Ep. 48 Pethokoukis Podcast| What every Republican (and Democrat, too) should know about taxes: A long-read Q&A with Stan Veuger

Take a listen to the podcast below. 

With the presidential election season in full swing, candidates in both parties are unveiling sweeping tax reform plans. But what’s smart public policy, and what’s mere political posturing? To help find out, I chat with Stan Veuger of the American Enterprise Institute on this episode of Ricochet’s Political Economy podcast.

Dr. Veuger received his Ph.D. from Harvard University and was a teaching fellow there before joining AEI. He is a regular contributor to The National Interest and U.S.News & World Report. He also serves as a board member of the Altius Society and as the chairman of the Washington, D.C., chapter of the Netherland-America Foundation.

Below are some excerpts from our conversation:

 

Pethokoukis: As the 2016 campaign season marches on, more of the candidates are rolling out tax plans, among them Marco Rubio, Jeb Bush, and Donald Trump. All of them promise deep tax cuts for the rich, middle class, and business. And all of them, most importantly, promise that those tax cuts will spur faster economic growth. I mean that is a basic premise of Republican economics: lowering tax rates will spur more work, savings, investment, and an ultimately higher GDP. But as I evaluate those plans, I want to make sure that I really understand how taxes and tax rates affect economic growth. So sort of my lead off question to you Stan is: What do economists more or less agree on as to how taxes affect growth, and where are there conflicts or disputes? Does the explanation I just gave you sort of match how economists think of the relationship between taxes and economic growth?

Veuger: Well, it’s certainly how some economists think about it. What I would say is that economists roughly agree that taxes certainly affect behavior to a large extent. For example, if you drop the capital-gains tax rate for a year, promising to move it back up a year from now, then many more people will realize their unrealized capital gains. So you definitely have these behavioral effects driven by tax rates.

At the same time, I think that is basically where the consensus ends. There are a lot of economists I think who would dispute that, for example, lowering the top marginal income tax rate significantly would increase economic growth substantially. For example, prominent Nobel Laureate and New York Times blogger Paul Krugman would say, “No, that doesn’t actually change anything, you’ll just be shifting money away from the public treasury to wealthy people.” The consensus is not as straightforward as I think what you just presented. My reading of the literature is more in line with what you said. I do think that if you increase their income per day, people will, everything else equal, choose to work more. If you lower taxes on business activity, then people will be more willing to start firms or expand. But as I said, I don’t think there is a consensus that’s as broad and deep as one might think.

Is there a difference between how taxes will affect the overall size of the economy versus affecting the sort of rate of growth. A lot of what this tax policy is supposed to do is affect the growth rate. So under one set of tax policies, the economy is growing at a rate of 2%. But if we lower the capital gains rate, lower top marginal rates, cut the corporate tax, then the US economy, instead of growing at 2% like it has for the past few years, can grow at 3% or higher. What is that relationship? Is there a connection between those two things – how you change tax incentives to changing how fast an economy can grow?

So again, some people would say yes, there is definitely that effect. People will point to evidence based on say European countries who have much higher effective tax rates both on the individual side and, until recently, on the corporate side — and certainly when you add in sales taxes — people will say “Yes, we see these differences, one of the big reasons why these European countries are so much less wealthy than the US and have grown so much more slowly over the last four years is because their tax rates are much higher.”

On the other hand, you can imagine the following: I cut your income tax and you say “Woah, that’s outstanding, an additional hour of work will bring me more money.” On the other hand I’ve also made you much wealthier because your tax liability has gone down. So you’ll have more money and you’ll be able to buy more stuff. Right? So the relative value of your leisure time will go up because you already have a ton of the stuff you wanted to buy before I cut your taxes, so you don’t feel the urge to go out and work.

What I’m saying is that there are two effects: There is an income effect, you’re now more wealthy overall so you have less of an urge to go out and earn more money. On the other hand, there is also a substitution effect that is an additional hour of work pays off more than it used to be. And a lot of people on the left will say that that income effect may well dominate the substitution effect, and that as a consequence we won’t see that much additional growth. I think that’s what a lot of the debates are about in the background.

