Tax Cuts vs. Tax Reform

Tax cuts vs. tax reform: what’s the real difference, and why does it matter? In this episode, we uncover why retroactive tax cuts and temporary tax breaks often miss the mark for long-term growth and how revenue-neutral tax reform can streamline the tax system without altering overall federal revenue. 

Erica York, Senior Economist and Research Director at the Tax Foundation, joins host Kyle Hulehan to reveal the true impact of tax policies on households and businesses and discuss how changes in marginal tax rates drive economic decisions. 

 

Links: 

https://taxfoundation.org/blog/unified-theory-misconceptions-tax-reform-debate/ 

Transcript

Kyle Hulehan: 0:01

Tax cuts versus tax reform. What's the real difference. And why does it matter? In this episode? We'll uncover why retroactive tax cuts and temporary tax breaks often miss the mark for long-term growth. We'll also explain how revenue neutral tax reform can streamline the tax system without changing overall federal revenue. Hello and welcome to the Deduction, a Tax Foundation podcast. I'm your host, Kyle Houlihan, and today we are joined by Erika York, Senior Economist and Research Director here at TF. Erika, how are you doing today?

erica: 0:33

Hey, Kyle, doing well. How are you?

Kyle Hulehan: 0:34

I'm doing good and better now to have you back on the show. You've been on a lot recently and it's excellent to have you here once again. So let's just dive right into this to kick off this discussion we're having about tax cuts and tax reforms. Could you maybe explain the basic difference between tax cuts and tax reform? How did these concepts fit into different economic philosophies?

erica: 0:58

So the big picture difference between the two is the problem they're trying to solve for. So tax cuts are designed to get at the level of tax collections. So the question of how much overall should we be taxing? Should the level of taxes go up or should they go down? Tax reform is broader. It's about how taxes are collected or the question of the structure of the tax itself. There's definitely overlap between the two. So as you're thinking about, tax reform and the structure and how we're raising taxes, tax cuts can be part of improving the overall structure, but tax reform doesn't actually have to cut taxes overall. And so why does it matter that there's like a distinction between the two? and I think that's an important question to ask and to like establish at the outset here. And that's because typically the primary goal of a change in tax policy, when a lawmaker is talking about, we're going to cut taxes or we're going to reform taxes, whichever word they use, the goal is to grow the economy. they're aiming to boost how much people work or boost how much. Businesses invest so that they can grow the economy and grow jobs and grow wages and grow income. And I'm going to borrow a lot from this framework that my former colleague, Scott Greenberg, outlined back in 2017 when lawmakers were originally debating the TCJA that contrasts what we can group into these like two competing theories of how taxes boost the economy. So politicians typically rely on this idea that he termed the folk theory of taxes in the economy and their argument essentially goes like this Spending is what drives the economy Taxes reduce how much money people and businesses can spend so if we lower the level of tax collections We can grow the economy by putting more money into people's pockets and then typically the policy debate centers around whose pockets we need to be putting more money into. Now, if we turn to what economists say about taxes, they rely on a very different theory, the neoclassical theory of taxes in the economy. And it starts from really different understanding of what drives growth in the economy. And that is that the size of the economy or the amount of taxes. Stuff we produce and the amount of income we earned is determined by how many hours people work. So that's labor, how much stuff they have to work with, like machinery and equipment and factories and computers and software, and that's capital. And then how businesses work to combine that labor. And that capital in an efficient way. And that's technology taxes come into play because we have a bunch of evidence that taxes affect how much people choose to work and how much businesses choose to invest. And so by changing and this is the key by changing the marginal tax rates on work and investment, federal tax policy can grow the economy. By encouraging people to work more and businesses to invest more. So then you see this kind of disconnect between these two schools of thought, because if a federal tax change doesn't affect marginal tax rates, it's not going to help the economy. It's going to do very little to incentivize businesses to invest or workers to increase how much they work. And that change at the margin is independent from the overall level of tax collections. So there's. There's a really big distinction between this idea of just cut taxes and change the level versus look at how specifically we're collecting taxes and what incentives that creates at the margin.

