Trillion Dollar Economists_How Economists and Their Ideas have Transformed Business
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In addition to being one of the most important fathers of tax reform—lower rates, broader base—Joe was instrumental in designing a plan for revenue sharing by the federal government with states and localities. Although he worked with Kennedy’s CEA Chairman Walter Heller on the idea, it was not implemented until the Nixon administration.
On a personal note, I was one of many research assistants (then working primarily for Arthur Okun) who had the privilege of working at Brookings during Joe’s tenure as economic studies chairman. After I finished my own two-year stint at CEA, Joe offered me a job as a junior scholar at Brookings, but at the time I wanted to get some legal experience under my belt, and I think I disappointed him by not accepting the offer. I did return to Brookings in 1984, however, and so any disappointment on Joe’s part hopefully was erased. When a dozen years later I was fortunate to be chosen director of economic studies myself, I would often go into the conference room across from the director’s office and look at Joe’s picture (along with Okun’s and George Perry’s) and pinch myself with my good fortune, and wonder whether Joe would have approved of the decisions I made.
One final thought and belated thank you to Joe: Even when I was a lowly research assistant at Brookings, he invited me to eat at lunch with the more senior stars in the department, a privilege I never forgot. One of the subjects that repeatedly came up at these lunches, often raised by Joe, would be the performance of the stock market, and thus the performance of the scholars’ defined contribution pension plans. I early on was thus sensitized to the need to save a portion of my salary, a lesson for which I am forever grateful (if only everyone in the country could eat lunch at Brookings with the economists they would learn this lesson, too, and be much better off for doing so for this reason alone!).
As I write this, in the first half of 2014, Washington policy and tax wonks have been focused on the possibility—growing more remote by the day—that Congress and the president may eventually agree on some kind of comprehensive tax reform, aimed primarily at cleaning up the business tax code, eliminating or narrowing many of the tax preferences built into the code, and using the money thus generated to lower the top corporate tax rate. At 35 percent, this notional rate is among the highest in the developed world. But the reason I say notional is that many, if not most, C corporations (those whose income is taxed twice, once at the corporate level, and then at the shareholder level through the dividends that corporations distribute) pay effective tax rates far lower than 35 percent. They can do this by taking advantage of various deductions and credits built into the tax code. In addition, many multinational companies are able to move their income and expenses around to different countries, with lower tax rates than the United States, in ways that reduce their overall tax burdens.
Maybe corporate tax reform that broadens the base and lowers the rate will happen sometime over the next several years, in the same way that the 1986 tax reform initiative did for individuals. It will be an uphill effort because any such reform will create both winners and losers, and the latter will do everything in their power to stop reform dead in its tracks.
However important business tax reform may be, the larger issue for the country over the long run is to what extent federal taxes will increase in order to sustain an even reformed system of entitlement spending, which as I noted at the outset of this chapter, will inexorably grow as baby boomers continue to retire and age, and medical costs continue to go up. In principle, one way to increase revenues is to cut back on tax preferences (for individuals and businesses) without lowering tax rates, or at least not lowering them so much, so that any base broadening effort actually generates more revenue and thus is not merely revenue neutral. Apart from the political difficulty of pulling off such a feat, it is unlikely that such an effort will come anywhere close to raising sufficient revenue to support growing entitlement spending while keeping the deficit at sustainable levels. Raising marginal tax rates across the board, in principle, would solve this problem, but it is even more politically intractable, in my view. It was not an accident that when the income tax cuts enacted by Congress in 2001 during the first term of President George W. Bush were set to expire at the end of 2012, President Obama asked Congress to renew them on all taxpayers except the tiny group of those earning more than $450,000, if married, or $400,000, if filing as an individual. The president judged that a middle class that had taken it hard on the chin during the Great Recession and its aftermath was clearly in no mood to return to the pre-Bush era of higher marginal tax income rates. I do not see any reason why this political calculus will change anytime soon.
There are some optimists out there who believe that if the U.S. economy somehow grew much faster the federal government would have sufficient revenues to sustain rising entitlement costs. Of course, all of us (or at least most of us) would welcome faster growth, and I discuss earlier in the book how a pickup in entrepreneurship is essential to achieve that outcome. But while faster growth would generate more revenues, it would also have the effect of raising federal spending as well, for a number of reasons. Social security benefit payments, for example, are tied to general wage growth. A substantial portion of health-care spending—under Medicare and Medicaid, and through the subsidies under the ACA—goes directly toward payments to physicians and other medical workers, or indirectly to workers who make medical equipment and supplies. Then there are the salaries of federal workers, which are tied in the long run to private sector wages, since government must compete with private employers for talent (whatever your attitude toward government workers may be).
On net, therefore, even a sustained faster rate of economic growth of, say, one percentage point—above the anemic 2 percent long-term rate projected by the CBO—may reduce the federal budget deficit by several percentage points of GDP by, say, 2040, but not by anywhere near the more than 6 percent of GDP deficit projected for that year. The failure of any growth dividend to close the long-term budget gap would become even more apparent in future years, since the projected gap itself is projected to rise over time in the absence of major entitlement reform, more revenues, or both. This is why none of the major bipartisan deficit-reduction reports takes the easy way out by saying that the United States can simply grow its way out of the long-term deficit problem.
