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Revenge of the Nerds

Thursday, February 23, 2017 9:20
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(Before It's News)

Ike Brannon

If some sort of fundamental tax reform does occur this year — and the odds of its happening are looking good — the politicians, economists, tax lawyers, congressional staffers, trade associations, think tanks, academics, corporations, and others claiming credit for having influenced the legislation that finally becomes law will be legion.

But the critical impetus for reform has arguably come from a loose clique of policy wonks with ties to an inconsequential congressional committee — a group that came to be called the Prosperity Caucus. Its monthly meetings — which began 30 years ago, shortly after the last big tax reform passed in 1986 — have been a regular abode for a long list of thinkers who have greatly influenced Republican thinking about tax reform. Its alumni now hold key positions in Congress and the Trump administration, and one happens to be the current speaker of the House. If any entity can rightly lay claim to credit for the reform, the Prosperity Caucus can.

The roots of the current tax reform efforts lie in a GOP push starting in the late 1970s to make the tax code more amenable to economic growth. It was not entirely a Republican-driven exercise; Paul Cunningham, a lawyer who was on the Democratic staff of the Senate Commerce Committee at the time, said that Democratic senators came to realize that anemic growth posed a threat to Democrats’ seemingly eternal control of the Senate and that they felt some urgency to boost growth, even if it meant embracing ideas previously thought to be anathema to the party. It was the prospect of electoral punishment that led his committee to embark on deregulation, and it also made Democrats on the Senate Finance Committee open to thinking about how they might change the tax code to boost growth.

Republicans were eager to take them up on this, but they weren’t quite sure how. At the time, committee staffs weren’t nearly as big as they are today — and staff numbers allocated to the minority party were minuscule. Think tanks were few and far between. Congressmen looking to come up with innovative tax changes couldn’t just ask the staff of the tax-writing committees or a few academic economists to help them.

While no one else in Washington seemed to appreciate the seismic changes in economists’ understanding of how the world worked, the wonks at the JEC had an idea of the implications.

However, there was a committee with staff eager to help — the Joint Economic Committee, which had been set up just after World War II along with the president’s Council of Economic Advisers. Congress’s intent was for the JEC to provide unvarnished economic advice, just as the CEA was supposed to do for the president. However, its lack of legislative jurisdiction made it a sort of ugly stepchild on the Hill. It wasn’t the place for ambitious staffers to make their mark, but it was the only place on the Hill where wonky economists could be found, usually without a whole lot to do.

While most members saw little reason to bother with the committee — Lyndon Johnson remarked it was as “useless as tits on a bull” and laid claim to its offices the minute he became majority leader — a few resourceful members had figured out how to use it. Hubert Humphrey chaired the committee when he returned to the Senate after his term as vice president and used its lack of jurisdiction as a way to hold hearings and call attention to a wide variety of issues.

A few Republican politicians eventually figured out its usefulness as well. In the late 1970s some members interested in tax policy — Senator Orrin Hatch, Senator Bill Roth, and Rep. Jack Kemp — began talking to its staff, which included Steve Entin, a top tax economist, as well as Hatch’s Budget and JEC staffer Paul Craig Roberts, who had an in with Robert Bartley, the editor of the Wall Street Journal editorial page, and Bruce Bartlett, who served Kemp and went on to cover the JEC for Senator Roger Jepsen.

The idea that intrigued the JEC staff was the potential to boost economic growth by cutting the top tax rates on individuals and businesses, as well as on investment income. The impact would come not by stimulating demand — then the mainstream response to a lack of growth — but by boosting the supply side of the economy. Companies would be encouraged to invest more in new plants and equipment, to boost the efficiency of their operations, and to give workers incentives to get more education and training as well as work more.

These days “supply-sider” is a term of derision in most circles, thanks to latter-day charlatans who sell every proposed tax cut as paying for itself. But in the 1970s, the economics discipline was trying to confront the disaster that two decades of demand-side management had inflicted not just on a stagnant economy, but on the intellectual underpinnings of the discipline as well.

Thinking about the supply side of the economy made a lot of sense at the time, as it does today, and was consonant with what was occurring in academia.

