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.