Tag: Tax Reform

Trump’s Tax Reform Proposals

The Trump administration has released proposals to guide the Republican push for major tax reform. The proposals are mainly supply side in nature, meaning cuts to marginal tax rates and other changes designed to increase economic growth. Major tax reforms are needed desperately, so kudos to Trump for taking charge and thinking boldly, particularly on business tax reforms. There are, however, a few misguided parts in his new plan.

Here are thoughts on the proposed business tax reforms:

  • Cutting the corporate tax rate from 35 percent to 15 percent would have a huge positive effect on the U.S. economy over time. It would encourage more capital investment and hiring, and it would reduce the incentive for corporations to avoid and evade taxes. Such a rate cut would cause the income tax base to expand automatically and substantially over time.
  • Cutting the tax rate on “pass-through” businesses to 15 percent, however, is a mistake. Policymakers should aim to equalize the overall rates on income earned by each type of business. So if the corporate rate is 15 percent, corporate income would face a combined tax rate of 15 percent plus the individual dividend rate of, say, 15 percent under tax reform, for a total of about 28 percent (0.15+0.85*0.15). Thus, the top rate on pass-through income should be cut to the same 28 percent.
  • Switching from a worldwide to a territorial system for corporations would encourage multinationals to move their headquarters to the United States. It would reverse the trend toward reincorporating abroad.
  • Ditching the misguided “border adjustment” provision the House proposed is a good move. Paul Ryan and Kevin Brady need to drop it so that tax reform can move ahead.

Here are thoughts on the proposed individual reforms:

  • Reducing the number of tax brackets from 7 to 3 (10, 25, and 35 percent) is a good reform. Cutting marginal rates reduces distortions, increases incentives to engage in productive activities, and reduces avoidance and evasion.
  • Repealing the special 3.8% investment tax is a good reform.
  • Eliminating itemized deductions—such as the state/local tax deduction—is a good reform. But we should also eliminate, or at least cap, the mortgage interest deduction.
  • Expanding child care benefits is a mistake. It would add complexity and distortion to what should be a private area of activity in the economy.
  • Ending the alternative minimum tax and the estate tax are both long overdue reforms.

What about the effects of tax reform on the deficit? Policymakers should put that concern aside for the corporate rate cut portion of Trump’s plan because the automatic expansion of the corporate tax base would mean that the government would lose little if any revenue over the long term. Exhibit A: Canada and Exhibit B: Britain.

However, policymakers should be concerned about the deficit effects of individual tax changes. Optimally, the budget impact of reduced individual tax rates should be offset by eliminating deductions and credits, spending cuts, and dynamic growth effects.

All in all, the Trump proposals push tax reform in a good direction. Trump, his advisors, and House leaders seem to understand the urgency of passing major tax reforms. But we need Republican senators to step up to the plate and think boldly as well. Republicans have an opportunity this year to pass reforms that would generate large and lasting benefits in terms income and opportunity for every American family.

Corporate Tax Cuts: Canada’s Experience

President Donald Trump and congressional Republicans are proposing to cut the corporate tax rate. With any tax cut, members of Congress want to know how much revenue the government may lose from the reform. I do not think that cutting our 35 percent federal corporate tax rate to 20 percent or so would lose the government any money over the long term. U.S. and foreign corporations would invest more in the United States, which would boost our economy, and corporations would avoid and evade taxes less.

Canada provides us with a real-world trial run of corporate tax cuts, and new budget data includes the latest revenue estimates. The nation slashed its federal corporate tax rate from 38 percent in the mid-1980s, to 29 percent by 2000, to 15 percent by 2012, as shown in Chart 1 below. Has the government lost revenue?

You be the judge. Chart 2 shows that corporate tax revenues in Canada have fluctuated with the ups and downs in the economy—revenues fell, for example, during recessions in the early 1990s and 2009. But even with the modest Canadian economic growth of recent years, revenues have held up under a much lower rate. Corporate tax revenues are 2.1 percent of gross domestic product (GDP) today, which is a bit higher than in the mid-1980s when the rate was more than twice as high.

