we should lower the rates and broaden the base.

But what does that get you?

A better tax code would be good for the economy, but by how much? When staring the massive U.S. debt square in the face, this is no longer an abstract concern — especially for the 12 people locked in a Capitol room to deal with it. According to the CBO, if GDP gets one percentage point higher over ten years, the federal government gets a $310 billion windfall: $266 billion in higher tax revenue and $46 billion in interest savings, offset by $2 billion in higher direct spending.

A little growth can go a long way.

How much growth is likely? To make things simple, we concentrate on revenue-neutral tax reforms. The level of taxation is, in the end, a political decision and not an analytic one. And revenue-neutrality puts aside the distracting debate over tax cuts paying for themselves (they typically don’t).

While there isn’t a consensus on the ideal tax reform, there are a range of estimates that encompass the options in broadening the base and lowering rates.

A widely cited study by highly respected economists David Altig, Alan Auerbach, Laurence Kotlikoff, Kent A. Smetters, and Jan Walliser simulated multiple tax reforms. They found that GDP could by as much as 11 percent higher from tax reform. Not surprisingly, the highest growth rate was associated with a consumption-based tax system that avoided double-taxing the return to saving and investment.

The study also simulated a “clean,” revenue-neutral income tax that would eliminate all deductions, loopholes, etc.; and lower the rate to a single low rate. By eliminating progressive marginal rates, it is probably biased toward growth, but income taxes are not as pro-growth as consumption taxes, leading to a slight bias against. So it seems like a good place to start.

According to their study, this reform raised GDP by 5.1 percent over ten years. So, with 5.1 percent higher GDP and CBO’s rule of thumb, the reform would reduce the deficit by roughly $1.5 trillion — revenues up by about $1.4 trillion, direct spending up by $10 billion, and interest down over $230 billion. That would more than meet the supercommittee’s mandate. Everyone could shake hands and go home.

That probably represents the upper bound for any serious policy discussion. Eliminating all credits and deductions and flattening the rate is probably not going to be the product of the deficit committee. However, with time so short, one possibility would be to simply turn to an existing product — the 2005, a bipartisan tax reform commission

Among its proposals was the Growth and Investment Tax Plan. This was a simple plan with three low rates. It retains individual taxes on capital gains and dividends, but on the business side goes to a cash flow tax. So admittedly, it may be more forward-leaning than what we can expect, but it retains several tax expenditures and is similar in rate structure to the Simpson-Bowles plan. The Treasury Department at the time estimated this would yield about 2.4 percent in higher GDP. That would reduce deficit by nearly $750 billion ($638 billion in higher revenues, $5 billion in higher direct spending, and over $100 billion in interest savings). That’s more than halfway to the $1.2 trillion needed to avoid the sequester.

Now you may be a skeptic of theories and commissions. If so, look to1986 as an example. As Kevin Hassett noted in recent testimony, according to a study by Victor Fuchs, Alan Krueger, and James Poterba, the 1986 tax reform produced about one percentage point higher growth over a long period, according to the consensus view of surveyed economists. Going back to CBO’s rule of thumb, a reform that generated this impact would yield $266 billion in higher revenue, $2 billion more in direct spending and less in interest by $46 billion — lowering the deficit by $310 billion. Certainly not earth-shattering, but not too bad for government work.

The bottom line is really simple: The improvement in long-run economic growth from tax reform cannot solve the U.S. debt crisis. But it can make a real difference.

Finally, if tax reform jump-starts the moribund recovery, this will add to the beneficial growth effects by getting the U.S. more quickly back to full employment. According to CBO, projected GDP doesn’t converge with potential GDP until about the third quarter of 2016. If we assume that a pro-growth tax reform gets us there two years earlier, this translates to 0.6 percentage points in higher growth per year. Plug that into the CBO’s rule of thumb and the supercommittee can definitely go home with a job well done. 

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