By Roy C. Smith
The Trump $1.5 trillion tax plan is really two-bills-in-one. A good one and a bad one.
The first is a legitimate effort at long overdue reform of the method and effect of collecting taxes from businesses. It would repeal a long out-of-date system of taxing income wherever earned around the world, after deducting local taxes paid, but allowing tax payments to be deferred until the income was brought back into the US. In a time of global business integration and competition, the present system is inefficient because (a) it applies a 35% tax rate to all income, the highest tax rate of any large, developed country, (b) but that tax rate is reduced by the deferment provisions to an average effect rate of about 26%, which happens to be the average corporate rate for OECD countries, (c) however, only a few hundred large global corporations get the benefit of deferral, so the vast majority of America’s 5.5 million corporations pay an exceptionally high rate, which clearly impedes their growth and development. A rate cut to 25% for smaller and midsized businesses would benefit them a lot.
By the way, the argument that the cash reflecting the deferred taxes, some $2.5 trillion or so, is “trapped” outside the country and cannot be used to fund domestic investment is phony. Corporations can and do lend money between subsidiaries, or borrow from banks with the deferred cash as collateral.
Two solid reasons for adopting these Trump corporate tax reforms are that it harmonizes the US tax system with those of our global competitors and levels the playing field. And, it will add sufficiently to after-tax cash flows from all `businesses and raise their returns-on-equity to enable more economic growth, a major objective of the Trump plan.
Another reform element of the Trump plan is the abolishment of the estate tax on inherited wealth. This tax is now only paid on wealth greater than $5.45 million ($10.9 million for married couples), but it is then taxed at the rate of 40%. Abolishing the tax would be a huge benefit for the very rich (just 0.2% of taxpayers), which, of course, attracts a lot of political heat. Yes, the heirs of Mr. Trump and much of his cabinet would prosper greatly from such a change, but the numbers are not big on a national scale, as the estate tax represents less than 1% of annual tax revenues. The estate tax was installed in 1916 and has endured since, largely because of the argument that without such a tax a permanent class of enriched “nobility” would emerge that would weaken our democracy. The counter argument to this was the America is the land of opportunity in which wealth could be created from very little, but an estate tax confiscated the fruit of such efforts – constitutionally protected private property on which federal, state and local income and property taxes had already been paid. The present estate tax law, enacted in 2016, is a trade-off between these points of view. There is not much appetite to bring estate taxes up again so soon after the last effort to reform it and eliminating, and, in any case, it won’t affect the economy much
The rest of the Trump tax plan is essentially bad because it will increase the fiscal deficit and probably won’t create much growth. It is a hodgepodge of business and personal tax cuts designed to satisfy traditional republican demands for lower taxes to stimulate growth. Mr. Mnunchin says the plan will pay for itself by increased tax revenues from added growth. Despite the popularity of the “Laffer Curve” that predicted such an outcome from the Reagan era tax cuts, it didn’t happen then and very few economists believe it will this time.
About 47% of tax filers don’t pay federal income taxes, so they won’t be affected. Analyses to date suggest that the tax cuts for middle income people will be offset by the loss of deductions that leave the average taxpayer about where he or she was. Lower rates on higher income people won’t matter that much, as most wealthy Americans pay much lower effective tax rates than the 39.6% maximum because of allowable deductions and so much of their income is from capital gains that are taxed at 22.8%. Reducing the maximum rate to 35% won’t result in much additional consumption on which incremental growth depends. The rich don’t spend their tax savings, but instead invest it in (already high-priced) securities. But at very low unemployment (4.2%) and inflation (1.5%), the odds are that whatever new spending there may be from the tax cuts will end up increasing wage inflation more than growth.
One feature of the Trump plan, however, could make a big, if unintended, difference. This is the provision that would allow corporations or individuals to utilize “pass-through” vehicles (limited liability corporations or partnerships) to benefit from a maximum rate of 25%. Pass through vehicles are entities that don’t pay taxes but pass income (and losses) on to shareholders to pay (or deduct) at individual rates. A small business owner can often lower taxes considerably by passing through, but some of the biggest users of these entities are hedge fund and private equity investors and real estate operators like Mr. Trump. If the 25% rate were adopted for pass-throughs, these types of investors would be major beneficiaries along with many wealthy lawyers, doctors, and others who would set up their own entities to channel income to get lower rates. But if the corporate rate is to be lowered to 25%, this provision really is unnecessary.
Certainly, the Trump tax plan has its share of political problems. To get passed, it will have to be presented to the Senate as a “budget reconciliation” measure that can be approved by a simple majority of 51 votes. For this to happen, the Senate must first pass a budget resolution based on the Trump budget submitted earlier this year (the House passed such a resolution last week). According to the bi-partisan Tax Policy Center, the budget will produce a deficit of $2.4 trillion over 10-years, or $240 billion per year (1.2% of today’s GDP, to be added to the existing fiscal deficit of 3.1%). This deficit will then have to be financed by additional government borrowings, which may upset the deficit hawks among Republicans (they have been quiet so far), the future debt ceiling bill that will have to be passed to accommodate it, and raise serious questions as to whether the $2.4 trillion estimate, or the Treasury’s of net deficit reduction is reliable. The Treasury forecast is based on “dynamic scoring” which assumes incremental tax revenues from a 3%+ annual growth that it says the tax plan will generate. In the past, dynamic scoring forecasts have been very inaccurate -- the amount of derived growth has been less than promised, and the deficits have been greater. Continually missing these forecasts partly explains why the US government’s debt to GDP ratio (107%) has grown to be the highest since WWII. This has been very worrying to many finance experts, debt rating agencies and those fearful of a debasing of the currency, and it should put some serious loyalty stresses on Republican senators who properly understand these issues.
The tax plan is unlikely to attract any support from Democrats, who are in lock-step that the whole thing is a give-away to the rich. It might get through the Republicans, but it will be tough on those Congressmen running for reelection in high-tax states that would lose the deductibility of state and local income and property taxes. The loss of this deduction is one of the last surviving means (after abandonment of the “border tax”) to gather new revenues to pay for the other cuts and increased defense spending.
The best outcome might be for Congress to pass only the good bill, the corporate tax reforms, and let the rest (like health care repeal) go for another time. Doing this could add to growth without growing the deficit. Middle class tax cuts may have been promised, but what would be delivered won’t be that much. Pass-throughs and an aggressive program of accelerated depreciation create distortions and unintended economic consequences that are more trouble than they are worth. Even the rich are resigned to paying some form of estate tax, so its repeal won’t really be missed.
Doing this, of course, would be an example of a half a loaf being better than none, something our present all-or-nothing Congress has been unable to accept as a working principle of governance.