Giving us more of our own income back will boost economic growth and will allow us to bolster voluntary alternatives to some of the federal government’s biggest agencies.
On December 22, 2017, President Trump signed the Tax Cut and Reform Bill. Overall, I think the positive aspects of the bill outweigh its negatives. A simplified personal income code that broadens the tax base (i.e. provides fewer exemptions) makes fiscal sense. A significant reduction in the top corporate tax rate and a handful of improvements to deductions targeted at small businesses will be a boon to economic growth and will help small business owners profitably invest for the future. Below I briefly discuss both static and dynamic forecasts of the increase in the federal debt due to the new tax law, yet I won’t focus on the effects of the debt since even the larger of the two estimates is only a small fraction of the total debt expected to accrue over the next 10 years.
I will lean on two sources, the Tax Policy Center and the Tax Foundation, to summarize the likely effects of the reform. The Tax Policy Center does a fine job explaining all the changes and has some quality analysis of the near-term effects. However, the Congressional Budget Office is required to analyze the fiscal impacts of all bills over a 10-year period. However, its conclusions can be misleading when a bill is written to last only a certain number of years and when it is likely that a future Congress will make significant changes to the bill.
The Tax Foundation has strong and dynamic analysis of the effects of the bill, but it is important to note that these estimates carry significant uncertainty and that some of the key provisions of the bill will sunset within the 10-year window. Further, it is unlikely that a future Congress will leave all these provisions in place.
There are two key terms needed to understand the foregoing discussion: income quintiles and tax incidence. Analysis of the impacts of the taxes for people with different incomes is typically broken up by income quintile. This breaks the income distribution into 5 groups. Average household income for each of the 5 quintiles can be seen here.
Though much focus has been put on the personal income tax cuts in the bill, the corporate tax cut is really the main feature. When discussing corporate tax cuts, we have to be aware of the fact that those who actually make the cash payments for the taxes may not actually bear the economic cost of the tax. Tax incidence analysis examines the economic effects of the tax and determines what groups; shareholders, employees, and consumers. Although this is often derided as “trickle-down economics,” tax incidence analysis is important enough to warrant a portion of every first-year economics course.
Business tax changes
In terms of its effects on business taxes, the bill:
- Reduces the top corporate tax rate to 21%;
- Places some limitations on deductions and eliminates others;
- And enhances some deductions aimed at smaller businesses, including the Section 179 deduction.
The Tax Foundation’s analysis of the corporate tax cut indicates that it will result in:
- An increase of total GDP of 1.7%, which comes mostly in the first 8 years, after which GDP will fall relative to the baseline when many of the provisions are repealed;
- A 1.5% increase in wage rates and the addition of 339,000 full time equivalent jobs;
- And a 4.8% increase in the capital stock.
The long-run increase in GDP offsets the reductions in revenue. This doesn’t mean that federal revenues will not decline — they will. The Tax Foundation’s static and dynamic analysis indicates that the changes in the bill (changes to both personal and business income taxes) will result in reductions in federal government revenue over the 2018-2027 time period of $1.469 trillion and $448 billion. The dynamic analysis takes into account the pro-growth effects of the business tax rate changes over the period.
Personal income tax changes
The Tax Policy Center provides a very informative table comparing current tax law with the new law:
- Tax rates are reduced for all but 2 brackets and the income ranges for most brackets are changed;
- The standard deduction is doubled and personal and dependent exemptions are eliminated;
- Education credits and deductions in current law are maintained;
- The child tax credit for dependents 17 and under is doubled to $2,000 and provides a $500 credit for other dependents;
- And the income limit for the child tax credit is increased from $110,000 for joint filers to $400,000.
Combining these and other changes to personal income taxes with the changes to business taxes will, according to the Tax Foundation, result in the following increases in after-tax income:
The benefits accrue fairly evenly across the income distribution, but the bottom quintile and top quintile estimates differ from those in the middle. Specifically, the lowest quintile’s after-tax income only rises by 0.8% and the top quintile’s after-tax income rises by 1.9%. While I’ve read a significant amount of handwringing over this, it is pretty unremarkable to me. The top 20% of income earners pay roughly half of all income taxes and the bottom 20% pay almost none. Thus, a tax cut would tend to increase the after-tax incomes of those who pay more.
The Tax Foundation goes a bit further and calculates a dynamic estimate of the effects of the tax bill if all provisions were made permanent. This is unrealistic in my view, but it is interesting to see the estimated effects on after-tax income. By making the provisions permanent, the positive growth effects dramatically increase after-tax income in 2027 for all income quintiles.
Overall, this bill is a good first step to creating a stronger economy. The next task for the legislature is to focus on finding spending cuts to match the tax cuts. Giving us more of our own income back will boost growth and incomes and will allow us to bolster voluntary alternatives to some of the federal government’s biggest agencies, the Social Security Administration and the Department of Health and Human Services, which together make up more than 50% of federal government outlays.
Levi A. Russell is an Assistant Professor at the University of Georgia.