Kyle Hulehan: 4:28

That is an excellent explanation of this. And I will say for dummies like me, I would say that. Reform is we're just thinking really broadly, and you can correct me if I'm wrong here, and then the cut is really just a short term kind of view. Is that kind of on the right track?

erica: 4:44

That's exactly on the right track. and maybe we can get into that a little bit more because there are times when this like folk theory applies and it is in the short term. So you can think of the idea of like needing to get people's money. Into their pockets if we're in a recession and the idea is, let's just, you know, pour some gas on the fire, get things going real quick, get back on track. That's a short term decision. And this folk theory can be valid in that short term decision making. But when we're thinking for the long term and what's. What's permanently going to lift how much people work and what's permanently going to lift how much capital, how much productive stuff they have to work with. It's not just this, let's juice the economy in the short term. It's let's fix these incentives. Let's fix this structure permanently for the long haul.

Kyle Hulehan: 5:35

And that kind of slides right into this. how do the tax cuts impact households differently from businesses? And what are the considerations for each of those groups? I

erica: 5:45

Yeah. So I think it's helpful to like think through a, a hypothetical debate that, that lawmakers might have if they're stuck in this folk theory of thinking like, we just need to cut taxes and get money into people's pockets. Then they might argue about, should we cut taxes for businesses or should we cut taxes for people? And if you're operating from the idea that like, we just need people to spend more and that's going to grow the economy, then there's a strong argument for cutting taxes for people because. especially lower, income households, they have a higher likelihood to spend that additional money that they'll get. And so if your framework is, we just need to juice spending, then you'll concentrate tax cuts on households. If your framework. Is closer to this neoclassical view. And you think Oh no, we need businesses to spend, then it might still be this, stuck in this mindset of, we just need to get money into the bank accounts of businesses. But that also runs into an issue because. Just because a business has more money in their bank account sitting there, that doesn't mean the underlying profitability of their investment options has changed. It requires a tax cut at the margin to change that profitability equation. another way to think of it, in the neoclassical framework is to think of the tax wedge that taxes create. And so that sounds like, you know, a technical term, but think of it as, let's say that your pre tax wage, what you thought you were going to get paid, let's say is 15 an hour, but your after tax wage is less than that. Once you take out the bite of income taxes and payroll taxes and others. But for our purposes, let's just think of the income tax. And so if you know, I work another hour. I'm supposed to get paid 15 an hour, but after taxes, I get some amount less than that. That difference is the tax wedge. And so if policy changes that tax wedge on that next hour of work, it incentivizes you to work more because you keep more of your after tax wages. The return to your labor has gone up. It's more profitable for you to work more or vice versa. If that tax wedge gets larger, You get less return for another hour of work, and that discourages you from working. You can apply that same tax wedge idea to business investment. This is how much profit I expect to get back from, this additional investment before taxes and after taxes. And depending on that tax wedge, that investment may or may not be worth it. And so if lawmakers can change that tax wedge, they can influence how much businesses invest. And if you encourage people to work more in the long run and businesses to invest more in the long run, that's complimentary and you get more output or higher income overall. And so that's really what lawmakers should target is those incentives that people and businesses face at the margin. For doing this productive activity,

Kyle Hulehan: 8:39

think something important in what you're saying that applies to this whole conversation we're going to have in general is that arbitrarily having tax cuts, isn't necessarily a good thing. Like to just cut taxes for the sake of cutting taxes may not do anything. You really have to think a few steps ahead. And so when we. talk about putting money in people's pockets versus changing marginal tax rates. What are the, important distinctions to keep in mind

erica: 9:05

Scott raises this question in the blog post he wrote back in 2017, and it's essentially we can improve this debate. If we ask a lawmaker, by what mechanism is your proposal going to increase the economy? So if you drill down there and really investigate it, I think you get a good answer or you at least improve the debate. I think a really simple example to see why a tax cut may not increase growth is to think of a retroactive tax change. so lawmakers have been actually debating right now a retroactive tax policy to restore some incentives for businesses to invest in research and development. For investment in machinery and equipment, and they're potentially considering going back, you know, as much as two years to provide these incentives retroactively. So that would be a tax cut and it would be a tax cut for stuff that already happened in 2022 and 2023 and now partway through 2024. And no business and no person that I'm aware of has a time machine. So if they get a tax cut for stuff they did in 2022, they can't go back and say, Oh, now that I know that the calculus has changed, I can increase how much I worked or how much I invested back in 2022. No, you can't, that's done. And so you're not changing incentives at the margin going forward for new investment. You're providing a tax cut for stuff that's already happened. Now there may be. other motivations to do that. Lawmakers shouldn't expect increased economic growth from a retroactive tax cut. Even though they're lowering the collections, they're not changing those incentives at the margin going forward.

