A Close Look at the Perry Tax Plan

Bruce Bartlett held senior policy roles in the Reagan and George H.W. Bush administrations and served on the staffs of Representatives Jack Kemp and Ron Paul. He is the author of the coming book “The Benefit and the Burden.”

In an effort to rejuvenate his flagging campaign for the Republican presidential nomination, Gov. Rick Perry of Texas announced his support for a flat-rate income tax in a Wall Street Journal op-ed article on Oct. 25.

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Mr. Perry said he would establish a single rate of 20 percent on corporate and individual incomes, with individuals receiving a personal exemption of $12,500. The estate and gift tax would be abolished, and there would be no taxation of dividends and capital gains. All deductions, credits and exclusions would be eliminated except for mortgage interest, state and local taxes and charitable contributions.

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The flat tax is an idea that has been kicking around Republican circles for 30 years. The publisher Steve Forbes made it the centerpiece of his unsuccessful 1996 and 2000 runs for the G.O.P. nomination. He is now advising Mr. Perry and was glowing in his praise for the governor’s plan. Writing in The New York Post, Mr. Forbes said it would “usher in a great economic boom.”

Larry Kudlow of CNBC, who has never seen a Republican tax cut he didn’t like, was so excited by Mr. Perry’s flat tax and Herman Cain’s 9-9-9 plan that he attributed the recent stock market rise to their influence. In a National Review column on Oct. 21, he said the stock market rally was “discounting a new G.O.P. growth plan that will replace the dreary Obama tax-the-rich mantra.”

Although Mr. Perry praised the simplicity of his plan, it would actually complicate the tax computation for many people, because they would have to calculate their taxes two or even three different ways when the alternative minimum tax was also included. That was because Mr. Perry’s flat tax would be an optional tax system; those who wanted to stay in the current system could do so.

This is really just a gimmick to allow Mr. Perry to say with a straight face that everyone would get a tax cut. “Taxes will be cut across all income groups,” he said. His plan allows Mr. Perry to skirt every difficult issue about the impact of tax reform, like the huge increase in taxes that would be paid by the poor because they would lose all refundable tax credits, including the earned income tax credit.

Keep in mind that refundable credits give many people a negative tax rate. That is, they pay no income taxes but still get a Treasury refund. Going from a negative rate to zero would mean a tax increase for such people, as a Tax Foundation analysis illustrates.

To prevent people from gaming the system, Mr. Perry would insist that all those choosing the flat tax would have to stay in that system permanently. It’s not clear if those paying income taxes for the first time would be permitted a choice.

The idea of an alternative flat tax system was originally cooked up by a Wall Street Journal editorial writer, Steve Moore. But at least his idea was that the alternative system would be something like a pure flat tax with no deductions whatsoever. However, Mr. Perry would keep three key deductions in his system, which undermines the whole point of the flat tax, which is to wipe the slate clean. It also makes no sense because those who want to keep the deductions for mortgage interest, charitable contributions and state and local taxes could simply stay in the current system.

One consequence of Mr. Perry’s flat-tax deviationism is that his proposed tax form is lengthened to a full page from the original postcard that Mr. Forbes promised. Because the 1040EZ tax form that most people use is also one page, it’s hard to see those who care about the length of their tax return flocking to the Perry plan.

Of course, if everyone could simply choose to be taxed less or not, it absolutely guaranteed that Mr. Perry’s plan would be a massive revenue loser. In 2007, the Tax Policy Center analyzed a plan similar to Mr. Perry’s that had been proposed by Senator Fred Thompson of Tennessee, who briefly competed for the 2008 Republican nomination. The analysis found that revenues from allowing people to choose would be substantially less than if everyone were forced into the new system.

Giving people a choice also substantially mitigated whatever positive economic effects would be achieved from a flat tax. Its whole point is to change economic behavior by, for example, forcing people to stop investing so much of their savings in owner-occupied housing and investing instead in corporate stock or other forms that will add to the economy’s productive capacity.

Because no one is forced to change their behavior under the Perry plan, there is no reason to think that there will be an increase in economic growth if it is implemented. It would just lose revenue and complicate the tax code. That’s all. Edward Kleinbard, a University of Southern California law professor, calls the Perry plan “a promise to put a unicorn in every pot.”

