Earl's Tax Deductions provides commentary and analysis by WP Houston partner Steve Metzenthin. If you wish to continue to receive it, please click the Subscribe button below. Otherwise after several more issues it will be dropped from publications you receive.

      ----Toby Cotton – Partner-in-Charge of Tax & Consulting for Whitley Penn
The Dismal Science and Tax Reform 12.1.17
President Truman, who had no appetite for and knew little about the dismal science, is reported to have said that he would prefer a one armed economist to advise him so tired was he of hearing “but on the other hand.” Nevertheless debates over tax reform are largely waged over differing views of economic theory and practice. Occasionally it pays to go back to the basics, so I dusted off my college textbook “Economics” by Paul Samuelson last week. Continue if you dare.

In the latest tax reform discussion, the disagreements are largely over (i) whether the Republican proposals will result in economic growth and (ii) which group of taxpayers will be winners and losers under the proposed legislation. Let’s drill down on the growth issue and start by observing where there is common ground among the competing groups, which for simplicity’s sake we’ll call Republicans (R) and Democrats (D).

Generalizing and the Blame Game

The simplistic view held by many R’s is that D’s don’t care about growth at all – that the D’s governing philosophy is to redistribute a fixed size pie to make it fair(er). The simplistic view held by many D’s is that R’s are concerned only with growth, and that if growth results in inequitable distribution of the pie, well, that’s just the free market at work.

Both extreme positions contain elements of ad hominem absurdity, appealing to prejudice and stereotypes, i.e., D’s are socialists and R’s are heartless. These characterizations may be valid on the outer dimensions of the bell curve: indeed there are Bubbas on the left and the right. But successful arguments in support of tax policy depend upon validation by established economic principles, and as a result must be far more sophisticated than merely insulting those who disagree with you. Or so we should hope.

Both R’s and D’s know that growth is the way out of our current predicament. However the means by which we attain that growth (and which taxpayer groups benefit from it) are hotly disputed. The D’s trend toward Keynesian solutions, holding that most economic problems are a function of insufficient consumer demand and striving to enhance it by direct government intervention, particularly in times of crisis and high unemployment. Keynes always felt that he was misunderstood in the sense that he was not, as he was commonly believed by some to be, a socialist (or worse); rather, he was informed to protect capitalism from its own excesses.

Supply side economists, typically supported by the R’s, follow more along the lines of traditional microeconomic thought – believing that if the proper incentives are provided, business will invest in capital and labor and the benefits will work their way down to all participants. The left uses the pejorative phrase “trickle down” to describe the philosophy and technique. The R’s will rely upon the “invisible hand” of Adam Smith, forgetting or disregarding that Smith was more writing about how things were as opposed to how they should be. Smith himself was no opponent of certain government interventions to affect equitable outcome.

At the poles, political difficulties arise because the R’s want to create growth incentives in the form of capital (that’s what you get when tax rates are cut) that is put in the hands of the business/wealthy class. The D’s don’t trust the business/wealthy class to do the right thing with that capital. They believe that business will spend it on executive compensation, stock buy-backs and the like, none of which create growth. Instead the legislation results in a transfer of wealth to those who don’t need it. Conversely the D’s seek to accomplish growth by raising aggregate consumer demand in the form of direct government subsidies to business and consumer and frequently specifying in the case of subsidy to business how that capital is to be spent, e.g. “shovel ready projects,” WPA, infrastructure investment, etc. The R’s believe that this interferes with market pricing mechanisms, distorts resource allocations and is inefficient and unlikely to generate growth. If carried to an extreme it leads to loss of economic and personal freedom, eventually threatening democracy itself. See Hayek, Friedrich A.

Where We Are Now

Moving into the current arena, the solutions proposed by the Republicans (ably assisted by the Tax Foundation, a right-leaning think tank; the President’s Council of Economic Advisers, and a gaggle of conservative economists who served in former Republican administrations and writing in the November 27, 2017, The Wall Street Journal) are classically supply-side and microeconomic in nature: tax rate cuts (especially the corporate cuts) and allowing first year expensing of capital acquisitions, by increasing the after-tax cash flow of investments, make it more likely that such investments will be undertaken by business. This will result in increased hiring; the capital improvements will increase labor productivity; wages will rise as market conditions adapt to the increased activity and productivity; and the resulting increase in aggregate consumer demand will benefit the labor force. The general consensus among those who see it this way is that these factors will generate 3%-4% aggregate growth during the budget window, sufficient to assure that the tax cuts pay for themselves.

