To average voters, the tax reform framework released by the Trump administration and Republicans in Congress looks baffling at best and perverse at worst.
A majority of Americans say the tax rate on big corporations is too low — and the GOP plan cuts that tax rate from 35 percent to 20 percent. Most Americans want to raise or keep constant tax rates for people earning $250,000 or more; the GOP plan would cut the top rate for them too. One poll suggests that 79 percent of Americans would support changing the tax code so corporations "pay as much on foreign profits as they do on profits made in the US.” The GOP plan would completely exempt foreign profits from US tax.
And you don’t need a poll to know that a proposal that raises the bottom tax rate for middle-class earners and cuts the top rate for the rich doesn’t look great.
But Republicans have a reason for doing this — and it’s not incompetence or carelessness. The tax reform package represents a synthesis of conservative economic thinking on taxes in recent years. In a number of cases, it includes changes that experts of both parties embrace.
That doesn’t mean the underlying rationale is correct, or that the package as a whole is a good idea (I don’t think it is). But the plan didn’t come out of nowhere, and it’s important to understand the thinking behind it. The arguments that shaped it are going to recur, both in state governments and in future Republican administrations, and could even influence Democratic policymaking in a number of areas.
Trump’s top economist thinks cutting corporate taxes mostly helps the middle class
Corporate taxes are very popular, largely because large corporations aren’t particularly popular and the prospect of taxing them rather than individual, identifiable people is very appealing. But as a former GOP presidential candidate once infamously put it, corporations are people. Or, rather, they’re made up of people, and when corporations are taxed, those people wind up paying the bill.
Which people pay the bill is a source of huge disagreement within economics. The corporate tax, almost by definition, has to translate into higher prices for consumers, lower wages for workers, or lower profits for shareholders.
Who pays what share of the tax has huge implications. The more it’s paid by capital — shareholders — in the form of lower profits, the more progressive it is and the less harmful to the middle class. The more it’s paid by labor — or, at least, labor apart from executives like the CEO — in the form of lower wages, the worse a deal it is for average workers. If it raises prices, that's perhaps worst of all; price increases are regressive because poor households spend more of their income.
Most government agencies argue that capital pays the bulk of the corporate tax bill. The Treasury Department puts the capital-labor split at 82-18, the Tax Policy Center at 80-20, the Congressional Budget Office at 75-25. Before relatively recently, it was standard practice to assume that capital paid the whole tax, and some observers argue that remains the correct approach, given recent empirical research showing that shareholders tend to be the exclusive beneficiaries of cuts in taxes affecting corporations. A recent survey of the empirical research by Reed College’s Kimberly Clausing found “very little robust evidence linking corporate tax rates and wages.”
Many conservatives, most notably President Trump’s chief economist Kevin Hassett, disagree. In an influential 2006 paper analyzing data in 72 countries across 22 years, Hassett and Aparna Mathur estimated that a "1 percent increase in corporate tax rates is associated with nearly a 1 percent drop in wage rates.” A second paper in 2010 found a slightly smaller effect (a 0.5 to 0.6 percent decrease in wage rates per 1 percent increase in corporate tax rates) but still concluded that labor was ultimately paying the tax.
That suggests that cutting corporate taxes would be a very easy way to raise wages for ordinary workers. Hassett has also gone a step further and, with his American Enterprise Institute colleague Alex Brill, argued that cutting the corporate income tax could raise economic growth enough to actually increase revenue: a Laffer effect. They conclude, based on a data set covering rich developed countries from 1980 to 2005, that the revenue-maximizing corporate tax rate is about 26 percent, significantly below the US rate.
Plenty of economists and tax researchers have argued that Hassett’s results are implausible and reach some absurd conclusions. Jane Gravelle and Thomas Hungerford at the Congressional Research Service noted that the initial Hassett-Mathur study predicted a $1 increase in the corporate tax would reduce wages by between $22 and $26.
But Hassett really, sincerely believes this, and his views are influential in conservative economic circles. That’s important in understanding why a massive cut in the corporate tax rate from 35 to 20 percent is such a key part of the GOP tax plan. If you believe this is a windfall for the middle class above all, it starts to seem like a more sympathetic proposition.
Conservatives think corporate tax cuts are essential for boosting growth
Besides the wage issue, there’s another reason conservatives typically support cutting corporate tax rates: because they hit capital at least in part, and orthodox economic models predict that the tax on capital should be zero.
Think of it this way. The corporate tax hits profits, which are paid out to shareholders because they invested money in the company. Suppose one person — call her April — earns $100 at her job and decides to save it by buying shares in a company. Her friend Betty also earned $100 at her job and wants to spend it all. If there’s a 10 percent tax only on wages, they’d pay the same tax: $10.