Mr. Perry has countered with an “analysis” by John Dunham, a former tobacco industry economist, that shows growth will explode under his plan. The analysis states that it was commissioned by the Perry campaign and presumably was not done free. Using “dynamic scoring,” the analysis says gross domestic product will be an astonishing $3.5 trillion larger by the year 2020. Implausibly, it says that federal revenues would be $407 billion higher than under the Congressional Budget Office’s current projections and will rise even as a percentage of G.D.P.

There is no explanation whatsoever for how these estimates were arrived at, and they appear to have come from some sort of black box. When I asked Professor Kleinbard, who was formerly staff director for Congress’s Joint Committee on Taxation, what he thought about this, he corrected me. The estimates came from a “black magic box,” he said.

As Simon Johnson of the Massachusetts Institute of Technology recently explained on this blog, studies show that perhaps a third of a tax rate cut might be recouped through higher growth, and only if spending is cut enough to keep the deficit from rising.

Governor Perry says he will slash spending to 18 percent of G.D.P. from its current level of 23 percent. No explanation was offered of how this would be done or how such a huge spending cut would ever be enacted by Congress. It should be noted that even if every domestic program other than Social Security, Medicare and Medicaid is abolished, that would not be enough for Mr. Perry to reach his goal — all those programs together come to just 4.2 percent of G.D.P.

Thus, Mr. Perry’s plan cannot be taken seriously. I don’t think it’s meant to be, at least by those of us who don’t plan on voting in Republican primaries. It’s just a signaling device, telling the Republican faithful that they can trust Mr. Perry on the tax issue.

Whether the plan makes any sense as a matter of policy is irrelevant to its purpose, which is to win him the Republican nomination. With an Oct. 25 ABC News/Washington Post poll showing the flat tax much more popular among Republicans than Mr. Cain’s 9-9-9 plan, it might just work.

Can Tax Cuts Pay for Themselves?

Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”

Can tax cuts “pay for themselves,” inducing so much additional economic growth that government revenue actually increases, rather than decreases? The evidence clearly says no.

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Nevertheless, a version of this idea, under the guise of “dynamic scoring,” has apparently surfaced in the supercommittee charged with deficit reduction — the joint Congressional committee with 12 members. Dynamic scoring sounds technical or perhaps even scientific, but here the argument means simply that any pro-growth effect of tax cuts should be stressed when assessing potential policy changes (e.g., reforming the tax code). For anyone seriously concerned with fiscal responsibility, this is a dangerous notion.

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Economists disagree about almost everything, of course, and the effect of tax cuts is no exception. One reasonable way to assess the evidence is to begin with the highest plausible effects, then see what happens if some of the more extreme assumptions are relaxed (this is a nice way of saying that we don’t believe everything the authors are trying to tell us).

I would start with a study by Gregory Mankiw, former chairman of George W. Bush’s Council of Economic Advisers – and therefore presumably on the tax-cutting side of American politics – and Matthew Weinzierl (published in The Journal of Public Economics in 2006 and, unfortunately, available only to subscribers) that shows the economic growth caused by a tax cut can offset, at best, a portion of the revenues lost by that tax cut.

Specifically, Professors. Mankiw and Weinzierl calculated that 32.4 percent of the “static” or direct revenue loss of a capital-gains tax cut and 14.7 percent of the static revenue loss of a labor tax cut could be offset in present-value terms by additional growth, ignoring short-term Keynesian effects (i.e., any immediate stimulus provided to the economy).

Now 32.4 percent is a lot, but it is far less than 100 percent. And a critical assumption for Professors Mankiw and Weinzierl is that government spending falls to keep the budget in balance. In their framework that’s a good thing — as they are effectively assuming away the consequences of any productive effects of government spending (e.g., what if less spending on schools means less education and this hurts “human capital” and therefore productivity down the road?).

Sticking for a moment with just with their view of the world, if instead the tax cuts are financed by additional debt, as was our collective experience during the 2000s, the ultimate effect of those cuts can be to lower economic growth in the long term, depending on whether the larger debt eventually leads to lower government transfers, lower government consumption, higher taxes on capital or higher taxes on labor. (Eric M. Leeper and Shu-Chun Susan Yang discuss this in “Dynamic Scoring: Alternative Financing Schemes,” also in The Journal of Public Economics, in 2008.)

