Tax Less, Get More

Hey deficit hawks: Two wrongs don't make right...

The REPUBLICANS' tax bill has made its first pass through the sausage factory without being chopped into little bits, writes Nathan Lewis at New World Economics in this story first published at Forbes.

The most important stuff is still in there, in particular a big reduction in corporate tax rates. Unfortunately, the process isn't over. All the negative influences that have hobbled tax reform over the past twenty years are still in force. It will now take courage and vision to deliver on the great ambitions that inspired its creation.

Resistance comes, first, from the deficit hawks. Congress has locked itself into an absurd and counterproductive system of static estimates and long-term deficit accounting, which have little relationship to reality. This is in part because they can produce seemingly-exact, but largely wrong, estimates of revenue effects.

The reality tends to be different: that we don't really know what will happen, with exactitude; that tax revenue/GDP tends to be pretty stable even after major reductions in tax rates; that various growth effects tend to be pretty good; that the healthier economy tends to allow lower spending/GDP; and that the result of all these things is a better economy and a smaller deficit.

The governments that have enacted big tax reforms seem to say: we need a system that allows the private economy to flourish, so let's just create such a system, and assume that the results are going to be great. It is not a process of bean-counting. When Germany and Japan were on their back in 1949, or Russia in 2000, or Estonia in 1994, or the US in 1921 or 1980, they just knew what they wanted, so they did it.

Maybe we have to play the bean-counting game today, but people should always be aware that it is just a charade along the way to the real game, which is for the future of the nation. And don't you think we would have a better future with a rational, business-friendly tax system?

I have examined many examples of successful tax reforms over the past century – including the more than thirty governments that adopted full-boat Flat Taxes since 2000 – and I can honestly say I don't know of one example of failure. Not one government had a big growth-friendly tax reform, and ended up with disappointing growth, disappointing tax revenues, and a budget problem. So, don't worry about it.

The deficit hawks should really focus on spending. Tax reform actually helps this process, because a healthier economy tends to moderate various demands on the government. In US history, spending/GDP tends to fall when the economy is healthy. For deficit hawks, lower taxes and less spending should be the goal, and if you ask them, most of them will agree. If the deficit is too big, then cut spending. And if you fail, and the big-spenders prevail, then so be it. You did your part. Don't try to fix the problem of reckless spending by keeping economy-stifling taxes unchanged, or making them even worse. Two wrongs don't make a right.

Nevertheless, the static accounting framework is what we will have to work with, at least for this time around. The idea of a "revenue-neutral" reform of individual income taxes was a good idea, but it naturally produces "winners and losers" within this static accounting framework. I think it would be a positive change overall, and that even the "losers" would be indirect beneficiaries, but the complaints of the "losers" might be great enough to make it politically difficult.

This leaves two basic options: go small, or go big. "Go small" means gradually watering everything down until it is so minor that people find it is pointless to quibble over irrelevant technicalities. Unfortunately, that is the way things have been trending. "Go big" might mean a big reduction in rates across the board, so that everyone gets a tax reduction of some kind.

Rand Paul, a prominent holdout in the Senate, has been arguing for "tax cuts for all." Elimination of big deductions like mortgage interest or state income taxes would be matched by big reductions in headline rates, or perhaps raising the threshold of those rates (the tax bracket) by large amounts. Everyone would be a winner, even if some would be big winners and others not so much. People rightfully don't want to pay for some other guys' good time. Unfortunately, this would tend to create large apparent revenue shortfalls via static accounting, even though the reality would probably be a stable revenue/GDP ratio and big gains in revenue, as the many Flat-Taxers have shown. If we have a hard cap on supposed revenue shortfalls, it tends to block the "go big" strategy, especially since we are already going big on corporate taxes.

Thus, this time around, it might be best not to try too much at once. Focus on a few key areas – I would say, corporate taxes, and elimination of the AMT and estate tax, with no phase-ins, phase-outs and other idiotic baloney. If it's a good idea, it's a good idea right now and for forever. There might still be some opportunity to "go bigger" on corporate taxes, for example a lower rate (15%) paired with full expensing of interest, to fully eliminate the artificial disadvantage of equity capitalization vs. debt (which in turn tends to lead to overlevered companies that end up in bankruptcy).

This leaves a long agenda for the future. Let's drop the "once-in-a-generation opportunity" talk. Instead, get busy on the tax reform of 2018, this time focused on individual income taxes. Go big. Everyone is a winner, even after large-scale reduction in exemptions. A top income tax rate of 25% seems about right. Also, it might be best to start by doing away with all the budgeting rules that make any kind of meaningful tax reform difficult.

When you raise your head above the scrum of interest groups, "winners and losers," and supposed budget shortfalls, you can see the bigger picture. Governments do not prosper while the people remain poor. It is always the other way – when the people prosper, the government's resources increase while its problems melt away. In the Analects of Confucius (5th century B.C.) we find:

Duke Ai said to Yu Tzu, "Last year was a bad year due to a bad harvest and so the taxes are inadequate to cover my expenses. What can I do?"

Yu Tzu said, "Are you not taxing the people ten percent of their income?"

Duke Ai said, "I am taxing the people twenty percent and it is not enough."

Yu Tzu said, "When the people have plenty, the government will also have plenty. But when the people are starving and unemployed, how can the government expect to carry on business as usual?"

Britain ended the Napoleonic Wars with a government debt/GDP ratio that some have estimated at over 200%. The British looked at this enormous burden, cinched up their courage against the screams of fiscal irresponsibility – they had just won at Waterloo – and, in 1816, eliminated the income tax in its entirety.

A disaster? No: they ruled the world for a century.