Kyle Hulehan: 10:41

that's very fascinating. and I'm thinking right now, so with temporary, tax cuts, when you're thinking about that,they're proposed as a quick fix. What are, the pros and cons of that, especially for businesses, planning for this long term investment, you're saying, and even when you're talking about the retroactive side of it, not changing anything.

erica: 11:00

Yeah, it's a similar calculus here. So temporary tax cuts, we're having a lot of those expire at the end of next year because lawmakers back in 2017, used temporary tax cuts to reduce the budgetary impact. So if you provide a tax cut for eight years, that costs less within the 10 year budget window that, that lawmakers are required to use than if you did it for the full 10 years. So sun setting things, the only pro is that it helps you fit into budget constraints. now I would say that it's less of a pro than it seems because oftentimes we get into this situation where lawmakers. reauthorized temporary tax provisions. So they end up costing what they would have if lawmakers did it for the long haul, but it introduces a lot of uncertainty and helps jump through the budget hoops. And that gets us to the cons, which are uncertainty. if you're a business and you're planning investment over a long time horizon, a temporary tax cut, that's only in effect for, a few years, Doesn't change that long term calculus. And so a lawmaker shouldn't expect to see a permanent and sustained increase in how much people work or how much businesses invest if they're only changing the calculus on a temporary basis. you may see some increased activity, especially if we're talking about tax cuts, for individuals on how much they work, if. If you look at what we estimated for the Tax Cuts and Jobs Act, which provided, significant tax cuts on the individual household side for a temporary period, you would expect some response to that, as those tax cuts are in effect. But as soon as they expire, that response goes away because taxes have now gone back up at the margin. So you haven't permanently changed things. And I think, I think that's the key. It's, it's. Always asking what is this mechanism by which we're expecting an economic effect. And if in the long run, that tax cut is going away, then it's not permanently improving the incentives that people face at the margin.

Kyle Hulehan: 13:00

When I think of this, I always try to provide analogies and some sort of visual cue for the listeners here. and I, when I think of this, I think of tax cuts as the caffeine boost, I have coffee right here and I haven't been drinking it because it hurts your vocals. And I try to keep sound good for the audience, but the caffeine, that's a quick burst of energy. But it doesn't change your overall health. that's just a burst of energy. On the other hand, tax reform, that's can be a lifestyle change, maybe a healthier diet, something to provide longterm stamina, and that's how my brain can think about it and picture this, it takes more effort and time for the long, sustainable reform, but in the end, you're a little bit better off for it.

erica: 13:41

I love that analogy. It's tax reform is like a good night of sleep. It sets you up for success.

Kyle Hulehan: 13:46

exactly. For the next day and for the future. So for, you know, revenue neutral tax reform, now that sounds complex, but can you break down what it is and how it aims to boost the economy without changing the overall federal revenue?

erica: 14:02

Yeah. So this is where the idea of tax cuts and tax reform come to a head because. You can improve incentives that people face without even changing the overall level of tax collections. Now that might sound impossible for people who think like, no, you have to cut taxes to improve the economy, but it boils down to this. Lawmakers have lots of different ways to raise tax revenue, and some of those ways are more harmful than others. And because we have taxes that create more economic harm per dollar of revenue raised than other taxes, we're You can improve the overall incentives without changing the tax collections. so imagine this, let's say that lawmakers decide they're going to cut a really harmful tax by$100 billion, and they're gonna make up that$100 billion by increasing a less harmful tax. At the end of the day, you've replaced the lost revenue, but you've. And so you've left the overall level of revenue essentially unchanged, but you grow the economy because overall the tax system is less harmful. And so that's why it requires this really careful thinking about what tax policies we're increasing and decreasing and where we're cutting taxes and where we're making up for it, because if you don't. Get that calculus right. If you, if you increase harmful taxes and decrease less harmful taxes, you can flip that on its head. And I'll tie in an example of where that's a potential risk right now. And that's with the tax policies we're seeing proposed by candidate Trump on the campaign trail. He's proposed making individual tax cuts permanent, further reducing the corporate tax rate, which would reduce distortions in the tax system by implementing some permanent improvements on the individual and the corporate side. But unfortunately, the way that he is considering raising the revenue to make up for some of that tax cut is by imposing tariffs and now tariffs are a very distortionary form of tax. You can think of them as like attacks on. On a technology trade is like a technology or an input to production. And so taxing that in itself is distortionary. But tariffs also invite foreign governments to impose retaliatory tariffs on US exports, which further Compounds the distortions without raising any more revenue for the US government. And so what our initial modeling suggests is that if that plan were fully pursued, it would actually reduce US economic output while reducing revenues. So it would be overall a tax cut, but it would leave output lower because it's replacing the lost revenue with even more distortionary sources of revenue.