More broadly, in 2005, the Congressional Budget Office, then headed by a Republican appointee, Douglas Holtz-Eakin, estimated that the economic effects of a 10 percent cut in income taxes would offset from 1 to 22 percent of the revenue loss in the first five years; in the following five years, the economic effects might offset up to 32 percent of the revenue loss, but might also add 5 percent to the revenue loss.

This is an entirely reasonable assessment — the budget office exists to provide balanced analysis for the budget process. The bottom line is that betting that tax cuts will pay for themselves is a high-risk strategy and not a good idea at our current levels of government debt relative to gross domestic product. We do not have a large margin for error. (Disclosure: I’m on the Panel of Economic Advisers for the the budget office, but I didn’t have anything to do with that study.)

Of course, economic studies do not necessarily have a direct effect on political discourse. For example, President George W. Bush asserted in 2007, “It is also a fact that our tax cuts have fueled robust economic growth and record revenues.” But this is nothing more than an assertion. Growth during the 2001-7 expansion was only 2.7 percent compared, for example, with 3.7 percent during the 1990s expansion (when tax rates were higher).

And much of the growth during the Bush period turned out to be illusory; it was based on our corporate and national accounting system, which measures profits (an important part of G.D.P.) but not on a risk-adjusted basis. When the risks materialized in the financial crisis of 2008-9, we lost so much output that G.D.P. per capita in real terms today is only at about the level of 2005.

To assess growth properly, you should look “over the cycle,” meaning roughly 10 years for the modern American economy. It is hard to argue that the last decade was any kind of growth success. Of course, other things happened during the 2000s, including further financial sector deregulation not directly related to the tax cuts.

That’s why we have the economic analysis, particularly by the budget office, to disentangle what tax cuts can really do. If the supercommittee buys into dynamic scoring for tax cuts, at best this would be wishful thinking. At worst, it would represent yet another round of fiscal irresponsibility at the top of American politics.

And if people are seriously considering altering the rules under which the the budget office operates, they should stop and think again. Changing the score-keeping guidelines at this stage would amount to undermining the credibility of the office, one of the few remaining impartial and well-informed observers of the nation’s economy.

Perhaps this strategy might yield some short-term political gains, but the damage to our creditworthiness would be immense, and the consequences would be felt sooner rather than later.

The nightmare downward spiral and fiscal implosion in the euro zone began with a few countries cheating on their numbers — first to get into the currency union and then to avoid various forms of official criticism. We do not want to start down the same path.

Jobs Deficit, Investment Deficit, Fiscal Deficit

Laura D’Andrea Tyson is a professor at the Haas School of Business at the University of California, Berkeley, and served as chairwoman of the Council of Economic Advisers under President Clinton.

Like many economists, I believe that the immediate crisis facing the United States economy is the jobs deficit, not the budget deficit. The magnitude of the jobs crisis is clearly illustrated by the jobs gap – currently around 12.3 million jobs.

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That is how many jobs the economy must add to return to its peak employment level before the 2008-9 recession and to absorb the 125,000 people who enter the labor force each month. At the current pace of recovery, the gap will be not closed until 2020 or later.

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History suggests that recovery from a debt-fueled asset bubble and ensuing balance-sheet recession is long and painful, with significantly slower growth in gross domestic product and significantly higher unemployment for a least a decade. Right now it looks as though the United States is following this pattern.

The jobs gap is primarily the result of the dramatic collapse in aggregate demand that began with the financial crisis of 2008. Even with unprecedented amounts of monetary and fiscal stimulus, the recovery that began in June 2009 has remained anemic, because consumers, the major driver of private demand, have curbed their spending, increased their saving and started to deleverage and reduce their debt — and they still have a long way to go.

As I asserted in my last post (and many other economists, including Lawrence Summers, Alan Blinder, Christina Romer, Peter Orzsag and Robert Shiller, have made this point, too), the jobs gap warrants additional fiscal measures to increase private-sector demand and promote job creation.

Sadly, current signals from Washington indicate that such measures will not be taken.

