Is Tax Reform Really Necessary?

I have been thinking a lot lately about the pending tax reform legislation. It seems to be an unquestioned article of faith that this legislation is much needed, that everyone is in favor of it and that it will work wonders. Perhaps, but at the risk of extreme unpopularity, I think someone at least should be asking a few questions.

First, I wonder why we are back cutting individual income taxes again when we have little or no proof that the last round of tax cuts produced the advertised results? Did the last income tax reductions boost personal saving and investment? Did they accelerate economic growth beyond what one might have expected from a conventional business cycle recovery? Did the last cuts generate so much federal income tax revenue that the budget shifted toward balance more or less on its own?

The answers will depend on who’s doing the talking, of course, but I have some significant doubts.

Second, I wonder why we are reviving the myth that corporations pay taxes? A major feature of this legislation is the shifting of more than $100 billion in taxes from individuals to corporations. I thought the case had long been made that a tax on corporations, in reality, is a regressive tax on consumers. But, suddenly, people who should know better are demanding that corporations pay their fair share.

Combination of Effects

You may well be asking: “What do you mean, corporations don’t pay taxes?” Corporations are in business to make money for their stockholders, who provide the capital to run and expand the business. If corporate taxes are increased by government edict, one or a combination of several things will happen. With no change in the prices it charges, the corporation’s profits will decline, as will the return to its stockholders. If the resulting return is below what stockholders think they can obtain elsewhere, the corporation won’t be able to attract new capital. To attract the capital it needs to keep growing--indeed, to stay in business--the corporation must increase the return to stockholders. How can it do that? It can cut costs and increase productivity in order to offset the effects of rising taxes, or it can raise prices to consumers if the market for its products will permit, or both.

To the extent that raising prices is the solution, one is led ineluctably to the conclusion that, in the end, consumers pay the higher taxes in the form of higher prices. Chances are that, in the long run, a large part of any increase in corporate taxes will end up this way; thus, corporations don’t pay taxes. Only you and I pay taxes. (And sometimes I wonder about . . . well, never mind.)

I have skipped over several technicalities, and some of these points are a matter of debate among economists; in any event, that’s my position. Accordingly, it annoys me to think that there is such massive support for the idea of shifting more than $100 billion in taxes from individuals to corporations (and, as we have seen, back again to consumers) and calling it tax reform or a tax cut for consumers. It is neither, and it couldn’t come at a worse time.

The American economy is balancing on a knife edge this summer. Growth in the economy is slow. Four major problems account for the sluggishness:

- New investment in machinery and equipment is very weak.

- Construction activity, particularly commercial and industrial construction and multifamily housing activity, is collapsing.

- Imports are growing while our exports are not, despite a 25% decline in the value of the dollar.

- The financial structure is viewed as potentially unstable, causing people to hold back from spending and investing.

Enter the growing probability of tax refrom. The removal of the so-called investment tax credit retroactive to last January, plus great uncertainty about the future of other tax incentives for investment, have helped to slow new investment to a crawl.

Tax uncertainty isn’t the only problem here, but I think it’s a major contributor. Uncertainty is the archenemy of growth. This is a dangerous time to be introducing major new uncertainties into an already fragile environment.

What does the $100-billion tax increase do for U.S. corporations? All other things being equal, it raises their costs and could force them to increase prices. In addition, if past is prologue, the only short-run effect of an individual tax cut on which we have hard evidence is that it tends to promote consumption. International trade experts tell us that America must consume less and save more. There is no other way out. From the point of view of reducing our trade deficit, are these tax reforms really the sorts of things we should be doing at this time?

Not Really Revenue Neutral

This legislation is billed as “revenue neutral,” meaning that it will neither increase nor decrease federal tax receipts. Well, if it’s neutral, can we really expect it to boost the economy, especially when we know so little about the long-term effects of the various elements of the overall legislation?

Of course, it’s not difficult to imagine that in reality, the legislation is not revenue neutral. If the deductions for individual retirement accounts are restored and the time gap is eliminated between the removal of deductions and the granting of personal tax cuts--as seem likely--it will be difficult for the conference committee to come up with the offsetting revenue.

Further, the assumptions behind the legislation’s estimates of future tax revenue are too optimistic. More likely than not, both individuals and corporations will immediately set about finding new and ingenious ways to minimize taxes. That’s human nature.

But what are we doing giving away federal revenue at a time when we’re wringing our hands over budget deficits in the $200-billion range--deficits that simply refuse to go away on their own? Didn’t we just pass a radical new Gramm-Rudman law to force ourselves into fiscal prudence? If we are not going to do much more about cutting federal outlays--and it’s clear to me that we’re not--is this the right time to be risking still more revenue losses?

As a matter of fact, what does this legislation have to do with the central issue of reducing the deficit? Isn’t it a side issue? Haven’t we missed the point? Who are we kidding besides ourselves? And please, please, do not dredge up those old “supply-side” arguments to justify this deflection of focus.

Besides, what if the uncertainties unleashed by all of the changes embodied in this legislation tip the U.S. economy into recession later this year? What happens to the deficit then? What happens to all of those tenuous bank loans to the energy, agriculture and construction areas and to less-developed countries? What happens to the dollar and the massive inflow of foreign capital that sustains our living standards despite gigantic internal and external deficits?

This country has troubles, folks, and the distribution of the tax burden, while important, does not strike me as the most vital issue of the day. It’s more like a smoke screen for the real issue: namely, the budget deficit. That this view is shared by the public at large is clear from the various opinion surveys. Tax reform is a Washington issue, not a national issue, make no mistake about it.

And yet, I can foresee the time when it could become a national issue; unfortunately, tomorrow’s debate likely will be the reverse of today’s. Socioeconomic pendulums do swing, and the pendulum will have swung pretty far in one direction by the time this legislation is put in place. History tells us that low tax rates on high incomes has not been a lasting proposition.