Originally posted at Forbes, January 2017

The proposed House Republican tax reform plan would dramatically change corporate and personal income taxation. Although I had no hand in its design, the proposal cites three articles I wrote or co-wrote to support its position on corporate tax reform. One is a NY Times column. The others are two co-authored studies found here and here.

One of the co-authors in the second study is UC Berkeley economist, Alan Auerbach. Alan also wasn’t consulted on the design of the House Tax Plan. But apart from the tax rate, the plan’s proposed reform of the corporate tax is similar in most respects to his proposal entitled “A Modern Corporate Tax.”

Alan and I have discussed the House tax plan at length. Given the influence we may have had on its design, it may be useful to House Ways and Means Committee Chair, Kevin Brady, and his colleagues as well as to the general public to provide some comments. (These comments are mine and not necessarily Alan’s.) But I mostly want to address Democrats who are taking a knee jerk response to the proposal when it has many elements they should love, including an embedded wealth tax.

Chairman Brady and his colleagues should be congratulated for designing a new tax system that makes major improvements to our existing system and that embeds a deep understanding of the economics of taxation. This said, the plan may need substantial tweaking to ensure it’s revenue neutral and maintains progressivity. It also needs to be complemented with healthcare, Social Security, and welfare reforms in order to lower total effective marginal net tax rates facing American workers.

Before discussing the House Plan, I want to be clear that my preferred tax reform, discussed in You’re Hired — A Trump Playbook for Fixing America’s Economy differs materially from the House plan. My plan a) eliminates the corporate income tax, the personal income tax, and the estate and gift tax, b) introduces a value added tax (VAT), a progressive personal consumption tax on top consumers that exempts consumption financed by labor income, an inheritance tax that kicks in after the receipt of $5 million, and a Co2 emissions tax of $80 per ton, c) eliminates the ceiling on the FICA payroll tax, and d) provides a $2,000 annual payment to each U.S. citizen.

In combination with my proposed reforms of healthcare, Food Stamps, and Social Security, all workers, no matter their wage rate, would face a 30 percent total effective marginal net tax on their labor income. Under the current fiscal system, the majority of U.S. workers face far higher total marginal net labor-income tax rates. Indeed, for low-wage workers, total marginal net labor tax rates are so high as to constitute a poverty trap. And for older workers, marginal net taxation can constitute a retirement trap.

This is documented in two recent studies I co-authored with Alan and Darryl Koehler. One examines U.S. inequality and work disincentives. The other covers work disincentives confronting the elderly. These studies show the importance of combining tax, healthcare, Social Security, and welfare reform in fully fixing our thoroughly broken fiscal system.

Now to the House Plan. Let me first discuss the corporate tax reform, which is the most significant part of the House plan and represents a major and long overdue shift toward consumption taxation. Then I’ll discuss the personal tax changes and finally respond to Lawrence Summers’ rather off-base Financial Times article suggesting the reform is “deeply flawed” — this despite the fact that in his early days he was, as are almost all public finance economists, a strong advocate of consumption taxation.

Corporate Tax Reform and Consumption Taxation

What does the House’s proposed corporate tax reform have to do with consumption taxation and why is moving to consumption taxation good for the economy, particularly for workers?

The answer starts with this formula for GDP: Y = C + I + X – M. Y stands for output (GDP), C for consumption (household plus government), I for domestic investment (investment at home), X for exports and M for imports. The formula is intuitive. It says that output (goods and services) produced in the U.S. is either consumed, invested, or shipped abroad in the form of net exports (exports minus imports).

Rewrite this equation and you get: C = (Y + M) – (I + X), which says that consumption equals the sum of output produced domestically plus output imported from abroad less the amount of this total that could be consumed but is not because its either invested domestically or shipped abroad as exports.

This rewrite tells us there are two ways to tax consumption, C. You can either tax it directly (e.g., via a retail sales tax or a personal consumption tax) or indirectly by taxing everything available for consumption, namely output plus imports, less investment plus exports.

By permitting 100 percent expensing (that’s the – I in the formula), the U.S. federal marginal effective tax rate on business investment would go from one of the highest, if not the highest in the developed world, to zero. The reason it’s zero is that the value of the immediate write off precisely offsets, in present value, the extra future taxes that arise from the extra Y generated by the extra investment. This is what you’d expect. When you tax consumption directly, you are placing a zero tax on the return from saving and investing. So when you tax it indirectly, the same thing should and does hold.

