Wanted: Pro-growth tax reform for the real world

West Side of the U.S. Capitol Building

Photo Credit: Morriswa (Wikimedia Commons)

America needs faster economic growth. Faster growth would mean more jobs, higher incomes, and less debt. Not only has the economy been slow to recover from the Great Recession and Financial Crisis, it was no great shakes even before the meltdown. As Fed Chairman Ben Bernanke said the other day, “The fact that unemployment has declined in recent years despite economic growth at about 2 percent suggests that the growth rate of potential output must have recently been lower than the roughly 2-1/2 percent rate that appeared to be in place before the crisis.”

Getting annual growth back to at least its post-war average of about 3.4% — plus a few years of hypergrowth to eliminate the jobs and output gap ASAP — should be a central goal of U.S. economic policy. This will require a full spectrum solution reforming education, regulation, immigration, and entitlements. But revamping the tax code has a big role to play, too. Any plan must result in a system that rewards innovation and work, not lobbying and cronyism. It would ideally generate enough revenue to pay for government without raising taxes on middle-income families. And it must be politically doable.

I love the idea of a flat-consumption tax, for instance. But while it meets the first objective, I’m not sure about the second. And I know it fails the third. But here are three approaches worth considering:

Unshackle business. Earlier this year, AEI’s Alex Brill offered a plan that would broaden the tax base and reduce the tax rate on business investment. It would kill or scale back some of the largest, most distortionary tax subsidies, while raising tax payments from higher-income earners without changing statutory tax rates.

The Brill Plan would a) phase down the corporate tax rate over the decade to 25%; b) make permanent the 50% bonus depreciation provision now in effect; c) gradually limit the tax benefit for home mortgage interest deductions; d) phase out the state and local tax deduction; d) repeal the alternative minimum tax to eliminate its compliance burden.

Focus on the family. Back in 2010, economist Robert Stein offered reform that, like Brill’s, would try to reduce the worst distortion in the tax code, while removing obstacles to capital investment. In addition, Stein would reduce the fiscal burden on parents, which he argues “actively discourages Americans from having children.” Among the core elements of the Stein Plan:

– Let companies distribute dividends tax free and permanently count a significant percentage of plant and equipment spending as business expenses in the year the purchases are made.

– Scrap the individual Alternative Minimum Tax and all itemized deductions except for mortgage interest and charitable donations. These two deductions would then be made available to all taxpayers, while decreasing the size so as to be revenue neutral.

– Set tax rates at 15% and 35%, with the width of the 15% bracket twice the size for married couples as for singles. Capital gains would be taxed at half those levels.

– Replace the standard deduction and personal exemption would be replaced by a tax credit of $2,000, adjusted for inflation annually, that could be used to reduce income taxes only.

– Replace the child credit, the ­child-care credit, and the adoption credit with one new $4,000 credit per child that can be used to offset both income and payroll taxes. It would grow at the same rate as the taxable wage base for Social Security, which is generally a rate faster than inflation.

Under this new tax system, most singles would get a tax cut of $175 while most married couples without children would get a tax cut of $350. But the biggest impact would be felt by parents. Take a married couple with two children, earning $70,000 a year: Under current law, this family generates income taxes of about $5,800 and payroll taxes of $10,710 (combining the employee and employer sides of Social Security and Medicare taxes). But under the tax structure outlined above, their income taxes would be completely eliminated and they would also receive a $1,500 credit against their payroll taxes. They would thus enjoy a tax cut of more than $7,000 per year compared to what they currently pay. …

So who pays more? Primarily high-income workers, but also upper-middle-class taxpayers who do not have children in the home (either because they have decided not to raise children at all, or because their children have already turned 18).

Invest, invest, invest. AEI’s Alan Viard has recommended a progressive consumption tax or “X tax.” Economic simulations suggest that replacing the income tax system with a consumption tax can boost economic growth. Here’s a summary from a proposal he contributed to:

The X tax consists of a flat‐rate firm level tax on business cash flow and a graduated‐rate household‐level tax on wages, fringe benefits, and defined‐benefit pension payments. Although the X tax is administratively similar to an income tax, the combination of two features makes it a consumption tax. First, households do not pay tax on interest, dividends, capital gains, or other income from saving. Second, firms immediately deduct business investments, rather than depreciating them over time.

