The current US tax structure is complicated and constantly evolving. In the first 20 years after the 1986 Tax Reform Act was passed, there were already about 15,000 changes to the basic law. The lack of transparency is costly: resources devoted to tax preparation and avoidance alone amount to more than 1% of GDP.1
The tax system is full of inconsistencies, preferences, complex rules, and contradictory definitions that encourage distortionary behavior by Americans in their legitimate attempts to minimize their tax liabilities. For example, there are multiple definitions of “child” for various tax credits and other tax rules that affect the amount paid.2
Additionally, there are parallel systems that are not fully integrated into one coherent tax structure. Within the income tax category, the Alternative Minimum Tax has rules that are layered on top of the basic tax rate structure, which override the tax calculation for a sizeable fraction of taxpayers.
Beyond that, the payroll tax, both employer and employee contributions, are distinct from the income tax rules, but for most Americans, act as a basic income tax that is an add-on to the income taxes that they pay. And while almost half of Americans pay no federal income tax, all wage earners are subject to the payroll tax, which amounts to a substantial tax burden for many.
Although the difficulties associated with tax preparation leap to mind as the motivation for reform, it is secondary in term of economic importance to adopting a tax program that will enhance economic growth. The adverse consequences of the current tax system, which retards growth, are more significant than those associated with compliance.
There is general agreement among economists, especially those who have studied the tax system carefully, that growth is most affected by taxes on capital.3 Notorious is the high US corporate tax rate of 35% that the US imposes, which results in obvious evasive action like locating business overseas. More important, but less visible, is the actual reduction in investment that occurs because capital is taxed so heavily in the United States. The marginal dollar of investment is one that can find its home in another country as easily as in the US. When we raise taxes on capital, a German investor who might have preferred to invest in an American company simply chooses to keep that money in Germany. The easy flow of capital across borders means that lowering tax rates will encourage more capital to flow to American businesses.
Furthermore, not all capital is taxed similarly. One study by the Treasury Department a few years back estimated that investments in the corporate sector were taxed on average at 24%, while those in the non-corporate sector were taxed at 17%. Because owner-occupied housing yields implicit rental in the form of housing services provided to the residents, investments in owner-occupied housing are untaxed. This leads to overinvestment in housing relative to other businesses.
A variety of estimates suggests that if investment were untaxed altogether, the economy would grow by an additional 5% to 9%.4 In the short run, the easiest way to accomplish this is to allow full expensing of investment with indefinite carry-forwards. This simply means that firms can deduct the cost of investments from their tax liabilities immediately and fully. Allowing full and immediate deductibility of investment expenses removes the distortions that impede capital investment and, as a consequence, raises productivity, incomes, and GDP.
There is another kind of investment is even more important in our economy—namely, investment in human capital. Economists have estimated the human capital portion of the total capital stock in the United States as between 70% and 90%.5 How does the tax system affect investment in human capital?
The personal income tax is the primary way by which taxes retard investment in human capital. Although most evidence suggests that a moderate increase in taxes does not have a strong adverse effect on hours worked or even labor force participation, increasing tax rates is likely to have profound effects on occupational choice and investment in the skills that are required to be productive in high-value occupations. Department of Labor data reveal that seven of the ten highest-paying occupations in the US are in medicine (including dental) and engineering. Young people choose to enter professions in part because of their inherent interest in the occupation and desire to have an impact on society. But there is little doubt that the high incomes associated with these occupations produce large pools of would-be professionals. Work by University of Chicago-associated economists has demonstrated that adjustment is strong and rapid. When there is scarcity of individuals in an occupation, wages rise as firms compete for those who are in the field. The increase in wages induces others, primarily the young, to enter, and the entry is quick, usually eliminating the upward pressure on wages within a few years.6
The personal income tax, and especially extreme progressivity, which places high burdens on professionals, discourages entry into professional occupations. Since human capital is such an important component of all capital, it is important to avoid over-taxing individuals directly.
What, then, is over-taxation? Despite past increases in tax rates, the US remains a relatively low tax country as compared with our G-7 neighbors. Indeed, some notable economists believe that one of the reasons why the US remains a high GDP-per-capita nation is that we are resistant to the kind of high taxation that, for example, France and Italy have imposed on their populations.7 Unfortunately, the fact that we are relatively low provides little comfort for two reasons. First, we can do better. Our tax code creates many problematic incentives that if eliminated, would result in higher growth and even better lives for the next generations. Why settle for less when it is unnecessary to do so?
Second, even if we are content with the current situation, it is likely to be short-lived. Because government outlays continue to grow, we run a deficit each year that will continue to increase. Under one realistic scenario, the Congressional Budget Office estimates that our debt could be 175% of GDP (or more than double the current ratio) in a little over 20 years.8 High deficits and debt service can eventually only be financed through taxes, and if these scenarios materialize, our relatively low taxes will become ancient history.
