Sorry, Washington: Tax reform won’t do much for growth

November 16, 2012

Washington loves its panaceas. A few years ago, it was Army Gen. David Petraeus who could fix any problem -- up to and perhaps including the presidency. Then it was the Simpson-Bowles commission, or maybe the congressional supercommittee on deficit reduction. Today’s cure-all? Tax reform.


House Speaker John Boehner and the all-healing tax reform.  (EPA/JIM LO SCALZO)

Tax reform “will result in the additional revenue the president seeks,” said Republican House Speaker John Boehner in his post-election news conference. “It will support economic growth, which means more revenue is generated for the Treasury. And it will improve the efficiency of the system, which means additional revenue as well.” He went on to quote former Treasury Secretary George P. Shultz, who said the 1986 tax reform was “the unsung hero of the very good economic times we had for a long time.”

That’s the Washington consensus on tax reform: It slices, it dices, it cleans up after itself. But that’s not the economic profession’s consensus.

In 1997, Alan Auerbach and Joel Slemrod conducted an exhaustive survey of the studies on President Ronald Reagan's 1986 tax reform. The results were mostly disappointing. The strongest effect they found was in “the timing of economic transactions” - - for instance, the rush to take capital gains before a new, higher rate kicked in. After that, it was “financial and accounting responses,” such as the effort to transform corporate income into individual income in order to, again, avoid higher taxes. All this is good news for tax lawyers, but what about moving the growth needle?

“At the bottom of the hierarchy is the response of real activities chosen by individuals or firms.” On this, the authors concluded, the evidence is “mixed.” Oh.

Over the past week, I’ve asked a dozen economists whether tax reform is likely to supercharge -- or even kind of charge -- growth. The consensus is summed up well by former White House economic adviser Lawrence Summers: “Given there’s a need to raise revenue, doing it by closing loopholes is probably a better way to do it than doing it by raising rates,” Summers said. “It can promote fairness, simplicity and resistance to special interests. But the idea that this is some important offensive growth strategy is implausible.”

Bruce Bartlett, who helped write Reagan’s 1981 tax plan, is even more emphatic. “I am not familiar with any tax reform that raised growth, here or anywhere else,” he said.

Some kinds of tax reform could raise growth, at least in theory. Additional research by Auerbach, for instance, suggests that a sharply regressive consumption tax could add as much as 4.5 percent to gross domestic product over 15 years, in part because of the labor market effects of cutting taxes significantly on the rich and raising them on the poor. But no one is advocating that.

Instead, Washington policymakers are debating an approach -- broadening the tax base through closing tax expenditures, credits and deductions -- that isn’t likely to do much at all.

Tax economists Alex Brill and Alan Viard put the problem clearly in a brief for the American Enterprise Institute: “One of the major arguments some supporters of base broadening make - - that such reforms reduce work disincentives -- is generally mistaken. Work incentives depend on effective marginal tax rates rather than statutory tax rates, and revenue-neutral base broadening leaves the former roughly unchanged.”

Translated from tax policy-ese, the basic point is that if you’re not cutting total taxes -- the “effective marginal tax rate” -- you’re not going to drastically alter the incentives people have to work. As a result, you’re not going to see much added growth from tax reform, especially if the revenue contributed by various groups remains largely unchanged. All that should be pretty intuitive; if you’re not changing who pays taxes or how much they pay, you’re not changing all that much. Simplifying the tax code only gets you so far.

However, if Republicans and Democrats can agree on tax reform, it almost certainly will do more than simplify the code. It will increase taxes on the rich. And though there’s no reason to expect that will harm the economy in a major way, it will probably create a slight drag on growth. “I think of tax reform more as a way of limiting the losses the tax increases bring,” Auerbach says.

Another argument in favor of tax reform is that it will improve economic efficiency by letting the market, rather than the tax code, direct the flow of resources. Eliminate the exclusion for employer-provided health insurance and less money will flow to health care. Cap the mortgage-interest deduction and housing won’t be such an attractive investment.

“In their hearts, almost all economists believe that getting rid of tax expenditures will be good for growth because decisions will not be distorted by differences in taxes,” said Michael Greenstone, an economist at the Massachusetts Institute of Technology who also directs the Hamilton Project at the Brookings Institution. “Unfortunately, I don’t think there is much empirical evidence on this question either way.”

Which isn’t to say that tax reform isn’t worth the effort. Everyone agrees that it can help a bit, and most everyone agrees that raising taxes by reforming the code is probably better for the economy than raising taxes by increasing marginal rates (though many caution that, given our fiscal problems, generating revenue is the most important goal and promises of higher revenue through tax reform often don’t pan out). Tax reform doesn't slice, dice or cut through cans. If it’s a “game changer,” it is only in the sense that it gives Republicans a face-saving way to do what needs to be done: raise taxes.

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