The House Republican tax plan has been unveiled at a time when the sluggish economy needs a boost. This has been the weakest economic recovery since the 1940s. Firm deaths have exceeded firm births since 2008. The low unemployment rate does not count millions of working-age Americans who have simply stopped looking for jobs. Median family income remains near 2007 levels. Productivity, which is the most important long-term determinant of living standards, has grown at an anemic 0.6 percent annual rate since 2011. Moms and Dads are working harder, yet falling further behind.
Thus, the House Republican tax plan is intended to increase economic growth, provide tax relief, and achieve simplification. It modestly achieves all three, as explained in the following ten observations:
1. The most important pro-growth provisions would reduce the statutory corporate income tax rate from 35 percent -- the highest rate in the developed world – down to a 20 percent rate that is in line with our trading partners. It would also join the rest of the world by adopting a territorial tax regime that should end the exporting of jobs and investment overseas. These reforms should increase business investment, which is 88 percent correlated with job growth.
2. Unfortunately, the provision to allow full, immediate business expensing of new investments would expire after five years. No rational company makes long-term investment and hiring decisions based on temporary tax changes – and risk-averse companies will not simply assume that an unspecified President and Congress will renew the policy five years down the road. Rather than expand their long-term investment plans, most companies will simply move up their planned investments into the next five years. This timing shift would create a temporary investment and growth peak, followed by a trough. Long-term investment totals would not change, and thus neither would long-term economic growth.
3. The business expensing expiration is meant to minimize its cost and stay within the $1.5 trillion cost cap that Congress set for itself. The more pro-growth approach would combine immediate, permanent business expensing with a five-year phase-in of the corporate tax rate cut from 35 percent to 20 percent. Yes, phasing in tax cuts is usually economically destructive (see the 2001 versus 2003 tax cuts). In this case, under these budget constraints, the approach is pro-growth because it aligns tax policy with the business investment timeline. Under this superior framework, Companies could immediately expand and make new investments – receiving an even larger tax benefit because it is against the higher initial tax rate – and then a few years down the road when the investments are yielding profit, they could catch the new, lower corporate tax rate. This change would be an economic and budgetary win-win.
4. On the second goal of tax relief, the bill seems to provide across-the-board benefits. Lower- and middle-income families would almost surely come out ahead. Nearly doubling the standard deduction more than compensates for raising the next marginal tax rate from 10 percent to 12 percent over a small income range. And replacing the personal exemptions with an expanded child credit would benefit families with children. The loss of deductions such as for student loan interest payments would matter to some, but most lower- and middle-income families should broadly do well.
5. On the individual side, lawmakers also included stealth reforms that would take advantage of inflation to add tax revenues later. First, they would inflation-adjust the income tax brackets using the Chained CPI, which is a lower (but more accurate) adjustment than what the IRS currently uses. This would push families into higher tax brackets more quickly. The new $10,000 cap on deducting property taxes would not be adjusted for inflation either, and thus would hit more families over time. The proposed $500,000 loan limit for the mortgage interest deduction is not adjusted for inflation (neither is the current $1 million limit, but that affected far fewer families). And like the current $1,000 child tax credit, the expanded $1,600 credit would not be adjusted for inflation. Collectively, these reforms would raise much more revenue as time goes by (especially if inflation rates rise), and limit the benefit of key tax preferences.
6. While upper-income taxpayers would generally come out ahead with the repeal of the Alternative Minimum Tax and the estate tax, the new proposal is less generous than earlier drafts. First, the 39.6 percent tax bracket would not be cut for millionaires. Second, for upper-income taxpayers, there is a clawback provision that rescinds some of the tax benefits of passing through the new, lower 12 percent tax bracket at lower incomes. Finally, the draft further limits the ability of a business to deduct the cost of an executive’s annual compensation beyond $1 million. This means more of this compensation (such as stock options) would be subject to both the 20 percent corporate tax rate and the 39.6 percent individual tax rate.
7. The homebuilder and realtor industries may have overplayed their hands. While it was expected that they would criticize any limitation of the property tax deduction, key voices also harshly criticized the near-doubling of the standard deduction that would help some families no longer need the mortgage interest deduction. Essentially, this crossed the line from wanting to cut taxes for homeowners (which is fair) to punitively seeking to maximize taxes for non-homeowners. Accordingly, one may conclude that Republican tax writers simply wrote off these organizations as unreasonable, and then hit them harder by lowering the loan limit for the mortgage interest deduction from $1 million to $500,000.
8. On the final goal, this tax bill achieves modest simplification. A few dozen tax preferences would be eliminated, and doubling the standard deduction would make it easier for many families to file their 1040s. However, complicated pass-through tax rules, a claw back on tax rate cuts for upper-income families, and the retention of many tax preferences would limit this simplification.
9. As the bill is scored, Republicans may be forced to add additional anti-growth policy expirations to avoid having any cost beyond the tenth year. Of course, this issue was completely avoidable. Had Republicans written a budget resolution that covered 30 years – which budget rules clearly allow – they would have been allowed to enact a tax reconciliation bill that does not require policy expirations for three decades, which is an eternity in tax policy. Instead, they inexplicably wrote a traditional ten-year budget resolution that requires any deficit-financed tax cuts to expire in a decade.
10. In the short-term, a key question is whether lawmakers can keep this cost within the $1.5 trillion cap set in the budget (or better yet come in below the cap), and avoid adding to the cost as the bill moves through Congress. In the long-term, the most important tax question is whether lawmakers will reform the Social Security and Medicare costs that are driving a $78 trillion budget deficit over the next 30 years – and which threaten to overwhelm any tax cuts enacted in 2017.
Ultimately, today’s draft marks the beginning of the tax reform legislative process. The Senate Finance Committee plans to unveil its own reforms, and the rest of the Congress will have its say. The House plan provides an adequate starting point for tax reformers.
Brian Riedl is a senior fellow at the Manhattan Institute. Follow him on twitter @Brian_Riedl.
Photo by Win McNamee / Getty Images
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