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Trump’s Tax Plan Would Spur Growth

By Edward P. Lazear • Wall Street Journal

President Trump’s tax plan leaves many details undefined, but there is plenty to evaluate. The administration claims its proposed changes would encourage growth and make the tax system more efficient. History suggests they will.

Less certain is the claim that the tax cuts will pay for themselves. Although budget concerns should always be paramount when cutting taxes, revenue neutrality does little to guarantee that this—or any—administration will exercise fiscal responsibility.

Most economists favor moving away from taxing capital and toward taxing consumption through value-added or sales taxes. Taxing capital squelches growth because capital is mobile and can cross borders in search of the highest risk-adjusted, after-tax return. Economists in both parties have scored the effects of eliminating capital taxation in favor of a pure consumption tax. Estimates range from a 5% to 9% total increase in gross domestic product.

There are a number of ways to move toward a consumption tax and reduce taxes on capital without instituting a national sales tax or VAT. One is to lower tax rates on corporate profits and “pass-through” income, as the president proposes. Another is to permit full expensing—to let companies deduct the entire cost of investments immediately.

Expensing creates a positive incentive for corporations because they receive the tax benefit only when they invest in themselves. A Treasury Department analysis done while I was chairman of the Council of Economic Advisers showed that a given dollar of tax cuts through expensing is more powerful than rate cuts in the short run by about a factor of four.

Rate cuts, on the other hand, benefit new and old capital alike and confer tax benefits on companies that have invested in the past. This saves companies money, but provides no direct incentive for new investment. In the long run, the distinction between expensing and rate cutting disappears because all capital is new capital and so is taxed at the lower rate.

Tax-rate cuts on pass-through income will have additional growth effects, but the administration hasn’t released enough details to score them. Separating capital income from wage income may add some complexity, but that’s not a new problem. Defining income and profit is not straightforward. Tax accountants already struggle to determine true costs, including business owners’ implicit wages.

State and local taxes would no longer be deductible under Mr. Trump’s plan. Much has been said about the cross-subsidization of high-tax states such as New York and California by low-tax states such as Florida and Texas. Removing this deduction would mean that overall federal personal income-tax rates can be lower and generate the same revenue. Beyond that, there is a subtle and positive growth effect of eliminating state tax deductions.

The deductibility of state taxes provides incentives to raise overall taxes at the state level. Californians and New Yorkers bear only part of the cost of their tax increases; the rest is passed on to other states’ taxpayers through the deduction. This leads state governments to overtax their citizens, resulting in economic distortions and reduced overall growth.

Tax cuts enacted through the Senate’s budget-reconciliation process must sunset after 10 years, although this may not be the roadblock to lasting reform that it seems. Recall that the Bush tax cuts of 2001 had the same sunset provisions, but most are still in effect. Congress renewed them in 2010 and again—apart from those on the highest earners’ rates—in 2012.

The Trump administration’s plan may get the economy about halfway to a pure consumption tax. That could generate a GDP gain of between 2.5% and 4.5%. In 2016, the Congressional Budget Office estimated that corporate income-tax payments were $415 billion, or about 12% of federal tax receipts. Rate cuts that spurred 4% growth would generate total tax revenues of about $120 billion—assuming no other tax reductions—which is not quite enough to offset the loss of income to the government. Cutting individual income taxes makes the revenue-neutrality task more difficult because personal tax-rate cuts do not generate the same growth effect as rate cuts on capital.

The net effect of the proposed corporate tax cuts would be to increase the deficit by about 0.5% of GDP. This is significant, but revenue neutrality should not be the standard by which a tax plan is judged. Even revenue-neutral tax changes do not solve our budgetary problems. The CBO projects growing deficits, exceeding 7% of GDP annually, in two decades. Unless we are willing to accept major tax increases in the future—most likely through the introduction of a VAT—we will need to reduce government spending significantly to narrow the gap. This means re-examining entitlements, particularly Medicare, Medicaid and other health programs. Even a revenue-neutral tax reform plan would not come close to achieving fiscal responsibility.

The strongest argument in favor of the Trump administration’s plan is that it moves in the right direction on capital taxation and will achieve growth. Because there is a direct connection among GDP growth, productivity growth and wage growth, the Trump proposals will help raise incomes and thereby benefit Americans overall.

Mr. Lazear, who was chairman of the President’s Council of Economic Advisers from 2006-09, is a professor at Stanford University’s Graduate School of Business and a Hoover Institution fellow.