Taxing in the 21st Century

Several Republican Presidential candidates (Trump, Bush, Rubio, Paul, Kasich, Jindal, Santorum, and Cruz to name a few) have outlined fairly specific tax plans aimed at accelerating U.S. economic growth. Most follow a similar pattern of eliminating deductions and lowering rates, which has worked quite well in the past (the Reagan Recovery being the standout example as seen in Chart 1). While the impulse to dust off the Reagan playbook is quite strong given the empirical data, conservatives really need to aggressively rethink how we tax and be careful not to knee-jerk back to past solutions. It is on this point where Sen. Ted Cruz’s tax plan stands out and should be applauded. While I have reservations about how the specifics of his tax plan, he has shown the greatest willingness to move away from the orthodoxy and rethink the nature of our tax code (more on his plan will follow)

Chart 1

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With each passing day, the Reagan era grows more distant (an admitted redundancy that is still important to remember), and reflexively returning to his playbook is fraught with political danger (more and more voters were not old enough to cast a ballot for him) and policy danger. Conservatives need to do a better job delineating solutions from principles. Principles are what we believe (and as such are relatively unchanging) whereas solutions are how we implement principles (and as such change as the problems change). It is a disservice to Reagan’s legacy to simply suggest cutting marginal rates is the best answer to a slow economy as this implies there is a magic formula that would solve any problem.

The genius of the Reagan Administration was its ability to take conservative principles and apply them to policies to craft specific solutions to the problems of the day. We need to keep these principles, but today’s problems may necessitate different solutions. In brief as conservatives, we believe in returning power to the individual and away from the collective. Ultimately, individuals make better decisions regarding their own lives than a bunch of bureaucrats can hope to. This means entrusting power in the people and keeping government interference to a minimum.

Armed with these beliefs, Reagan focused his tax relief on capital. In 1981, the US was suffering from high unemployment and high inflation (stagflation). Reagan took over an economy that was treating capital poorly. As can be seen in the following chart, labor was gaining share in the economy—at the expense of capital, leading to a retrenchment in investment. There was a supply of capital crisis. When capital is treated poorly (ie 70% marginal tax rates and windfall profit taxes), holders of capital are less likely to invest it. When you don’t see capital investment, an economy grows too tight, sending prices skyrocketing (Chart 3, NB inflation is inverted). As prices soared, consumer confidence fell, leading to less spending and subsequently an even worse environment for investing.

Chart 2

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Chart 3

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Recognizing the supply problem the economy faced, Reagan freed up capital by rolling back regulations and focusing tax cuts on top marginal rates (bringing them down from 70% to 50% and later 28%). Reagan’s capital-aimed economic policies worked remarkably well, bringing inflation down and consumer confidence back (Chart 3) while economic growth soared (Chart 1). Reagan took conservative principles (empowering the individual rather than the collective) and applied them to the problems of the day (unfavorable policies inhibiting capital and causing an inflation shock) to create policies that bettered the lives of Americans.

Fast-forwarding to the present day, we have conservatives offering a variety of tax plans aiming to spur growth. When looking at tax plans, we need to drill down to the basics and ask the question: why we tax? The answer is simple: to fund government expenditures. There are some things government must spend money on (ie defense), and we cannot sustainably borrow money to pay for everything. Depending on the speed one wants to bring down our debt load, tax revenue likely needs to be 17.5-20.5% of GDP on average over the medium term.

It then becomes a matter of constructing a tax code that has the best impact on the economy over the medium term. In a sense, offering a tax break to one group needs to be offset by taxing another group; for instance, opting against an estate tax (which many conservatives call for) would cost revenue that needs to be made up elsewhere. On the other hand, eliminating ineffective deductions (the deductibility of corporate interest expense perhaps?) helps to fund tax breaks elsewhere. Ultimately, we would build a tax system that generates the necessary revenue while having the best economic impact, and this tax code could be dramatically different from our current convoluted mess (spoiler alert: it would be).

