With tax cuts, GOP pays lip service to limited government

With tax cuts, GOP pays lip service to limited government
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Most of the discussion about the "Big Six’s" framework for income tax reform has focused on how hard it will be for Congress to pass a tax bill like this. But passing tax reform should be hard, if it’s done well.

Doing it well would mean fixing the structural problems that induce a wasteful allocation of resources, favoring activities that have no claim for preferential treatment. Fixing such problems can improve the economy, make people better off, and doing so might even cause the economy to grow more quickly for some period of time.

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Favoring some activities over others raises a fundamental policy question — To what extent should the government involve itself in the economy? Many conservatives who pay lip service to limited government get cold feet when it comes to sweeping away the interventions that occur via the tax system.

 

The framework tiptoes in the right-but-hard direction. It proposes, by not calling it out for abolition, to eliminate the deduction for state and local taxes that provides a subsidy for their spending mostly to high-income folks who live in high-tax areas, a subsidy that would never be approved by Congress as a stand-alone program.

It also would address the inefficient and leverage-inducing tax incentive for corporations to borrow that arises because interest payments are deductible, but there is no deduction for the cost of attracting equity financing; the plan calls for a “partial” limitation of the interest deduction.

But the plan sidesteps many other structural problems. It doesn’t tackle the preferential tax treatment of employer-provided health insurance under which, unlike for cash compensation, health insurance expenditures are deductible to employers but not taxable to employees.

This makes providing compensation in the form of health insurance significantly more attractive than it otherwise would be, especially so for high-income taxpayers, and creates strong incentives for employers to offer more generous health benefits than they would absent the tax break.

It doesn’t deal with the huge subsidy to owner-occupied housing implicit in the income tax. It doesn’t touch enacting a carbon tax, which is widely supported by both conservative and liberal economists.

The framework touts simplicity, which sounds easy and good. But its nod to putting the tax form on a postcard, which sounded radical when Steve Forbes championed it in 1996, sounds quaint in 2017 when the great majority of individual taxpayers either use software or accountants to file.

Cutting the number of tax brackets from seven to three would quicken your software by just a nanosecond or two. In a 21st-century filing simplification, the government would offer free software to everyone and pre-populate the site with the information they already get from employers, banks and other places; many other countries do this, and we could, too.

Some simplifying proposals, such as getting rid of the alternative minimum taxes, would clarify tax planning, if not filing. Expanding the “zero tax bracket” would provide the ultimate simplification for those who would no longer need to file.

But other aspects of the plan would be a mess, such as trying to limit the proposed 25-percent tax rate cap to real business income, as millions of people “discover” what they do is run a business.

Tax cuts are easy, and tax cuts are everywhere in this plan. The corporate tax rate would drop from 35 percent to 20 percent, non-corporate business income would be taxed at no more than a 25-percent rate, and the estate tax rate would go to…well, zero.

The top individual rate would fall from 39.6 percent to 35 percent (although an additional tax rate “may apply”), and the other individual tax rates may also be cut, but it’s hard to tell how because the brackets to which the new proposed rates apply are not spelled out.

The tax cuts are too easy and not done well. They are too easy because they are too big. The Tax Policy Center, doing the best they could with the limited details in the framework, estimates that the plan would lose $2.4 trillion of revenue over the next decade.

The resulting deficits would lower national saving at a time when we should be saving more, not less, to prepare for the looming costs of Medicare and Social Security. The Congressional Budget Office has estimated that each dollar of the deficit reduces saving by 57 cents and investment by 33 cents.

Note to supporters of limited government: Cutting taxes without cutting spending does not reduce the cost of what government does, it just puts the burden off to the future.

The tax cuts are not done well because much of them would go to the wrong people. The framework lists middle-class tax relief first among its goals, which makes sense given the stunning rise in income inequality, but many of its pieces don’t fit that goal.

Abolishing the estate tax benefits a few thousand families a year, all with over $11 million of wealth. Cutting the top income tax rate reduces the tax liability of married couples who make more than $470,000 per year.

Who would benefit from slashing the corporate tax rate is highly controversial, although relatively rich shareholders would be high on the list of beneficiaries. Eliminating the carried interest loophole, which benefits real estate investors, venture capitalists and hedge fund managers — and which President Trump has previously supported —didn’t make it into the framework.

Supporters of tax cuts argue that taxing businesses less and allowing immediate write off of investment will stimulate more investment and be good for the economy. They have a point, as the weight of economic studies supports this claim.

But these studies suggest a fairly modest impact, certainly not one that would trigger a sustained boost to the rate of economic growth. The case for lowering the corporate tax rate rests more on it eliminating the incentive of multinational companies to shift taxable profits out of this country.

All in all, the effect on the economy rests on netting the gains from the limited structural improvements and increased investment against the drain due to the deficit busting.

As a tax bill winds its way through Congress, the pressure will be to ditch the structural reforms that gore someone’s ox and loosen the discipline about deficits. That will be easier, but not better.

Joel Slemrod is the Paul W. McCracken collegiate professor of business economics and public policy at the Stephen M. Ross School of Business at the University of Michigan and professor of economics in the Department of Economics. He wrote, with co-author Jon Bakija, "Taxing Ourselves: A Citizen's Guide to the Debate over Taxes," now in its fifth edition.