Economists all agree that tax reform is pro-growth if it broadens the base (such as by eliminating deductions) while reducing marginal tax rates. There is less agreement on other aspects of the issue, such as which types of households should see tax cuts, whether a lower corporate rate would benefit workers or shareholders the most, and whether it would be a good idea for the government to bring in less tax revenue overall.
Given all this, what type of tax reform should be our highest priority? In our current situation of low economic growth, the answer appears to be lower rates.
Your marginal income-tax rate is the percentage you pay in taxes on your last (or next) dollar of income. If you’re in the 25 percent tax bracket, for example, your marginal rate is 25 percent — you lose 25 cents of each additional dollar you make, even though your average tax rate will likely be closer to 10 percent of your total income after deductions, credits, and exemptions are applied. Lower marginal rates help boost growth because they increase individuals’ incentive to work harder and businesses’ incentive to invest in new opportunities. While people debate how big this effect is, it is a consensus belief that lower rates are pro-growth even when coupled with base-broadening measures that ensure the same amount of tax revenue is collected.
When it comes to the corporate income tax, rate cuts not only spur growth but raise wages as well. Glenn Hubbard, dean of the Columbia Business School and a former head of the White House Council of Economic Advisors, has written that 70 percent of corporate tax cuts may go to higher wages instead of payouts to shareholders. Other research has suggested a range of 45 to 75 percent.
This idea, that cutting taxes on corporations actually benefits workers along with shareholders, is more controversial and much less appreciated. However, among experts in the field it seems to be a reasonably well-shared and non-partisan view. This is important because the more middle-class workers benefit from cuts to corporate tax rates, the more such cuts are consistent with the ideals of a progressive tax system.
What about the idea of bringing in less tax revenue overall, providing a stimulus to the economy by letting people keep more of their money? A bevy of central-bank research economists from around the world studied the effects of fiscal stimulus (including tax cuts and deficit spending) in the wake of the most recent recession. Their research shows that larger deficits don’t stimulate the economy much, particularly when the deficits are seen as permanent (as they would be from a tax cut) and when the Federal Reserve is not accommodating. Accommodation from the Fed typically involves interest-rate cuts, in contrast to the Fed’s current posture of slowly increasing rates. Given that the Fed is unlikely to meet this tax-reform package with monetary accommodation, central-bank models suggest that the size of the tax cut will not determine how pro-growth tax reform is; it is rate cuts that matter.
To be sure, government spending is bad for the economy. It leads to a misallocation of resources, creating favored industries that are too big and disfavored sectors that are too small relative to the size they would be in a free market. Tax cuts that slowed spending would be good — but we are far more likely to see tax cuts that simply increase the deficit, which politicians show few signs of caring about. A tax cut that doesn’t shrink spending does not boost growth by much.
While a lower overall tax burden would be nice, lower marginal rates are better if you want to jumpstart growth.
Thus, the ideal approach to our current situation would be to reduce marginal rates while eliminating deductions and credits and closing loopholes. This would give us a simpler tax code and lead to less government intrusion in our decision-making, both of which should also be pro-growth.
While a lower overall tax burden would be nice, lower marginal rates are better if you want to jump-start growth. Therefore, Republicans should prioritize rate cuts: Get the marginal rates for individuals and corporations down so that we can get back to more normal levels of economic growth, and broaden the base enough to make the changes revenue-neutral or at least close to it.