Let benefits trickle up with middle-class tax cuts

Let benefits trickle up with middle-class tax cuts
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House and Senate Republicans are so eager to get tax reform done in the next 30 days that they think it wise to release two very different bills competing for our attention. No ordinary mortal, including members of the tax-writing committees, can possibly keep it all straight, and the fog of tax politics makes everything even more elusive.

What’s really important here? Only two questions, really: First, are large deficit-increasing tax cuts a good idea right now? Second, if they are, how should those benefits be shared?

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Almost all the bloviating and talking points are irrelevant. No one has any reason to care how many tax brackets there are. The IRS tables in your Form 1040 instructions tell you how much tax to pay for a given amount of taxable income, and online or standalone tax-preparation software does it all automatically.

 

While it is true that our corporate tax system is a sad, sick beast of a tax, reforming the corporate tax should logically concern a few thousand specialists, at most. If what we want is a healthy, rational corporate tax system, we could enact that through standalone legislation that could be revenue neutral yet efficiency-enhancing.

Instead, the House and Senate corporate tax proposals fail elementary public finance economic norms by allowing firms simultaneously to deduct immediately all business investments, while allowing those firms also to deduct the interest costs of borrowing the money to make those investments.

The combination yields negative effective marginal tax rates on these investments. In other words, all of us will subsidize corporate investments in machines, even when they replace rather than complement workers, through our tax system.

So let’s return to the two important questions. First, why is a deficit-busting tax bill a good idea right now? Let’s be clear: the Congressional Budget Office estimates that the cost of the current bills would be roughly $1.7 trillion over the next decade, not $1.5 trillion, once Uncle Sam’s increased borrowing costs are considered.

No rational economist has suggested that these tax cuts will by themselves lead to so much increased growth as to turn these deficits into surplus revenues.

We are waiting for the nonpartisan Joint Committee on Taxation staff’s official report on the dynamic growth effects of the legislation, but once one considers the anti-growth implications of increased government borrowing and the probable sunset of many business cuts to comply with the Senate’s rules for using the reconciliation process, dewy-eyed growth prognosticators are likely to be disappointed.

So again, why a large deficit-funded tax bill? The economy is doing reasonably well. Interest rates are very low, financing for new business opportunities is readily available and corporate profits are at record highs. So a Reagan-era “supply side” story seems out of place — the supply of capital isn’t constraining growth.

The principal justification is that the middle class deserves a tax cut. But that’s also the same as saying, the middle class deserves fewer government services, because eventually the money must be found to pay for the new deficits.

More immediately, only a small fraction of each bill is aimed directly at middle-class wage earners. The House targets only about $216 billion (out of $1.5 trillion) directly to wage-earners at all income levels.

The Senate is a bit kinder here, but even so, the Senate reserves only about $450 billion for wage-earners. Killing or weakening the estate tax, for example, helps only a few thousand very wealthy families each year.

Perhaps the thought is that the average worker bears an unconscionably heavy tax burden, once payroll taxes are considered. But compared with other rich countries, the U.S. “tax wedge” (the difference between what employers pay and employees take home) is fairly small.

More tellingly, the United States is the lowest-taxed large economy in the world, full stop. We excel in whining about taxes, but our burdens are light by world standards.

Tax reform is not the same as Tax Christmas — there aren’t many free gifts waiting under the tree to be distributed to one and all, once one takes the long view, inclusive of the consequences of greater deficits. But if we nonetheless insist on celebrating Tax Christmas this holiday season, how should the goodies be parceled out?

Here, keep in mind that income comes in only two flavors: We earn labor income (wages, salaries, most net income from our own business, etc.), and we earn capital income (income from investments of all sorts). So what we are really asking here is, how much should labor get, and how much should capital get?

If the objective is middle-class tax cuts, here’s what we know for a certainty: The middle class has very little capital, and therefore very little capital income. Labor income is very top weighted in this country, but capital (and therefore capital income) is even more so.

If what we want is middle-class tax cuts, the future be damned, that’s not difficult to do. Give the middle class tax cuts already, and be done with it. That way, economic growth can trickle up, in the form of increased demand.

We are told that if only we cut the tax burden on capital, that will percolate down to wages. Simple models tell us this must be so, but those simple models in turn do not describe the United States, as many economists have explained.

Most pedigreed, consensus corporate tax models agree that when the dust settles, capital owners get the lion’s share of any benefits from capital income tax cuts (particularly against the background of expensing all investments).

In addition, the special tax brackets for pass-through businesses are an invitation to gaming and further reward capital owners, not the working man.

Imagine that you read that tech firms are migrating from Silicon Valley to Santa Monica and Venice, near Los Angeles. You realize that this will increase demand for housing in the latter two communities, and so you decide to strike before anyone else sees the opportunity.

Do you invest in residential real estate in Santa Monica and Venice, or do you invest in residential real estate in Pasadena, 25 miles and a cultural millennium away, on the theory that what’s good for Santa Monica must ultimately percolate to prices throughout Los Angeles County?

Don’t let the future of this or that cherished deduction obscure your view here. There are only two important questions for the country arising in tax reform, and neither one has received the attention it deserves.

Edward D. Kleinbard is the Robert C. Packard trustee chair in law at the USC's Gould School of Law, and a fellow at The Century Foundation. Kleinbard was one of four individuals honored as 2016 International Tax Person of the Year by the nonpartisan policy organization Tax Analysts.