In December, scholars David Hope and Julian Limberg released a study with the London School of Economics (LSE) examining the economic effects of reducing tax rates for high-income individuals and corporations. The paper illustrates how overlooking an important element of the tax system—the structure of the tax base—can lead to an incomplete understanding of how tax reform impacts the economy.

The paper uses data from 18 countries in the Organisation for Economic Co-operation and Development (OECD) to measure how reducing taxes on higher-income earners would affect economic growth, income inequality, and unemployment. The authors found that the tax changes led to increased income inequality, but no significant effects on either economic growth or unemployment.

The authors constructed a method to identify changes in tax progressivity and the tax burden on higher earners, including tax changes impacting individuals, corporations, and inheritors. They identify both the Economic Recovery Tax Act of 1981 (ERTA) and the Tax Reform Act of 1986 (TRA) as major tax cuts in the U.S. Their finding suggests, however, that their method has trouble identifying tax reforms that encourage greater capital investment. Both U.S. tax reforms were identified in the study as major tax cuts, but they had very different effects on the American economy.

The ERTA in 1981 reformed the U.S. tax treatment of depreciation, moving the schedules from Asset Depreciation Range (ATR) to the Accelerated Cost Recovery System (ACRS). It also increased the investment tax credit and reduced marginal individual income tax rates (see Table 1). Using Tax Foundation’s General Equilibrium model, we found that the 1981 tax reform was highly pro-growth.

In contrast, the TRA of 1986 reduced economic growth according to our model, as it moved away from accelerated deprecation by adopting the Modified Accelerated Cost Recovery System (MACRS), repealed the investment tax credit, and taxed capital gains as ordinary income. It also reduced the corporate tax rate from 46 percent to 34 percent and simplified individual income tax breaks, but the net effect was to reduce economic output in the long run while being revenue neutral.

Table 1: Contrasting the Components of the 1981 and 1986 Tax Reforms
Tax Policy Economic Recovery Tax Act (’81) Tax Reform Act of 1986
Top Marginal Tax Rate on Individual Income Reduced from 70% to 50% Reduced from 50% to 28%
Corporate Tax Rate No change Reduced from 46% to 34%
Cost Recovery Accelerated depreciation (ACRS) Lengthened depreciation schedules
Alternative Minimum Tax Lowered AMT rate Raised AMT rate, exemption phased out
Investment Tax Credit Expanded Eliminated
Capital Gains Tax Reduced from 28% to 20% Raised to 28% (taxed as ordinary income)
Other Indexed tax brackets to inflation, reduced each tax bracket rate by 23%, increased maximum IRA contribution, created R&D tax credit, raised estate tax exclusion Consolidated the tax brackets from 16 to 2, increased personal exemption and standard deduction, several base-broadening provisions like passive loss limitation

Source: Tax Foundation, Modeling the Economic Effects of Past Tax Bills.

Tax policy changes can be pro-growth, can reduce the tax burden faced by higher earners, or may do both at the same time. It is misleading to point to a tax reduction on higher earners and assume it implies an increase in incentives to work and invest. The structure of tax changes matters—tax rates are important, but far from the entire story.

More specifically, it appears that the paper does not consider how cost recovery rules impact the effective tax rate faced by businesses. In fact, one of the source papers uses an average tax rate on capital that does not consider the value of depreciation deductions.

The same issues affect the evaluations of tax reforms made in other OECD countries. Many countries were inspired by the U.S. tax reform in 1986 and modified their tax bases in ways that were sometimes harmful to economic growth. The changes were designed to achieve revenue neutrality, as countries were concerned that corporate tax rate cuts would generate fiscal imbalances, but altering the tax base in a harmful way can undercut the benefits of lower tax rates. Revenue-neutral tax reform can be pro-growth, but it depends how the revenue is raised: some tax changes are more economically damaging than others.

Several international examples in the LSE study likely had ambiguous effects on economic growth. For example, Sweden’s 1991 tax reform reduced the statutory corporate tax rate but eliminated many pro-growth investment provisions. One study found that the tax reform overall did not significantly alter investment incentives and that other macroeconomic conditions likely contributed to the decline in Sweden’s corporate investment that occurred following the tax reform.

Similarly, Italy’s 1998 corporate tax reform cut the statutory rate and eliminated “distortions” in its treatment of corporate income. An analysis of Italy’s reforms estimated that the totality of the changes had differing impacts across firms and likely did not significantly impact net capital formation. 

Examining historical tax changes is a helpful way to establish how tax reforms affect economic growth. But both tax rates and the tax base need to be examined to get a complete picture of the relationship between tax changes and economic growth.

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