Let’s compare to the United States. While Canada’s 15 percent federal corporate tax will raise 2.1 percent of GDP this year, the 35 percent U.S. federal corporate tax will raise just 1.7 percent. Thus, the Canadian corporate tax raises relatively more than the U.S. tax—even though the rate is less than half the U.S rate.

 

 

Canada historic tax revenues here. New Canadian budget data here.

 

Corporate Tax Cut and Border Adjustment

The House Republican tax plan would cut the federal corporate tax rate from 35 percent to 20 percent, but it would broaden the tax base in a misguided way. It would deny businesses a deduction for their imported inputs to production, but exempt exports from their taxable income.

This base change would raise tax revenues by about $100 billion a year, which is causing major blowback in the business community. It would be a radical change in the structure of business taxes and cause large disruptions in the supply chains and tax liabilities of many firms. No other nation that I am aware of structures their income tax base that way.

I’m for radical change in the tax system, but not radical change that would increase taxes on so many businesses and make the system more complex. Yes, border adjustment would reduce tax avoidance and cut compliance costs related to transfer pricing, but it would create other avoidance and compliance issues by spurring manipulation of imports and exports on tax returns.

Most supporters of border adjustment know that the economics of it are dubious, but support it anyway because it would limit the deficit impact of tax reform. That’s an understandable goal, but there are three better solutions than broadening the tax base in a way that would harm companies.

1) Match a corporate tax rate cut with corporate welfare spending cuts. Romina Boccia, Tom Schatz, and I identify $50 billion in corporate welfare cuts in a new op-ed. And it’s easy to find another $50 billion in cuts in tables 1 and 2 here to match the $100 billion from border adjustment. Unlike the proposed tax base broadening, spending cuts would boost growth by reducing microeconomic distortions caused by federal programs.

Concerns about the”Border Adjustable” Tax Plan from the House GOP, Part II

I wrote yesterday to praise the Better Way tax plan put forth by House Republicans, but I added a very important caveat: The “destination-based” nature of the revised corporate income tax could be a poison pill for reform.

I listed five concerns about a so-called destination-based cash flow tax (DBCFT), most notably my concerns that it would undermine tax competition (folks on the left think it creates a “race to the bottom” when governments have to compete with each other) and also that it could (because of international trade treaties) be an inadvertent stepping stone for a government-expanding value-added tax.

Brian Garst of the Center for Freedom and Prosperity has just authored a new study on the DBCFT. Here’s his summary description of the tax.

The DBCFT would be a new type of corporate income tax that disallows any deductions for imports while also exempting export-related revenue from taxation. This mercantilist system is based on the same “destination” principle as European value-added taxes, which means that it is explicitly designed to preclude tax competition.

Since CF&P was created to protect and promote tax competition, you won’t be surprised to learn that the DBCFT’s anti-tax competition structure is a primary objection to this new tax.

First, the DBCFT is likely to grow government in the long-run due to its weakening of international tax competition and the loss of its disciplinary impact on political behavior. … Tax competition works because assets are mobile. This provides pressure on politicians to keep rates from climbing too high. When the tax base shifts heavily toward immobile economic activity, such competition is dramatically weakened. This is cited as a benefit of the tax by those seeking higher and more progressive rates. …Alan Auerbach, touts that the DBCFT “alleviates the pressure to reduce the corporate tax rate,” and that it would “alter fundamentally the terms of international tax competition.” This raises the obvious question—would those businesses and economists that favor the DBCFT at a 20% rate be so supportive at a higher rate?

Brian also shares my concern that the plan may morph into a VAT if the WTO ultimately decides that is violates trade rules.

