Tax Reform Error #2: Phasing-in Lower Tax Rates

Since 1981, Republican legislators have shown a strong penchant for phasing-in tax rate reductions over several years.  That tradition is maintained in Ways and Means Committee Chair Dave Camp’s proposed 979-page “simplification” of the U.S. tax system.  The Camp draft retains a very high top tax rate of 38.8 percent on businesses that file under the individual income tax as partnerships, proprietorships, LLCs or Subchapter S corporations. For those choosing to file as C-corporations, by contrast, the Camp proposal would gradually reduce the corporate tax rate by two percentage points a year over five years, eventually reducing it from 35 to 25 percent. 

The trouble with phasing-in lower tax rates is that it creates an incentive to postpone efforts and investments until later, when tax rates will be lower.  Reducing the corporate tax rate by two percentage points a year would create an incentive to repeatedly delay reported profits, year after year, holding back the economy and tax receipts.  Sensible tax planners would write-off expenses soon as possible, including interest expenses, but defer investment until future years when the tax rate would be reduced on any resulting added earnings.  

Meanwhile, the widening gap between corporate and noncorporate tax rates (a difference of 13.8 percentage points after five years) would encourage many small businesses, farms and professionals to set up C-corporations to shelter retained earnings.  Owners of closely-held private corporations can defer double taxation indefinitely by not paying dividends and taking most compensation in the form of tax-free corporate perks. Many enterprises contemplating the new incentive to shift income from individual to corporate tax forms after five years would postpone expansion plans until after they made that switch, further depressing the economy and tax receipts.

The Republican Party’s proclivity for phased-in tax cuts may have originated with former Federal Reserve Chairman Alan Greenspan.  In his January 25, 2001 testimony before the Senate Budget committee, Chairman Greenspan said, “In recognition of the uncertainties in the economic and budget outlook, it is important that any long-term tax plan … be phased in.”  That was the same advice he gave in January 1981 when Greenspan and I served on President Reagan’s transition team.  Unfortunately, his advice to phase-in lower tax rates was followed both times, with disastrous results.

During the deep recession from July 1981 to November 1982, Congress opted to postpone most tax relief until the 1983-84 tax years.  Individual tax rates were ostensibly reduced by 5 percent in October 1981, but with only three months left in the year that meant just 1.25 percent.   Rates were again reduced by 10 percent in July of 1982, but that applied to only half of that year’s income.  Meanwhile, bracket creep from high inflation kept pushing people into higher tax brackets (until indexing took effect in 1985), negating much of the intended effect.  The final 10 percent reduction in July 1983 was not fully effective until calendar year 1984. 

Oddly enough, the painful blunder of phasing-in the Reagan tax cuts after a recession was repeated by the Bush administration in March 2001, three months after the economy slipped into recession.  Aside from the fiscal frivolity of adding a 10 percent tax bracket on the first $12,000 of income (cutting taxes $300-600 at all incomes), reductions in the four highest tax rates were originally scheduled to be very gradually phased-in by 2006.  Congress later came to its senses in May 2003 and reduced marginal tax rates. Yet substantial damage was already done.   University of Michigan economists Christopher House and Matthew Shapiro found, “The phased-in nature [of lower tax rates] contributed to the slow recovery from the 2001 recession, while the elimination of the phase-in helped explain the increase in economic activity in 2003.” The harmful impact of the phase-in was confirmed by Cornell University economist Karel Mertens and Morton Ravin of University College London. 

Mertens and Ravin also found that lower corporate tax rates do not reduce U.S. tax revenues, partly because lower tax rates increase domestic investment while reducing tax incentives to take on excess debt.  The Camp plan to phase-in a 25 percent corporate tax rate over many years would be as unnecessary as it would be counterproductive.  Most other countries reduced their corporate tax rates to 25 percent or less long ago – creating marginal effective rates on new investment that are commonly less than half the U.S. level – with clearly beneficial effects on their economies and tax receipts.  

The important, unlearned lesson of 1981 and 2001 is that phased-in reductions in marginal tax rates can make things worse before they make things better.

An uncompetitive U.S. corporate tax rate fosters excessive tax-deductible debt and gives a big cost advantage to foreign enterprises.  There is nothing to be gained, and much to be lost, by improving the U.S. tax climate slowly rather than quickly.