Tax Reform and Rule #1 of Tax Policy

Recently I spoke to a group of hotel owners and operators about tax reform and how they could prove why tax reform will spur stronger economic growth. First, I asked them: “What would happen if you doubled the rates you charge for rooms?” After letting this sink in and observing a sea of furrowed brows, I then asked them: “How many of you have promotional programs in which you offer discounts under certain conditions?” This was followed by knowing nods. You see, there’s the proof. Prices matter.

Howard Gleckman, a researcher for the Tax Policy Center, has provided another perspective on this same point in discussing Seattle’s new “head tax,” a per-employee tax on every employee in the city. As Gleckman points out, this violates “Rule # 1” of tax policy: If you want less of something, tax it. Apparently the wise city fathers of Seattle believe they have too many employees, so they want to drive some away. No doubt they will succeed, one way or another.

If you want less of something, tax it, because then you drive up the price of that more heavily taxed item, which means people will shift their purchases and activities to something else. In Seattle’s case, it means some employers will have yet another reason to move out. Seattle’s recent implementation of a $15 minimum wage has already led to the predicted response of lower employment and fewer hours worked. Apparently the response of fleeing employers was insufficient, and so Seattle added the head tax to its arsenal of job destroyers.

Prices matter. Whether in regard to competition among competing local gas stations or any other good or service. The tax code – through high tax rates, a poor system of allowing companies to charge off the cost of their capital purchases, the antiquated international tax regime, and many other aspects – significantly raised the total return businesses had to earn to warrant an investment.

If you want less of something – tax it. The tax system meant at a fundamental level that businesses were being driven by the tax code to invest significantly less in new productive capacity just because of the tax system. By significantly reducing business tax rates and addressing the other factors driving up the cost of capital, the recently enacted tax reform reflected the analog to Rule # 1: If you want more of something, tax it less. Tax reform very significantly reduced the “price” of investment and therefore will increase business investment, will increase the stock of productive capacity, will increase labor income and jobs, and will result in significant reflows of tax revenue to all levels of government.

Those who argue tax reform won’t increase economic growth for years to come are in effect saying Rule #1 is wrong, despite the hoteliers’ reactions. They are saying prices don’t matter, which is unlikely to be the case in their own purchasing and investing decisions. These tax reform naysayers are disputing one of the crown jewels of all economics – the supply and demand curve. Tax reform will work, even in Seattle.

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.