A Retrospective on the Tax Law of 2017 and Prospective on the Next Tax Laws Note some estimates represent work in progress that is subject to revision

A Retrospective on the Tax Law of 2017 and Prospective on the Next Tax Laws Note some estimates represent work in progress that is subject to revision Jason Furman Harvard Kennedy School M-RCBG Business & Government Seminar Series Cambridge, MA February 15, 2018 Harvard Kennedy School 79 John F. Kennedy Street Cambridge, MA 02138

1. Description of the Tax Law 2. Direct Impacts 3. Macroeconomic Analysis 4. Impact of Debt Financing 5. The Next Tax Laws Outline

1. Description of the Tax Law On December 22 the President signed the tax law

1. Description of the Tax Law Overview of the tax law As Passed 2019 Law Made Permanent Individual $779 billion $976 billion Estate $83 billion $134 billion Passthrough $265 billion $422 billion Corporate $329 billion $676 billion TOTAL $1,456 billion $2,209 billion *Most individual and all estate and passthrough provisions expire after 2025.

1. Description of the Tax Law Major Individual, Passthrough and Estate Changes Standard Deduction Personal Exemption Alternative Minimum Tax Nearly doubles to ~$24,000 for a married couple Repealed Reduced Rates 7 brackets, top reduced from 39.6% to 37.0% Child/Family Credit $2,000 child credit, refundable up to $1,400 Itemized Deductions Limits State and local deduction to $10,000 and caps mortgage interest at $750,000 Individual Mandate Effectively repealed after 2018 Passthroughs Estate tax 20% deduction on income for certain passthroughs Exemption raised from $5.5m to $11m ($22m for a couple)

1. Description of the Tax Law Major Corporate Changes Rate 21% Expensing Interest Limitations Base broadeners and other raisers International Provisions Transition Anti International Abuse Rules 5 years then phased out through 2026, limited to equipment Caps net interest deduction at 30% of adjusted taxable income Eliminates deduction for manufacturing income, reduces Net Operating Losses, requires amortization of R&D (delayed implementation) Territorial System Deemed dividend at 15.5% for liquid assets and 8% for illiquid assets Minimum tax on excessive foreign earnings associated with intangibles

1. Description of the Tax Law 2. Direct Impacts 3. Macroeconomic Analysis 4. Impact of Debt Financing 5. The Next Tax Laws Outline

2. Direct Impacts The tax law cost $1.1 trillion with dynamic feedback ($1.5 trillion excluding feedback) Billions of Dollars 300 250 200 150 100 50 Cost of the Tax Law 0-50 -100 Conventional score Dynamic score Conventional score, extension of 2019 policy 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 Source: Joint Committee on Taxation.

2. Direct Impacts The immediate effect is larger after-tax incomes for all groups with larger boosts at the top Percent Change 5 4 3 2 1 0-1 -2 The Tax Cuts and Jobs Act Change in After-Tax Income 2019 2025 2027 Income Group (Thousands of 2017 Dollars) Source: Center on Budget and Policy Priorities (Huang, Herrera, Duke 2017).

2. Direct Impacts The indirect effects of the bill matter enormously Macroeconomic impact of the corporate tax cut Consequences of deficit financing Future tax changes matter as much as this one

1. Description of the Tax Law 2. Direct Impacts 3. Macroeconomic Analysis 4. Impact of Debt Financing 5. The Next Tax Laws Outline

3. Macroeconomic Analysis Summary of the macroeconomic impact of the tax law 2018 Longer Run Cash Flow Small + 0 Fiscal Impact + (Keynesian) - (Debt crowd out) Incentives + Smaller +

3. Macroeconomic Analysis How much of the investment/bonus announcements were net new due to tax law?

3. Macroeconomic Analysis The demand-side stimulus is very positive in 2018-19 but roughly neutral thereafter Fiscal Stimulus of the Tax Law and Bipartisan Budget Act of 2018 Percent of GDP 1.2 1.0 0.8 0.6 0.4 0.2 0.0-0.2-0.4-0.6 Bipartisan Budget Act of 2018 Tax Law 2018 2019 2020 2021 Calendar Year Source: Author s calculations based on JCT (2017) and CBO (2017).