A constant 35 percent tax rate will apply to firms’ cash flow and to wages in the highest bracket, with lower rates on other workers. Initially, a 15 percent tax rate will apply to the first $50,000 of taxable earnings and a 25 percent rate to taxable earnings between $50,000 and $100,000. The 15 and 25 percent tax rates may vary over time to keep revenue at 19.9 percent of GDP in future years. There would be no head‐of‐household filing status and no standard deduction.

Viard also likes the idea of a personal expenditures tax, which would work as follows:

Each household files an annual tax return on which it reports income, deducts all savings (deposits into savings accounts, asset purchases, amounts lent to others, and payments made on outstanding debt), and adds all dissaving (withdrawals from savings accounts, gross proceeds of asset sales, amount borrowed from others, and payments received on outstanding loans). The resulting measure equals the household’s consumption, which is taxed at graduated rates.

Viard explains the advantage of shifting to a consumption tax from an income tax:

Income taxation penalizes saving, a major source of long-run economic growth, while consumption taxation does not. Under an income tax, a worker who saves to consume in the future is taxed more heavily than a worker who consumes today. Both workers pay tax on their wages, but the worker who saves also pays tax on the returns to his or her saving. In contrast, under a consumption tax with a constant tax rate, both workers pay the same percentage tax on their spending, so there is no bias against saving. … Replacing the income tax system with an X tax would boost saving, which would increase the capital stock and promote long-run growth.

There’s a lot more to these plans than my summaries. But what they have in common is a focus on reducing economic inefficiencies and distortions — such as the current code’s anti-investment bias — that reduce economic growth. The plans also maintain the progressive nature of the current tax code or even expand upon it — while also keeping marginal rates low. They are the very opposite from President Obama’s approach which is to a) create a tax-hike straitjacket by trimming tax breaks while also raising marginal rates, and b) raise taxes on investment and innovation.

So who’s going to champion these ideas?

9 thoughts on “Wanted: Pro-growth tax reform for the real world

  1. If, as you do, one fails to understand what creates growth, then your suggestions to create growth are no likely to be successful than a doctor who doesn’t know why a patient is sick would be in curing that patient.

    Growth, or the absence of it, is not a function of the tax code. Growth is the result of business and consumer confidence, and in particular, those businesses and consumers who have money to spend/invest. Confident businesses invest in new staff, products and equipment. Confident consumers spend their money rather than stockpiling it for future emergencies.

    Tweaking the tax code can not create confidence. Nervous businesses are not going to buy equipment, regardless of the tax rate, if they don’t think they’re going to get a positive return on their investment. (there might be a few cases where a lower tax might shift the short term ROI on a particular project from unprofitable to profitable, but in most cases, a lower tax would only reduce the loss).

    Furthermore, since economic growth is a function of the amount of money in play, tweaking the tax code in a supposedly revenue neutral way only shifts money between segments, it doesn’t lead to an increase in the money being circulated. Taking away a deduction from one group would, all other things being equal, result in a contraction of spending and confidence in that group. Giving that dollar amount of deductions to another group creates growth only to the amount of the contraction in the now-disfavored group (to illustrate, taking away $20,000 in deductions from me to give $20,000 in rate reductions to another group only shifts money from one pocket to another, it doesn’t result in any more money being invested or spent).

    If you want to create growth, you have to look at what creates confidence and, in these times, what saps confidence. Tweaking the tax code won’t increase overall confidence. Eliminating the fear of higher taxes, regulations, gas and food prices, and the frustration over stagnant house prices would do far more to boost confidence than any revenue neutral tax reform.

  2. “Tweaking the tax code can not create confidence. Nervous businesses are not going to buy equipment, regardless of the tax rate, if they don’t think they’re going to get a positive return on their investment. (there might be a few cases where a lower tax might shift the short term ROI on a particular project from unprofitable to profitable, but in most cases, a lower tax would only reduce the loss).”

    Bingo. Someone else gets it. While Mr. Pethokoukis plays with his tax bracket thermostat, moving it up and down by a degree to see if can cop himself a chill, he indulges the fantasy, for him and his readers, that this is all that makes an economy.

    Of course it doesn’t. And naturally, he skirts the issue of corporate taxes, even as firms like General Electric pay less than 10%, while someone who cleans toilets pays more.

