AMID THE CLATTER and clutter of official Washington’s daily dysfunction, a movement is slowly gathering steam to design and enact pro-growth tax reform that reduces marginal tax rates—which is to say, tax reform that is not a Trojan Horse for a tax increase.
This has been a long time coming. In 1986 Ronald Reagan signed a bill that simplified the tax code significantly. It replaced the 14 existing rates, which ranged from 50 to 11 percent, with two rates, 28 percent for top earners and 15 percent for everyone else. Corporate tax rates were cut from 46 percent to 34 percent. The bill passed with 74 votes in the Senate and 292 votes in the House—overwhelming, bipartisan margins. Both parties had learned (even if Democrats refused to acknowledge it publicly) that lower marginal tax rates help economic growth.
Since 1986 there has been some backsliding. In 1990, George H.W. Bush won a vote—also bipartisan—to raise the top marginal tax rate to 31 percent. Three years later, with no Republican votes, Clinton bumped the top business rate to 35 percent, and the top individual rate to 39.6 percent.
In a reversal of this trend, George W. Bush pushed through temporary tax cuts in 2001 and 2003. These reduced the death tax, cut rates on income, capital gains, and dividends, and expanded child deductions. Barack Obama turned around and increased 20 taxes as part of Obamacare, though he has also signed a bill that made the Bush tax cuts permanent for 98 percent of Americans.
In other words, since 1991 at least, never in power have Democrats cut taxes and never in power have Republicans raised taxes: a very partisan divide. Now, with a split Congress, what hope is there for a bipartisan tax reform package that would lower taxes, simplify the code, and be revenue neutral à la Reagan’s in 1986? Doubters point to Obama’s persistent demand that any tax bill include at least $1 trillion in higher taxes. The product of Obama’s debt commission, the so-called Simpson-Bowles proposal of 2011, would have increased federal taxes as a percentage of GDP from a historical average of between 18 and 19 percent to 21 percent—a $5 trillion tax hike over 10 years. Not pro-growth. Not revenue neutral.
Republican enthusiasm is easy to understand. House Budget Committee Chairman Paul Ryan’s ambitious plan has become the official position of the Republican caucus in the House and Senate. Through block grants, it would give individual states control of various federally funded welfare programs. It would reform Medicare, allowing competition to keep prices down. On the spending side it would save us $5 trillion over the next 10 years. Without the Ryan plan—or something like it—by 2050 the federal government will absorb 40 percent of GDP—as opposed to around 20 percent of GDP, if Ryan’s plan is enacted. Bluntly put, with Ryan we remain America, but without Ryan we become France.
So on paper the GOP has come a long way toward solving the budget problem: Defend the sequester budget limits won in 2011 and, as soon as we win the Senate and White House, pass the Ryan budget. Done. But the Ryan budget provides only an outline for tax reform, which is why House Ways and Means Committee Chairman Dave Camp and Senate Finance Committee Leader Orrin Hatch are now focused on putting meat on the bones of what they intend to be the most pro-growth tax reform legislation the nation has ever seen.
PRO-GROWTH TAX reform is the antidote to four years of economic sluggishness. Had the economic recovery that began in July 2009 been as strong as Reagan’s tax cut-driven recovery, 6.8 million more Americans who are jobless today would be employed in the private sector, and total growth in real GDP might be as much as 13 percent higher.
Any future plan for tax reform must do three essential things: lower tax rates on businesses and individuals, shift from a worldwide tax system to the territorial tax systems of most of our successful competitors, and move to full and immediate expensing of new business investment.
Of these three, rate reduction has received the most attention. Even Obama and the Democrats must hear from American businesses that cannot compete in a world in which they are taxed at a rate of 35 percent, when the European average is 25 percent, Canada is 17.5 percent, and China of all places is 25 percent. The small business community, much of which pays taxes at the individual rate, stands firm in demanding that it fall to 25 percent alongside the business rate. This “small” business community wields a significant amount of power. There are 4.1 million subchapter S—or “pass through”—corporations with a net income of $334 billion. Together these employ 31 million Americans, or one quarter of the private sector workforce. They know that taxing the rich is code for taxing independent businesses.
If territoriality is a less visible tax-related question to most Americans, it is not less important. Most nations only tax economic activity that takes place within their borders. The United States is the only major economy that taxes money that its citizens and companies earn overseas. An American earning a dollar in France pays French taxes and then American taxes on top of that. This is punishing for millions of Americans who work abroad and crippling for American firms with worldwide business investments. Microsoft, Apple, Cisco, and drug companies point out that there is some $2 trillion sitting overseas that could come back to the United States as soon as we shift to a territorial tax system. Meanwhile, that $2 trillion ends up financing factories overseas. Even Democrats should see this is self-destructive.
Last but not least, any prospective tax reform should make it easier for businesses to re-invest their earnings. Fortunately Republicans have been making progress on this front since 1981, almost always with help from the other side of the aisle—including in 2010, when Obama extended the Bush tax cuts. Expensing reform would rip out about 1,000 pages of the tax code and reduce the cost of all new investment.
Right now these three reforms are wrongly seen as mutually exclusive. For example, it is often assumed that lower rates must come at the expense of weaker depreciation for investment and less robust territoriality. But the Joint Tax Committee has agreed to estimate the revenue costs of tax cuts using both static and dynamic methods. A static model that does not take supply-side responses into account finds, for example, that cutting the business and individual rates to 25 percent would “cost” the government $5 trillion within the decade. But we know from American history—and from common sense—that lower rates and faster capital cost recovery will increase growth. Increasing economic growth by 1 percent for one decade would probably increase tax revenue by $2.5 trillion. Increase growth by 2 percent, and Uncle Sam raises an additional $5 trillion over ten years.
Cutting rates, taxing Americans only on their domestic economic activity, and moving to immediate expensing for business investment: Here are steroids for economic growth.