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Posts Tagged ‘Fiscal Policy’

Because of what he’s said on entitlements, infrastructure, child care, and other issues, I’ve been skeptical about Donald Trump.

But if recent headlines are true, I may develop a man crush.

Here’s a story from The Hill.

Donald Trump is ready to take an ax to government spending. Staffers for the Trump transition team have been meeting with career staff at the White House ahead of Friday’s presidential inauguration to outline their plans for shrinking the federal bureaucracy, The Hill has learned. The changes they propose are dramatic. The departments of Commerce and Energy would see major reductions in funding, with programs under their jurisdiction either being eliminated or transferred to other agencies. The departments of Transportation, Justice and State would see significant cuts and program eliminations. The Corporation for Public Broadcasting would be privatized, while the National Endowment for the Arts and National Endowment for the Humanities would be eliminated entirely. Overall, the blueprint being used by Trump’s team would reduce federal spending by $10.5 trillion over 10 years. …At the Department of Justice, the blueprint calls for eliminating the Office of Community Oriented Policing Services, Violence Against Women Grants and the Legal Services Corporation and for reducing funding for its Civil Rights and its Environment and Natural Resources divisions. At the Department of Energy, it would…eliminate the Office of Electricity, eliminate the Office of Energy Efficiency and Renewable Energy and scrap the Office of Fossil Energy, which focuses on technologies to reduce carbon dioxide emissions. Under the State Department’s jurisdiction, funding for the Overseas Private Investment Corporation, the Paris Climate Change Agreement and the United Nations’ Intergovernmental Panel on Climate Change are candidates for elimination.

This warms my heart. It might even send a thrill up my leg, to borrow a phrase from Chris Matthews.

But that’s not all.

The Washington Examiner also has a report that has me salivating.

Making good on a promise to slash government, President-elect Trump has asked his incoming team to pursue spending and staffing cuts. Insiders said that the spending reductions in some departments could go as high as 10 percent and staff cuts to 20 percent, numbers that would rock Washington if he follows through. At least two so-called “landing teams” in Cabinet agencies have relayed the call for cuts as part of their marching orders to shrink the flab in government. …The teams also are looking at staffing cuts over four years through attrition, a hiring freeze and reorganization. The plan is winning cheers in conservative, anti-tax and anti-spending corners in Washington that have long sought massive cuts in the bureaucracy. …Trump is likely to face a wall of opposition from Democrats and federal unions who consider much of the federal workforce on their side.

Sounds great, right?

But before getting too excited, keep in mind that these articles simply refer to options that Trump’s team is preparing. It’s still an open question whether Trump actually embraces these policies.

So my man crush is on hold until I see whether Trump actually decides to do what’s right for the nation.

But if he does, I have some very helpful three-part advice for successful fiscal policy.

  1. The budget is a garden.
  2. Counterproductive agencies, programs, and departments are like weeds in the garden.
  3. Don’t trim weeds, pull them out by the roots.

In other words, don’t cut programs by 10 percent, 20 percent, or even 50 percent. If you do that, it’s like cutting off a weed at ground level. If the root system is still there, it’s just a matter of time before it regrows and begins to suffocate the good plants (i.e., the private sector).

Instead, shut them down. Eliminate them. Raze the buildings. And pour a foot of salt on the ground so nothing can regrow.

Simply stated, it’s very easy to restore a budget cut at some point in the future. But if a part of government is totally wiped out, then special interests have to go through all the effort of recreating that function. And that’s not overly easy given the separation-of-powers system that the Founding Fathers wisely created.

Another advantage of killing off programs and agencies is that voters will see that they were never needed in the first place.

Get rid of the National Endowment for the Arts and people will quickly see that the hysterical claims of its supporters were nonsense.

Shut down the Department of Commerce and, other than cronyists, folks won’t even notice that it’s gone.

Cut off all funding for the Organization for Economic Cooperation and Development and the only losers will be the bureaucrats who no longer get to enjoy business-class junkets to Paris.

I’ve already identified several cabinet departments that should be terminated.

  • Get rid of the Department of Housing and Urban Development.
  • Shut down the Department of Agriculture.
  • Eliminate the Department of Transportation.
  • Abolish the Department of Education.
  • Pull the plug on the Department of Energy.
  • Phase out the Department of Veterans Affairs.
  • Dump the Small Business Administration.

John Stossel also has a bunch of suggestions for Trump’s first week.

…there’s a lot of good Trump and Pence could do their first day, or, let’s be generous, their first week. …Monday: Abolish the Department of Commerce. …Commerce just happens; it doesn’t need a department. Today the Department of Commerce spends $9 billion a year subsidizing companies with political connections, gathering economic data, setting industry standards and doing a bunch of things companies ought to do for themselves. Get rid of it. Tuesday: Abolish the Department of Labor. The Department inserts itself into almost every protracted argument between workers and management. Why should we let government referee every argument? Let workers, bosses, unions and their lawyers fight it out. …The Labor Department also spends about $9 billion gathering information on workers. Top labor-union bosses make six-figure salaries. I’m sure their organizations could spend a little on statistics and workplace studies. Leave the poor, oppressed taxpayer out of it.

For the rest of the week, he suggests wiping out the Small Business Administration, the Department of Education, and the Department of Energy, so you can see we’re on the same wavelength.

The bottom line is that President Trump (I didn’t think I’d ever write those words) is in a position to…um, well…make America great again.

But that means pursuing a fiscal policy consistent with America’s founding principles.

I’m not expecting miracles, but it would be nice to see some semi-serious spending restraint when the dust settles. And any good results will be much more durable if they’re based on program terminations instead of haircuts.

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Mancur Olson (1932-1998) was a great economist who came up with a very useful analogy to help explain the behavior of many governments. He pointed out that a “roving bandit” has an incentive to maximize short-run plunder by stealing everything from victims (i.e. a 100 percent tax rate), whereas a “stationary bandit” has an incentive to maximize long-run plunder by stealing just a portion of what victims produce every year (i.e., the revenue-maximizing tax rate).

