Kotlikoff: NYT is Peddling Fake Economics on the Tax Bill

By Laurence Kotlikoff

Originally posted at Forbes, April 2017

Today’s NY Times features an article written by four NY Times reporters, who refer to the business part of the House Republican tax proposal as imposing “a substantial tax on imports.” This is #FakeEconomics as in it’s simply not true.

The tax plan proposes transforming the U.S. corporate income tax into a combination of a 20 percent value added tax (VAT) and a 20 percent subsidy to wages. A VAT is an indirect way to tax consumption. If the House Republicans were proposing to tax consumption via, say, a retail sales tax, these reporters (and their colleagues at the Times and in other media companies) would never suggest the Republicans were trying to tax imports, i.e., impose tariffs.

But because the proposal is using different words to reference taxing consumption, these reporters have, apparently, gotten mightily confused. They aren’t the only ones. The Koch Brothers, Walmarts, other retailers as well as a number of Republican Senators are convinced that a VAT plus a subsidy to wages somehow places tariffs on imports. Now did these companies and politicians miseducate the NY Times or did the NY Times and others in the news media miseducate them? Either way, one expects reporters for the NY Times to check with tax economists before writing about taxes.

Here’s the simple math that shows why the House Republicans in their “Better Way” plan are proposing to tax consumption and subsidize wages. Ignoring for now the wage subsidy, their proposed business tax would tax Y + M – I – X. Y stands for final domestic output (also known as the sum of the value added at different stages of the production of final goods and services). M stands for imports. So Y + M represents all the goods and services (corn to keep it simple) that is available to be consumed. But some of this corn that was either grown in the U.S. or brought into the U.S. will be invested (planted). That’s the I. And some of it will be sold abroad for foreigners to consumer or plant. That’s the X. So what’s left over after subtracting I + X from Y + M is what’s consumed domestically, namely consumption, C. I.e., C = Y + M – I – X. Stated differently, if you tax Y + M – I – X you are taxing C, consumption.

The reporters have concluded that since M shows up in the formula for the VAT tax base with a positive sign and since the House tax plan includes a VAT plus a wage subsidy (yes, more on that shortly), the tax plan imposes a tax on imports, i.e., a tariff. If that were the case, every country in the World Trade Organization that has a VAT, and that list includes every developed country apart from the U.S., would be imposing tariffs (at different rates). But the WTO realizes that one needs to look at the VAT tax base comprehensively (i.e., add up all its components) and when you do so, you find that it’s a tax on consumption, which includes nothing that harms imports relative to exports. By analogy, the reporters could claim that the tax plan proposes subsidizing intermediate inputs since Y equals gross business receipts less intermediate inputs.

The actual mechanics of including M – X in the VAT tax base is called border adjustment. The press has morphed this into border adjustment tax. But that language doesn’t change the fact that the VAT is a tax on consumption, plain and simple. It’s not a tax that will make imports more expensive relative to exports. It it were, the WTO would never have permitted its member countries to adopt or retain their VATs.

When a country introduces a VAT its exchange rate appreciates by 1/(1-t) percent, where t is the VAT tax rate, to ensure that the cost to importers of importing (buying products abroad) and the amount received from exporting (selling products abroad) doesn’t change. Tariffs raise the relative cost of importing compared to exporting. But thanks to exchange rate adjustments, the introduction of a VAT produces no change in this relative cost. Consequently, adopting a VAT, which means doing border adjustments, does not, as the NY Times puts it, constitute “taxing imports”.

There is strong empirical evidence that the introduction of VATs leads to exchange rate adjustment by precisely 1/(1-t) percent leaving the relative cost of imports (also called the terms of trade or the real exchange rate) unchanged.

What about countries that have fixed exchange rates? Those countries will and do adjust the levels at which they peg their rates. If they don’t they can expect a run on their currencies, which will be overvalued.

As the above math makes clear, including M-X in figuring the base of the value added tax is critical to taxing consumption. If M-X is left out, the country ends up taxing C – (M – X), i.e., in addition to taxing consumption, the country puts a special tax on exports and provides a special subsidy to imports. This is “Buy Foreign,” not “Buy American.”

