Tax Reform Principles Part 1: Promoting Economic Activity

The Joint Committee on Taxation (JCT) recently published a report providing an overview of the U.S. federal tax system and certain policies to consider for tax reform. If you're interested, you can read the entire report here. https://www.jct.gov/publications.html?func=startdown&id=5015

The report identified three questions to ask when evaluating a governmental tax system.

1. Does the tax system promote or hinder economic efficiency?
2. Is the tax system fair?
3. Is the tax system simple and easily administered?

In the evaluation of economic efficiency, one criteria considered is how the tax system changes, or potentially distorts, taxpayer behavior. You have probably heard people say that they don't want to work overtime or make more money because they lose too much in taxes. Given the current maximum federal tax rates of approximately 45%, this doesn't make economic sense. Even if you have to give up 45%, you still get to keep 55%. For example, if you earned an extra $1,000,000 and had to pay $450,000 in taxes you would still have $550,000 after taxes. Would be be better off making the extra $1,000,000 or not? However, the truth is the tax code does alter behavior, some good, and some not so positive. 

Another aspect is the extent to which the tax code promotes economic growth. This factor includes effective and marginal tax rates, but it also includes the vast number of incentives contained within the code. Advantageous depreciation provisions and solar energy credits are two examples. Certain depreciation rules allow taxpayers to deduct all, or a significant portion, of the cost of new equipment in the year of acquisition rather than recouping the cost over several years. Solar energy credits reduce the after-tax cost of the equipment and make the overall cost of solar energy more competitive to cheaper fossil fuels. Not only are these incentives designed to benefit the purchaser, but they are also intended to spur economic growth and manufacturing activity by helping to create demand for products. Tax rules also help achieve certain public policy goals, such as creating more green energy.

The final measure is the encouragement to produce domestic goods and services. As many barriers to global business enterprises have been removed in the past 50 years, there has been a lot more focus on how the U.S. is competing with foreign businesses. This was a major issue during the 2016 election cycle and was probably the key to President Trump's victory. Many people have felt the negative impacts of a global economy, especially in the manufacturing sector and are looking for Washington to encourage domestic manufacturing and production. There is a general consensus within Washington that U.S. tax policy is making it more difficult for manufacturers to complete with foreign companies. Since politicians across the political spectrum favor some type of corporate tax reform, it's reasonably likely corporate tax changes will be enacted in the near future.

The next articles will focus on fairness and tax administration.

Given these three criteria, do you think the U.S. tax system promotes or hinders economic activity?