A 1961 article by John Muth, little noted initially, laid out the tenets for what came to be called “ration­al expectations.” The idea was later picked up by Robert Lucas, Muth’s colleague at Carnegie Mellon, and Thomas Sargent, each of whom went on to win the Nobel Prize in economics. Rational expectations theory ran counter to the mainstream of economists who took their inspiration from John Maynard Keynes. The Keynesians seized on an empirical finding by the New Zealand economist A. W. Phillips, whose study of the British labor market found that when unemployment was high, wages increased slowly; when unemployment was low, wages rose rapidly. The same relation seemed to hold in other economies, suggesting to the Keynesians that there was a stable and predictable tradeoff between inflation and unemployment. It came to be called the Phillips Curve. During the 1960s, many governments were apparently successful in exploiting the tradeoff, reducing unemployment by increasing inflation modestly.

The simultaneous low growth, high inflation, and high unemployment of the 1970s (so-called stagflation) was utterly inconsistent with the Keynesian models of the time. The models suggested that inflation ought to lull workers into accepting wages that were lower than they realized, since they wouldn’t immediately recognize how inflation had eaten away what they could purchase. Firms would find the lower real wage beneficial and they would hire more workers, since the prices of what they produced had increased more than labor costs, and the economy would grow as a result.

Rational expectations could explain stagflation: It held that workers ultimately can’t be fooled, and would understand inflation and its uses. The implication of rational expectations was that demand-side management of the economy was futile. The economists who understood this began to think about the supply side of the economy to get more economic growth.

The implications of rational expectations theory were not quickly appreciated on Capitol Hill; Congress was still contemplating tax rebates to goose demand and the Federal Reserve was continuing to pump the money supply for the same reason, at least until President Jimmy Carter appointed Paul Volcker as the Fed chairman in 1979.

While no one else in Washington seemed to appreciate the seismic changes in economists’ understanding of how the world worked, the wonks at the JEC had an idea of the implications. What’s more, they had a few congressmen who actually listened to them — a rare occurrence in any era.

Their message to the members was more than just telling them to cut taxes: They argued that taxing capital income was an extremely costly way to generate revenue and reduce inequality because of its drag on economic growth. They thought the 70 percent top rate should be reduced, and that that rate cut might pay for itself. But they also wanted shorter depreciation schedules, lower corporate tax rates, and a lower tax rate on investment income like capital gains and dividends. While the staff never met Lucas, Sargent, or Muth, they were of similar minds. Lucas, who may yet win another Nobel Prize for his work on growth theory, once remarked that cutting the tax on capital income to zero was the closest thing to a free lunch he had ever seen, a sentiment that Steve Entin had been preaching for some time. Muth likewise expressed puzzlement that a corporate income tax even existed.

The meetings between the JEC staff and Hatch, Kemp, and Roth came to play an integral role in the Kemp-Roth tax cuts of 1981, which reduced business taxes, increased the exemption for the estate tax, and lowered the top personal tax rates to 50 percent. For the economists it was an indisputable success, but it proved to be an ephemeral one. Entin and Roberts decamped to the Treasury Department to advise the Reagan administration while Bartlett remained at the JEC as staff director for a few years, eventually moving to Treasury in 1988. Their handiwork was quickly undone. The first step was the Tax Equity and Fiscal Responsibility Act of 1982, or TEFRA — a package of tax increases that liberals like to associate with the concurrent rise in economic growth. The second step was the payroll tax increases that resulted from the deal between the Reagan administration and Congress to restore Social Security to solvency shortly thereafter.

In another affront to the JEC clique, the Tax Reform Act of 1986 largely ignored their gospel of the primacy of capital cost recovery. While it lowered tax rates for corporations and small businesses as well as individuals, it largely paid for the lost revenue by lengthening depreciation schedules and raising tax rates on other investment income. While economists praised the elimination of scores of costly and unproductive tax provisions and other accretions to the tax code, most of them returned within a few years. Entin pronounced it nothing short of a disaster from his perch at Treasury, predicting that it would rob the economy of trillions of dollars of potential growth. Hatch shared that view and was one of the few senators who voted against the bill.

