There is a lot to digest in the new tax reform plan released by the House Ways and Means Committee this week. Here are my three favorite and least favorite aspects of the plan:
1. The most pro-growth reform in the whole plan is the permanent reduction of the corporate income tax from the highest rate of all OECD countries to one that puts us roughly even with our trading partners. The plan would reduce the rate from 35 percent to 20 percent. Ideally, we would get rid of the corporate tax altogether since it is a distortive, outdated, and opaque tax. That being said, since this is not the in the cards right now, a 15 percentage-point cut, and making that cut permanent, is a big improvement over the status quo.
In addition, don’t listen to the talking points from the Left that argues that a corporate tax cut only benefits big corporations. Not true. A significant share of the corporate tax (scholars have argue anywhere between 25 percent and a 100 percent) falls on workers. Outside of some political circles that are immune to facts, it has become uncontroversial to say that a cut to the corporate tax will boost the economy and grow wages. How much growth is the question. At this point, any growth that will boost the labor market and wages should be welcomed.
2. When a preliminary tax reform framework was released in September, Republicans argued that reform would get rid of a significant number of deductions and credits. This was a welcome talking point, but I was doubtful that it would translate into actual action. As it turns out, they weren’t kidding, and the tax writers did a serious job of cutting through the government-dispensed tax privileges, provisions that play favorites using the tax code and tilt the playing field toward special and well-connected interest groups.
Take the mortgage interest deduction, which has been treated as a sacred cow for decades. The bill would reform it in two ways. It is being indirectly weakened by the doubling of the standard deduction. The result of this policy change is that many fewer taxpayers will choose to itemize their taxes, hence fewer taxpayers will end up claiming the mortgage interest deduction. And it is being directly weakened by moving from a mortgage interest deduction on homes up to $1 million to a $500,000 cap. It could have been more radical, but it is a good start.
The tax writers also deserve a cheer for sticking to their promise to get rid of a big chunk of the state and local tax deductions. They are keeping the deduction for the property tax but are capping it to $10,000. And they are getting rid of the deduction for state and local income taxes, which will end the federal distortion that enables punitive tax policy in states such as California, Illinois, New York, and New Jersey.
3. The plan is proposing some reforms to the Death Tax. As with the corporate income tax, the ideal policy change would have been to repeal it entirely. Instead, they promise to repeal it in 6 years (which of course means it may never happen) and until then they double the exemption so fewer people are hit by this odious form of double taxation. It is far from perfect, but it is a serious improvement over the current system, which extinguishes private capital and imposes massive compliance costs and hurts the economy.
Now, the stuff I don’t like:
1. Because Republicans are refusing to cut spending, or even restrain its growth, they have very little leeway to implement significant reforms. They have also made the tax reform effort into an exercise in finding many ways to raise revenue to pay for tax reforms we like. As a result, we are getting some good policy changes that are much smaller than we could have hoped for alongside temporary measures and frankly bad sources of revenue.
That’s what happens when you try to fit two pounds of sugar in a one pound bag. All of which is very disappointing when you realize that simply capping spending growth at 1.96 percent annually would have allowed a $3 trillion tax cut while also balancing the budget over 10 years. Moreover, increased deficits tomorrow means that we won’t be able to maintain the tax cuts in the future. So basically, we are once again trading off lower taxes for us today on the back of tomorrow’s taxpayers.
2. Republicans are doing all sorts of silly things to try to make the numbers work and to mitigate the class warfare attacks. In 2011, the top marginal income tax rate was 35 percent for taxpayers making more than $480,000 a year. President Obama at the time called for a 5.6 percent surtax on millionaires, and conservatives and Republicans exploded. They called taxing millionaires with the 40.6 percent rate class warfare, which it was. They pointed out that top income earners are already shouldering a disproportional share of the income tax, which is true. They pointed out that increasing marginal tax rate would be counter-productive and hurt growth because it affects the decision to work, invest, or stay idle, which is true too. So on and so forth.
Now, fast forward to 2017. Today, Republicans are okay with keeping the current 39.6 percent rate, which is already higher than the top rate in 2011, for those making more than $1 million a year. While this is not an increase on higher income earners and the economic bang for lowering that rate is probably small, it remains disappointing. Our income tax is highly progressive, and this, plus lower taxes on the middle class, only accentuates the trend. It also isn’t sustainable to shift more and more of the tax burden onto top earners, especially if lawmakers continue to refuse to cut spending. That’s a longer-term recipe for ending up with a Value-Added-Tax or other new sources of revenue.
Making matters worse, there is one feature of the tax reform plan that effectively raises taxes for singles making more than $1,000,000 and couples making above $1,200,000. That’s the so-called "bubble rate" which phases out the 12 percent rate for those taxpayers in the targeted income ranges. Those eager to defend the tax reform plan at any cost are arguing that this is not an additional tax rate and hence we shouldn’t get so worked up about it. It is true that it is not an additional tax rate but we should care because its ultimate effect is somewhat to 45.6 percent from 39.6 percent. As Brian Riedl of the Manhattan Institute clearly explains, “Within this $1.2 million to $1.6 million income range, every additional $100 in taxable income will bring $45.60 in new taxes. That is a marginal tax rate of 45.6 percent. Simple as that."
In the same way, the fact that this feature exists elsewhere in our awful tax code, in particular for some of the most distortive and unfair preferential provisions in the code, is not an excuse for the bubble rate. Nor is the excuse that President Ronald Reagan did it in 1986 a good reason to do the same. It's a hidden tax hike, in addition to being complex and unfair. As if that’s not enough, higher marginal rates aren’t good for the economy.
We can argue that we may be willing to swallow these less than ideal features of the reform plan because they ensure some $350 billion in savings over 10 years (between not lowering the 39.5 percent rate for millionaires and the bubble rate) in exchange for some good tax policies like being able to lower the corporate tax rate to 20 percent. However, we shouldn’t pretend that on their own the policies are pro-growth or desirable.
3. The plan introduced some worrisome features on the corporate tax side. First, rather than rely on the reduction of rates to lower avoidance and transfer pricing behaviors, the bill introduces a global minimum tax. Depending on its final design, it could be quite distortive and punishing down the road. Also, such a feature is almost guaranteed to be made worse after the Senate takes a shot at the tax reform bill. The plan also included “a 20 percent excise tax” on U.S. and multinational companies that purchase goods from related foreign corporations. With some important differences, the provision still looked like the dreadful border adjustment tax that we spent months battling and defeating at the beginning of year. Thankfully, during the Ways and Means markup Tuesday night, the tax feature was mostly stripped from the bill.
Conclusion: I'm not naive enough to expect legislation that is clean and simple. And I also recognize that there are trade-offs, so I recognize that any good tax bill will have some bad provisions. But it's nonetheless rather frustrating that the ratio of good provisions to bad provisions is not nearly as positive as it should be. And I shudder to think what we may be looking at by the time the Senate puts forth an even weaker version.