Magical Thinking on Tax Reform

Everybody loves the idea of tax reform. And tax reform can be very good policy.

But advocates often turn to magical thinking about how good tax reform can be, and a recent column by George Will offers two examples of this problem.

First, Will writes that “if America’s long-term economic growth [rate] were 3.5 percent, the result would be the restoration of cheerfulness. If long-term growth is closer to 2 percent, the result will be continuing social disappointment and political crankiness.” He then implies that the sweeping tax reform plan proposed by Rep. Dave Camp, (R-MI), the retiring Chair of the House Ways and Means Committee, would raise annual growth rates by as much as 1.5 percentage points, if only Congress would get over the politics and enact it.

Will is right that raising the growth rate by 1.5 percentage points would be a big deal, but tax reform won’t do that. The non-partisan Joint Committee on Taxation estimated the economic effects of Camp’s plan eight different ways. Each used dynamic scoring that includes the macroeconomic effects of the plan. Under the most optimistic scenario, JCT figured the Camp plan would boost the annual growth rate by 0.16 percentage points – about one tenth as much as Will implies.

Most of the estimates, though, projected added growth rates of much less–around 0.01 to 0.06 percentage points per year. Thus, if JCT is correct, the benefits of Camp’s plan would be one or two orders of magnitude smaller than the 1.5 percent annual change in the growth that Will suggests. One reason: Camp would raise effective tax rates on saving and investment, as Donald Marron and I note in a blog post earlier this year.

Will calls tax reform “the indispensable igniter of sustained growth.” It is a nicely turned phrase but it has little support in the economic literature. Many other factors affect growth. And the relationship between previous tax reforms, individual tax rates, and growth is weak at best.

Major changes in tax policy have had negligible impacts on the economy. The Reagan tax cuts had minimal effects on growth. This view is espoused not just by some liberals but by none other than Martin Feldstein, chairman of the Council of Economic Advisers under President Reagan, who makes this point in two separate papers (one co-authored with current CBO director Douglas Elmendorf). The Tax Reform Act of 1986 that Will trumpets had minimal effects on economic growth, as demonstrated in a paper by leading tax economists Alan Auerbach and Joel Slemrod.

The economy boomed in the 1990s despite an 8.6 percentage point hike in the top individual income tax rate in 1993. President George W. Bush’s 2001 and 2003 tax cuts initiated little growth. The economy grew at below-average rates from 2001-2007 (before the financial crisis sent the economy through the floor), despite expansive monetary policy and the tax cuts.

Will’s enthusiasm for tax reform also leads to a second bit of magical thinking. As in the growth example, he is motivated by a real concern, in this case noting that median income plunged almost 9 percent between 2009 and 2012. His idea: “Give earners on the lower rungs of the ladder of upward mobility a boost by cutting their payroll taxes.” He’d finance this by ending special tax breaks for carried interest of hedge fund managers.

Now, that is a very nice idea. But the numbers just don’t add up. Abolishing subsidies for carried interest would raise only about $1.4 billion per year over the next decade, according to the Administration, which favors the idea. If we used that money to subsidize just the lowest 35 million earners, (in 2013, 82 million people earned less than $30,000) we would be giving them each about 80 cents a week. That is not going to do much to help. A policy that offered significant help to lower-income workers would cost, again, one or two orders of magnitude more money than we can get from taxing carried interest as ordinary income.

Tax reform is important but policy makers and the public should not be misled about its true trade-offs. Unfortunately, the benefits of reform are more modest than its backers sometimes claim and its costs are often higher. We should still be interested in improving the tax system, but we should be clear-eyed about the costs and benefits of reform.