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Can Income Tax Reform Spur Economic Growth?

September 15, 2014 09:00 AM

There’s a long-held understanding among economists that the United States tax system can have an important effect on economic growth. Such a connection has loomed rather large during the recent economic downturn. Debate still remains about how the income tax system affects the economy, how large those effects are, and what the potential is for reform to the system  to boost the national economy.

The Urban-Brookings Tax Policy Center in Washington, DC held a forum on Tuesday, September 9 that discussed a new paper by William Gale from the Tax Policy Center, and Andrew Samwick of the Nelson A. Rockefeller Center at Dartmouth College. Gale and Samwick first presented their research; a discussion with Chye-Ching Huang, Center on Budget and Policy Priorities, William McBride, Tax Foundation, and Howard Gleckman, Tax Policy Center, followed. Leonard Burman, Director of the Tax Policy Center, introduced the panel.

The central question considered by the panel concerned economic growth: would simple tax cuts be enough or would a combination of individual income tax reform that reduced rates and eliminated subsidies be a better approach? Gale and Samwick both indicated that the answer was “yes, but not by much.” In their newly released paper, Effects of Income Tax Changes on Economic Growth, both concluded that while some initiatives are more beneficial than others, in an overall sense, reforms would do little to move the economy in a positive direction. Cuts in individual income taxes or a much more broader-based reform are more likely to produce modest economic growth.

“What we found was that not all tax changes will have the same impact on growth,” said Samwick. “Reforms that improve incentives, reduce existing subsidies, avoid windfall gains, and avoid deficit financing may have some effect in the long-term, but can also create trade-offs between equity and efficiency.”

Gale suggested there were five ways to finance a tax cut in the current economy. “First, we can borrow more—but a deficit-funded cut has low-to-marginal effect on growth,” he said. “Second, it could be paid for with future tax increases. Third, cut unproductive spending—while the inverse would be the fourth way, by cutting productive spending. Finally, cuts could be financed by broadening the base through tax reform.”

The panel discussed at length that the real benefit to the economy through tax reform comes from scaling back inefficient tax preferences, rather than reducing tax rates. Such changes would make it more possible for people to allocate resources to maximize their economic benefit over savings. If such a shift occurs and is large enough, then the overall size of the economy would grow.

McBride commented that “incentives matter; in this case, to save and invest. But it is hard to find big effects from individual tax reform, while much easier from the corporate side.” Even if the growth rate doesn’t change, it has a better long-term effect because future economy would be operating off a larger tax base. Corporate taxes, however, are more harmful to growth in the current economy.

“Tax cuts don’t do much to boost the overall economy,” said Huang. “While they may increase incentives to work, save, and invest—what it does instead is increase people’s after-tax income, so they may work less and consume more, reducing savings.”

McBride agreed. “Saving is a form of delayed consumption,” he said. “The U.S. is ranked the highest in consumption among other developed countries, meaning that people are more inclined to spend now rather than save towards the future.”

Gleckman closed the forum by asking the panel why tax reform should be considered, if it doesn’t boost the economy? There are still matters of equality and fairness that can be addressed, responded Huang. “Dumping tax subsidies would also help reduce a budget deficit.”

However, using tax reform as a tool to launch a new era of economic growth is more of a disappointing thought exercise, rather than a solid plan for the future. “Not all tax changes will have the same impact on growth,” concluded Gale. “Changes in the level of revenues and the structure of the tax system can influence economic activity, but not all tax changes have equivalent or even positive effects on long-term growth.”


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