Tyler Cowen of George Mason University elaborates on this theory in this very helpful video.

As you can see, Olson’s theory mostly is used to analyze and explain the behavior of autocratic governments. Now let’s apply these lessons to political behavior in modern democracies.

I wrote last year about a field of economic theory called “public choice” to help explain how and why the democratic process often generates bad results. Simply stated, politicians and special interests have powerful incentives to use government coercion to enrich themselves while ordinary taxpayers and consumers have a much smaller incentive to fight against that kind of plunder.

But what’s the best way to think about these politicians and interest groups? Are they roving bandits or stationary bandits?

The answer is both. To the extent that they think their power is temporary, they’ll behave like roving bandits, extracting as much money from taxpayers and consumers as possible.

Though if you think of democracies as duopolies, with two parties and rotating control of government, then each party will also behave like a stationary bandit, understanding that it’s not a good idea to strangle the goose that lays the golden eggs.

And this is one of the reasons why I’m a big fan of “tax competition.” Simply stated, politicians and special interests constrain their greed when they know that potential victims have the ability to escape.

Here’s a report from the Wall Street Journal that is a perfect example of my argument.

Germany could reduce its corporate tax rate in the wake of similar moves in the U.K. and the U.S., German Finance Minister Wolfgang Schäuble said. Europe’s largest economy should simplify its complex tax system for companies in order to…remain competitive internationally, Mr. Schäuble told The Wall Street Journal in an interview. He also said that while Germany opposed beggar-thy-neighbor tax competition between mature industrial nations, Berlin would also consider cutting tax rates if necessary.

And such steps may be necessary. In other words, Germany may reduce tax rates, not because politicians want to do the right thing, but rather because they fear they’ll lose jobs and investment (i.e., sources of tax revenue) to other jurisdictions.

U.S. President-elect Donald Trump has said he would like to cut the corporate tax rate from 35% to 15% as part of a broader tax overhaul. In November, U.K. Prime Minister Theresa May said the main corporate rate there should fall from 20% to 17% by 2020. These followed announcements about corporate tax-rate cuts by Japan, Canada, Italy and France.

Let’s look at another example.

I made the economic case for Brexit in large part because the European Union is controlled by anti-tax competition bureaucrats and politicians in Brussels.

Well, it appears that the British vote for independence is already paying dividends as seen by comments from the U.K.’s Chancellor of the Exchequer.

Philip Hammond warned yesterday that the Government will come out fighting with tax cuts if the EU tries to wound Britain by refusing a trade deal. …Yesterday, Mr Hammond was asked by a German newspaper if the UK could become a tax haven by further lowering corporation tax in order to attract businesses if Brussels denies a deal. In his strongest language yet on Brexit, the Chancellor said he was optimistic a reciprocal deal on market access could be struck… But he added: …‘In this case, we could be forced to change our economic model and we will have to change our model to regain competitiveness. And you can be sure we will do whatever we have to do. …We will change our model, and we will come back, and we will be competitively engaged.’ …Earlier this year Mrs May committed Britain to having the lowest corporation tax of the world’s 20 biggest economies. The intention is a rate of 17 per cent by 2020.

In other words, yet another case of politicians doing the right thing because of tax competition.

The stationary bandits described by Olson are being forced to adopt better tax policy.

So it’s very appropriate to close with some wise counsel from a Wall Street Journal editorial.

The EU needs more tax competition from government vying to stimulate business investment. …The real tax-policy scandal is that so few European governments understand there’s a cause-and-effect relationship between oppressive tax rates and low economic growth.

P.S. Since we’re looking at tax competition, Europe, and bandits, keep in mind there’s considerable academic work showing that Europe became a rich continent precisely because there were many small nations that competed with each other. Those jurisdictions felt pressure to adopt good policy because the various leaders wanted lots of economic activity to tax. All of which helps to explain why modern statists are so hostile to decentralization and federalism.

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Last year, I shared some remarkable research from the Organization for Economic Cooperation and Development about the negative relationship between government spending and economic performance.

The economists at the Paris-based bureaucracy looked at data from its member nations (primarily Europe, North America, and the Pacific Rim), discovered that the countries with bigger government experienced less growth, and concluded that there would be much more prosperity if those nations merely reduced government modestly.

So you can imagine what sort of numbers that study would have generated if a few jurisdictions with genuinely modest-sized government, such as Hong Kong and Singapore, were part of the data.

But that’s a separate issue. Today’s topic is about a study from another international bureaucracy. The European Central Bank has new research looking at the impact specifically of excessive pay for government bureaucrats. Here are the key findings from the nontechnical summary at the beginning of the paper.

…there are benefits from government wage bill reform that go beyond the objective of fiscal consolidation. …a rationalisation of government wages and employment policies can generate favourable labour market effects in the medium to longer term through competitiveness and efficiency gains. Competitiveness gains materialise through the spillovers effects of public wage moderation on the determination of private sector wages. …An important aspect of the debate on public wage bill restraint concerns how long such policies can be sustained over time. …Additional margins of short-term adjustment include the moderation of still high public-to-private wages gaps, or a possible continuation of the downsizing trend in public employment, depending on the country-specific situation. …Finally, the paper argues that reforms affecting public sector personnel are most effective and have more sustained effects when the measures implemented are of a structural nature… Some examples are…measures to streamline the size and scope of government.

Wow, an international bureaucracy writing about the economic benefits that accrue if policy makers “streamline the size and scope of government.” Be still, my beating heart!

If you’re a policy wonk, you’ll like the fact that the study is filled with lots of interesting data and charts.

…aggregate data show that the euro area government wage differential with respect to the private sector increased from 20% in 2007 to 25% in 2009, and subsequently fell to 23% in 2014.

