Alarm bells ring on fiscal changes

The ranks of fiscal conservatives may be dwindling, but the reasons to be alarmed at trends in government expenditure, taxation, deficits and debt in many countries are increasing.

Events in the United States — politics, economics and the pandemic — have fused together to produce fiscal changes that make the alarm bells ring more loudly there than almost anywhere else.

Americans should be on red alert about this, but fiscal conservatives in other countries are also concerned about what we see happening in Washington; because economic trends and ideas — both good and bad — have a way of spreading from major countries.

In the 1980s, for example, Ronald Reagan’s ideas on taxation gave a powerful impetus to a world-wide push towards lower tax rates. It will be very harmful to economic freedom and economic performance if President Joe Biden’s tax increases lead a worldwide movement in the other direction.

Fiscal conservatives believe in smaller government that limits itself to its core functions; low taxes; balanced budgets in normal times; and disciplined levels of public debt so that the public finances are ready for the next crisis.

These are all now under attack at the same time. To be fair to Biden, it is not all his work. It is a very long time since fiscal conservatives held sway in Washington. But under Biden the assault on fiscal conservatism is reaching a crescendo.

The contours of his ‘spend, borrow and tax’ plan are now clear from the president’s address to Congress on April 28. On top of what was spent in 2020, we now have a Rescue plan, a Jobs plan, an Infrastructure plan and a Families plan.

Although it is not clear whether there is some overlap and duplication in these labels, what is clear is that they amount to eye-watering, multi-trillion dollar spending — much of which appears to have more to do with satisfying the Democratic party base than achieving the stated objectives.

The federal deficit looks like being at least 15 per cent of GDP — by far the largest in the developed world — for two consecutive years. This may have been understandable in the circumstances of 2020… but in 2021, when the economic rebound recovery is well under way?

According to IMF projections, federal debt is set to increase from 108 per cent of GDP in 2019 to 133 per cent in 2021. The higher debt rises, the less flexibility government has to respond to the next crisis, whether it is financial or geopolitical.

Then there is the tax plan, which aims to add around 2 per cent of GDP to revenue. This may not sound much, but it is the largest tax hike in decades. The best that can be said about it is that at least the administration is acting as if its spending will ultimately have to be paid for by tax dollars, not borrowed dollars.

However, it remains to be seen whether the deficit can be contained by increasing taxes while simultaneously ramping up spending. History suggests not. It is more likely that the tax increases damage the economy and fail to produce the expected revenue. Tight control of government spending is a much more effective route to reducing the deficit.

Economic damage is all the more likely as Biden’s tax plan is at its most harsh against the most mobile factor of production — capital — through increased taxes on business income and capital gains. Corporate profits tax is one of the most harmful to business investment, innovation, productivity and real wages. International tax competition for mobile capital is a force for good, working against the many forces for higher taxation.

The administration apparently believes it can minimise the adverse fallout by stifling international tax competition, which it demonises as a ‘race to the bottom’ — hence the call for a global minimum tax of 21 per cent. If they can remove the incentive for capital to move, it becomes so much easier to tax.

But while there has been a long-term downward drift in headline corporate tax rates, there has been no race to the floor. The US was slow to participate, but the Trump administration did so in one large leap. The Biden advocates say this was excessive and they are “only” clawing back half of it, but conveniently overlook the base broadening measures that were part of the Trump package, while adding more base broadening of their own.

Up to a point, the US initiatives are in harmony with efforts already under way at the international level — but hitherto resisted by the US — to counter base erosion and profit shifting (BEPS).

There is doubtless a lot of gaming of differences between national business tax systems by multinationals and international cooperation to counter it is warranted — although the extra revenue to be extracted by doing so is probably much smaller than is often believed to exist.

This basically requires a comprehensive international agreement on a formula to allocate for taxing purposes the profits of multinationals to the various countries in which they operate, whether or not they have a physical presence in them. It does not require a global minimum tax. It is a sensible project, but a very difficult one to gain international agreement on.

But there is much more to Biden’s corporate tax plan than a new and warm embrace of international cooperation. There is a large domestic agenda at play, involving a permanent expansion of public expenditure and tax increases to finance it, with the taxes shaped at least to give the appearance of reducing inequality; even if their ultimate effect will be to retard the growth of jobs and real wages that Biden wants to achieve.

The corporate sector is merely the largest port of call in this drive for more revenue and redistribution. The Biden plan also continues the rising trend in upper income taxation that has been under way ever since the top federal rate was slashed to 28 per cent under the Reagan administration. That lasted just three years before it was increased in the first Bush administration, then increased further by Clinton.

Since then, there has been a tug of war over the top tax rate between Republican and Democratic presidents, but each time the top rate has been cut it has not gone back to where it was before. A 3.8 per cent surcharge has also been added on investment income to help finance health insurance reform.

The top rate is still well below the 70 per cent level Reagan inherited, and the 90 per cent that prevailed from the war until the early 1960s, but it is also the case that the tax base has been broadened greatly since that era. Indeed, there has often been an explicit trade-off between base broadening and tax rate cuts, but when the rate cuts were reversed the base broadening remained or went even further. The Biden proposal continues this sleight-of-hand approach.

Many Americans will be watching anxiously to see whether Biden’s proposals are modified as they pass through the Congress, but their fate is also of international interest.