Kyle Hulehan: 16:49

And that's why you need to think about, this whole picture of the economy at large. And I think that's a great example. You know, we've heard a lot of different ideas proposed recently in the past month or so, and they have not been the best right now. And I think that's why there's they're not really taking the whole picture into account. And right now, what I'm wondering is what does the empirical evidence say about how labor and investment respond to changes in the marginal tax rates.

erica: 17:19

Yeah. So this neoclassical theory that capital and labor respond to taxes sits on very solid ground. there's economic evidence going, you know, back to the. decades and there's newer evidence to that further confirms the responsiveness of capital, especially to changes in tax rates. I think I'll highlight just one recent paper that came out looking at the effect of the tax cuts and jobs act corporate changes. Most of those were on a permanent basis. So the. The tax cuts and jobs act permanently lowered the corporate income tax rate from 35 percent to 21%. It also made a lot of other changes to the tax base that offset a lot of the revenue loss for that corporate rate cut. So it wasn't fully revenue neutral on the corporate side, but it did broaden the base and lower the rate. So fits in this tax reform bucket of improving incentives on the margin. And the paper found that Yes, indeed. When you lower the tax burden on investment going forward, you get increased investment. They found a statistically significant and rather large response of corporations that got tax cuts under the TCGA provisions going on to increase. Increase their level of investment in the economy, which is what Tax Foundation and our modeling predicted would happen after the TCGA and others as well. And so I think it again confirms that when you have this right theory backing up your reasoning for doing a tax change, when you're thinking about the incentives at the margin, you will, by improving those incentives, improve economic outcomes.

Kyle Hulehan: 18:55

And so a big part of this and some of the issues we see are, is the public debate, and all of the conversation around this, especially, online, anywhere, it can be a little bit toxic or frustrating. but what are some ways, we can improve the public debate around tax policy to focus more on the mechanisms of economic growth?

erica: 19:19

I think conversations like this help and then questions to make sure that, if someone is saying their tax idea is going to boost growth, digging into the nuances of what mechanisms are at play, is this an argument just about, putting money in people's pockets? Or are we really talking about improving the incentives that people face because people respond to incentives? Another tool that's really helpful is tax foundations model. we can model how politicians are proposing tax changes, and we can model how that actually affects these incentives. This tax wedge on labor, this tax wedge on capital. And estimate how capital and labor will change in response. So we can see if the messaging matches up with what the actual effects would be. I think that's another way to help bring some objective analysis into the debate to see does the messaging around this tax plan, say that the idea to fully replace income taxes with tariffs actually match up with economic reality. Unfortunately, oftentimes it doesn't. Oftentimes we find that. That we're operating under this folk theory instead of under the neoclassical theory that, that is much more well supported when it comes to improving the long run economy.

Kyle Hulehan: 20:31

And I think sometimes we forget a little bit that, taxes do really actually affect behavior. I can speak to this in all reality. Last week, I Had to with my girlfriend buy a new fridge and the guy at Home Depot told us, Hey, if you buy this fridge, you're going to get a little bit of a tax break that you can write it off because it has certain environmentally friendly elements to it. And I was like, awesome. And then we bought that one. So that's like how this works is someone. tells you that and you're like, Oh, I can pay less taxes. Cool. Like it does affect how I do. I bought that one specifically for that reason. you, when you're providing the correct incentives and really thinking about the picture in the right way, you're, you'll get people to move in the right direction.

erica: 21:14

Yeah. And you remove the, essentially the barriers that are created by tax. If we think about, investment in particular, like the tax code can create a really big barrier. Big burden, a really big barrier against investment because in many ways it can be biased against, a business buying a piece of equipment or expanding a factory or even building a new factory. there can be a really large tax burden associated with that. If you remove that tax burden, you improve the structure of the tax system. You reduce that bias. Then you Get the tax system out of the way of that productive activity that would otherwise be occurring.

