Wharton’s Kent Smetters discusses a new book he has co-edited titled, ‘The Economics of Tax Policy.’

The last major tax reform — personal and corporate — came some 30 years ago. Despite much tweaking in the interim, “everybody agrees that something needs to be done” to modernize the tax code, says Kent Smetters, a Wharton professor of business economics and public policy. What’s more, Congress looks likely to take up the issue soon. To help understand the best approaches to reform, Smetters and co-editor Alan Auerbach “went to about a dozen of the leading authorities in tax analysis” to get their views on taxes affecting business, the environment, retirement, capital gains and estates, college attendance and other areas.

Tax Reform
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Tax Reform

The result: their just-published book, The Economics of Tax Policy, a collection of articles by those tax experts. The book also looks at the effects of various tax approaches on economic growth, income distribution and low-income families, as well as compliance and enforcement. Auerbach is a professor of economics and law at the University of California, Berkeley, and former head of the economics department at the University of Pennsylvania.

[email protected] spoke with Smetters about some highlights of the book. An edited transcript of the conversation follows.

[email protected]: Kent, thank you for joining us today. Please give us an overview of the book.

Kent Smetters: The idea was very simple. We haven’t had a major tax reform since the 1986 Tax Reform Act, and so everybody agrees that something needs to be done. We simply went to about a dozen of the leading authorities in tax analysis, to cover everything from looking at the corporate tax rate to environmental taxes, to lots of other things that taxes interact with.

And we said: Ok, what do we really know about the impact of taxes on things like the environment or how businesses operate, or how people save or not save for retirement. Each author surveyed the literature, they really brought their attention to what is it that we really know about that particular area of taxation.

[email protected]: Before the Tax Reform Act of 1986, individual tax rates were relatively high. But there were so many loopholes that the effective rate was really low. You said earlier that that 1986 law closed most of those loopholes. A lot has changed and that seems to be the thrust of the book.

Kent Smetters: Some of those loopholes have come back, but at the same time, 1986 [marked] … the last big, bipartisan major policy change in Washington. [Since then,] the biggest thing that has changed is globalization. In particular, before 1986 people really didn’t talk about locating income offshore. We didn’t have the $3 trillion of earnings located offshore because of the corporate tax rate being so high. Globalization has really changed the algebra. Our U.S. tax system is still very much old-school. It thinks of the U.S. as the economy, rather than it being a large, open economy in a global system.

“We haven’t had a major tax reform since the 1986 Tax.”

[email protected]: On page two of your book, you jump right into what are the corporate tax rates for various countries. And the United States is right at the top — at 35%.

Kent Smetters: Even higher than France.

[email protected]: We often hear that the 15 top Fortune 500 companies didn’t pay anything in taxes, or we will hear 35% — that’s the official rate, but what companies actually pay, the real effective rate, is much less. And you have an explanation for that. One reason it is less is that people are keeping their money overseas.

Kent Smetters: Yes. We really have to figure out the cause and the effect. In other words, it’s not right to say, well, 35% is kind of a funny number, because the effective rate, what people are actually paying is maybe half of that amount, depending on what city you look at. The way to really think about it is, that’s a very high statutory rate, especially in today’s world. And so what happens is companies like Apple, Microsoft, Google and Oracle and others are able to figure out how to shift a lot of their earnings offshore to avoid that very high corporate tax rate.

The corporate tax rate is very high, and the fact is that we don’t have this border adjustment that’s currently being debated in Washington. There’s all this distortion [that leads companies] to locate income offshore. Now, in some cases, we also have rewards for investing in new capital. So that’s sometimes called bonus depreciation or expensing. That’s already part of the existing corporate tax rate: The House GOP plan and the Trump plan would increase that even more. That’s one reason why the effective rate is a little bit lower. But the cases you’re talking about, of large companies not paying anything, that’s mainly income shifting.

[email protected]: It is interesting, because you’re discussing the concept of lowering the rate in order to encourage investment and so forth. But in I think the second chapter, you start talking about how tax cuts in recent years — whether individual tax cuts or corporate or both — even though there have been cuts to encourage investment or savings, they’ve actually not done that very much.

Kent Smetters: That’s probably the most controversial chapter, written by one of the more liberal economists [William G. Gale, senior fellow] from Brookings and one of the more conservative, Andrew Samwick at Dartmouth. And what they showed is that a lot of tax cuts in the past don’t seem like they have led to stimulus.

[email protected]: So is that corporate or individual or both?

Kent Smetters: It’s both. They look right across the series of them — so they look at a lot of tax cuts where both the individual and the corporate were reduced at the same time. The main reason that they find [for why the tax cuts did not lead to stimulus] is that the tax cuts are often not funded, and so the government loses a bunch of revenue, it has to float out a bunch of debt, and that increase in debt actually has the opposite effect. It competes with private capital for international capital flows and household saving, and so it works in the opposite direction to offset a lot of the gains.

And the few cases that we have a revenue-neutral change, those seem to be working in a positive direction, especially over time. But when it’s just a tax cut and you haven’t cut government spending at the same time, you’re just increasing the debt and that’s a lot less effective.

[email protected]: On tax enforcement — these are taxes that people should be paying, but they’re skirting the law in some way. And they’re not paying them. It’s an enormous amount of money. This isn’t closing loopholes. This is just money that maybe if the IRS knew how to find people, they’d be able to question it?

Kent Smetters: It’s hundreds of billions of dollars a year in revenue that’s lost.

[email protected]: So it is tax evasion — $450 billion was lost to noncompliance. This is 2006 numbers. And $385

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