Here’s the relevant chart. The blue line, which links to the left axis, shows the degree to which bureaucrats are overpaid compared to the private sector. For the past 10 years, the “pay premium” has been in the 20 percent-25 percent range.

This problem of excessive pay for the bureaucracy has been a growing problem.

…general government compensation of employees grew faster than nominal GDP over the whole 2007-2014 crisis period

Though once the “austerity” era began about 2010, there was a bit of reform to bureaucrat compensation (in Europe, “fiscal consolidation” mostly meant higher taxes, but some spending restraint), particularly in nations that were forced to make changes because investors were becoming increasingly reluctant to lend them more money..

Here’s a chart showing bureaucrat pay as a share of GDP, with the blue bar showing the amount of economic output consumed by government workers in 2010 and the yellow dots showing the level in 2014. Some countries increased the relative burden of bureaucrat compensation and others reduced it, but what strikes me as noteworthy is that Germany and the Czech Republic deserve praise for keeping the burden low (honorable mention for Luxembourg and Slovakia) while Denmark stands out for being absurdly extravagant.

For a longer-term perspective, at least with regards to the size of the bureaucracy, here’s a table showing the share of the population getting a paycheck from government. Fascinating data. I especially like the columns on the right, which show that Ireland, the Netherlands, and the United Kingdom deserve credit for reducing over time the amount of bureaucrats relative to the private sector. The nations that have moved farthest in the wrong direction, by contrast, are Greece (gee, what a surprise), Spain, Portugal, and Finland.

Now let’s get to the meat of the study, which looks at the economic impact of less bureaucracy.

The authors cite some of the existing academic research, much of which focuses on the degree to which excessive pay for the public sector causes economy-wide distortions that make nations less competitive and result in slower growth. Basically, excessive pay for bureaucrats forces private employers to increase pay as well, but in ways that aren’t sustainable based on underlying levels of productivity.

A seminal work Alesina et al. (2002) found that reducing public wage expenditure generates reductions in private wages per employee, which improves competitiveness, increasing profits, investment, and economic growth. …A key argument is that public wage restraint may set in motion a labour market adjustment through the inter-linkages with private wages. …The literature has found robust evidence of significant interrelations between public and private sector wages per employee. A wealth of recent empirical papers provides evidence of a direct causal relationship between these variables. …The empirical literature tends to find that public employment crowds-out private sector employment.

But when fiscal pressures force politicians to cut back on the excessive pay for government employees, this enables the private sector to have pay levels that are consistent with sustainable long-run growth.

The authors share some of their new findings.

…the recent consolidation period has contributed to some competitiveness gains in the euro area, in view of the evidence provided on the partial correction of the public-private wage premium. …Overall, the restraint in public wages directly reduced unit labour cost (ULC) growth in the euro area during the 2010-2014 period. …The existence of distortions in public-private wage gaps…can be particularly harmful for competitiveness given that public sector activities are concentrated in non-tradable sectors, which are less exposed to international competition. …There is evidence that the recent public wage restraint has driven the partial correction of the existing positive public-private wage premium in the euro area.

The authors close by discussing some policy implications.

Well-designed government wages and employment policies and reforms may generate overall economy competitiveness gains and increase the efficiency of the labour market. …public employment adjustments can affect GDP and total economy employment positively if there are large inefficiencies in the government sector… In addition, if a public pay gap exists, the latter positive effect of public wage restraint becomes amplified as labour market inefficiencies are also reduced.

This is helpful research. It’s not often that a government bureaucracy releases a study showing that overpaid bureaucrats hinder overall economic performance.

Though I hasten to add that the study only looked at the macroeconomic effect of excessive pay. As I argue near the end of this video I narrated for the Center for Freedom and Prosperity, the additional problem is that various bureaucracies are engaging in activities that are economically harmful. In the case of the United States, the Department of Agriculture, Department of Education, and Department of Housing and Urban Development would be just a few examples of agencies where programmatic spending surely is more damaging that bureaucrat compensation.

The good news is that the ECB study also recognizes the need for structural reform. That’s why there was a reference to the need to “streamline the size and scope of government.”

The bad news is that politicians don’t care about this consensus.

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I wrote yesterday to praise the Better Way tax plan put forth by House Republicans, but I added a very important caveat: The “destination-based” nature of the revised corporate income tax could be a poison pill for reform.

I listed five concerns about a so-called destination-based cash flow tax (DBCFT), most notably my concerns that it would undermine tax competition (folks on the left think it creates a “race to the bottom” when governments have to compete with each other) and also that it could (because of international trade treaties) be an inadvertent stepping stone for a government-expanding value-added tax.

Brian Garst of the Center for Freedom and Prosperity has just authored a new study on the DBCFT. Here’s his summary description of the tax.

The DBCFT would be a new type of corporate income tax that disallows any deductions for imports while also exempting export-related revenue from taxation. This mercantilist system is based on the same “destination” principle as European value-added taxes, which means that it is explicitly designed to preclude tax competition.

Since CF&P was created to protect and promote tax competition, you won’t be surprised to learn that the DBCFT’s anti-tax competition structure is a primary objection to this new tax.

First, the DBCFT is likely to grow government in the long-run due to its weakening of international tax competition and the loss of its disciplinary impact on political behavior. … Tax competition works because assets are mobile. This provides pressure on politicians to keep rates from climbing too high. When the tax base shifts heavily toward immobile economic activity, such competition is dramatically weakened. This is cited as a benefit of the tax by those seeking higher and more progressive rates. …Alan Auerbach, touts that the DBCFT “alleviates the pressure to reduce the corporate tax rate,” and that it would “alter fundamentally the terms of international tax competition.” This raises the obvious question—would those businesses and economists that favor the DBCFT at a 20% rate be so supportive at a higher rate?

Brian also shares my concern that the plan may morph into a VAT if the WTO ultimately decides that is violates trade rules.