So, which of those effects do you think is more powerful, and is there just one effect? Does it matter the age of the person? Might there be different effects in different countries? Is there a possible way to generalize how taxes will affect how people act?

Yeah for sure. One good example is that economists have typically found that second-earners show much bigger effects when confronted with tax cuts than primary earners. So a lot of primary earners work a full week and they just don’t have that much margin to maneuver, whereas secondary earners can choose to suddenly enter the labor force. That’s a very big jump in participation and a contribution to economic growth. So you definitely see very different effects depending on the situation the person is in. Which is not weird.

And you also see effects that I think people don’t often take into account when they think of tax policy. They often think, “Yes, we are going to cut taxes and then next year we will unleash business activity like we have never seen before.” There’s other effects that I think may well be more important. So I think if you say, “OK, now we’re going to increase the top marginal tax rate to 60%,” you know people will say “OK, why would go to finance or major in computer science if everyone is going to end up making the same amount of money anyway – I may as well become a poet or a puppet master.” Okay, so I think human capital accumulation is affected very much by tax rates, but not on the kind of horizon that we think of, and you know potentially not even within the budget window, which is the magical ten years we have to judge all tax plans within.

So if you’re goal is to increase the growth potential of the American economy, increase its ability to grow at a faster rate, and you have this menu of tax changes that you wish to make, should your expectation be that a) the US economy is a big, giant thing and a is a super carrier, and b) that it’s going to take a while for these tax changes to affect those kinds of decisions people make – whether it’s a career choice or what have you?

Yeah, so I think some of these changes take a while to materialize, like the career or occupational choice thing I just mentioned. Other changes, like the immediate expensing of business investment, which a bunch of the candidates have proposed, I think would have much more immediate effects. Also because corporations are much more focused on the implications that tax changes have for their day-to-day decision making, and because they often have a much broader range of options that they can act on immediately. Whereas on the individual side, you know once you’re forty, people change careers but it’s harder and a lot harder to do immediately – it’s typically not worth it for a two point change in your marginal tax rate.

When people look at the Reagan tax cuts, what people saw were across-the-board tax cuts that seemed to have an almost immediate, an almost magical, effect on the economy. An economy that was in a recession – we went to a fast economy that was growing at something like 7% in ’84, and then kept growing at 3.5-4% for many years afterwards. Then you had the 90s boom. So one lesson people draw is that if you cut taxes you are going to have just an immediate accelerator effect on the economy that potentially will last a long long time and will really change incentives for people. So what are the right lessons and the wrong lessons to draw from the Reagan tax cuts?

Well, I think the key lesson is those pretty aggressive tax cuts certainly won’t jeopardize the future of western civilization.  And that’s what a lot of people on the left sometimes seem to argue, that you know it’s utterly irresponsible to even talk about cutting marginal tax rates for individuals or for corporations. We know that that’s just not true. And there is a reasonable chance that we will have additional growth.

On the other hand, I wouldn’t assign all of the growth we saw in the 1980s to the Reagan tax cuts alone. For example, the monetary policy environment I think was much more positive than it was in the 70s when there were staggering levels of inflation, you know partially driven by natural resource shocks but also by terrible Federal Reserve policy. All of that was gone in the 1980s and I think that helped a lot. The other lesson that I think is often overseen is that, well especially what the 1986 tax reform plan did was to lower individual rates relative to corporate rates.  So that shifted a lot of corporate activity and a lot of corporate income that people had sheltered in corporations to the individual side. So that made individual tax revenue increases look very large I think.

And you shouldn’t interpret all of that as actual increases in economic activity as opposed to shifting of activity and income from one source to another. And I think that’s a mistake people often make. They say “Look, we cut the individual rates, revenue went up,” but that revenue wasn’t newly generated in a sense. A lot of it came from what used to be corporate income. And some of the tax plans make me worry that they’re going to do the opposite thing. If you abolish all of the – if you basically reduce corporate and capital income rates to 15% and 0% for example, then I would worry that a lot of people will move what is now their personal income to a shell corporation and you will see massive drops in revenue that I don’t think are forecastable if you don’t take that margin into account. So I think that’s a lesson that they also need to learn from the experience in the 80s.

