Becker Friedman Follow

The Becker Friedman Institute @UChicago supports inquiry on significant economic and policy question
Mar 28 7 min read

A Pro-Growth Tax Structure

by Edward P. Lazear

Reduce or repeal capital taxes and keep personal taxes low for growth
that benets all.

The current US tax structure is complicated and constantly evolving.

In the rst 20 years after the 1986 Tax Reform Act was passed, there
were already about 15,000 changes to the basic law. The lack of
transparency is costly: resources devoted to tax preparation and
avoidance alone amount to over 1% of GDP.1

The tax system is full of inconsistencies, preferences, complex rules,

and contradictory denitions that encourage distortionary behavior by
Americans in their legitimate attempts to minimize their tax liabilities.
For example, there are multiple denitions of child for various tax
credits and other tax rules that aect the amount paid.2

Additionally, there are parallel systems that are not fully integrated
into one coherent tax structure. Within the income tax category, the
Alternative Minimum Tax has rules that are layered on top of the
basic tax rate structure, which override the tax calculation for a
sizeable fraction of taxpayers.

Beyond that, the payroll tax both employer and employee

contributions are distinct from the income tax rules, but for most
Americans, act as a basic income tax that is an add-on to the income
taxes that they pay. And while almost half of Americans pay no
federal income tax, all wage earners are subject to the payroll tax,
which amounts to a substantial tax burden for many.

Although the diculties associated with tax preparation leap to mind

as the motivation for reform, it is secondary in term of economic
importance to adopting a tax program that will enhance economic
growth. The adverse consequences of the current tax system, which
retards growth, are more signicant than those associated with
compliance.
Capital Taxes Hamper Growth the Most
There is general agreement among economists, especially those who
have studied the tax system carefully, that growth is most aected by
taxes on capital.3 Notorious is the high US corporate tax rate of 35%
that the US imposes, which results in obvious evasive action like
locating business overseas.

More important, but less visible, is the actual reduction in investment

that occurs because capital is taxed so heavily in the United States.
The marginal dollar of investment is one that can nd its home in
another country as easily as in the US. When we raise taxes on
capital, a German investor who might have preferred to invest in an
American company simply chooses to keep that money in Germany.
The easy ow of capital across borders means that lowering tax rates
will encourage more capital to ow to American businesses.

Furthermore, not all capital is taxed similarly. One study by the

Treasury Department a few years back estimated that investments in
the corporate sector were taxed on average at 24%, while those in the
non-corporate sector were taxed at 17%. Because owner-occupied
housing yields implicit rental in the form of housing services provided
to the residents, investments in owner-occupied housing are untaxed.
This leads to overinvestment in housing relative to other businesses.

A variety of estimates suggest that if investment were untaxed

altogether, the economy would grow by an additional 5% to 9%.4 In
the short run, the easiest way to accomplish this is to allow full
expensing of investment with indenite carry-forwards. This simply
means that rms can deduct the cost of investments from their tax
liabilities immediately and fully. Allowing full and immediate
deductibility of investment expenses removes the distortions that
impede capital investment and, as a consequence, raises productivity,
incomes, and GDP.

Distorting Human Capital Investment

There is another kind of investment is even more important in our
economy namely, investment in human capital. Economists have
estimated the human capital portion of the total capital stock in the
United States as between 70% and 90%.5 How does the tax system
aect investment in human capital?

The personal income tax is the primary way by which taxes retard
investment in human capital. Although most evidence suggests that a
moderate increase in taxes does not have a strong adverse eect on
hours worked or even labor force participation, increasing tax rates is
likely to have profound eects on occupational choice and investment
in the skills that are required to be productive in high value
occupations.

Department of Labor data reveal that seven of the ten highest-paying

occupations in the US are in medicine (including dental) and
engineering. Young people choose to enter professions in part because
of their inherent interest in the occupation and desire to have an
impact on society. But there is little doubt that the high incomes
associated with these occupations produce large pools of would-be
professionals.

Work by University of Chicago-associated economists has

demonstrated that adjustment is strong and rapid. When there is
scarcity of individuals in an occupation, wages rise as rms compete
for those who are in the eld. The increase in wages induces others,
primarily the young, to enter and the entry is quick, usually
eliminating the upward pressure on wages within a few years.6

The personal income tax, and especially extreme progressivity, which

places high burdens on professionals, discourages entry into
professional occupations. Since human capital is such an important
component of all capital, it is important to avoid over-taxing
individuals directly.

All Benet When Growth is Strong

What, then, is over-taxation? Despite past increases in tax rates, the
US remains a relatively low tax country as compared with our G-7
neighbors. Indeed, some notable economists believe that one of the
reasons why the US remains a high GDP-per-capita nation is that we
are resistant to the kind of high taxation that, for example, France and
Italy have imposed on their populations.7

Unfortunately, the fact that we are relatively low provides little

comfort for two reasons. First, we can do better. Our tax code creates
many problematic incentives that if eliminated, would result in higher
growth and even better lives for the next generations. Why settle for
less when it is unnecessary to do so?