3. Macroeconomic Analysis Estimates of the effect of the Tax Cuts and Jobs Act on GDP generally 0.0 to 0.2 p.p. increase in the annual growth rate over the next decade Percentage Points 0.40 0.35 0.30 0.25 0.20 0.15 0.10 Change in Ten-Year Annual Growth Rate: 20 Percent Corporate Tax Rate Estimates Percentage Points 0.40 0.35 0.30 0.25 0.20 0.15 0.10 Change in Ten-Year Annual Growth Rate: Tax Cuts and Jobs Act Estimates 0.05 0.05 0.00 Mathur and Kallen 2017 Barro et al. 2017 * Feldstein 2017 0.00 CEA TPC JCT Moody's PWBM Tax * Economy.com Foundation * Note: Starred estimates calculated assuming 5 percent convergence rate to estimated long-run change in output level. Based on sources listed and author s calculations.

3. Macroeconomic Analysis Side note: These are not national income, and certainly not welfare Subtract payments to foreigners and increased depreciation to get National Income Subtract cost of reduced labor and reduced consumption (Tax reform can also raise welfare more than GDP if it reduces consumption distortions, but little of that in the Tax Cuts and Jobs Act) Plausibly welfare effects are ½ or less of the GDP growth effects These issues are very important when combining static distributional impacts with growth/wage effects.

3. Macroeconomic Analysis The reason plausible growth estimates are lower than many optimists have assumed 1. Crowd out. This is one source of difference but is not the most important difference. Moreover, crowd out is more than just the standard fiscal version: Non-corporate/residential capital shifting to corporate sector Foreign-financed investment which must be repaid (increases GDP but not GNP / National Income) Higher rates of depreciation (increases GDP/GNP but not National Income) Increased domestic borrowing reducing investment 2. Corporate capital is only about two thirds of GDP 3. Analysis needs to factor in the full plan: offsets are not lump sum

3. Macroeconomic Analysis You need a large increase in corporate capital to generate meaningful GDP increases Fixed Assets in 2016 $57 trillion (304% GDP) - Government Assets $14 trillion - Private Residential $20 trillion - Passthrough Assets ~$10 trillion = Corporate Fixed Assets ~$12 trillion (65% GDP) Using the BEA input-output tables you need an 18% increase in corporate capital to get a 3% increase in the level of GDP. If capital shifts from residential/non-corporate as is likely the needed increase would be much larger. Source: Bureau of Economic Analysis; author s calculations.

3. Macroeconomic Analysis The biggest issue is whether estimates are for parts of the plan or the entire plan My Two Part Tax Plan 1. Cut all tax rates in half 2. Must pay taxes on 2X your taxable income How to Model This? A huge increase in growth! OR No change at all? Many of the estimates of cutting the corporate rate are akin to estimating only the first part of this plan.

3. Macroeconomic Analysis The statutory U.S. rate remains above the non- OECD average (but low for large economies) Hungary Ireland Latvia United Kingdom Slovenia Poland Czech Republic Turkey Iceland Finland Estonia Slovak Republic Switzerland Sweden Denmark Norway Israel Korea Spain Netherlands Chile United States Canada Luxembourg Italy New Zealand Greece Portugal Japan Mexico Australia Germany Belgium France United States 2017 non-us OECD avg = 23.7% 2017 non-us G-7 avg = 28.0% New US Combined Rate = 25.8% Old US Combined Rate = 38.9% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% Source: PWC.