Most importantly, the efficient tax code would change over time because our economy is ever-changing. While conservatives should continue to push for as low of a tax burden as possible with a simple code that leaves individuals with as much power as possible, how that translates into marginal rates, deductions, and so forth can change a bit. Reagan faced an economy that treated capital poorly, and so, he lessened capital’s tax burden. Today’s economy is far different. Under Obama (as you can see in Chart 2), labor has done absolutely terrible, losing share to capital. This decline helps to explain why aggregate economic statistics (like 5% unemployment) seem out of whack with how most in the middle class feel. As such, it is critical to build a tax code that incentivizes work to get people back into the work force and working. This requires creative thinking from expanding the earned income tax credit, to contemplating the implications of a negative marginal tax rate bracket, and closing loopholes that provide little economic bang for the buck.

On the whole, it is hard to look at most of the Republican tax plans and not believe they would be better than the status quo, though none is without flaws. Most plans (like Rubio, Bush, and Kasich) stick relatively close to traditional conservative orthodoxy, but Cruz’s stands out. Cruz basically throws out the current system, has a 10% income flat tax, and a 16% business flat tax. Per the Tax Foundation, the Cruz plan costs about $3.6 trillion over a decade, but based on their view that the economy will be 13% larger (a plausible but definitely not unfriendly view), they see it only costing $770 billion. The US, in aggregate, is certainly not under-taxed, so there is nothing wrong with a tax plan that offers a moderate tax cut like Cruz’s does. I would note (that based on my rudimentary number-crunching) most of the growth driven revenue gains would be realized at the back end of the decade with years 9 and 10 generating up to $1 trillion of the incremental $2.8 trillion in revenue. Essentially, the revenue hit is not $77 billion/year, rather, it is much larger upfront and shrinks, possibly even gaining revenue at the tail end.

At first glance, it looks like Cruz provides labor with a massive tax cut, given the low 10% rate that for a family of 4 kicks in after 36k. However, his business tax would tax both profits and payrolls. So an employee earning $100,000 would pay a 10% flat tax, but his employer would also pay a 16% tax ($16,000). Under current law, the Social Security payroll tax is only 6.2%, so Cruz is really using a tax increase on payrolls to fund cuts elsewhere. Frankly relative to current law, Cruz is providing a dis-incentive to employee people.

Alongside this, Cruz would allow for the immediate expensing of equipment. Put in simple terms, buying a robot would not be subject to a 16% tax but hiring a worker would be. We continue to see a push towards automation in the economy. While painful for the worker being automated out, this is a good thing. I think we would all agree that on net ATMs have been a positive, even though they were a negative for bank tellers. Businesses should automate when the underlying economics make sense, but we don’t want decisions being made for tax purposes. An economy functions most efficiently when capital is allocated based on underlying economics and not tax implications. When taxes start changing allocation decisions, a government is picking winners and losers, which more often than not ends badly (how’d that Solyndra loan work out?).

Now, the government should not actively impede automation as this would leave the US poorly positioned in world trade and slow growth. The tax code should be neutral on the matter, and let economic reality be the determinant. Amazingly, this is one of the few things our current code does somewhat well. Employers pay a payroll tax but can deduct payroll immediately while purchases of equipment are deducted over multiple years (ignoring temporary tax breaks). When calculating the present value of the tax implications of the decision (a worker or machine), they roughly cancel out (or come fairly close), meaning that business owner would choose the economically wisest.

Cruz’s plan tilts the playing field away from workers and towards capital, incentivizing automation. Now if the pre-tax economics of hiring a worker or automating are the same, a business would choose to automate because it receives more favorable tax treatment. Interestingly, there is a pretty good case to be made that this plan would have worked particularly well in 1980 when the cost of capital was too high. Similar to Reagan’s steep marginal rate cuts, the Cruz plan would incentivize investing and have increased aggregate supply to bring inflation under control.

While Cruz’s plan benefits from original thinking, it solves past problems and would likely exacerbate the trend in chart 2 where labor has lost ground under Obama. This is one reason why I think the Tax Foundation’s growth expectations could be a bit optimistic. The Foundation does say the capital stock rises 44%, which makes sense as lower taxation would create more capital. The fact it grows 3x the economy does show the diminishing return of excess capital in the current environment. In fact, the issues with our capital stock could be dealt with more simply and just as effectively in two strokes. First, stop taxing repatriated profits at 35%, which would bring back $2 trillion. Second, Dodd-Frank has disincentivized bank lending, and as such, banks are carrying $2.5 trillion in excess cash. Roll back some of these regulations, and banks would be free to increase lending to small business and others, which would push growth faster.

