Tax Reform: The Good, the Bad, and the Really Ugly—Part Three

“We have a system that increasingly taxes work and subsidizes nonwork.”

– Milton Friedman

“You must be the change you wish to see in the world.”

– Mahatma Gandhi

“Real change requires real change.”

– Former Speaker of the House Newt Gingrich

Today we come to part 3 of my tax reform series. So far, we’ve introduced the challenge and begun to describe the main proposed GOP solution. Today we’ll look at the new and widely misunderstood “border adjustment” idea and talk about both its good and bad points. What follows may make more sense if you have first read part 1 and part 2. Next week we’ll explore what I think would be a far superior option, though one that is based on the spirit of the current proposal. If House leadership thinks they can get the present proposal through (doubtful), then they should stop messing around and do something really controversial by changing the entire terms of engagement. As my friend Newt Gingrich has often told me, “John, real change requires real change.”

Warning: There is something in this series to offend almost everyone. Everything is fair game. If nothing else, I hope that no one can accuse me of simply talking the Republican book. I think this letter will pretty much eviscerate the key component of the proposed Republican tax plan. I hope the plan will be seriously changed. Many of you have direct contacts with your Senators and Representatives on both sides of the aisle. I urge you to send this letter to them and talk to them. This is one of the most serious national conversations we have ever had.

We can all argue about how big government should be, but whatever we decide upon, we must pay for, if not through taxation then through a massive debt-deflationary depression or serious inflation. (Next week we’ll talk about how to avoid these problematic outcomes. Yes, it can be done.) It’s not a question of cost or no cost, it’s a matter of who will pay and how much. The question is how to allocate the cost efficiently, equitably, and with the least possible economic distortion.

I have talked to many of the participants in the tax reform process, both in Congress and in think tanks. The one point of agreement is that the tax system must be massively reformed. That point, unfortunately, is where agreement ends. Tax reform ideas usually fail because the status quo gives everybody some kind of perceived benefit. In reality, the benefit may be worth less than people think, but it’s preferable to the uncertainty of a new system. This is basic game theory stuff, where the status quo is seen as what the economist types would describe as a “Nash equilibrium,” or a situation in where everybody has figured out how to make the system work for them, whether or not they are happy with it in toto. As long as nobody disturbs the equilibrium, things go on as they have done – until they don’t. The topic of equilibrium is one we’ve covered in past weeks, and we’ll be returning to it.

Last week I described the tax reform ideas that House Speaker Paul Ryan and his caucus include in their “Better Way” blueprint. As I said, there’s a lot to like in their plan. There are parts of it I love. I am most enthusiastic about the pro-business/entrepreneurial encouragement they offer. Truly, we cannot resolve our national economic dilemma without growing the entrepreneurial and business side of our equation. One of the few things that the Paul Krugmans of this world and I agree on is that we must figure out how to grow our way out of the problems we face.

However, we must remember that the “Better Way” is simply a set of proposals at this time. President Trump announced on Feb. 9th that his economic team is drawing up its own “phenomenal” business tax reform proposal. He said the White House would reveal it in the next few weeks. We have no idea whether it will resemble the House GOP plan. We do know the president hasn’t sounded enthusiastic about the border adjustment tax idea. We are also reading about major pushback on the BAT from many Senators and Congressmen.

I’m not enthusiastic about the BAT either, to say the least. I fear it would come with serious macroeconomic side effects, and not just for the US. Cutting to the chase, when I say serious macroeconomic side effects, I am talking about its potentially triggering a global recession, which would mean a major bear market and a total reset of valuations in every asset class. Not the end of the world, but certainly not without pain and cost. Let’s pick up the story right there.