Democrats view consumption taxation as highly regressive. But they are badly confused on this point. Taxing consumption through time is mathematically equivalent to taxing what’s used to pay for consumption through time, namely current and future wages plus current wealth. And if you move, on a revenue-neutral basis, from taxing mostly wages, which is what we do in our country, to taxing wages plus consumption you are necessarily reducing the level of wage taxation and raising the level of wealth taxation.

But, Nancy Pelosi might say, the rich have low propensities to consume and if they don’t consume they won’t pay any consumption tax. To see the error in this view consider Scrooge McDuck swimming in his pool full of 50 billion one dollar bills. One day the government enacts a 25 percent sales tax leading to a 25 percent rise in consumer prices.

Scrooge still has his 50 billion pieces of paper, but their purchasing power falls by 20 percent, i.e., after paying sales taxes they can only buy 80 percent of what was previously the case. “But,” Nancy will say, “Scrooge won’t pay any taxes because he’s so stingy he never buys a thing.”

True, but when Scrooge dies, his money will pass to his nephew, Donald, who will inherit 20 percent less purchasing power. So Scrooge and Donald are in the same boat as if the government had simply taken away 20 percent (10 billion) of Scrooge’s dollar bills. As for the propensity to consume wealth, it’s 100 percent when considered in present value. Eventually, someone, be it Donald or his descendants, will use Scrooge’s 50 billion pieces of paper to buy consumption and when they do they will pay Uncle Sam his due. In present value this amount is $10 billion.

Mathematically, we economists can’t tell the difference between an indirect wealth tax or a direct one — for a good reason. There is no economic difference. And for Scrooge, the House tax bill represents an indirect wealth tax. What’s more, the House tax bill is solely a tax on wealth because in addition to taxing consumption it provides a subsidy to wages. I.e., corporations will be taxed on Y – I – (X-M) – W, where W stands for wages. Stated differently, the House corporate tax reform entails establishing a value added tax plus a wage subsidy. The proposal also calls for eliminating net interest deductions. This also represents a form of implicit wealth taxation for shareholders of leveraged corporations.

In sum, the proposed corporate tax reform has some very progressive elements. The one caveat is the reduction in the corporate tax rate from 35 percent to 20 percent. This will provide a major break to corporate shareholders without impacting the effective marginal corporate income tax rate, which would, in the presence of expensing, be zero whether the rate is set at 35 percent or 20 percent. Hence, my first proposed tweak is to either leave the rate at 35 percent or set it to 20 percent, but establish transition rules such that corporations who would otherwise have paid 35 percent on future profits earned on investments that they’ve written off (in full or in part) pay the same tax. This will produce significantly more revenue, which is going to be needed to keep the reform from producing a large deficit.

Why the Corporate Tax Reform Will Incentivize Investment and Raise Wages

Under the House Plan, the effective marginal tax on new investment in the U.S. will be zero. Again, this is true whether the statutory corporate tax rate is kept at 35 percent or lowered to 20 percent. A zero marginal effective tax on new investment is a long way down from it’s current value, which appears to be around 30 percent if not higher. This reduction will produce a major influx of investment in the U.S. According to simulations I’ve run in a large-scale economics model, one can expect a roughly 10 percent rise in output and a roughly equal rise in real wages. The reason that wages will rise is that workers will have more machines, equipment, factories, plants, and other forms of capital with which to work. I.e., they will be more productive.

This projected increase in wages is yet another strong reason for Democrats to support the House tax bill. This is not supply-side malarky, of which there has been a great deal over the years. This is simply common sense. If Washington State were to tax corporate investment at, say, 30 percent, and South Carolina taxed it at zero percent, corporations would stop investing in Washington and start investing in South Carolina. Come to think of it, this is exactly what Boeing has done, although certainly not fully and for incentives that do not primarily involve taxes.

