Tax policy won't fix the economy on its own

Many tax policy experts spin a simple fairy tale when they talk about how to reform the tax system. They say that we just need to cut tax rates, which will expand the economy, which in turn will reduce the deficit. But unfortunately, in the real world, we face real budget constraints and a real scarcity of resources.

My latest Tax Notes column which came out today (subscription-only access here) is basically a recap of my testimony on March 1st before the Senate Budget Committee.  It’s a written version of the script I used for my oral remarks, plus a chance to report (or vent) about the line of questioning that came from one of the Republican senators that day.

About the basic premise of the hearing, which was called “”Tax Reform to Encourage Growth, Reduce the Deficit, and Promote Fairness,” I explain that:

I recently heard the three tax reform goals listed in the hearing’s title referred to as a “fiscal trilemma,” suggesting it might not be possible to achieve them all.²  Equating the three with a dilemma suggests that working toward them will be a negative experience. Indeed, many policymakers are caught speaking of at least one of the goals with partisan disdain: “encouraging growth” (a popular Republican goal) might be labeled by some Democrats as “pandering to the rich”; “reducing the deficit” by including at least some new revenue (a popular centrist goal) might be labeled by some on both sides as “killing jobs”; and “promoting fairness” (a popular Democratic goal) might be called “class warfare” by some Republicans.

Nonpartisan economists would respond that all three goals will benefit the economy. And the good news is that it really is possible to find tax policy changes that would help achieve all three goals — and possibly help achieve simplicity. That good news is doubled by the recognition that different policymakers actually like all the goals more than they’ll admit in public, but they assign different implicit weights to the different goals — suggesting that the only way to ensure bipartisan agreement is to make sure a proposal helps achieve all three goals.

I then explain the problem with the tax policy “fairy tale” that sounds so happy and easy:

[M]any so-called tax policy experts spin a simple fairy tale when they talk about how to reform the tax system. They say that we just need to cut tax rates, which will expand the economy, which in turn will reduce the deficit. But unfortunately, in the real world, we face real budget constraints and a real scarcity of resources. Real economists know that optimizing means not just maximizing benefits but weighing benefits against costs so that benefits net of costs are maximized. In the context of the real world and our experiences with the economic effects of different tax policies, cutting tax rates to achieve all of our goals is pure fantasy.

I made three main points in my testimony regarding the goals of encouraging growth, reducing the deficit, and promoting fairness:

And the only part of the Q and A where I have to admit I felt a bit “bullied” was this:

One of the more hostile exchanges at the hearing was when Sen. Ron Johnson, R-Wis., questioned what we thought the maximum marginal tax rate should be. Each time [Len] Burman [of Syracuse, the other witness invited by Chairman Conrad] and I tried to respond that it depends on the breadth of and distortions within the existing tax base, Johnson interrupted and insisted on our providing a specific number without any qualifications. It was obviously a setup, as [Dan] Mitchell [the Republican witness from the Cato Institute] described in a blog post. Although I reluctantly gave a specific answer of 70 to 80 percent, I wasn’t advocating a marginal tax rate that high but only responding that a total marginal tax rate — combining taxes at all levels of government — any higher than that would be a bad idea. I tried to point out that the maximum marginal tax rate could mean the rate on the richest person in the country’s last dollar earned. I believe 70 to 80 percent is around Laffer curve levels — the highest rate possible before revenue is lost. [In the Tax Notes column I cited this NBER paper by Christina and David Romer.]

That maximum marginal tax rate is totally different, however, from the survey results Mitchell cites that show people not wanting anyone to be taxed at more than 30 percent. Mitchell understandably likes the interpretation that ordinary Americans are referring to the maximum top marginal tax rate bracket. But I really doubt that most Americans understand the difference between marginal and average tax rates, or if they do, that they are inclined to automatically think top marginal rate (on the last dollar earned) when asked about the maximum tax rate that top earners should pay. When thinking about what’s fair, I think most people have in mind the common-sense statistic of taxes paid relative to income, or the average tax rate.

In fact, if the very richest people in America faced a marginal tax rate on their millionth-plus dollar earned of 70 to 80 percent, their average tax rate would still very likely be close to 30 percent. We might contemplate such high marginal rates at the top if we had failed to achieve the best solution of broadening the tax base and we were trying to make the tax system more progressive (while raising revenue for deficit reduction) by only raising — or creating new — top marginal tax rate brackets.

[But] Let’s be clear that I spent the whole hearing advocating for base broadening that would keep rates low. But I was asked what the maximum top marginal tax rate could be that the economy could handle, regardless of how successful or not we might be with base broadening efforts…

I encourage EconomistMom readers to view the hearing video and judge for yourself whether Senator Johnson was playing nicely or not.  Either way, I don’t think his or Dan Mitchell’s view that marginal tax rates on the rich are already high enough to be worrisome has much basis in reality.  (Nor did the story that came out the very day of the hearing (March 1) about Dan Mitchell’s organization, the Cato Institute, and how much it is influenced by the Koch brothers, help Mitchell’s credibility as an objective and fact-based economist.)

Even so, I still would prefer we raise revenue by not raising marginal tax rates further and instead broadening the tax base (reducing tax expenditures) in (very easily) progressive ways.  The “trilemma” of tax reform is entirely possible to achieve and is actually the best way to succeed, politically and economically, in doing goodtax reform.