Second, the DBCFT almost certainly violates World Trade Organization commitments. …Unfortunately, it is quite possible that lawmakers will try to “fix” the tax by making it into an actual value-added tax rather than something that is merely based on the same anti-tax competition principles as European-style VATs. …the close similarity of the VAT and the DBCFT is worrisome… Before VATs were widely adopted, European nations featured similar levels of government spending as the United States… Feeding at least in part off the easy revenue generate by their VATs, European nations grew much more drastically over the last half century than the United States and now feature higher burdens of government spending. The lack of a VAT-like revenue engine in the U.S. constrained efforts to put the United States on a similar trajectory as European nations.

And if you’re wondering why a VAT would be a bad idea, here’s a chart from Brian’s paper showing how the burden of government spending in Europe increased once that tax was imposed.

In the new report, Brian elaborates on the downsides of a VAT.

If the DBCFT turns into a subtraction-method VAT, its costs would be further hidden from taxpayers. Workers would not easily understand that their employers were paying a big VAT withholding tax (in addition to withholding for income tax). This makes it easier for politicians to raise rates in the future. …Keep in mind that European nations have corporate income tax systems in addition to their onerous VAT regimes.

And he points out that those who support the DBCFT for protectionist reasons will be disappointed at the final outcome.

…if other nations were to follow suit and adopt a destination-based system as proponents suggest, it will mean more taxes on U.S. exports. Due to the resulting decline in competitive downward pressure on tax rates, the long-run result would be higher tax burdens across the board and a worse global economic environment.

Brian concludes with some advice for Republicans.

Lawmakers should always consider what is likely to happen once the other side eventually returns to power, especially when they embark upon politically risky endeavors… In this case, left-leaning politicians would see the DBCFT not as something to be undone, but as a jumping off point for new and higher taxes. A highly probable outcome is that the United States’ corporate tax environment becomes more like that of Europe, consisting of both consumption and income taxes. The long-run consequences will thus be the opposite of what today’s lawmakers hope to achieve. Instead of a less destructive tax code, the eventual result could be bigger government, higher taxes, and slower economic growth.

Amen.

My concern with the DBCFT is partly based on theoretical objections, but what really motivates me is that I don’t want to accidentally or inadvertently help statists expand the size and scope of government. And that will happen if we undermine tax competition and/or set in motion events that could lead to a value-added tax.

Let’s close with three hopefully helpful observations.

Helpful Reminder #1: Congressional supporters want a destination-based system as a “pay for” to help finance pro-growth tax reforms, but they should keep in mind that leftists want a destination-based system for bad reasons.

Based on dozens of conversations, I think it’s fair to say that the supporters of the Better Way plan don’t have strong feelings for destination-based taxation as an economic principle. Instead, they simply chose that approach because it is projected to generate $1.2 trillion of revenue and they want to use that money to “pay for” the good tax cuts in the overall plan.

That’s a legitimate choice. But they also should keep in mind why other people prefer that approach. Folks on the left want a destination-based tax system because they don’t like tax competition. They understand that tax competition restrains the ability of governments to over-tax and over-spend. Governments in Europe chose destination-based value-added taxes to prevent consumers from being able to buy goods and services where VAT rates are lower. In other words, to neuter tax competition. Some state governments with high sales taxes in the United States are pushing a destination-based system for sales taxes because they want to hinder consumers from buying goods and services from states with low (or no) sales taxes. Again, their goal is to cripple tax competition.

Something else to keep in mind is that leftist supporters of the DBCFT also presumably see the plan as being a big step toward achieving a value-added tax, which they support as the most effective way of enabling bigger government in the United States.

Helpful Reminder #2: Choosing the right tax base (i.e., taxing income only one time, otherwise known as a consumption-base system) does not require choosing a destination-based approach.

The proponents of the Better Way plan want a “consumption-base” tax. This is a worthy goal. After all, that principle means a system where economic activity is taxed only one time. But that choice is completely independent of the decision whether the tax system should be “origin-based” or “destination-based.”

The gold standard of tax reform has always been the Hall-Rabushka flat tax, which is a consumption-base tax because there is no double taxation of income that is saved and invested. It also is an “origin-based” tax because economic activity is taxed (only one time!) where income is earned rather than where income is consumed.

The bottom line is that you can have the right tax base with either an origin-based system or a destination-based system.

Helpful Reminder #3: The good reforms of the Better Way plan can be achieved without the downside risks of a destination-based tax system.

The Tax Foundation, even in rare instances when I disagree with its conclusions, always does very good work. And they are the go-to place for estimates of how policy changes will affect tax receipts and the economy. Here is a chart with their estimates of the revenue impact of various changes to business taxation in the Better Way plan. As you can see, the switch to a destination-based system (“border adjustment”) pulls in about $1.2 trillion over 10 years. And you can also see all the good reforms (expensing, rate reduction, etc) that are being financed with the various “pay fors” in the plan.

I am constantly asked how the numbers can work if “border adjustment” is removed from the plan. That’s a very fair question.

But there are lots of potential answers, including:

  • Make a virtue out of necessity by reducing government revenue by $1.2 trillion.
  • Reduce the growth of government spending to generate offsetting savings.
  • Find other “pay fors” in the tax code (my first choice would be the healthcare exclusion).
  • Reduce the size of the tax cuts in the Better Way plan by $1.2 trillion.

I’m not pretending that any of these options are politically easy. If they were, the drafters of the Better Way plan probably would have picked them already. But I am suggesting that any of those options would be better than adopting a destination-based system for business taxation.

Ultimately, the debate over the DBCFT is about how different people assess political risks. House Republicans advocating the plan want good things, and they obviously think the downside risks in the future are outweighed by the ability to finance a larger level of good tax reforms today. Skeptics appreciate that those proponents want good policy, but we worry about the long-run consequences of changes that may (especially when the left sooner or late regains control) enable bigger government.