In 1987 a group of staffers, admirers, and hangers-on of Jack Kemp — including Entin and various other economists with ties to the Joint Economic Committee — got together to begin planning Kemp’s presidential campaign. The group united around a platform of economic growth and continued prosperity — an almost laughably broad theme chosen to keep a sometimes prickly group of people with varied agendas together inside a big tent. The group called itself the Prosperity Caucus and their meetings involved borrowing a room downtown, buying beer and pizza, and bringing in a speaker — sometimes a congressman but more often an economist or other policy wonk — to help them brainstorm about potential ideas for Kemp to run on.

Of course, a little more than a year later Kemp’s campaign ran aground on the shoals of Lake George H. W. Bush, but the group kept holding its monthly meetings, and its basic structure survived, as did its symbiotic relationship with the Joint Economic Committee, whose staffers (on their own time!) invariably kept mailing lists, procured speakers, and bought pizza.

In the ensuing decades a number of people now poised to play a prominent role in tax reform came through the committee and participated in the Prosperity Caucus. Besides Entin, who’s about the only regular attendee for its entire 30-year run, the ranks of JEC alum who regularly attended the Prosperity Caucus at some point have included David Malpass — rumored to be the next deputy secretary of the Treasury — as well as Jeff Wrase and Robert O’Quinn, the chief economists for the Senate Finance Committee and the House Ways and Means Committee. Wrase is generally considered to be the best Republican tax economist in town.

Steve Moore and Jim Carter, who ran the group in the 1990s, helped the Trump campaign put together its own tax reform plan, while also running tax reform for the transition. Before them the group was run by Bob Stein, another JEC economist, who got help from his buddy Paul Ryan, who worked for Kemp at the time. When Ryan was elected to Congress he immediately went on the Joint Economic Committee. His successor at Ways and Means, Rep. Kevin Brady, went onto the committee shortly after Ryan did and later chaired it. And in 1987 Senator Hatch was appointed to the Finance Committee, which he now chairs.

The Ways and Means Committee tax reform blueprint largely embraces the Prosperity Caucus perspective. Ryan’s predecessor at Ways and Means, Dave Camp, proposed his own plan to fix the tax code, but a key difference is that the Ryan/Brady plan, dubbed “A Better Way,” treats capital investment much differently. Camp, who retired from Congress in 2014, called for eliminating bonus depreciation, whereby companies can deduct more of an investment up front than the amount by which it depreciates the first year, and would have used the savings to finance a lower corporate tax rate. The rationale, one Ways and Means staffer explained to me, was that companies simply did not seem to value accelerated depreciation and would have preferred a lower rate instead.

The Better Way plan, on the other hand, would allow companies to immediately deduct all capital investment — what economists refer to as full expensing. This is an expensive proposition, costing some $2 trillion in forgone revenue over a decade, but Ryan, Brady, and their advisers think it will greatly increase investment by firms, in turn boosting productivity, wages, employment, and growth. To make up for some of the revenue lost via full expensing, the Better Way plan gets rid of the ability of corporations to deduct interest payments from taxes: With full expensing, debt-financed investment would effectively have a negative tax rate, making the deduction superfluous for most.

The plan’s other revenue raiser is the move to border adjustability — the imposition of a 20 percent corporate tax on imports, while exempting exports from the domestic corporate income tax. Taken together these represent a revenue-neutral change but a radical departure from the current code.

The Prosperity Caucus/Joint Economic Committee gang has been cheering the Ryan/Brady plan the loudest: If there is one idea that ties the group together it is that taxing capital income is a terrible way to collect revenue and reduce income inequality. Steve Entin has been the Apostle Paul for the idea that companies should be allowed to immediately deduct capital investment rather than spread it out over its useful life, and he has converted many Republicans. It is worth noting that the models of the Joint Committee on Taxation suggest that a tax cut on capital produces more growth than an equivalent reduction in the corporate rate.

The major changes in the Better Way plan — border adjustability, full expensing, and the end of interest deductibility — effectively represent the rare example of a legislative agenda being driven not by vested interests but by ideas. As a result the plan has many critics, and actually achieving a reform that includes these provisions may be difficult.

But the odds are better than ever that a major tax reform will occur in the next two years, and it’s a safe bet that whatever emerges will have been shaped to a large degree by the work of an inconsequential committee and its pizza-and-beer offspring, the Prosperity Caucus.

Ike Brannon is a visiting fellow at Cato and president of Capital Policy Analytics.


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