There is widespread recognition that the U.S. income tax is a complex, highly inefficient, and costly way of raising revenues to finance government expenditures. In a February 2011 paper, Baker Institute Rice scholar George Zodrow and I proposed a base-broadening, rate-reducing reform of the U.S. tax system. While recent reports have highlighted the perceived unfairness of such a reform in a static analysis, it is also important to consider the potential economic benefits of such a reform. This blog presents preliminary estimates of the economic effects of a base-broadening, rate-reducing tax reform, similar to that outlined in the paper noted above, using the Tax Policy Advisers model — a model developed by John Diamond, the Baker Institute Edward A. and Hermena Hancock Kelly Fellow in Public Finance, and George Zodrow. The simulations show that such a base-broadening, rate-reducing reform would have significant positive economic effects on the U.S. economy, including increases in investment, the capital stock, employment, and real wages. Specifically, I find that the reform would, if passed immediately, increase GDP relative to the baseline by 5.0 percent over the next decade, while creating 5.9 million jobs. These gains are in addition to increases in GDP, investment, consumption, and employment that will occur as the U.S. economy continues to recover from the recent recession and as the population grows.
Results
The plan I simulate would reduce individual marginal income tax rates on wages and non-corporate business income by about 20 percent, reduce dividend tax rates by 62.2 percent, reduce capital gains tax rates by 25 percent, and reduce the corporate tax rate from 35 to 25 percent. I do not model the effects of enacting an allowance for corporate equity (ACE) as was advocated in the paper but instead simulate the effects of a base-broadening, rate reducing reform in the corporate sector that eliminates all business tax expenditures. The effects of such a reform on GDP are significant, as GDP increases by 4.6 percent five years after the reform, by 5.0 percent after 10 years, and 5.6 percent in the long-run. Transfer payments (excluding social security) increase by 3.9 percent in the long-run, which is not part of our proposal but is a necessary assumption to satisfy the long-run budget constraint of the government in the model. If these gains were used for debt reduction, the simulation results would show larger positive economic effects.
Investment increases by 8.0 percent after 10 years, and by 7.1 percent in the long-run. The U.S. capital stock increases by 5.2 percent in the long-run. The larger capital stock increases the productivity of labor in the long-run. Consumption increases by 3.7 percent 10 years after reform, and by 5.6 percent in the long-run.
Labor supply increases by 4.9 percent after 10 years. The before-tax wage increases by 1.1 percent in the long-run. And, before-tax wage earnings and the after-tax wage increase in every year after reform. Blundell, Bozio, and Laroque (2011) recently developed a statistical decomposition that provides bounds on the changes at the extensive and intensive margins for the United States. Using those numbers, this increase in labor supply represents an increase of about 5.9 million jobs.
It is worth noting that these results are consistent with those that have been found by others who have examined comparable (but different) reforms, such as Altig et al. (1997, 2001) and Carroll and Prante (2012).
Conclusion
There is widespread recognition that the U.S. income tax is a complex, highly inefficient, and costly way of raising revenues to finance government expenditures. For example, the National Commission on Fiscal Responsibility and Reform (2010) and the President’s Advisory Panel on Federal Tax Reform (2005) have highlighted the need to reform the personal and corporate income tax systems. In this post, I have presented the economic effects of a base broadening, rate-reducing tax reform proposed in Diamond and Zodrow (2011), similar in nature to the tax reform plan proposed by the National Commission on Fiscal Responsibility and Reform (2010). This analysis shows that the reform would have significant positive economic effects on the U.S. economy, including increases in investment, the capital stock, employment, and real wages. These results are likely to understate the potential positive economic effects of a lower corporate tax rate due to the incomplete modeling of the global economy and the potential benefits of a more level playing field across different types of assets and industries. In addition, the simulation results may understate the potential gains because it is assumed that increased revenues that are derived from a larger economy are used to increase transfer payments rather than reduce government deficits, which would have a positive impact on consumption and investment in the long-run. Finally, the simulated gains are in addition to increases in GDP, investment, consumption, and employment that will occur as the U.S. economy continues to recover from the recent recession and as the population grows.
John W. Diamond is the Edward A. and Hermena Hancock Kelly Fellow in Public Finance at the Baker Institute and an adjunct professor of economics at Rice University.