Sen. Johnson trying to save GOP from 'winner's curse' on tax reform

Sen. Johnson trying to save GOP from 'winner's curse' on tax reform
© Greg Nash

The GOP tax bill is good, but not great. It will increase investment, output and real wages, but by far less than a smarter reform can generate. Second, the GOP plan is revenue-neutral at best. Yet, we desperately need more taxes to shore up Social Security and Medicare and to rebuild our failing infrastructure.

Third, the plan incentivizes investment, but does so inefficiently and unfairly. It provides past investments essentially the same tax breaks as new investment. But only new investment will grow the economy. Rewarding large C-corporations (actually, their shareholders) for investments they made years ago is simply a giveaway. 

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The post-election rise in the value of the stock market, which values old capital, is evidence of this windfall.

 

The fourth problem concerns the GOP plan’s treatment of small businesses.Over 80 percent of U.S. companies are small. Collectively they account for only 40 percent of total output, but they are our main engine of innovation and growth.

Whether it’s Steve Jobs working out of his garage to build the first Mac computer or the Wright Brothers designing the first airplane in their bicycle repair shop, no major corporation started anywhere but small. 

Yet while the GOP bill (both the House and Senate versions) wastes loads of money rewarding the shareholders of C-corporations for investments made in the past, it actually raises taxes on small business (so-called pass-throughs). Consequently, big corporations will gobble up even more of the economy.

The higher tax burden on small businesses concerns state and local taxes (SALT). Under the GOP plan, small business won’t be able to exclude these costs, as is now the case, from their business income before it’s passed through to them as a personal tax liability.

Under the Senate’s bill, SALT is no longer deductible at the personal level. Under the House plan, there is a $10,000 limit on just the property-tax component of SALT.

The final big problem is the tax bill’s potentially devastating war on primary, secondary and higher education. There are provisions in both bills, namely the elimination or limitation of deductibility of state and local taxes, that will dramatically raise the cost of funding public education.

There are other provisions, particularly the taxation of graduate school tuition waivers, which will make getting a Ph.D. prohibitively expensive for current and future prospective graduate students.

​Sen. Ron ​Johnson (R-Wis.) has a ​tax plan that ​suffers none of these problems.  

​Whether he will try to block the GOP bill remains to be seen, but senators on the fence need to understand what he's proposing before voting on the GOP plan. The GOP is rushing to make an artificial deadline.

If they pass their flawed bill, they may experience "winner's curse" in the next election for a simple reason — large numbers of their constituents don't like the GOP bill. 

​Sen. Johnson's plan makes owners of large corporations (C corps) pay taxes on their companies’ profits at the personal level, i.e., based on the personal tax system’s progressive rates. This is the same pass-through tax treatment as owners of small businesses face.

Moreover, pass-through income is taxed at regular progressive personal tax rates, i.e., it’s not treated as capital gains or dividend income, which are taxed at lower rates.

B​ut wouldn’t this be a huge giveaway to the rich? No. Rather than having corporate profits taxed at 20 percent and then paying taxes at preferential rates on the remaining 80 percent when it is paid out as dividends or realized as capital gains, they’d have to pay tax at the top personal rate, currently 39.6 percent, on 100 percent of corporate profits.

For the super-rich, the right comparison is paying, under the GOP plan, 20 percent at the corporate level on 100 percent of corporate profits and nothing at the personal level versus, under Sen. Johnson's plan, paying 39.6 percent at the personal level. 

Why don’t the super-rich get hit by double taxation, i.e., having to pay taxes on dividends and realized capital gains? The answer is the super-rich invest in companies, again, often based in tax havens, which don’t pay dividends and never realize capital gains that exceed their capital losses.

Instead, they borrow against their stock to pay for their consumption and when they pass away, they leave their stock to their heirs with what’s called a "step up of basis," so their heirs never have to pay capital gains taxes either!

The Johnson tax plan puts an end to this game. Indeed, it could well be called "The Warren Buffett Tax." (Buffett has famously complained about the under-taxation of the rich.)

The super-rich, like everyone else, will need to pay personal taxes on worldwide corporate profits regardless of where in the world those profits are earned. In addition, they will need to pay those taxes in the same year the profits are earned.

The plan also eliminates four long-standing problems with the tax system — double taxation, the corporate lock-in effect, the personal lock-in effect and preferential treatment of capital gains and dividends.

If the plan precludes deductibility of interest on any new borrowing in defining corporate profits, taxes on which need to be paid at the personal level, it would eliminate a fifth problem — the bias toward debt finance.

Eliminating these problems will make our economy far more efficient. But doing so is just icing on the cake. In eliminating the corporate income tax, the plan makes our country, from a tax perspective, the best place for any corporation, American or foreign, to invest.

Simulation studies suggest a significantly larger economic boost to investment, GDP and real wages than the GOP plan.

The plan leaves our personal tax system alone. There is also no axing of our nation’s educational system education system. What about the impact on revenues? Because there are no personal tax changes, there is no $886 billion 10-year revenue loss from that channel.

If one limits deductibility of interest on new borrowing, revenues derived from taxing business income (again, at the personal level) could be close to their current level even on a static score. Hence, on a static basis, Johnson’s plan appears to be close to revenue neutral. On a dynamic basis, it should raise revenues significantly.

No tax expert I know thinks the current GOP plan is great policy. We can do far better. Republicans should adopt the Johnson tax plan before they experience the winner’s curse ­— winning passage of a tax reform they don’t really want.

Laurence Kotlikoff is an economics professor at Boston University and president of Economic Security Planning, Inc.