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Understanding the New Tax Plan America Needs

Respected economist Lawrence Lindsey has written a piece in the Weekly Standard that explains why the House Republican tax plan “is exactly targeted at the economic ills that afflict our country.”  First he establishes that the American economy really is sick:

“From 2011-2016 we observed the poorest economic expansion on record.”

“Barak Obama was the first president without a year of 3 percent real GDP growth while in office.”

“[F]rom 2011-2016, annual growth averaged more than a full point less than growth from 1965-2010, a period that includes drag from multiple recessions.”

“[G]rowth in real personal incomes and wages lagged behind the long-term historic average, and by several measures income inequality increased.”

Correctly diagnosing what’s been wrong with our economy

Three factors drive an economy: growth of the labor force, growth of the capital stock, and what economists call total factor productivity—how much output is produced by each unit of labor and capital. The poor economic performance of late cannot be blamed on the labor market. From 2011-2016, employment expanded rapidly, though the wages paid by those jobs were decidedly subpar. But from 2011-2015, capital formation plummeted—by almost 50 percent compared to the average annual growth rate observed from 1965-2010. Total factor productivity declined even more, from a long-term historic average of 1.1 percent to just 0.4 percent, a plunge of nearly two-thirds.  So the prescription should be one that boosts both capital formation and total factor productivity.

Decline in capital formation

From 2009-2011, for the first time since such data were collected, more firms went out of business than were formed. And from 2012-2014 (the last year for which data are available), firm births outpaced firm deaths by just 28 percent of the pre-2009 historic average. This means that the economy has been deprived of an important source of productivity. The decline in capital formation is another signal that growth-enhancing new businesses were not being created. Part of this can be blamed on overregulation, part on an anti-business attitude (remember “If you’ve got a business—you didn’t build that”?), and part on excessive and complicated taxation.

The Prescription: How the House Republican plan targets these problems

1. Capital Formation:

[I]t provides the best environment for capital formation we have ever had, especially in terms of cash flow for startups. Under current law, the cost of a new factory or machine is a deduction for tax purposes only over a period of years. Under the House plan, all investments can be expensed—that is, they’re eligible to receive an immediate deduction in the year they are placed in service. Since new investments typically do not produce enough income to offset their cost in the first year, the firm usually has a “net operating loss,” meaning that their costs exceed their income. As under current law, this loss can be carried forward into the succeeding years until the year’s income finally exceeds its expenses. By allowing expensing of new investments, most new firms will not owe any tax in their first few years of operation—the period when cash flow is most critical. That need for positive cash flow is particularly important now when banking regulations make it tougher than usual to secure loans to produce operating capital.

To understand how reckless government housing policies caused the 2008 financial crisis that resulted in the Dodd-Frank regulations that currently prevent community banks from giving small business the credit it needs to form or grow see my American Experiment post here.

2. Corporate Income Tax Rate:

[T]he House plan cuts the corporate income tax rate to 20 percent. The combination of expensing of investments and a 20 percent corporate rate will transform America from one of the worst places in the world to invest in new businesses into the very best. It is no coincidence that many large firms have announced new plant openings in America. Some attribute this to presidential tweets. Most firms I know make their decisions based on the numbers, and when you look at the numbers under the House tax plan, the place to open a new plant becomes obvious.

3. Territorial Tax System & Border Adjustability

[T]he proposed reform establishes a territorial tax system with border adjustability. Those are big concepts and widely misunderstood. The easiest way to think of the change is that right now firms are supposedly taxed on their worldwide income minus their worldwide expenses. The new plan will actually tax them on their domestic income minus their domestic expenses.

The two key words in that paragraph are “supposedly” and “actually.” Currently under worldwide taxation, we really don’t tax profits made abroad by U.S. companies. You have doubtless heard about the trillions firms have accumulated in profits overseas that everyone wants to repatriate, but think about why those trillions are there. Current law says companies theoretically owe tax on those earnings, but not until they actually bring the money home. Guess what? Firms simply don’t bring the money home. And while some schemes allow for “one-time” fixes, they don’t solve the actual problem. This bill will place a one-time tax on those earnings but then will get rid of the need to worry about the issue ever again. Only a firm’s domestic activities will be taxed, and by the way, they will be taxed in the most favorable jurisdiction in the world in which to do business. Think a lot of firms are still going to pile up profits abroad?

This brings us to border adjustability. Right now, every other country in the world bases a major portion of its tax system on this concept; sometimes it’s known as “destination-based” taxation. For example, Germany taxes based on where a good is going to be sold—its destination—instead of where it was produced. We currently tax based on where goods are produced and not on where they are sold. So, a Mercedes leaving Hamburg actually gets a rebate from the German government on its taxes (a so-called value-added tax) because it is destined for America, not Germany. And because we tax by where goods are produced, the Mercedes avoids taxation here as well. Alternatively, a Cadillac destined for Germany pays U.S. taxes because it was manufactured here and is then taxed again in Germany because that’s where it’s sold. So the Cadillac is taxed at two points in the chain, and the Mercedes is not taxed at all. Seem fair to you?

The president would call that rigged, but it is a self-inflicted wound. The House bill fixes this fundamental unfairness. The new tax base is figured by subtracting domestic costs from domestic sales. So, if the sale in question is not made domestically (meaning the good is not destined for America), it is not subject to tax, just like the Mercedes manufactured in Germany. But if the costs of production are not incurred here, they are not deductible—just like the Cadillac as far as Germany is concerned. Some critics have said that such a policy will drive up costs to consumers. It is a complicated story, but basic principles of supply and demand suggest that this is not the case.

4. Closing Loopholes:

[T]he final big advantage of the House bill: It closes loopholes, and there are three big ones in the current law. (1) Current law discourages investment by dragging out depreciation deductions. The House plan solves this with expensing. (2) Current law encourages debt rather than equity financing. The House plan phases out this differential. (3) Current law favors production abroad, which the House plan handles with territoriality and border adjustability. Public finance economists have encouraged these reforms since I was in graduate school 40 years ago. This is not a radical idea, but it is one that will make America work more efficiently.

Obviously, those that have taken advantage of these loopholes feel aggrieved; some of them will be net losers. But for too long, our economy has relied on financial engineering, instead of real engineering, to keep going. That strategy has reached the end of its rope. The ailment is clear; the diagnosis is clear; and so is the prescription—passage of the House tax reform package.

What a wonderful change this would be to finally have a tax code that would unleash growth and a broad prosperity.

Peter Zeller is Director of Operations at Center of the American Experiment.

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