Tax Reform Will Give Workers a Raise

Expect 3.2% growth, mostly taking the form of higher real wages. It happened in the 1960s.

 
 

ILLUSTRATION: CHAD CROWE
 

The tax-reform package now working its way through Congress is well-designed and far-reaching. It aims to address the reasons that the current economic recovery has been the most anemic on record. If it becomes law, we can expect economic growth to accelerate to roughly 3.2% for the next three to five years, then settle in at a sustainable pace of around 2.5%. This is well above current official expectations for long-term growth of about 1.9%.

Both history and economics suggest that most of this additional growth will accrue to workers in higher real wages. From 1965 through 2010, the economy grew at an average annual rate of 3.1%. It attained that pace by combining 1.5% employment growth with 3.2% growth in the capital stock and a 1.1% annual rise in total factor productivity. By contrast, the 2.1% average annual growth rate observed from 2011-16 combined the same rapid employment growth with a feeble 1.7% expansion of the capital stock and total factor productivity of just 0.5%. Real wages stagnated.

Any growth-oriented policy must therefore address the problem that, in the current recovery, capital-formation growth was nearly cut in half and productivity growth by more than half. The bill now under consideration does exactly that by focusing on incentives to increase investment in fixed capital. It also promotes entrepreneurship and small-business formation—the ultimate driver of productivity growth. In the current expansion, the pace of new business creation relative to business closure paled dramatically in comparison to the historical average.

The tax package promotes business investment by establishing expensing—immediate write-off—of spending on new equipment. That would bring taxation in line with actual business cash flow. Under current law, businesses must spend money now and receive deductions over time. That particularly hurts new and small businesses, which generally have the most pressing cash-flow needs.

Expensing sharply reduces the after-tax cost of buying new equipment. Business investment spending is the most sensitive part of the economy to these types of tax changes. The provisions in the bill will likely lead to a 7% to 10% increase in business fixed investment, enough to boost annual economic growth by at least one percentage point.

The package also promotes entrepreneurship, the key to productivity growth. Productivity growth does not descend magically upon workers once they get up to speed in their jobs; it occurs when individuals take on new jobs better suited to their skill sets. The signal for this is that the new job pays more—if it didn’t, the worker probably wouldn’t take it. New jobs open up in the economy when businesses are formed that create fresh market niches and exploit existing ones more efficiently than legacy companies.

The proposed legislation favors these businesses, as well as smaller businesses in general, by making expensing permanent for them and allowing an interest deduction up to a capped amount. It also provides a 25% rate on pass-through income from businesses that are not merely providers of personal services. Corporate profits would be taxed at 20%, but recall that shareholders are typically taxed at 15% on dividends. If corporations pass on their after-tax profits to shareholders, the combined rate would be 32%, higher than the 25% pass-through rate. The actual calculation is more complicated, but the new 25% rate provides at least rough justice for pass-throughs.

Some have argued that the economy cannot grow faster than its current rate because the labor market is at what most economists consider “full employment.” That misses the lesson of the current recovery. The majority of the growth in this expansion has come from adding more workers—essentially bringing the unemployed back into the workforce. That does nothing to enhance productivity. For the economy to grow at a more rapid rate, we need other sources of growth—namely productivity and capital formation.

If productivity and capital formation merely return to their normal historical levels, GDP growth would rise to 2.6% even with no further reductions in the unemployment rate and a slow-growing labor force, expanding at a rate of just 0.7% annually. But the entrepreneurship and capital-formation provisions in the tax bill are more generous than the historical norm. One should therefore expect that these factors will grow more quickly than in the past—especially in the near term, as there would be a “catch-up” period to bring the capital stock more in line with what it should be under the new rules. That is why we can expect growth in the next three to five years to exceed 3%.

There actually is a historical analogue to the legislation currently under consideration. In 1964 Congress enacted a tax cut that similarly encouraged capital formation and entrepreneurship. It cut the top personal rate by 21 points. It cut the corporate rate and introduced accelerated depreciation. The result was a boom that went on for the rest of the decade.

When a supply-side tax bill like this is passed at a time of full employment, labor’s share of the economic pie expands rapidly. That happened after the passage of the 1964 bill, and it will happen again if the current tax reform becomes law. Over the next five years, we should see labor’s share of the economy rise by four points, from the current 59% to 63%—a growing slice of a growing pie. It would not be surprising to see real wage increases of 4% to 5%. By contrast, in the current expansion, real wage growth has been flat, if not negative.

A rise in real wages would dramatically improve America’s society as well as its economy. It would lead to the first sustained decline in income inequality in more than 40 years. The American economy will finally start working in the interest of the great middle class and not simply those at the top. This is an important piece of legislation to pass. The country must not miss this opportunity.

Mr. Lindsey, a former Federal Reserve governor and assistant to President George W. Bush for economic policy, is president and CEO of the Lindsey Group.

Appeared in the October 11, 2017, print edition.

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