Instead, the risk grows that large, premature cuts in government spending will reduce aggregate demand, will tip the economy back into recession and drive the unemployment rate back into double digits.

Even if no budget deal is reached and no major spending cuts are made in the near future, there is now a serious risk that the rating agencies will downgrade government debt because of the political stalemate over a long-run deficit reduction plan. That would almost surely produce higher interest rates that could sink the economy into recession again.

Although the jobs gap and the high unemployment rate are the immediate problems in the American labor market, they are not the only ones. And there is no sign that the budget negotiations in Washington are going to address these other problems, either.

Even before the onslaught of the Great Recession, the labor market was in serious trouble. Job growth between 2000 and 2007 was only half what it had been in the preceding three decades.

Productivity growth was strong, but far outpaced compensation growth. Between 2002 and 2007, productivity grew by 11 percent, but the hourly compensation of both the median high-school-educated worker and the median college-educated worker fell.

During the same period, the real median income for working-age households declined by more than $2,000. The 2002-7 recovery was the only American recovery on record during which the income of the typical working family dropped.

And despite the recovery, job opportunities continued to polarize. Employment grew in high-education, high-wage professional technical and managerial occupations and in low-education, low-wage food-service, personal-care and protective-service occupations; employment fell in middle-skill, white-collar and blue-collar occupations. The drop in middle-income manufacturing jobs was especially precipitous.

To fashion the appropriate policy responses to these long-term structural problems in the labor market, it is first necessary to understand their causes. The key contributors are three:

1. Skill-biased technological change that has automated routine work while increasing the demand for highly educated workers with at least a college education, preferably in science, engineering or math.

2. Globalization or the integration of labor markets through trade and more recently through outsourcing.

3. The declining competitiveness of the United States as a place to do business.

Recent studies by Michael Spence and Sandile Hlatschwayo (discussed last week in Economix by Uwe Reinhardt) and by David Autor describe how technological change and globalization are hollowing out job opportunities and depressing wage growth in the middle of the skill and occupational distributions.

A widely cited commentary by Andrew Grove, former chief executive of Intel, and a prize-winning article by Gary Pisano and Willy Shih make similar arguments.

Many of the workers and jobs adversely affected by technological change and globalization are in the tradable goods sector, primarily in manufacturing. Nor is the United States labor market the only one to be affected by these forces: the polarization of employment opportunities is also occurring in the other advanced industrial countries.

Many of them, like Germany, are doing something about it. The United States is not. According to a recent McKinsey study, the United States is becoming a less attractive place to locate production and employment compared with many other countries.

A newly published study by the Information Technology and Innovation Foundation reaches a similar conclusion. The United States is underinvesting in three major areas that help a country create and retain high-wage jobs: skills and training of the work force, infrastructure, and research and development.

Spending in these areas currently accounts for less than 10 percent of all federal government spending, and this share has been declining over time. And that’s despite the fact that the borrowing costs of the federal government have been near historic lows and much lower than the returns on economically justifiable investments in these areas.

Such investments fall into the “non-security discretionary spending” category of the federal budget, the category in line to be cut to historic lows to reduce the government deficit over the next decade.

In my previous Economix post, I said a budget deal should pair fiscal measures aimed at job creation now with a credible plan to reduce the deficit gradually and that both should be passed at once as a package. I also urged that the plan include an unemployment rate target that would postpone serious deficit-reduction measures until the target had been achieved.

I also think the plan should include a separate capital budget that distinguishes government spending on education, infrastructure and research as investments with committed revenues over several years. A capital budget would close the investment deficit in those areas that strengthen American competitiveness and promote high-wage job creation. None of the budget plans currently under debate include a separate capital budget.

The labor market is suffering from two problems: an immediate jobs gap, primarily the result of inadequate demand, and a long-term shortfall in rewarding employment opportunities for American workers, primarily the result of structural forces.

As a result of these forces, even when demand has recovered, many of the good jobs lost during the last decade will not be replaced by new good jobs without significant public investments to strengthen the attractiveness of the United States as a production location.

So far, the deficit-reduction proposals attracting attention do not address the labor market’s dual problems and leave many American workers and their families to face another lost decade.