But if the tax applies to capital income too, then April ends up taxed twice. She pays the $10 wage tax, buys a stock with the remaining $90, and later sells it for $30 in profit. Then she owes another $3 in taxes on that gain. Betty paid $10 on her initial wages, but April paid $13 — effectively being penalized for saving rather than consuming.
Now, maybe that’s okay! It certainly seems fair for April to pay more taxes when her savings let her gain more income. But some economists think this is an inefficient kind of double taxation, which penalizes savings and reduced investment in the economy, to the detriment of everybody.
The conservative Tax Foundation is a particularly strong proponent of this view. Combined with the Hassett view that workers pay a big share of the corporate tax alongside capital, it leads to some startling conclusions. The Tax Foundation's model estimates that cutting corporate taxes from 35 to 20 percent increases GDP in the long run by 1.7 percent, a quite significant bump. Its analysis of the House GOP's 2016 plan, which bears a strong similarity to the current GOP framework and proposed the exact same corporate cut, suggested that it would raise all taxpayers' incomes by at least 8.4 percent due to increased economic growth.
Naturally, plenty of economists disagree with the idea that capital taxes, including corporate taxes, should be at zero. New, more nuanced models suggest that capital income should be taxed, and there’s some empirical research suggesting that cutting taxes on corporate income doesn’t increase investment at all, instead just increasing payouts to investors. UC Berkeley’s Danny Yagan found that the 2003 Bush cut to taxes on dividends (money coming from corporations and sent to investors) didn’t spur investment at all; it just encouraged companies to pay out more of their profits to investors. A large study covering a tax break for savings in Denmark (which also served to reduce taxes on capital) found that it didn’t encourage more savings but instead just pushed savers to redirect their money into tax-free accounts.
But other studies find that cutting corporate taxes does increase investment. Corporate investment in the US is at historic lows, as companies opt to spend money on share buybacks instead of research or new projects and facilities. That has made even a number of liberals open to the idea of a corporate rate cut; economist and commentator Noah Smith’s argument for cuts is perhaps the most compelling I’ve seen.
“Full expensing”: dull, but really important
Beyond cutting the corporate tax rate, the tax framework proposes a major change to how the corporate tax works: It would, for five years at least, allow companies to “fully expense” their investments.
Right now when companies buy something, they don’t deduct the cost of the entire investment in the first year. Instead, they deduct the cost of the item as it’s used over time, or as it “depreciates.” For instance, cars are generally depreciated over five years; office furniture is depreciated over seven. The schedules change frequently, and certain industries are often given bonuses that let them depreciate faster (NASCAR tracks, for instance, have their own depreciation schedule).
Full expensing gets rid of all of that. Instead, all investments would be tax-free the year they’re made. Corporate taxes would be imposed strictly on profits above and beyond normal levels. This leads some advocates of full expensing to argue that it lets the tax code target “rents” — above-normal profits that companies earn, typically due to monopoly or government-granted protections like patents. Rents are generally bad, and taxing them is generally good.
This change is typically combined with ending or (in the case of the new tax plan) limiting the deductibility of interest payments on corporate debt. That deduction is a hugely powerful part of the tax code, which makes it much cheaper for companies to finance new investments by taking out loans than by raising money from shareholders or reinvesting profits. It means the tax rate on debt-financed projects is negative 6.4 percent, compared to 35 percent for other investments; effectively, the government will pay corporations to borrow and invest.
Debt deductibility is very, very good news for banks and other companies that love to get leveraged up and take out massive amounts of debt. But it’s bad for anyone who worries about the financial sector taking over the economy, the increased power and profitability of Wall Street, and the risks of letting people bet massively with other people’s money. Getting rid of it to pay for full expensing, from that perspective, seems like a clear win. There’d no longer be a preference for debt, but investments would still be encouraged.
The Tax Foundation and other conservatives love full expensing. It would boost long-run GDP by 5.4 percent, the foundation estimates, far more than just cutting the corporate tax rate. And even some Democrats and liberals are on board. Obama’s former chief economic Jason Furman has endorsed the idea as part of a corporate tax reform package.
Others are more skeptical. Lily Batchelder, a tax professor at NYU Law and a former adviser to Obama and the Senate Finance Committee, has argued that that corporations make decisions less based on how much they can expense than on their statutory tax rate, and because full expensing costs money, it requires a higher corporate tax rate to not lose money. That higher rate might hurt investment more than full expensing helps.
And then there’s the matter of full expensing expiring under the new GOP plan. Merely allowing expensing for five years would frontload a lot of investment in those years, but it’s hard to imagine it would increase growth dramatically, because businesses would expect the old system to return quickly.
Even as many experts support full expensing, the way it’s currently implemented in the plan is a half-measure.
