Failure To Pass Tax Reform Would Have Dire Consequences

[This is part of an ongoing series entitled “The Case for Tax Reform,” which examines the importance of reforming the outdated tax code, and how achieving that goal will advance economic growth, jobs, and prosperity.]

Comprehensive pro-growth tax reform can do more to strengthen the U.S. economy for years to come than any other policy currently before Congress. At the same time, failure to achieve a significant tax reform would probably do more to weaken the economy, perhaps even triggering a recession, not to mention a wave of foreign purchases of U.S. companies, than any other policy currently before Congress. When U.S. Chamber of Commerce President Tom Donohue says, “failure is not an option,” he’s not kidding.

The U.S. economy has settled into a pattern of moderate, sustained growth. This growth was likely given a tidy uptick with Donald Trump’s election as it meant, at the very least, that Barack Obama’s heavy regulatory foot had been taken off the economy’s brake. On the other hand, as the remaining slack in the economy is taken up, the tendency will be for the growth rate to slide a bit pending future developments. One such development should be the beneficial consequences of a successful tax reform effort.

Many politicians and pundits seem quite enamored of cutting taxes. Tax cuts are nice, and often popular, but tax reform’s power to improve the lives of American families and businesses doesn’t lie in the prospect for a tax cut. Tax reform’s power lies in its ability to reduce and even eliminate many of the most damaging distortions the tax code inflicts on economic decision making. Substantially lower tax rates plus expensing and an internationally competitive tax system for American businesses competing overseas would all reduce these distortions dramatically, leading to more economically rational decisions and improving economic efficiency.

Improving efficiency and thereby raising productivity is the key to raising standards of living. The key to raising productivity is improving the allocation of capital and labor across industries and activities, increasing the amount of physical and human capital employed, and increasing the technological content of the capital employed. Tax reform can help in all these areas and do so more than any area of public policy available today. Want a stronger economy? Pass tax reform that works.

However, tax reform also comes with an economic warning label. Businesses and individuals have waited for decades for Congress and a President to accept the challenge to reform the tax code. Congress and President Trump are now on the same page and on the right page, but if they were to fail now it seems highly unlikely they’ll have a better shot in the next few years.

A big issue with tax reform is not merely how much better the economy could perform, but also how much weaker the economy would be without tax reform. One might think absent tax reform the economy would continue on its current trajectory of moderate growth, but that is incorrect. Tax reform’s prospects dimming to a feint flicker would almost surely trigger a dramatic decline in business investment at home. To remain globally competitive at home and abroad, many U.S. companies would be forced by the indefinite reality of the current, antiquated federal tax code to shift substantial operations overseas. The hope for tax reform has held these kinds of decisions at bay.

At the same time, a great many U.S. multinational companies would quickly become takeover targets of foreign companies. Why? First, because those foreign companies face much lower tax rates.

To understand the second reason, imagine a U.S. parent company with a profitable foreign subsidiary. The subsidiary, call it ForSub, is currently taxed at a U.S. rate of 35 percent. Suppose a foreign company subject to a 25 percent tax rate buys the U.S. parent company. In a flash, the tax on ForSub’s profits drops from 35 percent to 25 percent. This isn’t tax evasion, or even tax planning. This is a simple, rational, necessary economic response to public policy.

American and foreign businesses are poised at the edge of their seats waiting to see which way tax reform goes. Get it right, and foreign purchases of U.S. companies will be very rare, while many U.S. companies will be on the prowl for opportunities to purchase foreign companies – reversing recent trends. Blow the opportunity for tax reform and foreign companies will be the buyers.

If Congress failed to enact comprehensive tax reform, then the effects on investment and corporate ownership at home could be profound, certainly enough to knock the legs out from under the economy in the latter half of 2018. Tax reform is now truly a two-edged sword. Get it right, and the economy would be given a strong boost for years to come. Fail, and though the tax code will remain status quo, the rate of economic growth for a period would almost certainly drop a lot and quickly.

Washington has few opportunities to really help the economy, but Washington also thankfully has few opportunities for triggering a major slowdown or even recession. Tax reform offers the former, but failing to pass a solid tax reform threatens the latter.

About the authors

J.D. Foster

Dr. J.D. Foster is the former senior vice president, Economic Policy Division, and former chief economist at the U.S. Chamber of Commerce. He explores and explains developments in the U.S. and global economies.