P.S. This is not the first time that advocates of good policy have bickered with each other. During the 2016 nomination battle, Rand Paul and Ted Cruz plans proposed tax reform plans that fixed many of the bad problems in the tax code. But they financed some of those changes by including value-added taxes in their plans. In the short run, either plan would have been much better than the current system. But I was critical because I worried the inclusion of VATs would eventually give statists a tool to further increase the burden of government.

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The Republicans in the House of Representatives, led by Ways & Means Chairman Kevin Brady and Speaker Paul Ryan, have proposed a “Better Way” tax plan that has many very desirable features.

And there are many other provisions that would reduce penalties on work, saving, investment, and entrepreneurship. No, it’s not quite a flat tax, which is the gold standard of tax reform, but it is a very pro-growth initiative worthy of praise.

That being said, there is a feature of the plan that merits closer inspection. The plan would radically change the structure of business taxation by imposing a 20 percent tax on all imports and providing a special exemption for all export-related income. This approach, known as “border adjustability,” is part of the plan to create a “destination-based cash flow tax” (DBCFT).

When I spoke about the Better Way plan at the Heritage Foundation last month, I highlighted the good features of the plan in the first few minutes of my brief remarks, but raised my concerns about the DBCFT in my final few minutes.

Allow me to elaborate on those comments with five specific worries about the proposal.

Concern #1: Is the DBCFT protectionist?

It certainly sounds protectionist. Here’s how the Financial Times described the plan.

The border tax adjustment would work by denying US companies their current ability to deduct import costs from their taxable income, meaning companies selling imported products would effectively be taxed on the full value of the sale rather than just the profit. Export revenues, meanwhile, would be excluded from company tax bases, giving net exporters the equivalent of a subsidy that would make them big beneficiaries of the change.

Charles Lane of the Washington Post explains how it works.

…the DBCFT would impose a flat 20 percent tax only on earnings from sales of output consumed within the United States… It gets complicated, but the upshot is that the cost of imported supplies would no longer be deductible from taxable income, while all revenue from exports would be. This would be a huge incentive to import less and export more, significant change indeed for an economy deeply dependent on global supply chains.

That certainly sounds protectionist as well. A tax on imports and a special exemption for exports.

But proponents say there’s no protectionism because the tax is neutral if the benchmark is where products are consumed rather than where income is earned. Moreover, they claim exchange rates will adjust to offset the impact of the tax changes. Here’s how Lane explains the issue.

…the greenback would have to rise 25 percent to offset what would be a new 20 percent tax on imported inputs — propelling the U.S. currency to its highest level on record. The international consequences of that are unforeseeable, but unlikely to be totally benign for everyone. Bear in mind that many other countries — China comes to mind — can and will manipulate exchange rates to protect their own short-term interests.

For what it’s worth, I accept the argument that the dollar will rise in value, thus blunting the protectionist impact of border adjustability. It would remain to be seen, though, how quickly or how completely the value of the dollar would change.

Concern #2: Is the DBCFT compliant with WTO obligations?

The United States is part of the World Trade Organization (WTO) and we have ratified various agreements designed to liberalize world trade. This is great for the global economy, but it might not be good news for the Better Way plan because WTO rules only allow border adjustability for indirect taxes like a credit-invoice value-added tax. The DBCFT, by contrast, is a version of a corporate income tax, which is a direct tax.

The column by Charles Lane explains one of the specific problems.

Trading partners could also challenge the GOP plan as a discriminatory subsidy at the World Trade Organization. That’s because it includes a deduction for wages paid by U.S.-located firms, importers and exporters alike — a break that would obviously not be available to competitors abroad.

Advocates argue that the DBCFT is a consumption-base tax, like a VAT. And since credit-invoice VATs are border adjustable, they assert their plan also should get the same treatment. But the WTO rules say that only “indirect” taxes are eligible for border adjustability. The New York Times reports that the WTO therefore would almost surely reject the plan.

Michael Graetz, a tax expert at the Columbia Law School, said he doubted that argument would prevail in Geneva. “W.T.O. lawyers do not take the view that things that look the same economically are acceptable,” Mr. Graetz said.

A story in the Wall Street Journal considers the potential for an adverse ruling from the World Trade Organization.

Even though it’s economically similar to, and probably better than, the value-added taxes (VATs) many other countries use, it may be illegal under World Trade Organization rules. An international clash over taxes is something the world can ill afford when protectionist sentiment is already running high. …The controversy is over whether border adjustability discriminates against trade partners. …the WTO operates not according to economics but trade treaties, which generally treat tax exemptions on exports as illegal unless they are consumption taxes, such as the VAT. …the U.S. has lost similar disputes before. In 1971 it introduced a tax break for exporters that, despite several revamps, the WTO ruled illegal in 2002.

And a Washington Post editorial is similarly concerned.

Republicans are going to have to figure out how to make such a huge de facto shift in the U.S. tax treatment of imports compliant with international trade law. In its current iteration, the proposal would allow corporations to deduct the costs of wages paid within this country — a nice reward for hiring Americans and paying them well, which for complex reasons could be construed as a discriminatory subsidy under existing World Trade Organization doctrine.

Concern #3: Is the DBCFT a stepping stone to a VAT?

If the plan is adopted, it will be challenged. And if it is challenged, it presumably will be rejected by the WTO. At that point, we would be in uncharted territory.

Would that force the folks in Washington to entirely rewrite the tax system? Would they be more surgical and just repeal border adjustability? Would they ignore the WTO, which would give other nations the right to impose tariffs on American exports?

One worrisome option is that they might simply turn the DBCFT into a subtraction-method value-added tax (VAT) by tweaking the law so that employers no longer could deduct  expenses for labor compensation. This change would be seen as more likely to get approval from the WTO since credit-invoice VATs are border adjustable.

This possibility is already being discussed. The Wall Street Journal story about the WTO issue points out that there is a relatively simple way of making the DBCFT fit within America’s trade obligations, and that’s to turn it into a value-added tax.