    At this point, if you don’t think Mr. Pethokoukis is anything more than a sock puppet who is given a salary at this (cough) “think tank” to push the agenda of those who would benefit most by it while punishing the rest of the country, you have serious comprehension and cognitive difficulties.

    You play with those marginal rates, Jim. Like a kid building his little castle with wooden blocks.

  3. How about this: don’t have a child unless you can afford it. Stop paying people to have children they can’t afford. Stop taxing me to pay for your children that you can’t afford. Stop giving preferential tax treatment to people who have children they can’t afford (AND people who have children they CAN afford.) Stop taxing me to pay for the schooling of other people’s children. You pay property tax forever yet your kids are in school for only about 13 years. Based on the state of our educational system, you are getting ripped-off even for the 13-years your children are in school. Sending your children to public schools should be classified as child abuse in most locales. Why am I paying to abuse your children? Pregnancy is a 100% preventable condition. If you can’t afford to feed, clothe and educate a child: don’t have one.

    • Difference is vipertrunk is that majority of Americans look at education system as part of infrastructure not as a privilege.
      Even when my kids are out of school and long since grown and having children of their own, yes I will stay pay taxes for a public education system. Why because the next generation will be needed to continue in development, innovation and leadership for future.
      What welfare laws pay people to have children? FInd me a state that has incentives to have more children. Perhaps you should research your facts first.

    • Wow, you really don’t get Stein’s point one bit do you?

      The issue Stein is tackling is not “people are having children they can’t afford.” Rather, our entitlement system is biased against those with children, and we have a serious demographic problem.

      Yet, thanks to a lot of distortions in the tax code and other government spending, having a child is an act punished by the government, when we desperately need more children.

      The Stein plan simply reduces taxes for those with children (one can only eliminate their liability, they can’t turn it into positive income from the government) since they are the ones who really need the relief.

      As far as education being funded, let’s remember, Adam Smith was a strong advocate of a national education system, and compulsory public schooling for children. He viewed the benefits as far outweighing the costs. And if you can add innovative charter schools and religious schools to the mix, more power to it.

      You really might want to read up on these various plans before attacking them.

  4. Ahh, Steve and Max, getting the confidence genie and the other fairy-tale keepers of the “animal spirits” to give us a good start is all that is needed to simply get the economy going. Some ethereal entity to wave a magic wand over the country, as it were. What are you two waiting for? Just call up Geithner and Bernanke and tell them to ratchet up the confidence… Perhaps they’ll say something lucid, in response to you two, like tax policy fundamentals (pro-growth, pro-business, pro-investment tax policy) actually matter for long-term growth (we can wish). Confidence is derived as a result from one’s estimation of more tangible facts “on the ground”. Having an administration, such as this one over the last 4 years, that is just brutally anti-business coupled with a overly oppressive tax policy are tangible things that when improved upon will serve to increase overall confidence.

  5. There is no confidence genie, but that doesn’t mean the single biggest factor in economic growth is confidence. Growth only happens when production and consumption increase, and that doesn’t happen if people are excessively worried.

    As to what a confidence genie, if there were such a thing, could do? Remove the threat of tax hikes (the fear of billions of dollars getting sucked out of the private sector is definitely fear inducing). Roll back poorly written regulations that create confusion as to what is and what isn’t legal. Remove the threat of company busting litigation if a company were to so much as have a hiccup. Get a President who not only doesn’t threaten to stomp on the neck of businesses he doesn’t like, but who celebrates those who take risks to start and grow their businesses. Remove the artificial props to underwater and delinquent homeowners which only delay the uncertainty in the housing markets. Get an energy policy that promotes cheap energy regardless of the source.

  6. Interesting article. Just read a whitepaper on the new tangible asset regulations, it offers very good information readers will find it very informative @

  7. While I like this plan I see two issues:
    1) This is going to increase the number of people paying no income taxes and they will be labeled as freeloaders and deadbeats
    2) You’re going to be massively increasing the taxes on people at a time when they are expending a huge amount of money on college for their children (they will no longer receive the child credit and they will be deducting large amounts of money from savings – both of which trigger large increasing in the amount of taxes they pay). While the intent might not be to reduce the number of people going to college, I think that will be the effect.

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