3. Macroeconomic Analysis Macroeconomic modelling should reflect both the rate cut & other raisers Provision 2027 Revenue Impact ($billions) Reduce corporate rate to 21% -156 Eliminate manufacturing deduction, end expensing of R&D, limit interest deductions, limit NOLS 67 Other business and international 39 Total corporate -50 Many 20% corporate rate estimates model this But ignore these provisions (de facto treating them as lump sum) Source: JCT; author s calculations.

3. Macroeconomic Analysis Effective marginal tax rates over time Effective Marginal Tax Rate on Corporate Investment Under the Tax Cuts and Jobs Act Percent 40 30 20 10 0-10 -20-30 -40-50 2017 2018 2027 Equipment Structures Research and Development Note: Assumes 32 percent debt financing and 68 percent equity financing. After 2017, assumes that 15 percent of firms are constrained by the interest cap. Applies to 7-year equipment and 39-year structures, respectively. Source: Jason Furman s calculations based on Mathur and Kallen (2017) and Bureau of Economic Analysis.

3. Macroeconomic Analysis Shifts tax system from debt favoritism to equity favoritism; narrows differentials between investment types Effective Marginal Tax Rates (Percent) Type of Financing of Investment Investment 2017 2018 2027 Equipment Structures R&E Debt -2 8 21 Equity 10 0 12 Debt 25 26 29 Equity 32 21 21 Debt -60-14 8 Equity -32-26 -5 Note: After 2017, assumes that 15 percent of firms are constrained by the interest cap. Source: Author s calculations based on Mathur and Kallen (2017) and Bureau of Economic Analysis.

3. Macroeconomic Analysis Investment in equipment and structures would increase while investment in R&D would fall Percent 6 4 2 0-2 -4-6 -8 Percent Change in Investment in Steady State 1.3 3.7-10 -12-10.0 Equipment Structures Research and Development Note: Assumes 32 percent debt financing and 68 percent equity financing. After 2017, assumes that 15 percent of firms are constrained by the interest cap. Source: Author s calculations based on Mathur and Kallen (2017) and Bureau of Economic Analysis.

3. Macroeconomic Analysis Most of the effect of lower corporate rates is undone by the corporate offsets and crowd out AEI Model (Mathur and Kallen) Change in Ten-Year Annual Growth Rate Change in Longrun Output Level Effect of rate reductions alone 0.08 p.p. 1.64% a Percent reduction to growth based on raisers and crowd out Adjustment for repeal of domestic production deduction Adjustment for R&E amortization Adjustment for limitation of interest deduction Adjustment for other raisers Deficit crowd out (interest rates +15 bp) 9% 22% 21% 11% 19% Effect of all corporate provisions 0.00 p.p. 0.30% a Note: Detail need not add to total due to rounding. Source: Author s calculations based on Mathur and Kallen (2017).

3. Macroeconomic Analysis Some of what these growth estimates miss Improvements in the composition of investment could result in larger output effects: o The TCJA reduces the dispersion of average tax rates across sectors, including much larger rate reductions for current high tax sectors (e.g., retail and wholesale trade, utilities and transportation) and smaller reductions for current low tax sectors (e.g., manufacturing). o Shift from residential to corporate capital. o Shift from debt financed to equity financed. Higher tax rates on R&D could result in lower output/growth effects. Not confident it accurately captures international shifting. Unclear which direction this goes, more incentive to shift cash to the United States, but also lower cost to investing overseas and tax benefits to locating tangibles overseas. Future tax legislation will matter a lot. o What will happen to all the extenders left out of this bill? o Will delayed offsets actually happen (e.g., ending R&D expensing)? o What will happen to expensing after 2022? o What will happen to the individual, estate and passthrough provisions after 2025? o How will future political & deficit developments affect the outlook for taxes?

Stronger dollar 3. Macroeconomic Analysis International macroeconomic impact of the domestic provisions of the bill Increased investment demand and reduced savings leads to: Larger current account deficit. Advocates estimates consistent with ~3pp increase in current account deficit. Worsening Net International Investment Position. Could go from ~40% to ~50% of GDP. GNP below GDP (and National Income below GNP). Could reduce magnitude or reverse sign.

