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February 15, 2017

The Costs of Revenue Neutrality

 

The biggest conceptual hurdle to tax reform is deciding whether it must be revenue neutral or an actual net tax cut. We’ve argued that revenue neutral tax reform has only limited potential to stimulate increased economic growth, and that what the economy needs is an actual tax cut.

At the very least, if Republicans take the revenue neutral road, it should be considered neutral under dynamic scoring, which at least acknowledges the growth effects of tax cuts. The more typical static scoring does not even attempt to model the real-world impact of tax reductions on the economy.

Revenue neutral tax reform is sort of like rearranging the deck chairs on the Titanic. You already know the federal government is extracting too much money out of the private sector, but you try to improve things by lowering one tax here but raising another tax there to compensate.

If one tax change lowers revenue by $20 billion, you have to compensate elsewhere by raising $20 billion, or otherwise it isn’t revenue neutral. That’s what we mean by “pay fors” and “offsets”; they’re actually tax increases to pay for tax cuts. If you’re not careful, revenue neutral tax reform can actually be worse than the status quo.

That’s what happened to the last major Republican tax reform draft, the plan put together by former Ways & Means Committee Chairman Dave Camp. Chairman Camp’s motivations were noble and his labors appreciated, because he highlighted the many problems associated with staying within the revenue neutrality box.

In fact, Camp’s self-imposed burden of only rearranging pieces led to the incredible, counterproductive irony of a Republican tax reform plan that would actually increase the tax on capital over time. In other words, a Republican tax reform that would probably have slowed economic growth rather than stimulating it.

Camp’s plan did odd things like eliminate the tax deductibility of advertising, which is a normal business expense. There was no rationale offered for that change—just that he needed new revenue somewhere as an offset for other tax cuts.

That change would have had dramatic negative consequences for companies that advertise heavily, as well as for the outlets that run those ads. They would have been a loser, in other words, from revenue neutral tax reform. There will always be winners and losers under any revenue neutral tax reform.

A better approach is a bottom-up rethink of tax policy that results in a net tax cut off of everyone’s bottom line. And the best way to offset any revenue loss is to cut federal spending.  President Trump has indicated he wants to do both, and we encourage him to hold firm.


 

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