Cruz (and others) are fighting the last war, focusing tax cuts in places where they will provide less growth. Reagan’s ingenuity was not that he lowered taxes but that he recognized the problems he was facing and structured his tax cuts in a way to solve those problems. Labor and capital supply an economy, and he faced a capital crisis. By fixing that, he put us on a path for 25 years of prosperity. Today, capital is doing well, and our crisis is on the labor front. Labor force participation is lower than it should be, wage stagnation is real, and capital has done fairly well with the top doing very well under Obama (who has helped exacerbate the very inequality he rails against). Again, the solution to this problem is not to punish the top to subsidize everyone else as that slows growth over time. However while Reagan tried to stimulate capital, we need to stimulate labor. This means debating a larger EITC, considering negative marginal rates, incentivizing job training, and eliminating certain loopholes (like carried interest and interest deductibility) to fund lower marginal rates. It also means keeping capital gains taxes and rethinking total opposition to the estate tax (or at least the stepped-up basis).

Reagan’s principles and the tenets of supply-side economics are as relevant as ever, but conservatives need to engage in further debate about how those principles apply to today’s challenges. The best answer could be wholesale change to the tax code (like Cruz has boldly suggested) or sticking a bit closer to the status quo. Taxes at the end of the day are a means to an end, a way to fund government while creating the conditions for the most robust growth. This requires an analysis of what breaks provide the least value and what taxes slow growth the most in today’s economy (and then eliminating those breaks to fund the elimination of those taxes!). It also requires a deeper debate on what part of the supply curve needs the stimulus. Admittedly, stimulating labor, without doing so at the expense of capital, is a challenge but not an insurmountable one (pairing labor-focused cuts with fewer deductions, a quasi-territorial corporate system, modified Dodd-Frank, and reformed estate tax is our best bet in my estimation).

Conservatives need to do a better job explaining how our principles and faith in the American people rather than government translate into solutions for today and are not merely regurgitated answers to the problems of 35 years ago. That is a pre-requisite for winning elections, and more importantly, it is the only way to actually make the American public better off. Re-examining our tax orthodoxy is a good place to start. Hats off to Senator Cruz for doing just that. While I would question the specifics of his plan, he is starting a debate we very much need to have.

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Why We Tax–Moving Beyond Carried Interest

For the past few weeks (alright years), it feels like the debate on tax reform has centered around the “carried interest loophole” whereby private equity managers get their income taxed at a low rate. Based on the tax plans of Jeb Bush and Donald Trump, it appears the GOP is willing to remove the loophole as part of broader tax reform. Ultimately, removing the loophole is barely relevant, perhaps increasing revenue by $3-4 billion/year. Rarely has so much time been spent on an issue that matters so little. However, there are important policy lessons to be gleaned from the carried interest debate that actually have profound impacts on how and what we tax.

The Democrats have largely argued the point on “economic fairness” grounds, and republicans must be careful not to let the debate slip into this territoy because the fairness argument is misguided.

Let’s begin with the fundamental question: Why do nations tax? Nations tax to generate revenue that funds the government and associated social programs. Via these programs, the government (at the federal, state, and/or local level) provides national defense, education, welfare, economic and social security, etc. With the revenue, we can provide some comfort during retirement (ie Social Security and Medicare) or help those in hard times (ie unemployment insurance and food stamps), whatever that society deems fair and appropriate. The goal of taxation then is to provide the necessary amount of revenue while having the least impact on growth and the economy as in the end economic growth and not government provides the path for upward mobility and superior standards of living over time.

At the Federal level, we probably need to generate around 17.5-19.5% of GDP as tax revenue to provide services and run a roughly balanced budget. The challenge is finding the right mix of taxes that achieves this revenue run-rate while having the least negative spillover into the economy and capital allocation. By choosing not to tax X, we have to tax Y, so the economics savings of X better outweigh the costs of Y. It is at this level where the rationale for the carried interest loophole collapses. Was there really no better use for that $3 billion than exempting private equity managers from income tax rates? Almost certainly not. We are better off spending that $3 billion lowering taxes on the middle class who will spend their tax savings.