Personal Income Taxation

The House tax plan takes big steps toward simplifying and rationalizing the personal income tax. It eliminates the Alternative Minimum Tax, unifies the tax treatment of asset income, eliminates exemptions, eliminates the deductibility of state income tax and property taxes, raises the standard deduction and provides a new child tax credit. The plan also moves from seven to three tax brackets with the top rate dropping from 39.6 percent to 33 percent. Some of these provisions certainly favor the rich. But others favor the poor. And the personal tax reform may also generate less revenue.

I’m in the process, together with Alan, of examining the progressivity and revenue impacts of the personal income tax changes. I’ll relate our findings shortly in this space. For now let me say that I suspect the personal tax part of the plan will need to be tweaked to maintain progressivity and, potentially, revenues. If so, this would be my second tweak.

Treatment of Pass Through Business

The House tax plan would, it seems, tax small businesses not subject to the corporate income tax like corporations except they would be taxed at a 25 percent rate, not a 20 percent rate. My third tweak would be to tax all business, corporate and non corporate, at the same rate, say 23 percent and to extend limited liability to all companies apart from loans secured by personal property such as one’s home equity. In addition, I would require all small businesses to deduct at least 75 percent of their taxable income as wages and, therefore, pay taxes at the personal level (with its top 33 percent rate) at least 75 percent of their business income. The big concern here is that high earners who would otherwise be in the 33 percent bracket will disguise their labor income as business asset income to have it taxed at the proposed 25 percent rate. In the case that all business income is labor income, one quarter of such income would be taxed, under my modification, at 23 percent rather than 33 percent. This would, thus, provide a 10 percentage point tax break on a quarter of labor income. Hence, the top rate would then effectively be 2.5 percentage points lower or 30.5 percent, which is not a major difference. The language in the House tax reform plan, while vague on this point, appears to contemplate a similar requirement that a significant share of business income be treated as wage income and, therefore, be deductible from business income for purposes of taxing business income, but be included as wage income on the personal income tax.

Estate and Gift Taxation

The House tax plan would eliminate the estate and gift tax. I’m no fan of this tax since it generates relatively little revenue, while misemploying a small army of estate tax attorneys, accountants, and financial advisors. But I don’t believe increased concentration of wealth is healthy for our country and I believe that repealing this tax will lead to that result. So my fourth tweak is to introduce an inheritance tax on cumulative gifts and bequests received in excess of $5 million.

Critiquing Summers’ Critique

Former Treasury Secretary Summers wrote an op ed in the Financial Times on the 9th of January making four points. First, Summers claims that the corporate tax change will exacerbate inequality with more than half the benefits going to the top 1 percent. I’m not sure where his “half” comes from. The corporate tax reform has many aspects that would hurt and others that would help shareholders. As indicated, this part of the House tax reform plan effectively implements a wealth tax. It also will lead to a massive inflow of capital, which will lower the return to wealth at the same time it raise the return to labor. Estimating the net impact of the corporate reform on the top 1 percent is a very complex analysis, which I doubt Secretary Summers has undertaken. Moreover, as stated above, transition rules can be used to avoid any windfall gains from lowering the rate from 35 to 20 (or 23) percent.

Second, Summers says that “… the tax change will capriciously redistribute income, increase uncertainty, and place punitive burdens on some sectors, particularly importers” Third, Summers claims that the reform would violate WTO provisions and initiate a major trade war. Fourth, he worries that there will be a drop in federal revenues that will produce cuts in entitlement payments and government spending, engender personal tax hikes, and hurt the middle class.

Summers needs to get a grip. The House tax plan introduces a VAT plus a wage subsidy. Every major developed country except the U.S. has a VAT. The introduction of VATs in those other countries did not hurt importers and help exporters. Instead, exchange rates adjusted appropriately to produce no extra burden on the former and provide no extra assistance to the later. The boarder adjustments will also eliminate all incentives for companies to shelter profits abroad. VATs do not violate WTO provisions. Nor do wage subsidies provided at the personal level. Providing wage subsidies at the business level is no different from providing them at the personal level and the WTO rules can easily be modified to accommodate this equivalence. Finally, we should not retain a deeply flawed business tax structure, which generates precious little revenue, due to revenue concerns. Instead, we should use transition rules to ensure that the transition to the new business tax structure does not involve expensive freebies and that the reform is truly revenue neutral.

This article was originally posted at Forbes on January 11, 2017.