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Tax Reform: As Usual, We're Going About It All Wrong

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I really don't like to be cynical -- therein lies the way to dark and gnarled soul -- so I apologize in advance for this cynical statement (but keep reading... hope is on the way): whatever D.C. is debating right now, you can rest assured that it's mostly B.S., and I don't mean Bowles-Simpson.

To state the glaringly obvious, lobbyists are paid to steer the debate and ultimately the legislation their clients' way, and they're not bound by facts or logic or what's best for most people. The best way to understand our debates is to think of them like television commercials. It's about as likely that something called a "jobs" bill will generate jobs as drinking a particular beer will lead your super-hot downstairs neighbor to unexpectedly drop by to party with you.

We could certainly talk about guns in this context, but lately I've been thinking about this in terms of tax policy. I'll post something longer (and more upbeat) later in the week, but I'm increasingly convinced that linking taxes to growth, investment, and jobs the way we typically do is generally misguided and incentivizes beer-party scenarios: tweak the code and your [nation/state/city] will have more jobs than it knows what to do with!

There's a long and deep academic literature examining the responsiveness of labor supply, investment, income growth, and job creation to changes in the tax code, and that literature has led some economists, as opposed to many lobbyists, to embrace the mantle of small responders, i.e., particularly regarding tax changes, we believe the evidence points you toward smaller elasticities with regard to the variables above.*

There's no better example than taxes on capital gains. Ever since I've been in this business, and until I leave it, people have and will continue to argue that lower taxes on capital gains will boost investment, productivity, and jobs. And yet, there's virtually no evidence.

University of Michigan tax economist Joel Slemrod, another of the nation's leading tax policy experts, has found that "there is no evidence that links aggregate economic performance to capital gains tax rates." Similarly, [Tax Policy Center] has found no statistically significant correlation between capital gains rates and real GDP growth during the last 50 years. In addition, a new CRS report analyzing capital gains tax rates and economic growth finds that "analysis of such data suggests the reduction in the top [capital gains] tax rates have had little association with saving, investment, or productivity growth".

I often think of the two graphs at the bottom of this post in this context as well, using international evidence to show a) the lack of correlation between lowering top tax rates and per-capita income growth, and b) their positive correlation with income inequality.

So, does that mean tax reform is a bust? We shouldn't bother? Taxes don't matter?

It may well be a bust or worse with this Congress, but taxes do matter and yes, we should bother. As the inequality result noted above suggests, taxes matter in terms of exacerbating or ameliorating the growing inequality of market outcomes. Piling regressive tax changes on top of these pretax trends is what Alan Blinder calls "unnecessary roughness." Recent state shifts from progressive income taxes to regressive sales taxes are germane -- and very ill-advised -- in this context.

But besides the obvious distributional issues, in what ways do small responders like myself think taxes are important? Two reasons.

First, we've got to collect enough revenue to meet the present and future challenges for federal government, including retirement security of the large boomer cohort, public good demands including infrastructure and education, safety net, regulating markets, environment (not just climate change but super storms), and so on.

But it's the second reason why taxes matter that's more interesting in the context of those variables that tax-cut advocates are endlessly and meaninglessly blathering on about: jobs, growth, investment.

Instead of starting from what are basically discredited supply-side arguments -- the fiscal version of drink-our-beer-and-prepare-for-the-arrival-of-the-hotties -- tax reform should focus on what really drives economic growth these days: globalization, including currency and trade imbalances, technology, skill demands, connectivity, industry mix, capital markets and how those national and international phenomena interact our workforce, public goods/infrastructure, our airports, financial markets, technology, ports, and so on. Simply cutting taxes on the wealthy or the multinationals doesn't begin to scratch any of these critical economic itches.

I fear this is too abstract so let me give a few concrete examples (before I get back to the suburban dad's actual weekend employment: picking up and dropping off children). Financial market instability has proven to be a very large and intractable problem for growth and jobs in advanced (as well as ancient) capitalist economies. Some have argued that a small tax on financial transactions could help dampen some volatility from that sector while raising significant revenue. That's a simple example of the type of connections we should be exploring: identify market failures or vulnerabilities and ask if there's a tax change that could help.

It won't always be a tax increase either. President Obama has long recognized that tax policy could be used to incentivize private investment in public goods (from the above list: infrastructure) as well as the importance of credits to incentivize investment in clean energy (industry mix)-areas where the private sector will tend to underinvest.

Of course, let's not be naïve. Lobbyists can play this game too -- "a tax credit for my employers' industry will improve the nation's industry mix... and generate a zillion new jobs!" But like I said, there's some hope here if we're willing to get away from the current TV-ad-style debate that simply links tax cuts to jobs and growth in ways that a deep literature shows to be largely phony. Instead, proposed tax changes should have to stand on whether they'll a) help to raise the revenue we need to meet future challenges that are coming fast, or b) boost growth in ways that actually matter to contemporary economies.

*Where you see larger responses is in terms of tax planning in response to tax changes -- e.g., timing realizations to avoid a higher tax on them.

This post originally appeared at Jared Bernstein's On The Economy blog.