By Dr. Constantine Alexandrakis
Professor of Economics
Debates regarding tax reform usually revolve around the size of taxes. However, equally important is the design of the tax system. For example, consider two parents deciding if they should both work or one should stay at home with the kids, or an older worker deciding whether to retire or continue working. A higher marginal tax rate raises the percentage of each extra earned dollar that they have to pay to the government, thereby reducing their incentive to work. Similarly, since corporate earnings are distributed to their owners, taxing corporate income is equivalent to taxing stockholders, many of which are middle-class individuals who own stocks through their retirement accounts. This reduces the willingness of stockholders to fund new investment projects that raise productivity and hence wages. For these reasons, most economists argue that we should raise more revenue from taxing socially harmful activities like the emission of gasses that contribute to climate change, and less from taxing income generated from beneficial activities like work or investment.
Economists also argue that a tax code should be simple, have few brackets, and allow few exemptions. In contrast, our tax code is over 70,000 pages long, which raises the cost of compliance as taxpayers devote more resources in finding ways to take advantage of the various exemptions. It also gives special-interest groups an incentive to lobby in order to secure tax-exempt status, and benefits mostly rich individuals who face a high marginal tax rate. Finally, a good tax system should be able to generate enough revenue to finance the targeted level of spending to a degree that prevents the government debt from rising faster than GDP, a situation that could eventually cause lenders to lose faith in the U.S. government with repercussions similar to those faced by Greece.
In light of the above, Donald Trump’s tax plan has several desirable but also some undesirable elements. The plan cuts marginal tax rates on personal income, reduces the corporate income tax, and simplifies the tax code by reducing the number of brackets – eliminating individual exemptions and capping itemized deductions. According to the Tax Foundation, these reforms are expected to generate faster economic growth and have a positive impact on employment. On the flip side, even after we account for the positive impact on economic growth, the reforms are expected to reduce revenue between $2.5 trillion and $4 trillion over a decade. Trump has not yet articulated how he will address the shortfall in order to prevent the debt from rising. Finally, while Americans in all income brackets will pay fewer taxes, the richest taxpayers will benefit more.
Like Trump, Hillary Clinton wants to cap itemized deductions. Contrary to Trump, she wants to increase the estate tax and the marginal tax rate on individuals earning more than $5 million. This would make the U.S. tax system more progressive, although it is already the most progressive among advanced economies. According to the Tax Foundation, these reforms would reduce GDP by 1% relative to what it would have been over the long run, and have a small negative impact on employment and wages. Because of this and the fact that few people earn over $5 million per year, revenue would rise by only $200 billion over ten years, hardly enough to fund Clinton’s proposed expansion of social programs. For reference, U.S. GDP in 2015 alone was about $18 trillion. In summary, Clinton proposal largely preserves the status quo. It seems to be the safer choice, but doesn’t address the fact that since 2000 the rate of U.S. economic growth has been about half of what it was from 1950 until 2000. In my opinion, how people feel about the two plans will depend on how satisfied they are with the current economic reality, and their attitude towards risk.
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