But thanks to the NY Times and other purveyors of #FakeEconomics, the President has now decided to oppose border adjustment in putting forth his own tax reform plan. So we have a President who was elected on the basis of improving our trade balance pushing a plan to do the opposite. This result may, incidentally, explain the strong opposition to border adjustment by Walmarts. Since that company imports heavily, their success in helping kill border adjustment is leaving them with a tax-payer-funded subsidy on every penny of goods they import.

Let me also clarify another critical point about the House tax plan that reporters have neither understood nor publicly discussed. The House tax plan has two parts — a business tax reform and a personal tax reform. The personal tax reform has a variety of elements that, on balance, reduce our fiscal system’s overall progressivity. On the other hand, the business tax reform constitutes, as indicated above, the adoption of a VAT plus a wage subsidy. The reason that wages are subsidized is that the House’s business tax, like the current corporate tax, permits businesses to deduct wages in calculating their taxable income. Thus, the business part of the tax plan taxes not just C, but C – W, where W stands for wages.

Now when we consume, both now and in the future, we pay for that consumption from two sources — our current and future wages (labor income) and our current wealth. In taxing C but subsidizing W, the House business tax reform is protecting workers from paying any taxes, on net, on their part of C (the part of C they pay for now and in the future from their labor income.) Consequently, the business part of the House tax plan ends up taxing only consumption paid for out of current wealth. I.e., the business part of the House Republican tax plan effectively represents a wealth tax!

Furthermore, the current corporation tax represents, in my view, a hidden tax on workers because it leads corporations to invest outside of our country. But in so doing, they leave American workers beyond. This ends up lowering our workers’ wages. Simulation studies I’ve conducted with other colleagues suggest the current U.S. corporation tax is best thought of as a tax on the wages of American workers

To connect all the dots, what the Times and other reporters should have written was that the House Republicans, whether they knew it or not, were proposing, in their business tax reform, switching from a tax on wages to a tax on wealth — something that Democrats would presumably strongly support were Republicans to use other words and simply announce they were replacing the corporate income tax with a tax on current wealth. This highly progressive part of the House tax plan appears to leave the overall progressivity of the total business plus personal proposed reform roughly equal to that under the current tax system.

The House plan, in dramatically lowering the effective marginal tax rate on investing in the U.S., would also greatly stimulate investment in the U.S. leading to real wage increases, according to simulations I’ve been running with colleagues, of 8 percent. This dynamic feedback effect, were it to materialize, would go a long way to making the House plan revenue neutral. Moreover, one could modify the House plan to include lifting the ceiling on Social Security’s FICA tax. Doing so would ensure the plan raises revenue on balance and maintains current fiscal progressivity.

The President’s plan, as indicated, features no border adjustment. It also proposes a 15 percent, not a 20 percent tax rate. Both changes could mean less overall revenue despite a larger dynamic feedback (my optimistic estimate is a 10 percent rise in wages, but that’s assumes no increase in deficits). Indeed, the potential revenue loss from the President plan could be massive. He is proposing that all pass-through entities be taxed at 15 percent. In principal every American worker in a tax bracket above 15 percent could reestablish themselves as a consultant, proprietorship, partnership, LLC, or S-corporation and sell their labor back to their former employer. In so doing, they would ensure their income is taxed at 15 percent. This would not only produce a catastrophic decline in revenues. It would end fiscal progressivity as we know it.

Here are my three bottom lines. First, reporters who write about economics need to learn economics. Second, the NY Times and other media have done a great disservice to the public in claiming the House tax plan “taxes imports.” And third, the House Republican tax plan with border adjustment, but modified to include the elimination of the Social Security FICA payroll tax ceiling, is the way to go. Unfortunately, thanks in large part to #FakeEconomics, the House tax plan, like the House healthcare reform, appears to be dead on arrival. In its stead, we are facing the Trump tax plan. Good luck with that.

This article was originally posted at Forbes on April 26, 2017.  

Posted with permission from Mr. Kotlikoff.