There is one revenue alternative to the income tax that many economists have long favored, some in lieu of a portion of the income tax, and others as a supplement to it. That alternative is a federal tax on consumption, and specifically on value added. In contrast to a sales tax, which is levied on only the final sales of goods, a value-added tax, or VAT, is assessed on the value added at each stage of production of goods, and in principle, services as well. Over 130 countries assess a VAT, including all developed economies except the United States.9
Up to now, a VAT has been opposed by many Republicans who fear that once it is in place, it will be too easy for Congress over time to simply raise the rate (though why Congress should be any more willing to raise the VAT than marginal income tax rates I have never understood). For a totally different reason, many Democrats have opposed the VAT on the grounds that it would have a disproportionate negative impact on the poor and even on those earning middle-class incomes, since these individuals and households save less and spend more out of their incomes than high-earning taxpayers. To meet this latter objection, many VAT proponents have been willing to exempt from the tax various necessities purchased by low- and middle-income individuals, such as food, clothing, and medicines. But the more exemptions that are created, the less money the VAT will raise, unless the tax rate is increased, which would encourage black market activity in an effort to avoid it.
Nonetheless, many economists through the years have proposed variations of a consumption tax. By taxing consumption, the government would encourage more saving and thus help finance more investment leading to higher economic growth. Next I briefly summarize three leading VAT proposals in particular, apologizing to any economists who have o
utlined other consumption-based tax plans.
One of the earliest VAT-like tax proposals was the flat tax proposal developed in 1981 by Stanford economist Robert Hall and Hoover Institution economist Alvin Rabushka.10 Businesses would pay a flat rate based on their cash flow (revenues minus all nonwage expenses), while individuals would pay the same rate on their earnings above some exemption level. Syracuse economist Len Burman, who is also affiliated with the Urban Institute–Brookings Institution Tax Policy Center, has explained how this proposal is economically equivalent to a VAT, although not named as such, because wages are included in the value added subject to tax.11 Like each of the first three VAT proposals discussed here, Hall–Rabushka was designed to replace the current income tax and therefore, in principle if not in fact, to be revenue neutral.
Another widely publicized VAT-like proposal was developed by the late Princeton economist David Bradford, who served as a member of the CEA under President George H. W. Bush. His proposal modified Hall–Rabushka by introducing a progressive marginal tax rate structure. Tax economists Robert Carroll and Alan Viard later elaborated Bradford’s X tax, relabeling it explicitly as a progressive consumption tax.12
Most recently, Columbia law professor Michael Graetz, who served as an assistant secretary of the Treasury for tax policy under President George H. W. Bush, has outlined a very explicit revenue-neutral VAT plan. The Graetz proposal would impose a 12.9 percent tax on virtually all consumption (about 70 percent of GDP), while achieving the progressivity goal by eliminating the income tax for all those with incomes below $100,000, or about 80 percent of all taxpayers.13
As noted, each of these plans is designed to replace most or all of the current income tax and therefore by definition is revenue neutral. The revenue neutrality aspect makes each more politically palatable than any consumption tax levied on top of the existing income tax system, or even one designed to replace only a portion of the income tax in order to raise additional revenue overall. But since I have taken the view in this chapter that ultimately the federal government will need more revenues to sustain even a reformed benefit structure for the major entitlement programs, then I am most interested in consumption tax proposals as supplements to the income tax, ideally reformed to have a broader base and lower rate.
In principle, a consumption tax could simply be added in whatever amount is necessary to close the deficit to a certain level, but I do not believe that is politically achievable or sustainable. Any “fill the gap” consumption tax is too easily opposed by those who fear that once in place Congress would raise the tax rate to limit or eliminate the deficit, without imposing a significant constraint on federal spending.
When Congress, the president, and the public are ready for it, I think a more politically attractive approach is to tie the revenues of any consumption tax to a very specific, important part of the federal budget, and ideally one that is highly popular. The perfect candidate is Medicare, which has a strong and growing constituency, but also is a program whose costs require some constraint. Levying a VAT, for example, specifically to fund all or a portion of Medicare would make the tax easier to swallow, while also exerting some downward pressure on costs, especially if Medicare were converted to a premium support system. By dividing the estimated tax revenue from the VAT in a given year by the estimated number of beneficiaries, it would be possible to generate the average premium support payment for that year. Provisions can be made for having the general tax fund reimburse Medicare if tax revenues fell short of the premium support payments; or in the case of the reverse, if there were excess tax payments they could be applied toward deficit reduction in that year. Economists Henry Aaron, Len Burman, John Shoven, and Victor Fuchs of Stanford have proposed similar ideas.14
Furthermore, if the day comes when federal policy makers accept the need for a consumption tax, it is more likely to take the form of a VAT than a sales tax because many states already have their own sales taxes and would object to an additional federal tax of the same type. A VAT is at least different enough in character to minimize state opposition, although if the VAT were to take the form of a progressive wage tax, such as one like the Bradford plan (or its updated version outlined by Carroll and Viard), it would be extremely difficult, if not impossible, to impose it on top of the existing income tax. The stated objective of both the Bradford plan and the Hall–Rabushka flat tax is to replace the income tax, not to supplement it. Any of the VAT plans can easily be modified to generate additional revenue beyond that raised by the existing income tax: The tax rate could be increased and the number of taxpayers freed from paying income tax reduced from the initial proposals.
