The analysis of tax reform can be broken up conceptually into two distinct parts:
- how the tax changes affect individual or firm choices regarding the level of work, saving, and investment, and;
- how the changes affect the allocation of such activity across sectors of the economy.
Lim Rogers (1997) finds that a revenue-neutral shift to a flat-rate income tax with no deductions, exclusions, or credits other than a personal exemption of $10,000 per filer plus $5,000 per dependent would raise the long-term size of the economy by between 1.8 and 3.8 percent, depending on assumptions about the relevant behavioral elasticities.
Auerbach et al. (1997) find that moving to the same flat-rate income tax i.e., with the personal exemptions noted above would reduce the size of the economy by three percent in the long run. However, Altig et al. (2001) use a similar model to evaluate a more extreme policy reform revenue-neutral switch to a flat income tax but with no personal deductions or exemptions. They find that this would raise output immediately by 4.5 percent, and then by another one percent over the ensuing 15 years, although it would hurt the poor in current and future generations. The model illustrates two interesting results. First, tax reform can raise the overall size of the economy with a one-time change that puts the economy on a new growth path even if it does not affect the long-term growth rate.
The one-time effect of tax reform on the size of the economy dominates the effect on the overall growth rate. Second, there is often a trade-off between growth and progressivity in that model. However, more recent work has highlighted the role of uncertainty in tax reform, noting that a progressive income tax system provides insurance against fluctuating income by making the percentage variation of after-tax income less than the percentage variation in pre-tax income (Kneiser and Ziliak 2002; Nishiyama and Smetters 2005). This finding may change the terms of the trade-off between progressivity and growth effects.
The most recent example of simulation of comprehensive tax reform is the Joint Committee on Taxation’s (2014) analysis of the Camp plan. The JCT offers eight different scenarios depending on how the Federal Reserve responds, the underlying model of the economy used, and assumptions about behavioral elasticities. They find that Camp’s plan would raise the size of the economy from 0.1 percent to 1.6 percent over the next 10 years.
Both changes in the level of revenues and changes in the structure of the tax system can influence economic activity, but not all tax changes have equivalent, or even positive, effects on long-term growth.
The argument that income tax cuts raise growth is repeated so often that it is sometimes taken as gospel. However, theory, evidence, and simulation studies tell a different and more complicated story. Tax cuts offer the potential to raise economic growth by improving incentives to work, save, and invest. But they also create income effects that reduce the need to engage in productive economic activity, and they may subsidize old capital, which provides windfall gains to asset holders that undermine incentives for new activity. In addition, tax cuts as a stand-alone policy (that is, not accompanied by spending cuts) will typically raise the federal budget deficit.
The increase in the deficit will reduce national saving and with it, the capital stock owned by Americans and future national income and raise interest rates, which will negatively affect investment. The net effect of the tax cuts on growth is thus theoretically uncertain and depends on both the structure of the tax cut itself and the timing and structure of its financing.
Several empirical studies have attempted to quantify the various effects noted above in different ways and used different models, yet mostly come to the same conclusion: Long- persisting tax cuts financed by higher deficits are likely to reduce, not increase, national income in the long term.
By contrast, cuts in income tax rates that are financed by spending cuts can have positive impacts on growth, according to the simulation models.
The effects of income tax reform revenue- and distributionally-neutral base-broadening, rate-reducing changes build off of the effects of tax cuts, but are more complex. The effects of reductions in rates are the same as above. Broadening the base in a revenue neutral manner will eliminate the effect of rate cuts on budget deficits. It will also reduce the impact of the rate cuts on effective marginal tax rates and thus reduce the impact on labor supply, saving, investment, etc. However, broadening the base will have one other effect as well; by reducing the extent to which the tax code subsidizes alternative sources and uses of income, base broadening will reallocate resources toward their highest value economic use and hence will raise the overall size of the economy and result in a more efficient allocation of resources.
These effects can be big in theory and in simulations, especially for extreme policy reforms such as eliminating all personal deductions and exemptions and moving to a flat-rate tax. Still, there is a sound theoretical presumption and substantial simulation results indicating that a base-broadening, rate-reducing tax reform can improve long-term performance. The key, however, is not that it boosts labor supply, saving or investment since it raises the same amount of revenue from the same people as before but rather that it leads to be a better allocation of resources across sectors of the economy by closing off targeted subsidies.
One strong finding from all of the analysis is that not all tax changes will have the same impact on growth. Reforms that improve incentives, reduce existing subsidies, avoid windfall gains, and avoid deficit financing will have more auspicious effects on the long-term size of the economy, but in some cases may also create tradeoffs between equity and efficiency.