Second, the DBCFT almost certainly violates World Trade Organization commitments. …Unfortunately, it is quite possible that lawmakers will try to “fix” the tax by making it into an actual value-added tax rather than something that is merely based on the same anti-tax competition principles as European-style VATs. …the close similarity of the VAT and the DBCFT is worrisome… Before VATs were widely adopted, European nations featured similar levels of government spending as the United States… Feeding at least in part off the easy revenue generate by their VATs, European nations grew much more drastically over the last half century than the United States and now feature higher burdens of government spending. The lack of a VAT-like revenue engine in the U.S. constrained efforts to put the United States on a similar trajectory as European nations.

And if you’re wondering why a VAT would be a bad idea, here’s a chart from Brian’s paper showing how the burden of government spending in Europe increased once that tax was imposed.

Concerns about the”Border Adjustable” Tax Plan from the House GOP, Part I

The Republicans in the House of Representatives, led by Ways & Means Chairman Kevin Brady and Speaker Paul Ryan, have proposed a “Better Way” tax plan that has many very desirable features.

And there are many other provisions that would reduce penalties on work, saving, investment, and entrepreneurship. No, it’s not quite a flat tax, which is the gold standard of tax reform, but it is a very pro-growth initiative worthy of praise.

That being said, there is a feature of the plan that merits closer inspection. The plan would radically change the structure of business taxation by imposing a 20 percent tax on all imports and providing a special exemption for all export-related income. This approach, known as “border adjustability,” is part of the plan to create a “destination-based cash flow tax” (DBCFT).

When I spoke about the Better Way plan at the Heritage Foundation last month (my portion of the panel starts about 1:11:00 if you want to skip ahead), I highlighted the good features of the plan in the first few minutes of my brief remarks, but raised my concerns about the DBCFT in my final few minutes.

Allow me to elaborate on those comments with five specific worries about the proposal.

House Republican Tax Plan

House Republicans have released a proposal for major tax reform. Kudos to Ways and Means chairman Kevin Brady for stepping up to the plate and planning ahead for 2017. Brady and his staff did extensive outreach to think tank experts and the GOP caucus, and they have come up with a blueprint that focuses on savings, investment, simplification, and economic growth.  

The GOP plan would cut the top personal income tax rate from 40 percent to 33 percent, while consolidating the bracket structure from 7 rates to 3. The plan would reduce the top tax rate on small businesses to 25 percent, and it would repeal the estate tax and alternative minimum tax.

The corporate tax rate would be cut from 35 percent to 20 percent. That would be the single most important thing that the next Congress could do for the U.S. economy. Corporations build factories, buy equipment, and hire workers to earn after-tax profits. Slashing the marginal tax rate by 15 points would substantially increase the after-tax profits companies could earn on new investments, and they would respond accordingly. More capital investment would mean more job opportunities and higher wages for American workers.

We’ll Never Improve the Tax System by Clinging to Partisan Folklore

top marginal tax rates over time

A stubborn myth of the pro-tax left (exemplified by Bernie Sanders) is that the Reagan tax cuts merely benefitted the rich (aka Top 1%), so it would be both harmless and fair to roll back the top tax rates to 70% or 91%.

Nothing could be further from the truth. Between the cyclical peaks of 1979 and 2007, average individual income tax rates fell most dramatically for the bottom 80%  of taxpayers, with the bottom 40 percent receiving more in refundable tax credits than paid in taxes.  By 2008 (with the 2003 tax cuts in place), the OECD found the U.S. had the most progressive tax system among OECD countries while taxes in Sweden and France were among the least progressive.

What is commonly forgotten is that before two across-the-board tax rate reductions of 30% in 1964 and 23% in 1983, families with very modest incomes faced astonishingly high marginal tax rates on every increase in income from extra work or saving (there were no tax-favored saving plans for retirement or college).

From 1954 to 1963 there were 24 tax brackets and 19 of those brackets were higher than 35%.  The lowest rate was 20% -double what it is now.  The highest was 91%.

High and steeply progressive marginal tax rates were terrible for the economy but terrific for tax avoidance. Revenues from the individual income tax were only 7.5% from 1954 to 1963 when the highest tax rate was 91%, which compares poorly with revenues of 7.9% of GDP from 1988 to 1990 when the highest tax rate was 28%. 

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