Economic fairness is a challenging, intangible concept, and typically, the side getting the benefit is the one who deems the action is fair, irrespective of reality. Fairness is a powerful political argument in the short-run that wreaks havoc in the long-run. Theoretically, what is fairer than a communist system where all join in the spoils equally? Yet in reality, such systems atrophy, breed corruption, cronyism, and collapse (see the Soviet Union). Economic fairness quickly erodes into an effort to help out connected industries and firms, unleveling the playing field. Focusing on making the tax system more efficient (ie maximizing revenue while minimizing economic distortions and mal-incentives) often yields the same results while promoting a balanced, growing economy that benefits all over time.

It is from this perch that republicans should argue tax and economic policy, and the potential for change is breathtaking with carried interest just a drop in bucket. Whenever a financial decision is made for tax rather than economic reasons, chances are that an inefficient tax policy is in place, and the shining example of this is the deduction of corporate interest expense, something the Bush and Trump plans actually start to address. Under current law, corporations cannot deduct dividend expense but can deduct interest expense, which makes debt artificially inexpensive.

Making something artificially cheap tends to lead to more of it, and debt is typically not something you want to incent the creation of. Leveraged systems have greater fixed charges and can be more vulnerable to shocks. A major reason why the tech bubble bursting only lead to modest recession while the Housing bubble nearly precipitated a global depression was the tech wreck was (primarily not exclusively) an equity issue whereas the housing crash was (again primarily not exclusively) a debt issue. Put simply, you cannot go bankrupt if you don’t owe anyone money. Equity losses are painful, but being unable to pay back debt can be devastating. Now, this is not to say the government should actively disincentivize debt, which can play a critical role in a capital structure and is a preferred asset class for many investors.

Rather, the government should neither incentivize debt nor equity over the other, instead letting the pure economics lead to the decision. Unfortunately, we have a system of financial arbitrage (a clear sign of an inefficient tax policy) whereby companies issue debt to repurchase stock because tax savings make interest expense less than the cost of the stock’s dividend. Similarly, private equity firms can sometimes can generate excellent returns, merely by issuing debt to take out equity and enjoy a sizable tax break. Now sometimes, these transactions make good economic sense, and as such, they would continue without the tax deduction. However, transactions that don’t make sense would not occur, and that capital would be free to be used in ways that are actually economically justified, which would be supportive of long term growth.

Removing interest deductibility on nonfinancial firms (financial firms like commercial banks need it to operate as they are in the maturity transformation business) would raise around $120 billion/year (about 40 carried interest loopholes!). To make up for this lost revenue, we have to maintain absurdly high marginal rates, and in the end, less indebted firms are subsidizing heavily indebted firms. It just so happens that these less indebted firms are often in technology, healthcare, and many start-ups, which are the primary engines of growth and innovation. The firms we need to invest for our economy to grow are the ones saddled paying for someone else’s subsidy.

By removing just this one deduction, we could bring headline corporate rates down to about 25-27% from 35%, making the US tax regime much more competitive immediately while giving our most innovative companies more after-tax profits (as they are no longer subsidizing heavily indebted firms) to invest in the future. Recognizing that some small business rely on bank loans to fund growth, we could continue to permit the deduction of interest expense on the first $25 million of debt without meaningfully impacting the amount of incremental revenue.

Now obviously any reform has to be phased in over about 5 years to allow companies who have built capital structures based on tax policies time to adjust and move to equity funding in a gradual fashion to avert a shock. In the end, moving on interest deductibility is the logical next step in the carried interest debate, and it actually will generate meaningful revenue with which to lower rates. Plus by no longer incentivizing debt over equity, we will build an economy more appropriately funded and insulated from potential shocks, which will be constructive for long term growth.

Carried interest and interest deductibility are just two examples of inefficient tax policies that lead to the misallocation of resources and unnecessarily drag on growth. Addressing these and other loopholes to bring down rates is the best path to counter the democrats’ politically motivated but doomed-to-fail “fairness” pitch as this conservative approach is the surest way to achieving economic growth and help the middle class regain the ground it has lost under the Obama Administration.

Trump’s Rise and Manufacturing’s Demise

Everyday we are seemingly subjected to the punditry wrongly declaring that Donald Trump’s candidacy has peaked. Surely, he couldn’t withstand his “Mexican rapist” remarks…well, his poll numbers went up. Then, he attacked John McCain, implying POWs couldn’t be war heroes. Surely, that would turn off the GOP electorate…well, his poll numbers went up. Finally on Friday, Mr. Trump made remarks about Megyn Kelly that were widely interpreted to imply she was hormonal during the debate. Surely, attacking a beloved Fox host would send voters packing. Well, based on the early polling data, his numbers remain robust with 3 surveys showing him maintaining his national lead while 1 survey shows him taking an outright lead in Iowa.