So if I cut taxes, and I expect that there will be this immediate growth, some of that growth comes from changing peoples’ behavior. But doesn’t some of just come from people having more money in their pockets and then just spending it? It’s more demand in the economy.

Yeah, I think that’s fair. So this is a weird area of controversy, because a lot of people deny that these effects exist, you know, when the government increases its outlays during a recession. A lot of Democrats deny that these effects exist when you cut taxes, because in the end what do you think will happen? If you cut taxes but you do not cut spending at the same time, at some point in the future you know someone is going to have to make up the difference. But I think we can all agree that consumers do not perfectly offset their expected future tax liability. So you will see some of that stimulative effect. How big that stimulative effect will be depends on credit conditions, it depends on debt overhang. I think the Bush tax refunds have shown us that a lot of households will choose to pay off debt instead of spending more money. So you’ll see some of it, but its effects won’t be perhaps as big as the most optimistic supporters of stimulative tax cuts will say, certainly not if the economy is booming already.

Do you think that Republicans, people on the right, they over-emphasize the role of tax cuts?  You have the Reagan example, where you had big tax cuts that seemed to be followed by a ton of economic growth. In the ’90s, you have an example of higher taxes, and there also seems to be a lot of economic growth. Then in the 2000s, you had again some more tax cuts and the economy didn’t do so well. Is there too much of an emphasis on taxes as a way of influencing growth as opposed to some other policy ideas.

Yeah, perhaps. I mean tax policy  is certainly very important and it can help,  I just wouldn’t expect two additional points of growth every year, even if we move to some ideal tax plan that would never be at political equilibrium. And I agree with you, there’s other stuff you can do. Innovation and new technologies are an important source of economic growth and I don’t think that tax policy is necessarily the most important lever for generating either technological innovation or other types of innovation. And you know, in the end, you pointed out that there’s three big examples, and that’s part of the problem. As in a lot of these macroeconomic policies, we just don’t have that many observations. There’s a lot of other stuff going on in the ’80s, just came out of the ’70s, and there’s a lot of other stuff going on in the ’90s, too, right? Because we have the dotcom bubble that’s building, that contributed significantly I think to economic growth. And that was all happening in an international environment that was calm. You know a lot of countries were moving towards more productive economies. I think a lot of the benefits from the IT revolution were, of the legitimate ones and not the bubble, ones were being incorporated into business practices.

I would like to think those innovations – I would like, and this is my prior – I would like to think those innovations in the ’90s were at least somewhat influenced by the tax changes of the 80s. I mean that’s certainly an assumption by many on the right that because whatever the impacts of the Reagan tax cuts on growth in the ’80s that they changed the longer term incentives in the economy and then you ended up with you  know, the “tech boom.” So if you like the technology stocks rise, you can thank Ronald Reagan.

You know, maybe. But then again, is that a direct consequence of lowering the top marginal tax rate? I-

I’d like to think so, but I don’t know if it is.

Maybe, partially, I’m not sure I would go to the extreme of saying Ronald Reagan invented the internet. You know?

Right, right.

Which is clearly what you’re claiming.

On some days. depending on my mood. Well, all the Republicans would lower tax rates. On the other side, you have Democrats, some of whom might like to raise tax rates. You know, Bernie Sanders has talked about very high tax rates. How high can you raise tax rates before really beginning to bite economic growth and what is sort of the mechanism there? What do we know about the Laffer curve, the inflection points, but when are tax rates just too high and the economy just doesn’t start performing particularly well?

The typical answer from economics would be, every increase hurts you a little bit but the increases grow exponentially larger as your tax rates increase. The other thing I would say is, it depends a lot on what you do with the tax revenue. Right? If you think that your public sector is reasonably productive, then shifting more activity there is not as harmful as it is if you believe that your public sector is not as productive. This is one of the things that people often underestimate when they look at tax rates in northern Europe. But a lot of those public sectors are pretty productive. They manage to recruit good people, and I’m just not so sure that you can replicate that on a continent-wide scale. Especially if there’s no tradition of sort of clean, productive, quasi-technocratic government. But sure, I think what Bernie wants to do would harm growth prospects because he gets to the point where, you know it’s basically punitive and it’s unclear whether he really wants to increase revenue as opposed to just redistribute for the sake of spreading the wealth around as they used to say.

