The White House and congressional leadership recently outlined their proposals for tax reform. Though the outline left plenty up for interpretation, it was by far the most detailed tax proposal put forth by the Trump administration to date.
Without having all the details filled out by Congress in an actual piece of legislation, it is difficult to say with any accuracy exactly what the implications of the reforms would be, despite several outside groups' best efforts. From what we've been given, though, we can surmise at least a few takeaways.
The first is that the proposal would result in a better tax code than the status quo. When economists talk about "good" and "bad" tax codes, what they're typically referring to is whether a tax code is more or less efficient. Efficiency is the name of the game in economics, and the more efficient a country can make its tax code, the better.
Efficiency generally means making sure a tax code is simple, transparent, and fair. The new proposal would make the tax code substantially simpler and more transparent than the status quo. Under the proposed outline, not only would there be fewer personal tax brackets to worry about, but also fewer distortions from loopholes. Business taxes would also be greatly improved by moving to a system that makes it simpler for companies to do business internationally without having to move operations overseas.
It's too early to tell exactly how fair the new tax code would be, because of which details were left out of the tax proposal. In tax policy, as with most important things in life, the devil is in the details. Changes in fairness vs. the status quo will depend on the details that come out of congressional negotiations over the next few weeks, particularly at what income levels new personal tax rates are set.
The second takeaway is that the proposal will help grow the economy faster than it would under the existing tax code. The proposal makes America more competitive from an international business perspective, and strongly incentivizes investment over the next five years. It also lowers tax rates for the typical individual taxpayer and results in more after-tax income across the board.
At Moody's Analytics, we have run several interpretations of the proposed tax outline through our U.S. macroeconomic model and found that each scenario would result in a faster pace of economic growth over the next 10 years. This all adds up to a better tax code and faster economic growth in just a decade.
Given those benefits, the more astute among you will immediately begin to wonder: What's the catch? The catch, as it so often is with fiscal matters, is the cost.
Thus, the third and final takeaway is that the proposed tax reform could be very expensive. The proposed Senate Budget Resolution allows the net cost of tax reform to reach as high as $1.5 trillion over the next 10 years. Even in the federal government, that's real money.
To be fair, there are some out there who will immediately argue that the real cost of tax reform will be much less than $1.5 trillion. In fact, some will go even further and argue that the proposed reforms will juice up economic growth so much that the government will actually make more money in tax revenue, not less.
Though it is true that some of the cost of the $1.5 trillion will be offset by faster economic growth, the actual amount will be nowhere near enough to pay for it all. A general rule of thumb from tax professionals at the Joint Committee on Taxation says that for every 0.1 percentage-point increase in economic growth over 10 years, the government generates just under $300 billion in additional revenue.
That means that in order to pay for itself, a tax-reform package costing $1.5 trillion over 10 years would need to boost average annual GDP growth by more than 0.5 percentage points. Unfortunately, you'd be hard-pressed to find a reliable economic model that would project the proposed tax-reform outline increasing economic growth by even half that amount.
This creates a difficult policy decision for many in Congress. Is a more efficient tax code and slightly faster economic growth worth borrowing an additional $1.5 trillion over the next 10 years?
Even understanding all of these caveats, many would still argue an emphatic yes. We are in year eight of one of the most sluggish economic recoveries in American history, and we could certainly use a shot in the arm to get the economy growing again. However, our economic situation is at the point where we'll need a lot more than just tax reform to get us back to historical growth rates.
Productivity growth is not sluggish solely because of an inefficient tax system, and tax reform would make no difference to our growing demographic and workforce challenges. Couple that with the fact that we are carrying our largest national debt since WWII, and it's difficult to argue in favor of increasing the deficit for any reason. Even much-needed tax reform.
President Trump has been dealt a very bad hand when it comes to the federal fiscal situation. No president has inherited more debt upon taking the oath of office since Harry Truman, and in some ways Trump's predicament is actually worse than Truman's.
Truman's war debt was temporary; Trump's structural debt is not. This is debt that has built up over years of structural imbalances and several presidents, and it is not going to go away on its own. For context, the Congressional Budget Office estimates that if we were to make no change to federal fiscal policy over the next three years, 92 cents of every federal tax dollar would be earmarked for mandatory spending programs and interest on the debt by the end of Trump's first term.
Without borrowing more money, that leaves only 8 cents on the dollar left over for everything else, from aircraft carriers to Zion National Park.
Fortunately, unlike other hot-button issues in Congress, this isn't a binary decision. Tax reform doesn't need to cost $1.5 trillion and can be done in a more deficit-neutral manner. Deficit-neutral tax reform can still result in a more efficient tax system and faster economic growth. More important, it can accomplish those goals without the nasty debt hangover later on.
To overcome the economic challenges facing us in the years ahead, tax reform is an absolute imperative.
However, the hand we've dealt ourselves will require reform not to significantly add to the national debt. In the end, as much as the American public may want a big tax cut, the fiscal realities of today demand that reform be as deficit-neutral as possible. Fortunately, there's still plenty of opportunity to do just that.