Kyle Hulehan: 21:49

Absolutely. So looking ahead. What do you see as the biggest challenges and opportunities for US tax policy, especially, with the upcoming expiration of the TCJA and the political landscape leading up to the election?

erica: 22:06

Yeah, but the big opportunity would be to look at what the TCGA did, learn from that, see what it did really well, see what it didn't do so well, because there were areas where it increased marginal tax rates on investment, where it made the tax code more complicated. Get rid of the complicated stuff, focus in on really improving incentives at the margin, do it on a permanent basis, find ways to pay for it to make it revenue neutral, and end up with a result where we have a permanent, stable tax code, That's more conducive to investment more conducive to work. everybody's happy, but I'm afraid there's a very low chance of really seizing that opportunity for tax reform. And so I think that the challenges. Out outweigh the opportunity and one of those challenges is the budget situation where we are right now where debt and deficits are projected to be over the same time period when the TCGA will be expiring that creates really big pressure on lawmakers To find ways to offset the cost of taxes. And it's really hard to do tax reform. It involves some really tough trade offs to, to broaden the base, to get rid of these less efficient, but really in some cases, liked provisions and the tax code that certain constituencies are used to benefiting from, getting them to give those up and exchange for lower tax rates is a tough sell in many cases. And so it'll probably be easier for politicians to take a, more politically, I don't know, easy route, to, to avoid those tough choices and instead rely on things that are more economically harmful. we've seen. A lot of talk about tariffs talk about a higher corporate tax rate. Those would worsen these incentives. But in some cases, the politics were more favorable to that. So I think that's a really big challenge. There's also going to be a challenge to fall into this retroactive and temporary tax cut territory. to just extend the tax cuts for a little while to maybe extend them backwards for these business provisions that have already expired. When we're in a situation where debt and deficits are of concern, each dollar of revenue, it's really important to focus it in on where it gets the most bang for the buck. Doing retroactive and temporary tax changes, those don't rank very high on the bang for the buck chart. So I think that's another big challenge. and a big risk to really miss out on this opportunity, for improving the tax system overall.

Kyle Hulehan: 24:33

Yeah, I think the way I would summarize this is we need to stop playing checkers and start playing chess. Like a lot of this is the political posturing. A lot of the stuff we hear, Biden and Trump say right now is checkers. It's Oh, we're going to say this. It sounds good. It's cool news, but I'll get some headlines. Cool. but we need to be playing chess. We need to be thinking more broadly. We need to, like you say, Every dollar matters at this point. And we need to think about the tax harm hierarchy, which you talked about earlier, where are we getting this money and is it helping the economy and what are the ways to do that now it's really hard. It's really hard. And one of the things I thought of, as you were talking right there was, how, people think tax returns, like a big tax return is good for them. And it's like such a good thing. and it's not as good as people think it is, you're really just giving the government a loan. And it's the same thing that you were getting into where you're like, wait. What like why do you want a big return you can have that money all year long and I think people just aren't Quite grasping it when you're like, oh, you're gonna get rid of this credit It's if you had a better tax system overall, you wouldn't need the credit anyway, because you'd have more

erica: 25:40

Yeah. Yeah. It's all about those trade offs and all about thinking through the mechanisms that are really at play. the maxim for tax reform is Broaden the base and lower the rate. And so often people like get stuck on the broad and the base part, Oh no, you're going to be getting rid of my deduction or my exemption. And they forget about how everything works together. we saw this a lot with TCGA, right? People were really upset about the 10, 000 cap on the state and local tax deduction on salt. But most people didn't know that prior to TCGA, They were probably in the alternative minimum tax where they got zero salt. So even though in the ordinary tax system, this 10 K cap went in for lots of folks, that was an increase because they were not deducting any salt because they were in the AMT. And they also saw lower tax rates. So most people were better off overall, even though if you look at this one provision in isolation, it seemed bad. So I think that's another lesson for improving the debate and hopefully getting a good outcome after 2025 is don't just zero in on one little piece, look at the big picture, look at how it interacts with other parts of the tax system and overall it's probably an improvement, when you are broadening the base and lowering the rate.

Kyle Hulehan: 26:55

Erica, thank you so much for being on the show today. That was very informative Is there anything else right now that you're working on or doing that you want to plug right now? Any other work?

erica: 27:05

I'll just talk about tariffs again. We recently revamped our tariff tracker, updated the timeline. it's now been going on for six years. we first, our first update to the tariff tracker was in June 2018. and so the trade war has been going on for six years. Over half a decade now and the economic damage from it is piling up. And we've kept track of that, at taxfoundation. org and we'll continue to, unfortunately, because tariffs are on the rise.

Kyle Hulehan: 27:32

Check out all the great work Erica is doing at taxfoundation. org. Thank you for bringing on the show today.

erica: 27:38

Thanks, Kyle.

Kyle Hulehan: 27:39

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