We had high tax rates in the fifties, right? We had very high tax rates and there were some good economic –

Yeah, for like three guys. I mean, that’s not the same – There were never as many people subject to that as the numbers that are subject to the top rates now. You’re talking about the 90%?

Right, right. And it’s not like government was taking in a whole lot more revenue in the fifties –

Yeah exactly.

So when you look again at the Laffer curve, are we below the point, are we below the point, where taxes really begin to hurt? I mean do we have the room to cut?

I mean these are two separate issues. One is how do you maximize revenue? The other one is how do you maximize some sort of mix of revenue and growth potential and fairness? I think the experience of the Bush tax cuts has shown us is that we’re below the peak of the Laffer curve. If you raised all of the federal income tax rates, total revenue collected by our government would go up. I don’t think there’s much disagreement among economists on that point. But at the same time that doesn’t mean that that’s what you want to do. Perhaps the goal of tax policy is not to maximize tax revenue collected. The goal of tax policy is to give the federal government the resources to provide the services we desire that it should provide, that we can agree or disagree as to how many there should be. But certainly not everything. The goal is not to suck as much money out of the economy. We want to trade that off against the freedom we want to give to people to make their own decisions with their own money, the growth potential the economy has, and things like that.

So what sorts of changes would you recommend seeing where we are now if, again, that’s the goal – faster economic growth?

I would probably lower rates a little bit on the individual side, and if you want to shoot for the next five years? I would probably do more drastic things on the firm side. Because I think it’s much easier to incentivize investment increases than to really structurally transform the economy through individual tax rate changes. And depending on what your metric for economic success is, you could try and use the tax system to increase labor force participation rate a little bit. That’s probably easiest done through secondary earners or through the EITC (earned income tax credit). So it depends on if you want to have as many people as possible working, that’s a different goal from “I just want the GDP dollar number to be as high as possible.” And, you know GDP is not a perfect measure of either economic activity or human flourishing.

Well, we’re all for human flourishing-

Yeah I would hope so-

Are there countries that just have a much better tax system that the United States could draw lessons from? We talk a lot about Scandinavia. The left points to Scandinavia a lot. Well, who should the people on the right point to and say “They figured it out, they got it right?” Or more right than we have …

I think people on the right should point to Switzerland and Singapore more than they do. The problem is they’re in a way similar, but the scale is very different. I mean you could point to countries like Luxembourg or the Netherlands as well on the corporate side, but the US just cannot be a tax haven. It would just lose so much of its revenue, and you can’t have an economy the size of the US just leeching off the prosperity created in other places. So I would not point to the tax havens necessarily, they’re places we’re going to have to live with, or places we’re going to have to combat more actively. But I think that Switzerland or Singapore are places that have a pretty reasonable mix that the US could probably come close to mimicking, if not copy it entirely.

I don’t know if you happen to know off the top of your head and it’s somewhat unfair of me to ask you this, but, off the top of your head, what is their top rate for labor income and what would be their top corporate rate or capital gains? Do you have any idea off the top of your head?

That’s a very mean question. So in Switzerland it varies a lot from canton to canton. I think, for example, Zug which is just outside of Zürich, I think that one has the lowest rates – I think on the individual side it’s twelve or thirteen. On the corporate side, I think the top rate is twenty five. And on the individual side, it does vary a lot. But I don’t think any place hits 39.6.

We will include links to their tax code.

Yeah you obviously have no way to fact check this immediately, so I am pretty confident about the numbers I just gave you. They’re in the ballpark.

You mentioned that we just can’t willy-nilly cut taxes. We do have to pay the bills. Looking out long-term, will we have to take in more taxes, as say a share of GDP? Historically since World War II, it has been between 17 and 18 percent. Are we going to have to take in more tax revenue over the next generation, and if so how much do you think? 

I don’t understand why the idea is always that no, it’s impossible to change any of the entitlement programs we have. In the end, so much federal spending goes to Medicare and Social Security, there’s really no reason to run those programs through the federal government. You can prefund them. You can just have people save for when they’re old, and then they use that saved money to buy healthcare, to pay the bills, and to buy food. I think that’s the area where there’s the most room for progress on the policy-making front for Republicans. But for perhaps obvious reasons, they don’t emphasize that often.

