Tax Reform: What to Expect and What to Hope For

Tax Reform: What to Expect and What to Hope For

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With the failure of the House Obamacare replacement, it seems likely that Trump and the Republican leadership are going to put healthcare on the backburner for now.

There seems reason to believe the next policy item on the agenda for the GOP will be reforming the tax code. Unlike healthcare, which heavily divided Republicans, there is a broad consensus on the need to change the tax code. There is a lot to consider regarding what to expect from tax reform and what should be the goals

First, let’s examine why tax reform is needed. Our current tax system is harmful to small businesses. The taxes levied on businesses disproportionately impact smaller businesses rather than the big businesses the tax burden is meant to fall upon. Indeed, two-thirds of small business owners say that these high taxes threaten the viability of their businesses. Most small businesses cannot handle the tax burdens they face and end up just scraping by. This is not good for the economy. Clearly, our tax code needs to be modified to make sure that small businesses are able to grow. 

Additionally, there is the matter of our current corporate tax rate: it is the third highest rate in the world. A corporate tax that is this high weakens our ability to be competitive economically and disincentivizes investment. Additionally, tax reductions often have proven helpful to encourage economic growth and tax increases often slow long-run growth. For all of these reasons, it is clear the tax code needs to be fixed.

Now, we need to examine the current tax reform proposals available. The most available current proposal is the House of Representatives' "Better Way" tax reform proposal. This tax plan would reduce marginal tax rates and the cost of capital. It would also move towards destination-based taxation of businesses - a so-called “border adjustment.”

The proposal eliminates the estate tax and the gift tax. In the area of corporate taxes, it enacts a repatriation for current foreign profits at a rate of 8.75% for cash and cash-equivalent profits. It also reduces the corporate tax rate from 35% to 20% and eliminates the corporate alternative minimum tax. It also changes the way capital gains are taxed in a way that makes them de facto taxed at 50% of regular income tax rates.

Standard deductions are increased while all other deductions besides the mortgage and charitable contributions deductions are eliminated. 

This proposal has a lot going for it. For one, the corporate tax reduction brings the US down from the 3rd highest corporate tax rate to approximately the international average of 22%. This would increase the competitiveness of the US as a place to do business.

Additionally, this tax policy would have a very positive effect on GDP: the long-run economy would grow by 9.1%. Wages would increase by 7.70% and capital investment would increase by 28%. This is driven by the reductions in capital costs this plan enables.

The plan also includes a policy of repatriation, which likely would bring increased revenue from overseas into the country that subsequently would be invested. Additionally, the growth the plan will produce offsets the bulk of projected revenue loss from the cuts. Long-run growth would result in the initial projection of a 2.4 trillion budget shortfall over 10 years to a much more manageable $191 billion over ten years. Unlike some tax plans that would create a massive ballooning of the national debt, this plan would minimize revenue loss.

However, there is one key issue with this policy plan: the border-adjustment tax. A border-adjustment tax has similar shortfalls as protectionism: namely, other countries will retaliate and will cause our exports to decrease. There is also the risk it will pave the way for a value-added tax and cause representatives to discount the importance of spending restraint. The border-adjustment tax overall goes thoroughly against the rest of the principles embodied in the Better Way plan and there are only two real reasons for including a border-adjustment tax.

The first is to ensure revenue remains maximized, which could probably be better managed by slightly adjusting projected tax rates so the cuts aren’t as big as originally planned-for instance, by bringing the corporate tax down to the global average of 22% rather than 20%. The bigger reason, though, is as a concession to the protectionism that got Trump elected. This would be a mistaken course of action - if we are going to debate whether to bring tariffs back, it should be done openly and separate from the overhaul of the tax code. 

Overall, despite this key misstep, the Better Way plan is, on net, an improvement over the current tax code. It helps address a number of the issues with the tax system and does so without drastically increasing the deficit. Hopefully the issues with the current version of the plan will be addressed before it is passed, but even if they are not, this plan appears to be a vast improvement over the status quo.


Follow this author on Twitter @mitchellastern

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