Comparing Tax Plans: Growth

by Ramesh Ponnuru

Derrick Morgan of the Heritage Foundation writes again on the trade-off between pro-growth and pro-family reforms of the tax code. I have argued that the trade-off exists much more in theory than in practice. On paper, a tax-reform plan without any child credit (even the existing one) could feature a somewhat lower top income-tax rate than a plan that includes a credit and raises the same amount of revenue. That lower rate should yield improved incentives to work, save, and invest, and therefore higher growth. In practice, though, I don’t think these very low top-rate plans are at all politically plausible, and the extra growth from getting an extra few points off the top rate is unlikely to be substantial.

There are, in other words, diminishing returns to lowering the top marginal tax rate on income. However much taking it from 40 to 35 improves economic growth, taking it down further from 35 to 30 will have a smaller effect.

In his original comment on this trade-off, Morgan raised the possibility of a tax reform that would increase economic growth one percent a year. I asked for more details, and he obliged by mentioning a Joint Committee on Taxation model of Rep. Dave Camp’s tax-reform plan and a Tax Foundation model of an ideal tax system. Let me take those in order.

Most of the JCT’s estimates about the Camp plan suggest it will raise growth by well below 1 percent a year, and do not purport to show any permanent increases in the growth rate. Even at that, the JCT may well have overestimated the plan’s positive effects, as has been noted by—the Tax Foundation! I don’t at all mean to dismiss the Camp plan, which does have some good pro-growth elements. But there is every reason to think that the Lee plan, which includes an expanded child credit, would be more pro-growth. Lee’s plan brings the top income tax rate to the same level as Camp’s does while avoiding its tax increases on business investment. The Lee-Rubio plan in the works should be even stronger on this front.

The Tax Foundation model, meanwhile, deals with a pure 11.25 percent consumption tax (the document to which Morgan links provides few details beyond that). Even if you buy its assumptions about the effects this tax plan would have on growth, it is not something that has much chance of being enacted any time soon. And again accepting the terms of the model, it doesn’t quantify the trade-off posed by the child credit: It doesn’t tell you how much less additional wealth the country would get if the ideal plan moved the rate a bit higher to accommodate the credit.

Two more points about this ideal: It seems highly likely that it would involve raising marginal and average tax rates on some people, just as almost any tax reform would, which is worth bearing in mind when that criticism is lodged against the Lee plan. And even this ideal is a kind of compromise: If all we cared about was maximum economic growth at any target level of revenue, we would not have a flat rate but a regressive one.

In the real world, it is just not true that the money for an expanded child credit would have to come from increased taxes on work, saving, and investment (let alone from the most economically damaging of such taxes). Some of it can come from scaling back tax breaks. Some of it can come from decreased spending. And here again, the politics of these trade-offs look more promising for a plan with a child credit than for a plan without one. Scaling back the mortgage tax break, for example, would be very hard in any circumstances. But doing it in return for an expanded child credit seems like an easier sell than doing it in return for a lower top marginal tax rate.

To finish up this part of the argument: The Lee plan lowers taxes on work, saving, and investment, and future iterations will probably lower them more. Going much lower still would probably do little for growth while making the whole plan a much heavier political lift. And the resulting plan would be inferior to the Lee plan in terms of fairness to families, which I’ll cover in my next post.