Because that would be like privatizing Medicare, right? You would just be saving more – is that actually possible? You have people right now say, “Look, I can barely afford to save for retirement, and now you’re telling me I have to save for my healthcare as well when I’m old?” Is that possible?

Well, obviously privatizing would not be the word that we should be using. But look, I was pretty hopeful when Governor Romney picked Paul Ryan as his running mate, because he in the end had made a name for himself based on the idea of implementing reforms like voucherizing Medicare and reforming Social Security quite drastically in his budget proposals. When people think of a situation in which Medicare is a mix of a pre-funded program with vouchers, I think that they think of a world where everything else remains the same – because you know tax rates would come down a lot and the federal government would no longer have to spend as much money as it does on sixty percent of what it does.

So you could have ways to provide subsidies to people who struggle to pay for their old age income and health plans. But a lot of people would be able to use tax money that they no longer have to send to the government to pay for their own future needs. I don’t think it’s as unfeasible as you make it sound like it is. And it would have one massive positive effect – instead of having the pace of growth that you have now, all this money would be saved and invested. It would add significantly to the capital stock, which in turn would lead to more innovation and would raise wages for workers. So, I think that’s a big advantage that’s often overlooked when discussing these pre-funding options.

As we finish up, I want to move off taxes. There’s been a lot of talk in the news about the “gig economy” and how more people are free agents and independent contractors, and what kind of benefits those people should have. More broadly, should Americans who have full-time jobs have a richer set of benefits, including various kinds of paid leave, family leave, parental leave?

So instead of telling firms, OK, why don’t you reduce your pay a little bit and set that money aside to pay for maternity leave or for sick days or for whatever else you want to mandate firms to do, you could say, OK, we’re not going to mandate those things, but we’re going to make it transactionally easier for people to set aside money to finance spells of unemployment, or maternity leave, or allow people the opportunity, perhaps in a tax preferred way along the lines of 401Ks, to set aside money for that kind of contingencies.

I think that’s a much better way to deal with all of these mandates that people want to come up with, especially for, as you pointed out, if you’re very worried about our economy evolving to one where people have a lot of concurrent jobs and maybe a lot of switching from one job to another, rapidly fluctuating hours from week to week, rapidly fluctuating pay rates from month to month. Then it’s much easier for people and it gives people a lot more flexibility if they have a bunch of money that they can use to smooth out their work-life balance than if you say “Uber owes me a quarter of a day of maternity leave, and I have a week and a half from Airbnb and I have some pension money that’s sitting there … .” I think there’s real advantages to just giving people the flexibility to take care of their things themselves.

And just sort of an economic point, if a company is mandated to provide me leave, am I just paying for that myself in an inefficient way because the company will just pay me less and that‘s where that money comes from? Am I sort  of paying for that anyways myself throw a lower wage? 

Yeah exactly. Through a lower wage or through less of a chance to get hired. This idea actually comes from Larry Summers, who was a senior official in the Obama Administration and Bill Clinton’s Secretary of the Treasury –

He’s a very powerful man.

Very powerful man and a very powerful Democratic economist. He has a short little paper in which he explains – look if you’re going to mandate benefits, that means that the people who will benefit the most from those benefits will have to take pay cuts and no one will want to hire them.

For example, there’s some empirical evidence that the Americans with Disabilities Act made it harder for people with disabilities to find jobs. Because the employer knows, OK, if we’re going to hire that guy we’re going to have to make these assumptions or adjustments. Similarly, if you mandate maternity leave, then it will become less attractive to higher women. Then all those problems you do away with if you just give individual workers to make arrangements for these specific adjustments they want to make. Now, you may say that for some categories those adjustments are too big to bear. Obviously that is true for people with disabilities. In those cases you can make adjustments – I think you can make exceptions. I think as a general rule, it’s better to just give people the opportunity to save for these unforeseen or foreseen times when they will want to reduce their labor supply and perhaps increase consumption out of savings.