Supply-side tax reform

More often than not, when Washington has chosen to address the tax code, it has been in an effort to cut taxes to boost a soft economy. The current situation does not fit that bill, as the economic expansion is eight years old and the unemployment rate is as low as it has been in over 15 years.

Nevertheless, this economy sorely needs help — just in a different way.

Productivity growth has been anemic since the early stages of the recovery and, while there has been a cyclical bounce in employment, the percentage of the prime-working-age population that is employed or looking for work remains far below pre-crisis levels. To put it in economics jargon, the economy needs a boost to the supply side, not the demand side. In plain English, tax reform should focus on strengthening the incentives for businesses to invest and individuals to work and/or start new firms.

So, how do we pursue those goals?

First, the tax code, both for corporations and individuals, needs to be much simpler. Most households can’t even do their own taxes any more, and far too much time, energy and money is spent by households and businesses complying with an overly complex tax code. This leads to a lot of tax avoidance activity that may be financially beneficial in a narrow sense but ends up limiting the growth of the overall economy.

{mosads}Economists have long advocated that the tax base should be wider (i.e., that it have fewer loopholes so that more income is subject to taxation) and tax rates should be lower. Even if this were done in a revenue-neutral way, it would still likely be a substantial boost to growth.

Businesses would spend more effort figuring out how to grow their businesses — and, in turn, employing more people and generating more income — rather than trying to churn out profits by tailoring their activities to exploiting loopholes in the tax code. Similarly, households would be more focused on boosting their incomes and less on tax avoidance strategies.

Of course, while a simpler, flatter tax code sounds great to economists, it is more problematic from a political perspective, as those most adept at using the nooks and crannies in the tax code to lower their bills will scream if their “vital to the economy” break is brought into question.

Hand in hand with a wider tax base would be lower marginal tax rates. The current corporate income tax has a top marginal rate of 35 percent — the “marginal” tax rate refers to how much one would pay on one extra dollar of income; it is this concept, rather than the average tax rate, that governs people’s decisions about whether to work longer hours, expand their businesses, etc., which is why economists focus so much on this gauge — the highest in the industrialized world.

Our corporate tax code puts U.S. businesses at a disadvantage against global competitors, which unfortunately encourages firms to shift operations overseas to lower-tax locations. A tax cut is always fun, but in this case it is more vital, whether the net effect is a higher, lower or unchanged total tax bill, to get marginal corporate income tax rates down to an internationally competitive level, presumably partially or entirely paid for by closing loopholes (or to put it in more friendly terms, “simplifying the tax code”).

If the reform package is revenue-neutral, or even close to neutral, some firms will pay more taxes than before, while others will pay less. In other words, it is nearly inevitable that someone’s ox will be gored. The trick will be whether Congress and the Trump administration can do what makes sense for the economy as a whole, even if it means angering firms with powerful lobbies dedicated to preserving their favorite tax preferences.

Finally, to the extent that the U.S. economy suffers from low productivity growth (in my view, this is the economy’s biggest long-term problem right now), the tax reform effort should focus on improving the incentives for investment.

Capital spending by businesses provides workers with the tools (modern factories, improved equipment, etc.) that they need to be more productive. The lackluster performance of business investment during this decade has played a central role in the sub-par growth of the economy. Every decision made in terms of both the corporate and individual tax codes should be carried out with an eye to strengthening the incentives for investment. This likely would include lower marginal rates for corporate income as well as individual investment income (dividends, capital gains, etc.).

It also points to a more generous approach toward how corporations write off their investments. Currently, tax depreciation schedules drag on for years, but there has been discussion in Washington about moving toward or even all the way to full expensing of investment — i.e., allowing businesses to write off the entirety of the cost of their investments in the year in which the equipment or structure is purchased. This would provide a jumpstart to businesses’ incentive to invest and ultimately would likely boost economic growth, productivity and workers’ (and investors’) incomes.

Stanley is the chief economist for Amherst Pierpont Securities, a broker-dealer providing institutional and middle-market clients with access to fixed-income products.