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America can afford tax rate cuts to boost growth, wages, and employment.

November 2014

Key Points

* US fiscal health is currently robust enough to support a package of $300 billion in tax rate cuts, which could help get the nation's economy back on track.

* Lower marginal income tax rates for households and businesses would incentivize greater work and investment while reducing distortions in the tax system.

* The recent midterm elections signal a need for Congress and the president to cooperate on enhancing economic growth, and these tax cuts would be an effective step toward this goal.

Following the recent midterm elections, the stars are aligned for the United States to break out of its economic malaise. Republican control of both houses of Congress means that tax cut legislation can be passed and sent to the president by early 2015. The probable new chairman of the House Ways and Means Committee, Paul Ryan (R-WI), can work with the likely new Senate Finance Committee chair, Orrin Hatch (R-UT), to pass tax rate cuts that will boost growth, wages, and employment.

America's newly robust fiscal health in 2014 means that financing about $300 billion worth of new tax rate cuts for household and businesses is eminently feasible without threatening our fiscal health or price stability. In the current 2015 fiscal year, the Congressional Budget Office (CBO) estimates that the federal budget deficit will be about $469 billion, or about 2.6 percent of gross domestic product (GDP). That level, improved significantly from deficits of nearly 10 percent of GDP in 2009, approximates the average US debt-to-GDP ratio since 1974 (figure 1).

The broadest measure of fiscal health, the debt-to-GDP ratio, has stabilized at a fully sustainable 73 percent of GDP. The CBO predicts that moderate debt levels will hold steady relative to GDP over much of the next decade. That compares favorably to debt-to-GDP ratios of more than 90 percent in Europe and more than 140 percent in Japan (figure 2).

America's fiscal health, notwithstanding ongoing fears of "excessive" deficits and debt, is currently at its most robust level since before the financial crisis. By all metrics--primary deficit, net interest expense burden, and overall default--America's fiscal health is above average relative to the last 40 years and substantially better than the fiscal condition of Europe and Japan (figures 3-6). There is no US deficit or debt problem. Little wonder interest rates have stayed so low.

Congress, however, should not pass a wasteful and ineffective stimulus package like those it passed after the financial crisis, which spent hundreds of billions of dollars on maintaining bloated state and local government payrolls and dubious infrastructure projects. Rather, Congress should reduce the marginal income tax rates both for households and businesses by about $300 billion, or just 1.6 percent of GDP. Even without the highly probable boost to growth that lower tax rates would generate, allowing $300 billion of existing revenue to finance lower tax rates would boost the deficit-to-GDP ratio from about 2.6 percent in fiscal year 2015 to about 4.1 percent of GDP in fiscal year 2016. That level is close to the historical deficit-to-GDP ratio over the past 40 years (figure 1).

Tax rate cuts should be directed at both businesses and households, especially low-income households. Cutting the top marginal income tax rate for households and businesses to 25 percent would stimulate growth and revenue, with the revenue boost being enhanced by taxes collected on newly repatriated corporate profits.

Lower marginal income tax rates would incentivize greater work effort and investment while reducing distortions present in the tax system. The cost of the income tax rate cut could be held to $200 billion by removing some tax expenditures, like special tax breaks for various forms of real estate investment, sugar, and other arbitrary measures that distort investment incentives and forfeit tax revenue needed now to finance stimulative lower tax rates.

Income tax rate cuts alone do not do much to help below-median-income households because many of those do not pay income taxes. But everyone pays the payroll tax, and $100 billion of revenue could be productively invested in lowering payroll tax rates for households whose only federal tax liability is the payroll tax.

Total payroll tax revenue currently runs about $1 trillion, so $100 billion would finance approximately a 20 percent cut in the 6.2 percent rate paid by workers. Payroll tax relief and its stimulative effect on consumer spending by lower-income workers could be further enhanced by reducing payroll tax rates for households earning less than the median income, or about $51,900 per year.

Many still will object to "irresponsible" tax rate cuts that boost the budget deficit only moderately--to levels close to or below historical and global norms. Especially outspoken will be those opposed to lower tax rates. They will express fears of higher inflation in spite of the fact that, even after six years of increased post-financial crisis government spending, US and global inflation actually has fallen to levels implying a deflation threat (figures 7 and 8).

Doubts about the efficacy of expansionary fiscal policy abound. I have articulated my own doubts about the ability of expansionary fiscal (and monetary) policy measures to produce sustainably higher growth rates. Indeed, the poor experience with the 2009 stimulus package and packages announced thereafter support such skepticism. (1)

But the $300 billion of income and payroll tax rate cuts I am proposing is far different from the broader spending measures that dominated the postcrisis packages (though payroll tax rate cuts were included in some of the stimulus bills with some positive effects). Since tax rate cuts promise greater returns to extra work and investment effort, they induce more work effort and investment, which in turn boosts growth and employment. A cut in the corporate tax rate from its current 35 percent to 25 percent would also boost corporate tax revenue induced by repatriation of accumulated profits held abroad.

The modest income and payroll tax rate cuts I am proposing are, of course, adjustable. The size--about $300 billion per year, or about 1.67 percent of GDP--could be raised were more net stimulus desired, but the proposed scale seems about right: enough to boost growth without frightening deficit hawks. The mix is also adjustable. More resources could be directed to tax relief for lower-income households by raising the proposed $100 billion per year of payroll tax rate relief and/or directing it more to the workers with the lowest incomes. The initial figure of $100 billion per year seems a good starting point, enough to boost weekly take-home pay without exciting fears of gutting the benefits financed by payroll tax revenue.

The 2014 midterm elections signaled a widespread desire to move away from big-government solutions to economic problems and a strong need for Congress and the president to cooperate on producing measures that enhance growth. Tax rate cuts define less government control of income and spending and more control by households and firms.

Central banks, especially the Federal Reserve, are largely out of options to boost growth. Congress and the president can provide the extra boost needed to achieve their stated goals of increasing growth, employment, and wages, especially for lower-income workers. And the political cooperation that will be required to push through such stimulative fiscal measures would signal an important move by Washington away from gridlock and toward concerted fiscal steps to help boost growth and employment. Why not just do it?

Note

(1.) John H. Makin, "Print Money and Cut the Payroll Tax," AEI Economic Outlook (December 2008), www.aei.org/publication/print-monev-and-cut-the-pavroll-tax/.
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Title Annotation:RESEARCH
Author:Makin, John H.
Publication:AEI Paper & Studies
Geographic Code:1USA
Date:Nov 1, 2014
Words:1253
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