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What is the Cost of Tax Reform? (Tax Reform Part I)

The US House of Representatives passed in November the “Tax Cuts and Jobs Act” bill and the Senate followed with its own version shortly after Thanksgiving. Both bills intend to provide comprehensive tax reform and are premised on meeting three objectives:

  1. Reduce taxes on the middle class and on Americans and American businesses in general.

  2. Make the tax code simple enough so that most filers can file it on a postcard.

  3. Grow the economy through the underlying economics of job growth through supply side incentives.

These three objectives jointly lead me to address three burning questions, each of which is some combination of the three objectives stated above:

  • What is the true cost of tax reform?

  • Do the bills in their current form achieve the intended objective on face value?

  • What exactly does economics project will be the impacts of either bill ultimately becoming law?

In terms of the two bills that have passed, there are roughly 16 key differences between the House and the Senate versions, and about 6 key similarities between them. These differences will have to be resolved through the conference procedure and a final identical bill will have to be passed in both Houses before it gets to the President to sign into law.

As part of a fairly detailed three part response to these bills, in this blog I address the first question that seeks to provide clarity on the nature of Tax Reform in terms of its costs and how the specifics of any proposal should aim to mitigate them.

What does Tax Reform seek to achieve?

A common maxim in economics is that there is no such thing as a free lunch, and one of the central truths that the field of inquiry has gained notoriety for is in identifying the costs in what might have otherwise been perceived as a costless action, taken on face value.

So in keeping with tradition, I will proceed to throw light on the costs associated with Tax Reform by first pointing out what comprehensive tax reform seeks to achieve given some status quo situation, and therefore identifying in the process the necessary costs that arise from achieving it. I will then address them in the context of the current tax reform bills that have been passed.

As a capitalist economy, the expansion of government is often viewed as unnecessary and efforts to limit this is often at play in US politics. For whatever benevolent reason, whether to tame the excesses of markets, or to genuinely achieve some objective deemed to be in the interest of society or particular segments of society, the government is often seen to be overreaching and this is manifest through the continuing expansion of government activities and the resulting need to fund these activities. The public budget has therefore evolved as a necessary institution, specifying a tax code for a wide variety of taxes levied, and spending outlays that show the dispersion of these revenues along with additional borrowing among different government programs and activities. all of which have a nontrivial impact on society through their current structure.

Tax Reform becomes desirable when there are concerns that in the public budget something is wrong perhaps about the level of taxes, or the structure of taxation, or the process by which taxes are generated and collected, or combinations of some or all of these, when it appears that there are adverse impacts on individual Americans, as well as on the long run economic health of the country.

Ideally then tax reform would seek to reduce or eliminate any undue or burdensome taxes currently being borne by Americans at any income levels, remove inefficiencies in the structure of taxation at all levels of the process, and stimulate long run economic growth beyond what the status quo promises.

Cost of Tax Reform

So given these objectives it is straightforward to identify the costs that follow from any effective comprehensive Tax Reform:

First, basic math suggests that for any fixed level of government spending, reducing anyone's tax liability from the current levels, will necessarily increase, at least short term, what has been recurring deficits already present in our yearly budget situation. Deficits will increase and so will the accumulated Federal Debt which currently stands over $20 trillion. I call this the economic cost of tax reform as it represents the necessary naive tradeoff from reducing taxes while maintaining spending at its existing level.

Second, removing inefficiencies in the tax structure and process is perhaps quite an ambiguous objective but at a minimum it would include eliminating any current benefits that are not economically justified, along with streamlining the tax process so that compliance and administrative costs are also reduced. Interestingly this will have the effect of both reducing the deficit and positively impacting economic growth through reallocation of private and public spending toward productive endeavors. However for those who lose these benefits, their loss is a cost from tax reform. I call this the political cost of tax reform as eliminating benefits and redirecting spending necessarily alienates certain constituents.

Third, there would be costs associated with readjustments that will take place in the short term as individuals and businesses are now being properly incentivized in a way believed to foster the eventual long run economic growth envisioned by the tax reform. These readjustment costs I will call the social cost of tax reform because this is more of an economy-wide impact that could involve changes in social relations as individuals and businesses change their behavior in order to best take advantage of the new incentive structure.

The House and Senate Tax Reform Bills

Both the House and Senate bills passed reflect these costs. The obvious cost that is usually highlighted is the expected cumulative deficit over the next ten years, and the number in both bills is approximately $1.5 trillion.

These numbers though are the final numbers after having taken into account the possible positive revenue gains from eliminating assumedly being inefficient benefits that were previously provided but economically unjustified, and along with other extraneous measures notably in the Senate version such as making most of the tax reform on individual taxes temporary and including the repeal of the individual mandate for the Affordable Healthcare Act.

The fact that Tax Reform coming out of both bills does still yield a net deficit over the next ten years suggests that the overall tax burden on society is being reduced and that the costs associated with those that lose current benefits, as well as the costs of readjustment to the new situation are fully compensated for. This may be true in the aggregate but the distribution in society from the explicit changes brought about by the proposed bills show differently. Generally, corporations and the very wealthy benefit tremendously from facing lower tax liabilities, some of the low income class as well do benefit but the result for the lower middle class and for passthrough professional service businesses is arguably mixed.

There is however the presumption that in the long run everyone would benefit from the resulting incentivized structure due to economic growth that is projected to also deliver jobs and income growth across the board.

To clarify, the introduction of the incentivized structure is presumed to generate short term social costs that could be seen as businesses decide to invest more in capital accumulation than they would have done otherwise, and expand production, all of which would lead to higher production costs than otherwise. Businesses repatriating their profits and investments back to the US by facing a onetime tax on doing so also face a short term cost. Individuals choosing to spend their own time doing their taxes, as it is now much simplified trade off productive effort in doing something else. Tax preparation companies and tax lawyers now having to reallocate their time toward alternative productive uses incur adjustment costs. There are also potential government costs from perhaps reduction in the IRS staff and duties to eliminate job redundancy from having simplified the tax administrative process. All of these changes are expected however to cumulatively lead to long run faster output growth.

The Logic of Successful Tax Reform

Other than a unified government muscling its preferred ideology through as Tax Reform, the logic of my characterization of these different identified costs is to point out that the key to successful tax reform can be achieved by a package that minimizes the political cost subject to a permissible economics cost constraint taking advantage of the slack provided by the possibility of generating social costs.

In this case that would be found by defraying the costs from the loss of benefits through the other measures that expand considerably the deficit and by dispersing additional costs throughout society in the form of changes in society-wide incentives. The expectation being that the resulting economic growth from incurring the social costs should serve to bring down the economic costs (mounting deficits) in the long run, while doing minimal damage in the short run to various affected constituents.

So apparently the logic of successful tax reform seems to be met by both bills that have passed the House and Senate, it remains for them to resolve their differences which is really about how much their political costs are minimized.

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