One way to avoid such a confrontation would be to revise the cash flow tax to make it a de facto VAT.

The Economist shares this assessment.

…unless America switches to a full-fledged VAT, border adjustability may also be judged to breach World Trade Organisation rules.

Steve Forbes is blunt about this possibility.

One tax initiative that should be strangled before it sees the light of day is to give a tax rebate to exporters and to impose taxes on imports. …It’s a bad idea. Why do we want to make American consumers pay more for products while subsidizing foreign buyers? It also could put us on the slippery slope to our own VAT.

And that’s not a slope we want to be on. Unless the income tax is fully repealed (sadly not an option), a VAT would be a recipe for turning America into a European-style welfare state.

Concern #4: Does the DBCFT undermine tax competition and give politicians more ability to increase tax burdens?

Alan Auerbach, an academic from California who previously was an adviser for John Kerry and also worked at the Joint Committee on Taxation when Democrats controlled Capitol Hill, is the main advocate of a DBCFT (the New York Times wrote that he is the “principal intellectual champion” of the idea).

He wrote a paper several years ago for the Center for American Progress, a hard-left group closely associated with Hillary Clinton. Auerbach explicitly argued that this new tax scheme is good because politicians no longer would feel any pressure to lower tax rates.

This…alternative treatment of international transactions that would relieve the international pressure to reduce rates while attracting foreign business activity to the United States. It addresses concerns about the effect of rising international competition for multinational business operations on the sustainability of the current corporate tax system. With rising international capital flows, multinational corporations, and cross-border investment, countries’ tax rates and tax structures are of increasing importance. Indeed, part of the explanation for declining corporate tax rates abroad is competition among countries for business activity. …my proposed reforms…builds on the [Obama] Administration’s approach…and alleviates the pressure to reduce the corporate tax rate.

This is very troubling. Tax competition is a very valuable liberalizing force in the world economy. It partially offsets the public choice pressures on politicians to over-tax and over-spend. If governments no longer had to worry that taxable activity could escape across national borders, they would boost tax rates and engage in more class warfare.

Also, it’s worth noting that the so-called Marketplace Fairness Act, which is designed to undermine tax competition and create a sales tax cartel among American states, uses the same “destination-based” model as the DBCFT.

Concern #5: Does the DBCFT create needless conflict and division among supporters of tax reform?

As I pointed out in my remarks at the Heritage Foundation, there’s normally near-unanimous support from the business community for pro-growth tax reforms.

That’s not the case with the DBCFT.

The Washington Examiner reports on the divisions in the business community.

Major retailers are skeptical of the House Republican plan to revamp the tax code, fearing that the GOP call to border-adjust corporate taxes could harm them even if they win a significant cut to their tax rate. As a result, retailers, oil refiners and other industries that import goods to sell in the U.S. could provide a major obstacle to the Republican effort to reform taxes. …The effect of the border adjustment, retailers fear, would be that the goods they import to sell to consumers would face a 20 percent mark-up, one that would force retailers like Walmart, the Home Depot and Sears…to raise prices and lose customers.

A story from CNBC highlights why retailers are so concerned.

…retailers are nervous. Very nervous. …About 95 percent of clothing and shoes sold in the U.S. are manufactured overseas, which means imports make up a vast majority of many U.S. retailers’ merchandise. …If the GOP plan were adopted as it’s currently laid out, Gap pays 20 percent corporate tax on the $5 profit from the sweater, or $1. Plus, 20 percent tax on the $80 cost it paid for that sweater from the overseas supplier, or $16. That means the tax goes from $1.75 to $17 for that sweater, more than three times the profit on that sweater. Talk about a hit to margins. …Retailers certainly aren’t taking a lot of comfort in the economic theory of dollar appreciation. …the tax reform plan will dilute specialty retailers’ earnings by an average of 132 percent. …Athletic manufacturers could take a 40 percent earnings hit… Gap, Carter’s , Urban Outfitters , Fossil and Under Armour are most at risk under the plan.

And here’s another article from the Washington Examiner that explains why folks in the energy industry are concerned.

…the border adjustment would raise costs for refiners that import oil. In turn, that could raise prices for consumers. The border adjustment would amount to a $10-a-barrel tax on imported crude oil, raising costs for drivers buying gasoline by up to 25 cents a gallon, the energy analyst group PIRA Energy Group warned this week. The report warned of a “potential huge impact across the petroleum industry,” even while noting that the tax reform plan faces many obstacles to passage.

Concern #6: What happens when other nations adopt their versions of a DBCFT?

Advocates of the DBCFT plausibly argue that if the WTO somehow approves their plan, then other nations will almost certainly copy the new American system.

That will be a significant blow to tax competition, which would be very bad news for the global economy.

But is also has negative implications for the fight to protect America from a VAT. The main selling point for advocates of the DBCFT is that we need a border-adjustable tax to offset the supposed advantage that other nations have because of border-adjustable VATs (both Paul Krugman and I agree that this is nonsense, but it still manages to be persuasive for some people).

So what happens when other nations turn their corporate income taxes into DBCFTs, which presumably will happen? We’re than back where we started and misguided people will say we need our own VAT to balance out the VATs in other nations.

The bottom line is that a DBCFT is not the answer to America’s wretched business tax system. There are simply too many risks associated with this proposal. I’ll elaborate tomorrow in Part II and also explain some good ways of pursuing tax reform without a DBCFT.

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At the risk of sounding like a broken record (or like Donald Sutherland in Animal House), I’m going to repeat myself for the umpteenth time and state that the United States has a big long-run problem.

To be specific, the burden of government spending will inexorably climb in the absence of big reforms. This isn’t just my speculation. It’s a built-in mathematical result of poorly designed entitlement programs combined with demographic changes.

I wrote about these issues in a column for The Hill.

