Kotlikoff to WSJ: Where Critics of Tax Reform Go Wrong

by | Oct 18, 2017 | Larry Kotlikoff, Media

By Laurence Kotlikoff and Jack Mintz

Originally appeared in Wall Street Journal, October 2017

Tax Policy Center’s models don’t simulate how the GOP plan would draw investment to the U.S.

The Republican framework for tax reform is taking considerable heat. Former Treasury Secretary Lawrence Summers calls it an “atrocity.” Economics Nobel Laureate Paul Krugman describes it as “ten big lies.” These strong reactions rest in large part on a preliminary analysis of the plan from the Tax Policy Center. It claims that the tax plan won’t expand America’s economy or its tax base but will produce massive deficits. This pessimistic view does not reflect the best economic analysis.

Start on the business side. By our estimate, the GOP framework reduces the tax on investing in the U.S. from 34.6% to 18.6%. That’s a hefty tax cut and should greatly stimulate investment. The extra capital should, in turn, make workers more productive, raise their wages, and increase tax revenues. Given how little revenue the corporate tax collects thanks to its many loopholes, this part of the framework could, conceivably, pay for itself.

So why does the Tax Policy Center assume there will be “little macroeconomic feedback effect on revenues”? One answer might be that the framework’s changes to personal income taxes would create huge government deficits. Some “closed economy” models of a single country suggest such deficits would absorb Americans’ savings that would otherwise be invested, negating the positive effects of the business tax reform.

But this isn’t the answer given by the Tax Policy Center. Its analysis estimates that the personal tax reforms will generate more revenue, not less. The huge deficits it foresees will come, it says, solely on the business side.

The Tax Policy Center justifies this curious position based on its study last year of the framework’s predecessor—the “Better Way” plan released by House Republicans. Following the trail back, we find that last year’s study relied on two closed-economy models that do not simulate the current, let alone the future, global capital market. Yet it’s impossible to guess how corporate tax changes would affect America’s open economy without explicitly factoring in the conditions in competing countries—including not just their corporate tax rates, but their propensities and capacities to save and, thus, supply capital to the world.

Fortunately, a study posted this week co-written by one of us (Kotlikoff), along with MIT’s Seth Benzell and the Inter-American Development Bank’s Guillermo Lagarda, fills the gap. The study estimates the effects of the GOP tax framework using the Global Gaidar Model. The GGM simulates the entire world capital market—every country is included, broken down into 17 regions—and is calibrated using demographic information from the United Nations and fiscal data from the International Monetary Fund. It was developed over three years by Kotlikoff and a team of Russian and U.S. economists.

The GGM is a direct descendant of the AK model, an early macroeconomic simulation developed in the late 1970s by Alan Auerbach, a Berkeley economist, and Kotlikoff. Closed-economy versions of the AK model are used by the Congressional Budget Office, the Joint Committee on Taxation and even the Tax Policy Center.

Building and calibrating a single-country AK model is one thing. Creating a 17-region version is a much bigger challenge. Consequently, the GGM may well be the world’s only up-to-date global AK model. In our view, it’s the only one that is up to the task of predicting the effects of the Republican tax framework.

Unlike the “closed-economy models” being used by the Tax Policy Center, the GGM recognizes that foreigners can put capital into the U.S. Hence, the amount of investment depends on two things: the attractiveness of investing here, and the global supply of savings. It doesn’t depend on the size of Washington’s deficit because foreigners can buy the extra bonds issued by Uncle Sam. Putting it more formally, deficits leave our bills to our kids, but in an open economy they don’t “crowd out” domestic investment. That the Tax Policy Center suggests the opposite shows it is using the wrong models.

Simulating the Republican tax framework in the GGM produces a very different estimate. The GOP plan would raise America’s gross domestic product by 3% to 5%, depending on the year in question. It would increase the U.S. capital stock by 12% to 20%. And it would raise real wages by 4% to 7%, which translates into roughly $3,500 a year for the average working household. Moreover, due to the economy’s expansion, the framework’s tax plan is essentially revenue-neutral.

The GGM’s strong supply-side response to the corporate tax reform reflects the mobility of global capital and the inefficiency of today’s tax code—with its high investment disincentive and many loopholes. But the model does not have a built-in supply-side bias. The GGM predicts that cutting personal income taxes would produce deficits, crowd out capital and diminish long-run economic welfare. It also estimates that setting the corporate tax much below the 20% rate proposed by the GOP framework would necessitate personal income tax increases to prevent America’s debt-to-GDP ratio from rising.

The Tax Policy Center also suggests that the Republican framework is highly regressive. This ignores, however, the increase in workers’ wages predicted by the GGM. That said, we do share critics’ concern that the plan would disproportionately benefit the top 1%. One way to rectify the fairness problem and address the country’s long-term fiscal gap would be to add, as the framework foresees, a fourth personal tax bracket for those with very high incomes.

No economic model is perfect. But some are far better than others when it comes to the specific questions they were designed to answer. Unfortunately, notwithstanding its truly outstanding staff, the Tax Policy Center is influencing a critical debate using closed-economy models. Such models are simply unable to simulate accurately how the GOP tax plan will affect the economy—let alone its tax revenue, wages and fairness.

Mr. Kotlikoff is a professor of economics at Boston University and a Senior Fellow of the Goodman Institute for Public Policy Research. Mr. Mintz is a fellow at the University of Calgary’s School of Public Policy.

Appeared in the Wall Street Journal on October 18, 2017, print edition.