Investing in tax reform today will yield a strong economy tomorrow - A. Brill / AEI

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taxespicWith tax reform hopefully next on the GOP’s agenda, it is important for lawmakers to think about its revenue effects in a sensible way: focus on the long-run budget impact, not the 10-year horizon embedded in congressional rules. The budgetary “score” of a tax reform bill is the revenue gained from reducing tax breaks minus the revenue forgone from lowering tax rates. Done right, faster economic growth will be the byproduct and the score of a tax reform bill should be adjusted to reflect any macroeconomic impact. For example, pro-growth tax reform will yield additional revenue as the economy expands and the tax base grows. Recent Republican tax reform proposals have anchored on revenue neutrality. That’s a sensible approach, but revenue neutrality should be defined on a long-run basis, not a proposal’s deficit impact over a 10-year window, as the rules governing the Congressional budgetary process dictate. There are five primary reasons the 10-year budget window is a hindrance to sound fiscal policy in the context of tax reform.

First, the 10-year budget window exaggerates the cost of transition relief. New tax rules that increase taxes or eliminate preferences are often phased in over time. For example, a reform of the mortgage interest deduction may grandfather existing mortgages but offer less generous tax breaks for new home purchases in the future. Such a reform would raise relatively little revenue at first, but would have a long-run positive fiscal effect.

Second, the 10-year budget window unduly encourages the phasing in tax reductions. A simple way to make a tax proposal look less costly within the budget window is to phase in tax breaks. Phasing in a tax cut can sometimes be economically rational, but the budget rules encourage the use of phase-ins to squeeze large tax changes into more modest budget frameworks.

Third, the aggregate 10-year effect may mask the revenue trajectory. Consider two tax reform plans. One takes effect immediately and the revenue raisers are equal in cost to the tax cuts every year. The other plan takes effect gradually and backloads the cuts toward the end of the budget window. Both may have the same 10-year score, but the first plan will have a neutral long-run effect while the second plan will reduce long-run revenues.

Fourth, the 10-year budget window is likely to miss the most important macroeconomic effects. Pro-growth tax reform will increase the capital stock, raise wages, and potentially increase the size of the workforce. The resulting larger economy will yield more taxable income and therefore more tax receipts. But such positive effects take time, with the largest effects likely to occur after the first decade.

Finally, the long-run budget outlook matters more than the 10-year budget outlook. The most important reason that the 10-year budget window is unsuitable for scoring tax reform is the fact that the long-run fiscal outlook is far bleaker than the near-term outlook. The Congressional Budget Office recently projected that, under current law, the deficit will reach 9.8 percent of GDP in 2047, up from 2.9 percent today and on par with the average deficits experienced during the Great Recession.

For these reasons, lawmakers should focus on tax reform’s long-run fiscal impact, not its short- or medium-term revenue effect. If tax reform creates a temporary revenue loss within the 10-year window, but is revenue-neutral or revenue-raising in the long run (perhaps due to a boost to long-run economic growth), lawmakers should accept the revenue loss as the necessary transitional cost for reaching a pro-growth tax code.

Adopting a long-run perspective may not be easy, as budget hawks will call every $1 in near-term deficit-financed tax cuts fiscally irresponsible. But done right, an investment in tax reform today can yield a stronger long-run economy for our future.


brillaeiAlex Brill

Research Fellow – AEI




NOTE: Alex Brill is a research fellow at the American Enterprise Institute (AEI), where he studies the impact of tax policy on the US economy as well as the fiscal, economic, and political consequences of tax, budget, health care, retirement security, and trade policies. He also works on health care reform, pharmaceutical spending and drug innovation, and unemployment insurance reform. Brill is the author of a pro-growth proposal to reduce the corporate tax rate to 25 percent, and “The Real Tax Burden: More than Dollars and Cents” (2011), coauthored with Alan D. Viard. He has testified numerous times before Congress on tax policy, labor markets and unemployment insurance, Social Security reform, fiscal stimulus, the manufacturing sector, and biologic drug competition. Before joining AEI, Brill served as the policy director and chief economist of the House Ways and Means Committee. Previously, he served on the staff of the White House Council of Economic Advisers. He has also served on the staff of the President’s Fiscal Commission (Simpson-Bowles) and the Republican Platform Committee (2008). Brill has an M.A. in mathematical finance from Boston University and a B.A. in economics from Tufts University.

 

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