1. Description of the Tax Law 2. Direct Impacts 3. Macroeconomic Analysis 4. Impact of Debt Financing 5. The Next Tax Laws Outline

4. Impact of Debt Financing Deficits expected to rise to 5%+ of GDP and much more if major provisions are extended 5 4 4.3 Federal Deficit as a Percent of GDP Percent of GDP 9 Tax Extenders to Continue Current Tax Policy 8 Current Law + Sequester Adjustment/Disaster Relief 7.5 7.0 7 6.4 6.3 6.6 5.8 6.0 6.2 6 5.5 3 2 1 4.0 5.2 5.4 5.6 5.9 5.7 5.5 5.9 5.9 5.8 0 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 Source: Committee for a Responsible Federal Budget; Congressional Budget Office; author s calculations.

4. Impact of Debt Financing The impact on the debt grows over time and depends on what tax cuts are extended Percent of GDP 110 105 100 Federal Debt as a Percent of GDP With tax cuts and extenders to continue current tax policy 2027 95 With tax cuts 90 85 80 75 Pre-tax cut baseline 70 2018 2020 2022 2024 2026 2028 Source: Committee for a Responsible Federal Budget; Congressional Budget Office; author s calculations.

4. Impact of Debt Financing Future legislation will also have huge impacts on distribution e.g., lump sum financing Change in After-Tax Income under the Tax Cuts and Jobs Act, 2018 Change in After-Tax Income (Percent) 6 4 2 0-2 -4-6 -8-10 -12 0-20 20-40 40-60 60-80 80-90 90-95 95-99 Top 1 percent Expanded Cash Income Percentile Note: Excludes the effect of reducing the Affordable Care Act s shared responsibility payment to zero Source: Tax Policy Center and Gale (2018). Without Financing With Equal-per- Household Financing Top 0.1 percent

1. Description of the Tax Law 2. Direct Impacts 3. Macroeconomic Analysis 4. Impact of Debt Financing 5. The Next Tax Laws Outline

5. The Next Tax Laws Substantial future tax legislation is inevitable Legislated instability: o Routine extenders started expiring already o Health tax extenders started expiring already o Backloaded offsets start in 2022 o Expensing expires after 2022 o Individual/estate/passthrough end after 2025 Economic instability. Deficits of 5-7% of GDP and debt over 100% of GDP make future tax legislation inevitable. Political instability. Lack of bipartisan buy in.

5. The Next Tax Laws Tax reform needed now more than ever!!! Revenue. Will average 17 percent of GDP over the next five years. Bowles-Simpson called for 21 percent of GDP. Progressivity. The Tax Cuts and Jobs Act will widen the dispersion of after-tax incomes. Efficiency. Effective marginal tax rates on investment will be higher in the future than they were in 2017. Simplicity. Although for most people less itemizing will increase simplicity, substantial new complexity associated with passthrough provisions. Stability. Unsustainable fiscal situation colliding with delayed implementation and sunset of major provisions provisions that will cost 0.5 percent of GDP growing to 1.5 percent of GDP.

5. The Next Tax Laws Some infeasible/undesirable options going forward Full repeal: Fine (tax code ex ante was preferable) but infeasible and well short of optimal. Repeal/expire the high-income provisions: Would raise about 0.15% of GDP in revenue if limited to individual and estate provisions (about one-sixth of the total cost presunsets). Repeal/expire the high-income provisions & restore full/partial deductibility of State and local taxes. Restoring SALT would cost $644b (or 0.15% of GDP).

5. The Next Tax Laws What the next tax reform should look like Stability. Permanent tax law that is fiscally sustainable. Efficiency. Improve the base while raising rates. Expensing, end interest deductions, VAT, Carbon Tax, addressing health exclusion. Simplicity. Return free filing. Helping working/middle class. Childless EITC, fully refundable child allowance.