President Trump’s Council of Economic Advisers recently released a comprehensive review of corporate tax reform on wages and economic activity, and the GOP recently released its Tax Cuts & Jobs Act. Beneath the math and footnotes is a key point: Tax reform along the lines of the “Unified Framework” will be a boon to working Americans.
Against this analytical backdrop are some pointed critiques from Obama administration economists. As someone long interested in economic policy, watching the current economic jargon smackdown over who gains from tax reform is like watching specialists for the Golf Channel (Econ 101 long-run economic policy analysis) switch to the NBA (current Washington discourse).
{mosads}Tax reform is important, and workers will be winners. A little bit of Golf Channel can make the case that fundamental tax reform — reducing tax rates, particularly on business income, while broadening the tax base — raises pay.
Economists’ interest in fundamental tax reform reflects Willie Sutton’s insight about robbing banks — it’s where the money is. Estimates of the output effects of tax reform are for an increase in the level of GDP by 5 percent or more.
Indeed, recent work by Berkeley’s Alan Auerbach and Boston University’s Larry Kotlikoff suggest gains in GDP for the House GOP Better Way proposal of 9 percent, with accompanying wage gains of 8 percent.
This interest in reform drove the design of the Tax Reform Act of 1986, proposals for reducing double taxation of corporate equity by the Treasury Department and the American Law Institute (enacted in part in 2003), the Growth and Investment Proposal from the presidential tax reform commission in 2005, Obama administration arguments for lower corporate tax rates and the present efforts in Congress.
Much of the economic gains from tax reform come from reducing marginal tax rates on business income, as the Council of Economic Advisers has argued. Heightening potential gains, corporate capital has become much more mobile since the 1986 Act or the Treasury-ALI studies.
Most of our trading partners already absorbed these theoretical and practical lessons by lowering the corporate tax rate and turning more to consumption taxes to fund government. Business tax reform also packs a punch when it reduces tax biases against fixed investment and equity financing and when a broader tax base facilitates lower rates of taxation.
OK, but why should workers care about business tax reform? The simple answer is a wage increase. Explaining why makes a straightforward case for tax reform.
A cut in the corporate tax rate, all else being equal, increases capital formation, raising productivity and wages. Validating this claim doesn’t require analyzing results of recent studies of corporate taxes and wages, but simply linking the reduction in the cost of capital from tax reform to capital formation (an investment model) to GDP (a production function).
The gain in wages suggests that the tax burden was being shifted toward labor. Note that wage gains need not be limited to the static revenue raised from the tax. This is because the corporate tax also generates a waste in economic resources, or “deadweight loss.”
The recent formula gauntlets from Trump and Obama economists notwithstanding, this intuition requires no head-spinning math. You can still bear the burden of a tax even if you don’t write the check to the IRS.
Consider the Social Security tax: Up to an earnings limit, workers and employers both pay 6.2 percent of their income to the Social Security trust fund for a total of 12.4 percent. On paper, half of the burden of the tax is borne by the worker. In reality, all of it is.
The 6.2 percent of wages that firms pay to the government has to come from somewhere, and economists agree that it comes from workers in the form of lower wages.
Now back to tax reform: In simple textbook models, the long-run supply of capital is very sensitive to changes in the net return to capital. Reducing the corporate tax rate increases capital, productivity and wages. More capital means that each unit of capital has fewer workers to work with, that is, the tax cut reduces the productivity of each unit of capital.
So the after-tax return on capital rises after the cut in the corporate tax, then falls back as the capital stock grows. The process concludes when the after-tax return has fallen all the way back to its original level, which is determined by the underlying patience of savers.
A revenue-neutral reform that cuts the corporate tax rate is in workers’ interest, even if they have no capital. Why? Imagine the economy as a pie. Adding a pinch of corporate capital tax cuts increases the capital stock and GDP — that is, the size of the pie. The increase in the pie’s size is proportional to the productivity of capital.
Growth in capital raises the absolute size of capital owners’ slice because it’s proportional to the overall pie. In a revenue-neutral reform, the government’s slice doesn’t get bigger. What’s left belongs to workers.
The increase in the pie as a whole is proportional to the before-tax return on capital (the gain to the economy from new capital). As a result, the whole pie is growing faster than the slice for capital owners (which is proportional to the smaller after-tax return on capital).
Again, the government’s slice does not change. Workers must therefore get a bigger slice than the one they started with — even from a revenue-neutral corporate rate cut.
This gain is likely to be substantial, as the Auerbach-Kotlikoff and CEA analyses have suggested. Reasonable economists can disagree over the exact magnitude, but the higher wages for workers should propel political support for tax reform.
This prospect of a raise stands out as one of the most significant positive effects policy can have on the labor market.
Economists’ technical fouls of each other on the tax basketball court make good copy. But a hole-in-one of the wage increase the CEA report describes is what should grab the attention of congressional tax writers.
Glenn Hubbard is dean of Columbia Business School. He was chairman of the Council of Economic Advisers under President George W. Bush.