Democrats, relying on analysis by the Congressional Budget Office and the left-leaning think tank Tax Policy Center, argue that tax reform generated capital benefiting business and wealthy taxpayers will be used primarily for executive compensation and stock buybacks. They argue that the labor share of tax rate reductions is minimal, that there is already a glut of capital and that there is no reason to believe that fresh capital will be employed to provide growth. Since growth is minimal, the tax bill increases the federal deficit and the distribution of benefits to corporations and the wealthy is unjust and serves to increase income and wealth inequality.

Nobody disputes that labor has been late to the party when it comes to enjoying the benefits of the economic recovery that began in 2009. As a matter of fact labor hasn’t gotten to the party yet. Real wages for too many low and middle class taxpayers have remained flat. Unless you buy the line regularly espoused in The New York Times by Paul Krugman and his ilk that the Republicans are motivated by the desire to create a new gilded age (another ad-hominem attack), you should concede that people across the political spectrum are concerned about this. 

So the relevant question for the day is can this Republican tax bill assist labor? If you are a lefty Bubba, you’ve already decided the answer is no. If you are a righty Bubba, you have already decided yes. To break the tie let’s return to the textbook.

In classical economic analysis, wages will increase if there is a shortage of labor or if labor becomes more productive. Shortages of labor exist when the demand for labor exceeds the supply. This causes businesses to bid up labor prices in order to find workers. Though we are generally considered to have full employment in the current environment, the labor participation rate is down, as many workers have stopped looking for work. To the extent the Republican tax proposals generate business activity which puts people back to work, create labor tightening, cause those out of the work force to rejoin it, and cause business to invest in machinery and equipment which increases labor productivity, they could well begin to chip away at growing income inequality. The capital incentives provided to business will have resulted in creating a solid economic basis for increased labor rates, and labor’s share of the gross domestic product will have increased. Labor (that’s the middle class in today’s tax lexicon) will have finally arrived at the party. That’s really good news for all!!

How Steep is the Cliff?

Before Earl and I let you go, let’s take a quick look at the impact on the federal debt if the Republican bills are passed and they don’t generate growth. The voices from the left, historically not exactly deficit hawks, are becoming quite strident on this issue, so it’s worthwhile to answer the question. Today the federal debt held by the public (meaning that debt held by Social Security and the Federal Reserve as part of its quantitative easing program is excluded) is approximately $15 trillion. It roughly doubled during the Obama administration from $7 trillion to $14 trillion. Blame whatever part of that on George W. if you like, but those are the numbers. 

The budget “hole” created by the Republican tax bill is approximately $1 trillion, if you adopt the “current baseline” methodology they do in quantifying the bill; $1.5 trillion if you don’t. Let’s use the $1 trillion for this example. During the ten year budget window, the Congressional Budget office is projecting total federal revenues of $43 trillion. So the shortfall created by the tax act is $1/$43 or 2.3% of revenues. What about the impact on the federal debt held by the public at the end of the budget window 2027? The CBO projects that the debt will increase to approximately $25 trillion by that date, owing to 1.9% growth and increasing entitlements as yours truly and millions of other baby boomers go into retirement. Add our $1 trillion deficit to the projected $25 trillion and you have a new debt of $26 trillion. The tax deficit has added $1/$26 or 3.8% to the federal debt. It’s up to you to determine how cataclysmic this is.

"Earl's Tax Deductions" is a blog Steve Metzenthin writes for Whitley Penn about taxes, economics, and anything else he thinks about during his early morning walks with rescue dog Earl. That's Earl up top. The contents of this blog do not constitute tax advice. Any opinions expressed are Steve's and not Whitley Penn's or its partners. If you want to know what Steve does for paying clients, see his professional biography on the WP website.
Follow Steve (& Earl) on Social Media