…there is a big reason to worry about the slowdown in population growth in the U.S. Many of our entitlement programs were created based on the assumption that we would always have an expanding population, as represented by a population pyramid. …however, we’ve seen major changes in demographic trends, including longer lifespans and falling birthrates. The combination of these two factors means that our population pyramid is slowly, but surely, turning into a population cylinder. …this looming shift in America’s population profile means massive amounts of red ink as the baby boom generation moves into full retirement.

To back up my claim, I then cited grim numbers from the Congressional Budget Office, and also linked to very sobering data about America’s long-run fiscal position from the Bank for International Settlements, the International Monetary Fund, and the Organization for Economic Cooperation and Development.

Simply stated, the United States will become a failed welfare state if we don’t make changes in the near future.

But I point out that we can save ourselves from that fate. And it’s not complicated. Just make sure government spending grows slower than the private economy, which will only be possible in the long run if lawmakers reform entitlements, particularly Medicare and Medicaid.

…it’s also possible that Washington will get serious about genuine entitlement reform. …if Congress adopted the structural reforms that have been in House budgets in recent years, much of our long-run spending problem would disappear. …the real goal is to make sure that government spending grows slower than the private sector.

That’s the good news.

But here’s the bad news. Based on his campaign rhetoric, Donald Trump isn’t a fan of entitlement reform.

And if he says no, it isn’t going to happen. Writing for National Review, Michael Barone explains that Trump’s opposition is a death knell.

The election of Donald Trump has put the kibosh on…the entitlement reform sought by conservative elites… Trump…has made plain that he’s opposed to significant changes in entitlements… It’s hard to see how Republicans in Congress will go to the trouble of addressing entitlements if their efforts can’t succeed.

As a matter of political prognostication, I agree. Republicans on Capitol Hill are not going to push reform without a receptive White House.

It doesn’t matter that they’re right.

Conservative elites’ concern about entitlements is based on solider numbers… There’s a strong case for making adjustments now… The longer we wait, the more expensive and painful adjustments will be. …Conservative…elites may have superior long-range vision. But they’re not going to get the policies they want for the next four years.

But this doesn’t mean reform is a lost cause.

I explained last month that there are three reasons why Trump might push for good policy even though he said “I’m not going to cut Medicare or Medicaid.”

  • First, politicians oftentimes say things they don’t mean (remember Obama’s pledge that people could keep their doctors and their health plans if Obamacare was enacted?).
  • Second, the plans to fix Social Security, Medicare, and Medicaid don’t involve any cuts. Instead, reformers are proposing changes that will slow the growth of outlays.
  • Third, if Trump is even slightly serious about pushing through his big tax cut, he’ll need to have some plan to restrain overall spending to make his agenda politically viable.

And maybe Trump has reached the same conclusion. At least to some degree.

Here’s what is being reported by The Hill.

Medicaid has grown in size in recent years, with ObamaCare extending coverage to millions of low-income people who hadn’t qualified before. But Republicans warn of the program’s growing costs and have pushed to provide that money to states in the form of block grants — an idea President-elect Donald Trump endorsed during the campaign. Vice President-elect Mike Pence signaled in an interview with ABC this month that the incoming administration planned to keep Medicare as it is, while looking at ways to change Medicaid. …Block grants would mean limiting federal Medicaid funds to a set amount given to the states, rather than the current federal commitment, which is more open-ended. …Gail Wilensky, who was head of the Centers for Medicare and Medicaid Services…argued that…If federal money for the program were fixed, “states would have much greater incentives to use it as efficiently as possible,” she said.

The policy argument for Medicaid reform is very strong.

The real question is whether Trump ultimately decides to expend political capital on a much-needed reform. Because he would need to do some heavy lifting. If GOPers push for block grants, well-heeled medical providers such as hospitals will lobby fiercely to maintain the status quo (after all what’s is waste and fraud to us is money in the bank for them). Trump would have to be willing to push back and make a populist argument for federalism and fiscal responsibility rather than a populist argument for dependency.

I guess we’ll see what happens.

P.S. For what it’s worth, if Trump is going to fix just one entitlement program, Medicaid is a good choice.

P.P.S. In an ideal world, Medicare and Social Security also should be fixed.

P.P.P.S. That being said, if the major fiscal change of a Trump Administration is Medicaid reform, I’ll be relatively happy. I’ve been operating on the assumption (based in part of what he said during the campaign) that Trump is a big-government Republican. Sort of like Bush. I will be very happy if it turns out I was wrong.

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On December 24, I wrote that all I wanted for Christmas is a spending cap.

Alas, Santa did not manage to stuff that long-overdue policy down my chimney.

But I’m not surprised. For years, the flat tax was on my Christmas list and that never happened either. I guess I must have been bad. Or maybe Santa is a leftist or socialist.

So instead of simple and fair tax system under the tree, I kept getting lumps of coal in my stocking, which are cleverly disguised as new provisions of a metastasizing internal revenue code.

I’m still allowed to dream, however, so I want to share a new video about the flat tax from Prager University. It’s narrated by Steve Forbes, who (along with Dick Armey) helped popularize the flat tax in the 1990s.

Very compelling. Perhaps even more so than my video on the flat tax.

So what are the chances that we’ll ever get this type of reform?

In a column she wrote last year for Time, Amity Shlaes was somewhat optimistic that a flat tax has untapped support. She cited the fact that most GOP candidates either endorsed some form of flat tax or proposed changes that would move us closer to a flat tax.

The simple levy hasn’t been this popular since 1996, when Steve Forbes campaigned with the promise of a universal 17% income tax rate. Several of this campaign’s flat taxers are actually out-Forbesing Forbes. Ted Cruz is calling for a flat 10%. Ben Carson, Mike Huckabee and Rand Paul also propose some kind of flat rate. Jeb Bush, Marco Rubio and Donald Trump pay their respects with plans that reduce the number of tax brackets.

