Tax Reform Passes the Fairness Test

The usual assessments fail to account for the way liabilities change over a taxpayer’s lifetime.

 
 

Tax Reform Passes the Fairness Test
PHOTO: ISTOCK/GETTY IMAGES
 

The GOP tax plan should do three things. It should expand the economy while raising wages. It should pay for itself. And it should be fair.

The new plan’s business-tax provisions will reduce the effective marginal tax rate on U.S. investments dramatically, from close to 35% to under 19%. Depending on the year in question, my global dynamic macroeconomic model predicts a 12% to 20% expansion in the U.S. capital stock, producing an average $3,500 real wage increase for each American working household. Moreover, economic growth spurred by the business-tax cuts will raise tax receipts enough to make the plan revenue-neutral.

That means the plan passes the first two tests. What about fairness? Using conventional methods for assessing fiscal fairness, government agencies and Beltway think tanks have declared the House bill a giveaway to the rich. But these methods were developed before the advent of computer modeling and big data. Their conclusions are unreliable.

Myopic conventional fairness measures consider only the current year’s net taxes—that is, taxes paid minus benefits received. They ignore net future taxes, making it impossible to account for phased-in reforms as well as consumption and estate taxes. Moreover, these methods understate the tax burden on the rich who save more relative to the nonrich and thus face higher relative taxes in the future based on their resulting taxable asset income. 

Conventional measures also fail to account for the roughly 5.5% rise in pretax income I predict the tax plan will generate. Ultimately inequality is about relative spending, not relative taxes. And what we spend depends on what we earn, not just what share of our earnings we hand over to Uncle Sam. By lumping together people of all ages, conventional fairness measures compare apples and oranges: the young, most of whose taxes lie ahead, and the old, most of whose taxes have already been paid.

To correct Washington’s routine mismeasurement of fiscal fairness, I—along with economist Alan Auerbach and software specialist Darryl Koehler —developed a tool we call the Fiscal Analyzer. It uses data from the Federal Reserve’s nationwide survey of household income and wealth to study remaining lifetime fiscal fairness on a cohort basis. For example, we compare the average remaining lifetime net tax rates of rich and poor 40-year-olds. We calculate these tax rates by dividing remaining lifetime net taxes (measured in present value) by household resources (the present value of future labor earnings plus current net worth).

The Fiscal Analyzer includes some 20 federal and state business and personal taxes as well as transfer programs, including hidden taxes, such as Medicare Part B premiums, and transfers to the poor, such as food stamps and welfare benefits. It also calculates inequality in remaining lifetime spending for each cohort separately. Finally, the Fiscal Analyzer properly weighs all households’ future survival paths, taking full account of all net taxes, including estate taxes, paid along these paths and treating the present value of bequests as part of the spending of the decedents. In short, the Fiscal Analyzer assesses fiscal progressivity and spending inequality based on what economics actually says, not what politicians are used to hearing.

I’ve run the new tax plan through the Fiscal Analyzer assuming a 5.5% increase in workers’ wages. The new tax law makes little difference to spending inequality or net tax rates. The within-age-40-cohort spending share of the top 1% barely rises—to 12% from 11.9%. For those in the bottom fifth, spending share falls to 6.3% from 6.6%. This is a bigger deal given this group’s economic vulnerability. As for the middle 20%, their spending share remains at 13.7%. Remaining lifetime net tax rates are slightly lower at the top and slightly higher at the bottom.

Spending shares and tax rates are important, but not as important as the rise in earning and spending. The Fiscal Analyzer shows a 2.2% rise in remaining lifetime spending for the bottom quintile followed by increases of 5.4%, 6.3%, 6.5% and 7.2% for the next four quintiles. The rise for the top 1% is 7.1%. The poor don’t do as well, because they don’t pay as much in taxes, nor do they have much in earnings. Consequently, the absolute rise in spending is far larger for the rich.

There are many steps, like lifting the ceiling on Social Security taxable earnings, that could make the reform more progressive and produce badly needed revenue. But the new tax plan, while far from what I and other tax specialists would design, will boost the economy, generate more revenue, maintain fairness, and raise Americans’ living standards. It’s imperfect but worth passing.

Mr. Kotlikoff is an economist at Boston University and president of Economic Security Planning Inc.

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