Blog Post

The Trump tax cut

What’s at stake: on Wednesday, the Trump administration - now 100 days old - unveiled a draft tax plan including the intention to enact a radical cut to the corporate income tax, lowering it to 15 percent. While we are still missing details on how this and other measures would be implemented, we review some of the early reactions.

By: Date: May 2, 2017 Topic: Global Economics & Governance

Tyler Cowen argues on Bloomberg View that the U.S. can afford Trump’s radical tax cut. While there are some potential problems with President Trump’s proposal, there is no fiscal reason such a tax plan ought be ruled out. It seems the administration is willing to consider a tax cut that increases the budget deficit. Cowen argues that most versions of the plan, if executed properly on the details, would most likely boost economic output and create new jobs, also in light of the fact that the rate of return on private investment is probably higher than the return on public investment.

This argument for a corporate tax cut – “let’s borrow more now while rates are relatively low” – is remarkably similar to the argument that Keynesians have been using for more government infrastructure spending for years. So, Cowen argues, it does not make sense to argue that we can afford a big dose of government stimulus but we cannot afford a corresponding private stimulus: a more consistent view is that we need more investment on both fronts, and thus cuts in the corporate tax rate are a welcome start.

Yet, Cowen sees two main problems with the plan. First, it is uncertain whether it can pass various congressional rules, and there is a disturbing and repeated tendency for the Trump administration to lurch ahead with plans that are not properly vetted. Second, there is a danger that too much personal income will be reconverted into business forms, to reap the new, lower tax rates. It is essential to have greater and more detailed assurances that the tax reform will embody sufficient regulations to limit these kinds of arbitrage.

Larry Summers argues that President Trump is undermining his own Treasury secretary. Mnuchin has stated on multiple occasions that the administration’s tax proposals would not favor the rich. Whatever its other virtues, distributional neutrality is not a feature of the plan announced yesterday. Between massive corporate rate cutting, big tax cuts for the highest income individual taxpayers, elimination of the estate tax and other incentives, it is a certainty that the vast majority of benefits of the plan will go to a very small fraction of taxpayers.

Mnuchin also stated that tax cuts would be so good for growth that they would come very close to paying for themselves (the Laffer curve idea). In the context of an economy with 4.5 percent unemployment, it is absurd. Ronald Reagan asserted that tax cuts could pay for themselves during his campaign but his Treasury Department was far too serious to ever make such a statement. Summers concludes that the Treasury secretary’s credibility is an important national asset that could be needed at any moment, but it seems to be  squandered on behalf of a set of tax reform proposals that are at best a bargaining position.

Writing before the release of the tax plan, Greg Leiserson argues that a premature promise on tax rates could threaten tax reform. The core issue in tax reform is defining the tax base. While the precise assessment will ultimately depend on the yet-to-be-determined details of the package, the rates already tell the broad story. The reforms proposed by the Trump campaign would shift the U.S. tax system in the direction of a consumption tax but at the same time create a generous new tax benefit for people who can characterize their income as business income.

Leiserson argues that this has a potential for creating large-scale tax avoidance as a result of the shifting of labour income into the business tax base and argues that this particular design could provide preferential tax treatment of income derived from market power, rents, and luck, and for disguised labour income, possibly in the hopes of boosting entrepreneurship. Yet there is little reason to think that an open-ended tax preference for income derived from market power, rents, and luck relates in any coherent way to socially valuable entrepreneurship.

Ben Casselman highlights three questions that could decide the success of Trump’s plan. What sets Trump’s proposal apart is its size. President Obama once proposed cutting the corporate tax rate to 28 percent. House Republicans, in their 2016 tax plan, would cut the rate to 20 percent. Trump’s proposal would go further. Three key questions will help determine both its fiscal and political viability.

First, what counts as business? Most U.S. businesses don’t pay the corporate rate because they are not actually set up as corporations: they are limited liability companies or other entities that pass their profits straight through to their owners, where the income is taxed at the individual rate. Right now, this distinction doesn’t matter that much because the gap between the corporate and individual tax rates is small, but under Trump’s plan the choice of business structure would matter a lot.

Second, what counts as income? In the process of defining the tax base, the trick is deciding which loopholes to get rid of and every deduction and credit in the tax code has a built-in base of supporters who will argue their loophole is good economic policy.

Third, what about the deficit? The corporate tax cut will be costly and Republicans have previously insisted that any tax reform be “budget neutral”. Abandoning budget neutrality would pose a big problem for Trump: Senate rules mean Republicans will need some Democratic votes in order to pass a bill that increases the deficit over the long term. As a result, any tax cuts that aren’t paid for will likely have to be temporary. That’s a significant disadvantage for corporate tax reform in particular because businesses often plan years in advance and want to know what the tax system will look like in the future.

Matthew Klein points out that the suggestion that taxes paid to states and local governments would no longer be deductible from federal income taxes seems to have touched a nerve in some states, concerned that the change would raise the tax burdens of people who live in places such as New York City and California. Some worry that wealthy people in these places may relocate, which might force additional tax hikes on those who remain, or cuts in spending. Klein argues that this worry is misplaced – as there is no evidence that rich Americans really are that sensitive to state and local tax regimes – and that we should instead focus on two other key planks of the administration’s tax agenda: lowering federal tax rates for the rich and raising the standard deduction. Taken together, both of these measures would more than cancel out any impact from removing the state and local deduction for almost everyone potentially affected.

Meanwhile, the Kansas City Star argues that the president’s tax plan strongly resembles the disastrous tax plan passed in 2012 in Kansas, which Governor Sam Brownback once called a “real live experiment” in tax policy. First, the paper points out that the expected economic growth (“shot of adrenaline” to the Kansas economy) did not materialise, as job growth in Kansas has lagged behind peer states, neighbouring states and even some states that raised taxes. The American economy is changing dramatically. Healthcare jobs are up, while retail jobs have collapsed. Coal mining isn’t coming back and giving companies a huge tax break won’t change that. Second, the deficit will increase, although this may be less of a worry in D.C. than in Kansas, which passed a big tax increase in 2015 and is still $900 million short over the next two years. Third, the business tax cuts will be unpopular with low-middle income Americans.

The paper argues that Kansas is one of the most Republican states in the nation, yet its GOP governor is a political outcast because people resent the fact that thousands of business owners pay no state income taxes at all, while working people do. Ending the federal estate tax and the alternative minimum tax while eliminating federal deductions for health expenses and state and local taxes will make it worse.


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