LESSONS FROM HISTORY
A few weeks ago, I attended a dinner in Washington DC with Reagan’s former economic adviser Art Laffer. He recalled the passing of the 1981 Economic Recovery Tax Act, which cut marginal tax rates across the board by 25%. The only problem with the legislation, he told us, was that the reductions were phased in over three years. Businesses and investors, knowing they were going to get a tax cut in the next financial year, deferred their income and stalled economic activity. The economy went into a double dip recession. Interest rates spiked from 12% to 20%. Reagan’s popularity plummeted and Democrats gained 27 seats in the 1982 midterm elections.
In 1983, however, the tax cuts were fully phased in and the economy took off. The US saw GDP growth of 4.6% in 1983 and 7.2% in 1984. Reagan won the 1984 Presidential election by a landslide, carrying 49 out of 50 states. The lesson from Reagan is that tax cuts need to be immediate, dramatic and permanent, enabling businesses to invest with confidence and certainty. Republicans should follow the example of the 1986 Tax Reform Act, not repeat the mistakes of 1981, by closing loopholes, reducing tax rates and simplifying the tax code. They need to go into 2018 and 2020 riding a wave of economic growth and prosperity. Reagan showed it is the simplest formula for winning elections.
If this administration is going to implement fundamental tax reform, it needs to be done in a fiscally responsible way. House Republicans have put forward a plan to cut government spending by $5.4 trillion over the next decade. This includes savings from repealing and replacing Obamacare, as well as reforming Medicare by turning it into a premium support payment for future retirees. Entitlement spending reductions are essential if the US federal budget is to be put on a more financially sustainable footing.
Even though tax reform should be easier to pass than Obamacare repeal, the latter is still necessary. The ACA imposes over $600 billion in tax hikes on everything from investment income to prescription drugs. It also limits choices, drives up costs for the American people and puts government spending on an unsustainable path. The GOP needs to come up with a compromise bill, acceptable to both conservatives and moderates alike.
That means moderates should get to keep requirements on dependants, protections for pre-existing conditions, prohibitions on annual and lifetime limits, and a robust system of tax credits to replace Obamacare’s Medicaid expansion. Conservatives should get to send Medicaid back to the states and cap its growth rate, repeal the ACA’s tax increases, expand Health Savings Accounts (HSAs), and allow states to alter Obamacare’s benefit regulations and age-based community ratings.
To create a pro-growth tax code, President Trump needs to keep his election campaign promise to reduce the US corporate income tax from 35% to 15%. He also needs to listen to Speaker Paul Ryan who points out most businesses in America are taxed as individuals (or “pass-throughs”) and have a top tax rate of 44.6% when combined with state and local taxes. When businesses are taxed at 19% in the UK, 15% in Canada and 12.5% in Ireland, this makes the United States really uncompetitive. The tax rate on business pass-through income ought to be capped at 15% too.
Moreover, the federal government must stop taxing capital and only tax consumption by converting the corporate income tax into a destination-based cash-flow tax. Businesses should be able to fully expense their capital investments. This could allow for hundreds of thousands of highly paid manufacturing jobs to come flooding back to Michigan, Wisconsin, Ohio and Pennsylvania. The cash-flow tax should also be border adjusted. Instead of taxing where a product is made, it ought to tax based on where a product is sold. This would end the double tax on US exports and the incentive for American companies to move overseas.
Over the last few decades, most countries have been cutting their origin-based corporate taxes and increasing their border-adjusted consumption taxes. Trump ought to put the United States on a level playing field. He should also broaden the tax base by getting rid of all the special interest credits and deductions.
SIMPLIFYING THE INCOME TAX
Tax reform ought to incentivise work and investment, as well as simplify the income tax code. Most taxpayers should be able to file their taxes on a postcard. Americans spend an estimated 2.6 billion hours every year filing individual income tax returns. Any meaningful tax reform package should include scrapping all itemised deductions except for charitable contributions and mortgage interest, and cap the mortgage interest deduction on debts above $200,000. To offset this, Republicans ought to increase the standard deduction to $12,000 for single filers and $24,000 for married couples. This would create a simpler and fairer system, and lower the tax burden for those on below average incomes.
They should also allow for a 50% deduction on investment income, consolidate individual income tax brackets from seven to three, and reduce marginal tax rates to 12%, 25% and 33%. Of course the left will criticise this by saying it cuts taxes on the rich. However, rate reductions are mostly offset by closing loopholes that mainly benefit the top 1%. Moreover, this criticism completely ignores the Laffer Curve.
When Reagan’s Economic Recovery Tax Act cut the top income tax rate from 70% in 1981 to 50% in 1983, revenue from the rich more than doubled from $22 billion to $49 billion a year. A fairly recent report by Christina Romer, a “liberal” economist who served as an economic adviser to President Obama, suggests that a 1% increase in tax rates will lead to a 3% reduction in the tax base. This implies a top marginal tax rate of 33% is close to the revenue maximising rate.
While most personal credits should be eliminated for the purpose of simplicity, there is one credit that should most certainly stay: the Earned Income Tax Credit. It has widespread support on both sides of the political spectrum. Economists from the late Milton Friedman to Paul Krugman have supported its creation and expansion. Reagan believed it to be the most effective anti-poverty program ever created. Unlike most welfare programs, the EITC actually incentivises work instead of discouraging it. The only problem is the EITC doesn’t deliver much for childless filers and ought to increased from $500 to $1,500.
During the Presidential election, Ivanka Trump came up with the idea of creating another complicated tax deduction to help working families with the cost of childcare. This annoyed many conservatives who rightly saw it as further complicating the code. Since the election, Senator Marco Rubio has convinced Ivanka that a better and simpler way to help working families is to increase the child tax credit. His conservative rationale is that if business owners can write capital investments off their taxes, then parents should be able to do the same with their investment in raising the next generation. It also gives more freedom to parents in how they spend their money than a specific deduction for childcare.
The child tax credit should increase to $2,500 and be deductible against payroll taxes as well as the income tax. The phase-out threshold for married couples should also increase from $110,000 to $150,000 to end the marriage penalty. Moreover, refundability ought to be limited to $1,000. Families should get to keep more of their own money, rather than receive a welfare transfer payment. Effectively eliminating payroll taxes for low income families gives them a much greater incentive to move from welfare to work.
The tax plan I have outlined would create millions of new jobs in America. Using research from the Tax Foundation, I estimate it would increase GDP growth to 3% per annum. As a result, the US economy would be 10% larger within a decade. This means revenue to the federal government is likely to be higher over the long-term under this code. The benefits are roughly equal across the income distribution. The top and bottom quintiles would see increases in their after-tax income of 11%, while middle income taxpayers would get an average increase of 12%. That’s a boost to median household income of over $6,000.
After more than a decade of stagnant wages, these results would fundamentally transform the US economy. Republicans would be able to get back to campaigning positively on a platform of rising living standards. As Reagan showed, voters reward politicians who deliver economic prosperity. Trump ought to follow his example.