Trump’s resiliency in the polls begs the question as to why he has support in the first place and why his supporters are unyielding in their support despite the constant controversies in which he entangles himself. Trump’s rise can be ascribed to two primary factors: the rise of identity politics and collapse of American manufacturing.

Since 1984 as the electorate has grown increasingly polarized, political parties have focused their efforts on increasing the turnout of their base rather than persuading the shrinking number of independents. This trend has accelerated since the 2004 election when the Bush campaign made same-sex marriage an issue to drive up the evangelical vote. Similarly, during election years, the Democrats bring out their trifecta of the war on women, race card, and immigration reform to boost interest among the core elements of their base (single women, African-Americans, and Hispanics).

This is not to say that these groups do not have legitimate grievances; they do. However, our political parties use these issues to appeal specifically to certain group identities, even if they never fix the problems. Consider some of the cities where African-American poverty and crime are most endemic: Chicago, Baltimore, Camden, Oakland, and St. Louis. What do these cities have in common?

They are all run and controlled by the Democrats. Yet, the media never asks when African-Americans will abandon the Democratic party because the Republicans have done a horrible job of reaching out to the Black community (though some like Rand Paul and John Kasich are slowly making inroads). Given a history of tailored campaign pledges, the Democrats have built unparalleled credibility amongst African-Americans that will take years of work to chip away at even if Democratic policies continually fail those most in need. Years of identity politics and tailored pledged have given the party “the benefit of the doubt,” and that benefit has grown quite substantial.

We are seeing a similar phenomenon in the Trump campaign. One “identity” that the political parties have spent little time appealing to is working class white Americans. Fact is, the past 20 years have been hard for working class whites because the manufacturing sector has collapsed, shedding 5 million jobs. It is all but impossible to argue that any of Clinton, Bush, or Obama have helped the manufacturing sector in a meaningful way.

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The collapse in manufacturing has especially impacted working class white Americans. While there is a case to be made globalization made manufacturing losses inevitable, it isn’t surprising these voters (and their friends and family) have grown increasingly disenchanted with the political system. Since 1996, white support for the Democrat Presidential nominee has fallen from 49% of the two-party vote to 40% in 2012. At the same time, the GOP establishment has done little to win the trust of these voters. Bush’s economic policies did not particularly help them, and the party has struggled to explain how tax cuts for top earnings will help the working class. GOP candidates attend Koch fundraisers while opposing minimum wage cuts; simply put, it easy to caricature the GOP as the party of the rich. Working class whites are a demographic without any reason to be loyal to party orthodoxy.

Enter Donald Trump. His attacks on China and Mexico, while dubious at best from a factual perspective, tap into the anger of a working class that sees a political class pointing to the benefits of free trade and stronger headline employment numbers while it continues to lag behind in the so-called recovery. With his protectionist rhetoric and an ability to shun the donor class that is perceived to have conflicting interests, Trump has been able to tap into this anger and earn the trust if not the admiration of working class whites.

With manufacturing essentially being in secular decline for 20 years, it is no wonder this group of Americans feel completely disenfranchised and ignored by the political system, leading them to look elsewhere for a standard-bearer. The connection with Trump is an emotional one: “he’s looking out for us” rather than a policy-specific one. This connection is similar to the one African-Americans feel towards Democrats. It is tough to break, and it takes more than a few silly remarks (or even decades of failed policies…) to break, particularly when no one else is making a compelling case you should support them instead.

Now at some point, will Trump’s support dissipate? In all likelihood, yes. Given his limited record, eventually, voters will look for some policy substance and consider the decorum desired in a President. It is unclear that Trump can pass these tests. Nonetheless, his rise and staying power offers a critical lesson for all the other candidates. A large part of the American electorate feels disenfranchised by a political system that has left them behind, in large part because the manufacturing backbone of this country has materially weakened. A candidate able to break out of our standard identity politics by offering a clear, substantive, unifying, and uplifting message to these and all voters could add a powerful base of support and build a decisive majority in the 2016 election.