A better way

If you tax investment, you tend to get less of it. And because workers rely on invested capital to produce the goods and services we consume everyday, falls in investment inevitably lead to falls in wages. In fact, economic theory tells us that because investment is so responsive to changes in tax rates, workers would be better off if we abolished taxes on capital investment (like corporation tax) entirely and instead raised taxes on consumption to compensate for lost revenue. Top economists, such as Greg Mankiw, Bob Lucas, and Marty Feldstein believe that we could boost long-run wages by almost 10% if we made these changes.

Defenders of taxing capital (such as Thomas Piketty) typically argue that the models used to advocate for abolishing capital taxes are overly simple or make unrealistic assumptions. That can’t be said for a new paper by Kotlikoff, Benzell and LaGarda that simulates the effect of the US adopting Congressman Paul Ryan’s ‘Better Way’ tax plan.

Ryan’s tax reform proposal replaces the U.S. federal corporate income tax with a 20 percent business cashflow tax (BCFT), which allows firms to write-off all investments and wages against their bills, but at the same time ends the deductibility of net interest payments. It also includes a border-adjustment mechanism that exempts net exports (exports minus imports) from business tax receipts. Put simply, it transforms the corporate income tax into a VAT style tax on domestic consumption (levied on firms) with a payroll tax cut. As Kotlikoff et al points out, this would effectively lower the marginal tax rate on capital to zero.

Typically, models assessing the effect of switching from capital to consumption taxes make a number of restrictive simplifying assumptions, such as infinitely-lived agents, homogenous skill levels and zero trade. Kotlikoff, Benzell, and LaGarda take a different approach.

Their model assesses the effect on 17 different regions, taking into account realistic estimates of life expectancy; demographic change; migration flows; a separate energy sector; government transfer programs; and international corporate tax rates. It is the most comprehensive attempt to model the effect of fundamental tax reform I’ve ever seen.

They find that compared to the status quo, in the first ten years of the reform:

• The US Capital Stock would increase by 25 per cent
• Pre-tax wages would increase by 6 per cent
• US GDP would be nearly 8 per cent higher – an 0.8% boost to GDP growth for the first decade of the reform

They also model what would happen if other countries match the US’s tax rates. They find that:

• GDP would still be about 5% higher, but not as high as if other countries didn’t try to compete with the US with. lower tax rates
• Interestingly, because Americans own a significant proportion of overseas assets, lower overseas tax rates will lead to increased asset incomes in turn boosting income tax receipts and allowing for extra income tax cuts.

One of the more bizarre findings of the paper is that in the long-run (2100) GDP would be lower under the Ryan plan. But, this shouldn’t be seen as a negative. In fact, Kotlikoff, Benzell and LaGarda point out that the lower GDP result is driven by higher wage rates leading people to work slightly shorter hours and spend more time on leisure. In other words, people are still better off.

Kotlikoff, Benzell and LaGarda’s results are even more powerful when you consider they do not consider two of the biggest arguments for switching to business cashflow tax. First, they don’t consider the possibility that the reform will make overseas tax avoidance harder and make collecting taxes from IP intensive tech firms easier. Second, they don’t consider the effect of ending the debt-equity bias, which many top economists believe would make financial crises less frequent.

Paul Ryan’s been forced to drop major aspects of his tax reform plan in order to keep the Senate and Trump administration on side. Instead, Ryan will go for straightforward corporate tax rate cuts and shorter capital allowances, an improvement to the status quo, but sub-optimal when he could be take advantage of what Nobel Laureate Bob Lucas once called “the largest genuinely free lunch I have seen in 25 years in this business”.

In the UK our corporation tax set-up isn’t quite as bad as in the US, but it’s far from perfect. We may have a low statutory rate but the effective rate (i.e. the one people actually pay) is still high. That’s because we have some of the least generous capital allowances in the world. We should pick up the baton that Ryan dropped and fix our broken corporate tax system.