Second, even if we are content with the current situation, it is likely to

be short-lived. Because government outlays continue to grow, we run
a decit each year that will continue to increase. Under one realistic
scenario, the Congressional Budget Oce estimates that our debt
could be 175% of GDP (or more than double the current ratio) in a
little over 20 years.8 High decits and debt service can eventually only
be nanced through taxes and if these scenarios materialize, our
relatively low taxes will become ancient history.

Lowering capital taxation and paying close attention to the

progressivity of the tax structure both benet the rich directly. The
middle- and lower-income parts of the income distribution also
benet, however. I have found that there is a close relation between
average income wage growth and productivity. Furthermore, there is
a close link between GDP growth and productivity growth, the former
being the sum of productivity growth and growth in work hours.
Because of this, unless we ensure that the economy grows, which
means that productivity grows, we will not have wage growth.

This is not always perfect, nor does it aect all parts of the income
distribution equally at all times. But the link is undeniable.9 In recent
years, growth favored high-income earners relative to low-income
ones, but the poor and rich alike did best when economic growth was
robust.

To the extent that changing the tax system can bring us back to the
kind of growth that we enjoyed during most of the 20th and early 21st
centuries, we will raise the standard of living of not only the wealthy
but also of those less well o. The changes are always dicult to
eect because almost any change will mean that there will be some
losers. Still, the prosperity of our children depends on moving to a
more ecient tax code. The easiest way to get there is to reduce, or
ideally, eliminate taxation of capital and avoid the trap of making
personal rates too high for any income group.

. . .

Footnotes
1 Simple, Fair and Pro-Growth: Proposals to Fix Americas Tax System.
The Presidents Advisory Panel on Federal Tax Reform, US
Government Printing Oce, November, 2005.

2 Lazear, Edward P. and James Poterba. A Golden Opportunity, Wall

Street Journal, November 1, 2005.

3 Mankiw, N. Greg and Matthew Weinzierl. Dynamic Scoring: A Back

of the Envelope Guide Journal of Public Economics, 90, 89, (Sept
2006), pp 141533. Also, OECD Tax Policy Study 20 Tax Policy
Reform and Economic Growth. OECD Publishing, 2010.
4 See, for example, Alan Auerbach (2001)

5 See, for example, Dale Jorgensen (1996)

6 See Richard Freeman (1976); Sherwin Rosen (1992) on lawyers.

7 Edward Prescott (AER, May 2002 Ely lecture).

8 Congressional Budget Oce The 2015 Long Term Budget Outlook,

June, 2015, p. 81.

9 See Edward P. Lazear, If Only Hillary and Bernie Would Recall

JFK, Wall Street Journal, January 29, 2016.

References

Auerbach, Alan, David Altig, Laurence J. Kotliko, Kent A. Smetters,

and Jan Walliser. 2001. Simulating Fundamental Tax Reform in the
United States. The American Economic Review 91(3): 574595.

Congressional Budget Oce. The 2015 Long-Term Budget Outlook.

Washington, D.C., June 2015.
https://www.cbo.gov/sites/default/les/114th-congress-2015-
2016/reports/50250-LongTermBudgetOutlook-4.pdf (Accessed January
15, 2017)

Freeman, Richard. 1976. A Cobweb Model of the Supply and Starting

Salary of New Engineers. Industrial and Labor Relations Review 29(2):
236248.

Jorgenson, Dale W., Chrys Dougherty. 1996. The American Economic

Review 86(2): 2529. Papers and Proceedings of the Hundredth and
Eighth Annual Meeting of the American Economic Association. San
Francisco, CA, January 57, 1996.

Lazear, Edward P. and James M. Poterba. A Golden Opportunity. The

Wall Street Journal, November 1, 2005. Accessed January 15, 2017.
http://www.wsj.com/articles/SB113081277739884933.

Lazear, Edward P. If Only Hillary and Bernie Would Recall JFK. The
Wall Street Journal, January 29, 2016. Accessed January 15, 2017.
http://www.wsj.com/articles/if-only-hillary-and-bernie-would-recall-
jfk-1454022388.
Mankiw, N. Greg and Matthew Weinzierl. Dynamic Scoring: A Back
of the Envelope Guide. Journal of Public Economics 90(89): 1415
1433.

OECD. 2010. Tax Policy Reform and Economic Growth. OECD Tax
Policy Studies 20. OECD Publishing.

Prescott, Edward. 2002. Richard T. Ely Lecture: Prosperity and

Depression. The American Economic Review 92(2): 115. Papers and
Proceedings of the One Hundred Fourteenth Annual Meeting of the
American Economic Association.

Presidents Advisory Panel on Federal Tax Reform. Simple, Fair, and

Pro-Growth: Proposals to Fix Americas Tax System. November 2005.
https://www.treasury.gov/resource-center/tax-
policy/Documents/Report-Fix-Tax-System-2005.pdf (Accessed
January 15, 2017).

Rosen, Sherwin. 1992. The Market for Lawyers. The Journal of Law
and Economics 35(2): 215246.