The following article is authored by Wendy Edelberg.

• A review of the eight major tax reforms passed in the U.S. since 1986 finds insignificant long-term impacts on gross domestic product.
• Still, policy makers frequently focus on how tax reforms are expected to affect economic growth.
• By contrast, policy makers pay too little attention to potential effects of reforms on revenues, firm and consumer behaviour and the distribution of income.
   

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Tax policy debates weigh many competing goals, but they often prioritise the expected impact on aggregate output. In theory, fundamental changes to the tax code have the potential to dramatically affect output by changing incentives to work and invest. In practice, however, major tax reforms in the U.S. have had little long-term impact on gross domestic product.

A close look at major tax reforms enacted by the U.S. in the last four decades provides further insights (Edelberg and Harris, 2023).

In the short term, changes in demand can be significant in response to tax changes that take effect quickly, such as a boost to spending from an immediate cut in tax rates.

In the long term, though, the review of eight major tax reforms shows that the most comprehensively estimated impacts of those reforms have ranged between a 0.5 per cent increase to a 0.5 per cent decrease in the long-term level of output.

In other words, over the past four decades, even major tax reforms have not appreciably affected economic growth or the productive capacity of the U.S. economy. This lesson applies across a range of tax reforms that had markedly different revenue and incentive impacts and across a wide range of macroeconomic models with varying specifications and assumptions.

There are practical reasons why the effect of tax reform on aggregate output is smaller than one might find in theoretical models. For one, politically feasible tax policy changes are often much less drastic than the changes simulated in those models. 

To be clear, tax reforms can influence behaviour across a sweeping range of decisions, and they can substantially change the level of revenues and the distribution of income. The Tax Reform Act of 1986 offers an illustrative example. This act, which some consider to be the gold standard of tax reform since it expanded the tax base while lowering tax rates, had a close to negligible impact on growth. This act did, however, affect decisions about how to organise businesses and how to allocate capital. Another key example is the Tax Cuts and Jobs Act (TCJA) of 2017. The TCJA increased the short-term after-tax income of the top quintile of taxpayers by 3 per cent, but it has had close to no impact on the size of the economy.

The U.S. tax code touches virtually every aspect of the economy, from housing to health care to the use of fossil fuels. Changes to the amount of revenue raised would also have important long-run consequences, as lower deficits would increase the size of the U.S. economy and reduce the probability of a fiscal crisis.

But debating the efficacy of a proposed tax reform by whether it slightly increases or decreases the size of the economy is a misplaced emphasis; politically feasible tax reform in the U.S. will not dramatically alter future economic growth. Instead, policy makers would be better off prioritising the effects on federal tax revenues, the distribution of income and changes in behaviour to further broaden societal goals.

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References

Edelberg, W. and Harris, B. (2023) Look beyond gross domestic product to assess the effects of tax reforms, The Hamilton Project. Available at: https://www.hamiltonproject.org/publication/paper/look-beyond-gdp-tax-reform/ (Accessed: 20 November 2023).

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Wendy Edelberg is the Director of The Hamilton Project and a Senior Fellow in Economic Studies at the Brookings Institution.

The facts, ideas and opinions expressed in this piece are those of the authors; they are not necessarily those of UNESCO or any of its partners and stakeholders and do not commit nor imply any responsibility thereof. The designations employed and the presentation of material throughout this piece do not imply the expression of any opinion whatsoever on the part of UNESCO concerning the legal status of any country, territory, city or area or of its authorities, or concerning the delimitation of its frontiers or boundaries.