Lowering capital taxation and paying close attention to the progressivity of the tax structure both benefit the rich directly. The middle- and lower-income parts of the income distribution also benefit, however. I have found that there is a close relation between average income wage growth and productivity. Furthermore, there is a close link between GDP growth and productivity growth, the former being the sum of productivity growth and growth in work hours. Because of this, unless we ensure that the economy grows, which means that productivity grows, we will not have wage growth. This is not always perfect, nor does it affect all parts of the income distribution equally at all times. But the link is undeniable.9 In recent years, growth favored high-income earners relative to low-income ones, but the poor and rich alike did best when economic growth was robust.
To the extent that changing the tax system can bring us back to the kind of growth that we enjoyed during most of the 20th and early 21st centuries, we will raise the standard of living of not only the wealthy but also of those less well off. The changes are always difficult to effect because almost any change will mean that there will be some losers. Still, the prosperity of our children depends on moving to a more efficient tax code. The easiest way to get there is to reduce, or ideally, eliminate taxation of capital and avoid the trap of making personal rates too high for any income group.
1Simple, Fair and Pro-Growth: Proposals to Fix America’s Tax System. The President’s Advisory Panel on Federal Tax Reform, US Government Printing Office, November 2005.
2Lazear, Edward P. and James Poterba. “A Golden Opportunity,” Wall Street Journal, November 1, 2005.
3Mankiw, N. Greg and Matthew Weinzierl. “Dynamic Scoring: A Back of the Envelope Guide” Journal of Public Economics, 90, 8-9, (Sept 2006), pp 1415-33. Also, OECD Tax Policy Study No. 20 “Tax Policy Reform and Economic Growth.” OECD Publishing, 2010.
4See, for example, Alan Auerbach (2001)
5See, for example, Dale Jorgensen (1996)
6See Richard Freeman (1976); Sherwin Rosen (1992) on lawyers.
7Edward Prescott (AER, May 2002 Ely lecture).
8Congressional Budget Office “The 2015 Long Term Budget Outlook,” June, 2015, p. 81.
9See Edward P. Lazear, “If Only Hillary and Bernie Would Recall JFK,” Wall Street Journal, January 29, 2016.
Auerbach, Alan, David Altig, Laurence J. Kotlikoff, Kent A. Smetters, and Jan Walliser. 2001. “Simulating Fundamental Tax Reform in the United States.” The American Economic Review 91(3): 574-595.
Congressional Budget Office. “The 2015 Long-Term Budget Outlook.” Washington, D.C., June 2015. https://www.cbo.gov/sites/default/files/114th-congress-2015-2016/reports/50250-LongTermBudgetOutlook-4.pdf (Accessed January 15, 2017)
Freeman, Richard. 1976. “A Cobweb Model of the Supply and Starting Salary of New Engineers.” Industrial and Labor Relations Review 29(2): 236-248.
Jorgenson, Dale W., Chrys Dougherty. 1996. “International Comparisons of the Sources of Economic Growth.” The American Economic Review 86(2): 25-29. Papers and Proceedings of the Hundredth and Eighth Annual Meeting of the American Economic Association. San Francisco, CA, January 5-7, 1996.
Lazear, Edward P. and James M. Poterba. “A Golden Opportunity.” The Wall Street Journal, November 1, 2005. Accessed January 15, 2017. http://www.wsj.com/articles/SB113081277739884933.
Lazear, Edward P. “If Only Hillary and Bernie Would Recall JFK.” The Wall Street Journal, January 29, 2016. Accessed January 15, 2017. http://www.wsj.com/articles/if-only-hillary-and-bernie-would-recall-jfk-1454022388.
Mankiw, N. Greg and Matthew Weinzierl. “Dynamic Scoring: A Back of the Envelope Guide.” Journal of Public Economics 90(8-9): 1415-1433.
OECD. 2010. “Tax Policy Reform and Economic Growth.” OECD Tax Policy Studies No. 20. OECD Publishing.
Prescott, Edward. 2002. “Richard T. Ely Lecture: Prosperity and Depression.” The American Economic Review 92(2): 1-15. Papers and Proceedings of the One Hundred Fourteenth Annual Meeting of the American Economic Association.
President’s Advisory Panel on Federal Tax Reform. “Simple, Fair, and Pro-Growth: Proposals to Fix America’s Tax System.” November 2005. https://www.treasury.gov/resource-center/tax-policy/Documents/Report-Fix-Tax-System-2005.pdf (Accessed January 15, 2017).
Rosen, Sherwin. 1992. “The Market for Lawyers.” The Journal of Law and Economics35(2): 215-246.