As with the premium support idea for Medicare, many detailed design issues must be resolved if and when federal elected officials and the public embrace a supplemental VAT. The central one is the tradeoff between the breadth of the tax base and the tax rate. Clearly, the more consumption is taxed—Graetz essentially would tax it all while others would exempt different kinds of consumption, such as financial services and some necessities—then the lower the rate that is required to achieve any revenue objective. But with a narrower base and a higher rate, the incentives increase for black market activity aimed at avoiding the tax. By design, the VAT is more difficult to evade than a straight sales tax because each economic actor in the supply chain has an incentive to report all of its expenses, in order to lower the value added which is subject to tax. With these reporting incentives, federal tax authorities are thus in a position to check on the reported value added of the producers further behind in the supply chain, which proponents of a VAT argue help make the tax effectively self-enforcing. Still, higher tax rates can encourage entirely parallel economic activity aimed at evading the VAT at all stages, which is why policy makers must be sensitive to the level of the tax rate even under a VAT.
The business impact of any consumption tax is clear: If the goods or services are in the tax base, then any tax on them will reduce demand. The magnitude of this demand-depressing effect depends on the size of the tax (measured as a percentage of the final product or service price) and what economists call the elasticity of demand. If the product or service is price-elastic, then demand will fall by a greater percentage than the tax percentage; if the converse is true, then the percentage drop in volume will be less than the tax percentage.
These demand-related effects, which any undergraduate student in economics should learn in the first few weeks of class, are only the first round or direct impacts of a consumption tax. To the extent that the tax helps reduce the deficit, and especially if the tax is of sufficient magnitude to keep the deficit at a sustainable level, then the tax will reduce interest rates, and thus interest costs for all those who borrow funds. For consumers, this extra money enables them to spend more on goods and services generally than they otherwise would be able to spend. On net, demand for some goods and services therefore may increase once this indirect income effect is taken into account, while for other goods and services the income effect at least would partially offset the direct demand-depressing impact of the tax. As for firms, lower interest rates mean a lower cost of capital, and thus an inducement to increase investment in equipment and buildings. Firms providing these goods, and the services related to them, as well as their workers will benefit.
All of this is to say that the immediate or direct impacts of any tax will overstate, perhaps by a considerable margin, the negative impact on the goods and services subject to the tax, and will ignore the sectors that benefit from an economy less burdened by debt and interest costs than would otherwise be the case. Keep this thought in mind when considering an even more controversial tax, a tax on carbon emissions.
Taxing Carbon
Up to this point in the book, I have tried to stay away from highly controversial issues—even more controversial than premium support and consumption taxes—but now that ends. I simply can’t write a book about economists and their ideas and their potential impact on business without di
scussing how economists approach the issue of climate change. At one point in the writing of the book, I hesitated even to broach the subject because I didn’t want any readers to dismiss the rest of what I have to say—which I believe is important and at least widely accepted by most economists—simply because they may not accept what I have to say about climate change. I have ducked discussing another highly controversial policy issue, the Affordable Care Act, in any significant detail because, at least at this writing, there is no consensus among economists about the virtue of that law or what to replace it with.
That is not the case with climate change, since economists belonging to both political parties at least have been willing to entertain the need for a public policy response. So I ask any readers who have made it to this point in the book to have an open mind and bear with me during this discussion because I am simply bringing up the subject as an illustration of how economic ideas already on the policy shelf could one day be implemented and have an important effect on business and the economy. By that test, it is impossible to ignore the subject of climate change.
I have been careful to phrase the issue in terms of climate change rather global warming because the impact of climate change, to the extent it is caused by man-made carbon emissions, may not always be manifested as warmer weather everywhere all the time, although there is strong evidence of a long trend in global warming that cannot be explained by natural causes alone.15 In addition, I want to focus on the net impact of man-induced climate change. Some parts of the world may benefit from warmer climates induced by CO2 emissions. At the same time, many other parts of the world are likely to be worse off from higher ocean levels (coastal areas), more severe storms, and other weather-related changes in climate. The world’s leading modeler of the economic effects of climate change, William Nordhaus of Yale University (see following box), has calculated that the costs suffered by areas damaged by climate change outweigh the benefits to parts of the world from a man-made change in temperatures and weather patterns. To be more precise, he has calculated the net cost to the world economy, in 2008 prices, from waiting for 50 years to reduce CO2 emissions to a sustainable level is $4.1 trillion. As Nordhaus puts it, “Wars have been started over smaller sums.”16 More recent studies have suggested a disturbing negative link between higher global temperatures and productivity, which if true, would add to the costs of waiting to address climate change that Nordhaus has calculated.17