She explains why the current approach is arbitrary and unfair.

…tinkering is the great weakness of a progressive structure. For if one authority wins license to tinker, so may another. Eventually every interest group convinces others that it is only fair to introduce its ornaments, its exceptions, or its doodads to a tax code. A progressive structure grows organically and disproportionately, becoming a monument to…crony capitalism.

And even though people get tricked when they equate “progressivity” and “progress,” there’s an underlying belief in equal treatment that pushes them in the direction of a flat tax.

In a paper recently presented at the American Accounting Association, scholars Michael and Theresa Roberts report that nearly 8 in 10 business students they polled believe a progressive income tax to be fairer than a flat tax. Still, when asked to actually ascertain a fair amount for a tax payment, the vast majority of the same pollees, even self-identified liberals, picked an amount that correlated to a flat, or even a regressive, rate. This suggests that while Americans like the sound of the word “progressive,” even educated citizens don’t necessarily love progressivity’s effect. Whatever they say at a party, people may quietly prefer proportionality to disproportionality… The Roberts-Roberts paper concludes that “a majority of both liberal and conservative Americans may view a flat income tax rate as fairer than progressive income tax rates.”

Amity’s point about “self-identified liberals” is a natural segue to a Forbes column by Rick Ungar. He approaches the topic from a left-of-center perspective and has considerable sympathy for the flat tax. Not because he likes proportionality, per se, but because he recognizes that the current system has been perverted by special interests.

I’ve long been open to the possibility of trying something new… How can a progressive come to the conclusion that the flat tax might be a better way to go? …American progressives have long had an allergic reaction to the very notion of a flat tax…and with good reason. On it’s face, a flat tax (and the many variations of policy included under the name flat tax) is, indeed, a regressive system more likely than not to benefit the wealthy at the expense of the less wealthy. …However, you have to ask whether or not our current progressive system is truly progressive or, in reality, a system that has been so perverted by special interest tax breaks and benefits as to no longer be legitimately described as progressive. …what do you think is contained in all of those 74,000 plus pages in the United States tax code? …When the higher earner is, in reality, paying at a lower tax rate than her employees who earn far less, thanks to all the special interest perversions built into the tax code, that is very much a regressive tax system. …maybe the time has come to try something new.

Though Ungar isn’t quite willing to embrace the flat tax.

There are, however, some conditions to my willingness to get on board—two to be exact. First, I worry about how the flat tax would impact on those who do not earn much money and have to support their families on a salary that makes both feeding and housing that family a constant, painful challenge. …my second concern…what assurances do we have that this new system will not be corrupted just as the present system was corrupted?

The first concern is easy to address. Every flat tax plan has a generous allowance for all households based on family size. This “zero-bracket amount” would be more generous than the combined standard deduction and personal exemptions in the current tax system. Indeed, because of my concerns about people viewing government as being free, I actually think the amount of tax-free income people would be able to earn is too large. So Mr. Ungar probably can relax on that point.

The second concern, though, is much harder to solve. The risk of a flat tax is that the system somehow will get compromised and degenerate back to the mess we have now. I like to think the American people, after finally being freed from today’s awful system, would vigorously fight to preserve the flat tax. But I also confess there are no guarantees. But here’s the deal. The worst thing that happens is that the current system re-emerges. That obviously would be a big disappointment, but that downside risk is rather tame compared to the downside risk of a national sales tax or value-added tax, which is that politicians would pull a bait and switch, never get rid of the income tax, and then we wind up with a French-style tax system (and the bloated government it finances).

Let’s close by considering a new argument for the flat tax.

Preston Cooper of E21 explains that a single rate protects people in expensive parts of the country from disproportionately harsh taxation.

…data from the Bureau of Economic Analysis (BEA) show that in states such as Arkansas and Mississippi, $100 can buy $115 worth of goods, while in New York and Hawaii, the same dollar value will only get you $86 worth. …This provides yet another argument for a flat tax. …areas with higher prices also tend to have higher incomes, because employers must compensate for their employees’ reduced purchasing power. Therefore, people earning $44,000 in West Virginia can afford the same standard of living as someone earning $58,000 in Hawaii, despite the gap in nominal income. But the federal government does not account for these regional price disparities when setting tax policy. The progressive federal income tax means that those who earn a higher income in nominal terms will pay a higher tax rate. However, the varying cost of living across the United States means that those who earn a higher nominal income may not actually be any richer, yet will still have to pay the taxes for it. This violates an important goal of tax policy known as horizontal equity: people with the same income ought to pay the same amount in taxes.

Using the example of a single adult, Cooper shows that people living in high-cost-of-living states can pay hundreds of dollars in extra tax compared to people with similar levels of purchasing power in low-cost-of-living states.

Looking at this data, I’m temped to say “serves them right” since the list is dominated by blue states that routinely elect politicians who support class-warfare tax policies and lots of redistribution.

But that knee-jerk reaction is misguided. A fundamental libertarian principle is that the law should treat everyone equally.

So how can this work?

A potential solution is to adjust federal tax brackets in different states for differences in purchasing power. But price disparities do not end at the state level: prices also differ by metropolitan area. People in New York City pay higher prices than people in Buffalo. This phenomenon exists even within cities, as anyone who has compared apartment prices in Manhattan and Queens can attest. There are far too many jurisdictions to effectively adjust tax brackets for cost-of-living differences. A better remedy is to apply a flat income tax at the federal level. Under such a tax everyone would pay the same proportion of their income to the federal government, eliminating the interregional redistribution that comes with progressive taxation.

This makes sense.

When I argue for the flat tax, I tend to focus on the economic benefits (low rate, no double taxation, and no loopholes) and the moral benefits (less corruption, more fairness, and better compliance).

Now I can augment that fairness argument because the government shouldn’t arbitrarily penalize people based on where they live.

So, yes, we should have a flat tax. Other nations shouldn’t have all the fun.

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