Exempting foreign profits from tax brings the US in line with other rich countries (for better or worse)
The GOP tax plan moves the US from a “worldwide deferral tax system” — in which US companies are taxed on all their earnings but foreign profits aren’t taxed until they’re brought back — to a “territorial system,” in which foreign profits aren’t taxed at all. In the meantime, all money and assets that companies now hold overseas would be taxed at a low one-time-only rate, to encourage companies to bring back money they’ve kept abroad to avoid taxes.
The basic rationale is that the US is behind the times and can’t compete with lower corporate tax countries in Europe. We don’t impose a much higher corporate tax on companies than our peers, largely because we have many more deductions and loopholes. But our statutory tax rate of 35 percent is quite high in international context. Combined with state and local taxes, the US tax rate on corporations is 38.9 percent. Compare that to 34.4 percent in France, 30.2 percent in Germany, 30 percent in Japan, and 19 percent in the UK. If companies respond to statutory rates more than deductions and the like (as many economists believe they do), this is a significant incentive to do business abroad rather than in the US.
All those other big, rich countries also have territorial systems and don’t tax income earned abroad. That, conservatives argue, makes them more attractive places to locate than the US, which forces companies to choose between keeping money abroad tax-free or bringing it home to face taxes. If the US had a territorial tax, that money stashed abroad could, in theory, come home without penalty, which advocates argue would lead to more investment. The fact that it doesn’t, conservatives contend, is one reason “inversions” where companies relocate their headquarters overseas have been becoming more common.
That said, territorial systems also have significant problems. They can encourage companies to locate more factories and business activities abroad, because they won’t face US tax on it. Moreover, territorial taxation provides a big loophole that encourages tax avoidance: Companies can pretend that more of their income comes from foreign subsidiaries in low-tax countries like Ireland, when really the money is coming from sales and business in the US. That foreign income won’t face US tax in a territorial system, just the lower foreign rate.
The Trump administration says it’s planning provisions to avoid this kind of “base erosion.” I’ll believe it when I see it.
The plan expands the child tax credit, a major “reform conservative” priority
In its trademark vague way, the GOP tax reform framework specifies that the child tax credit, which currently offers $1,000 per kid, will be increased. It doesn’t say to what it’ll be increased, but it’ll go up.
There are two things happening here. One is that the standard deduction, personal exemption, and child credit are all sort of duplicative parts of the tax code, and many tax reform efforts of all ideological stripes want to find some way to merge them into a more coherent system. Right now you get $4,050 off your taxable income for each kid you have due to the personal exemption, and then another $1,000 off your total tax bill due to the child credit.
There’s no reason these have to be separate provisions, and because the child tax credit is partly accessible to families that don’t pay income taxes, it makes sense to eliminate the personal exemption in order to boost the child tax credit. That’s exactly what the tax framework does. The personal exemption currently also helps adults, so the framework folds its adult benefits into a larger standard deduction (partially offset by increasing the bottom tax bracket from 10 percent to 12 percent).
This isn’t great news for families who itemize taxes, who now get a personal exemption and would lose it without benefiting from a higher standard deduction under the GOP plan. But there’d be many fewer such families, both because the plan eliminates the state and local tax deduction and because the standard deduction’s increase will cause fewer people to itemize.
Beyond simplification, the child tax credit boost reflects a years-long push by “reform conservatives,” including National Review writer Ramesh Ponnuru and former Bush administration economist Robert Stein, to increase the credit. Their cause has been embraced by Sens. Marco Rubio (R-FL) and Mike Lee (R-UT), who in turn appear to have convinced Ivanka Trump to abandon her old plan to add a deduction for child care in favor of increasing the child tax credit.
The idea has a political rationale, in that it allows conservatives to argue they're focusing on middle-class families as well as corporations and the wealthy. But it also has a policy rationale. In a 2010 article in National Affairs, Stein argued that the welfare state is actively deterring families from having children.
"A growing body of economic literature shows that in the United States, Social Security and Medicare have 'crowded out' the traditional incentive to raise children as a protection against poverty in old age," Stein explains. "Most workers foresee getting enough support from the public retirement system to stay out of poverty when they get older, making it less likely that they will have to call on direct aid — either in cash or in kind — from their own children."
Worse, this deters families from creating future workers necessary for financing the social safety net for the elderly. "Even as these systems depend upon a population of productive young workers at the national level, they diminish the economic need for children at the individual level — and so undermine their own sustainability," Stein writes. The solution is to counteract this disincentive by creating a child tax credit.
Notably, reform conservatives have not pushed to make the child credit more accessible to low-income families. Currently, only families making $3,000 or more can get it, and it phases in slowly at that point. Rubio and Lee want to make the credit a little more accessible, by lowering the earnings threshold to $0 and slightly increasing the phase-in rate, so that it’s “refundable against payroll taxes” (which start at $0 in earnings and take about 15.3 percent of people’s pre-tax earnings).
The Trump administration, however, says the new plan won’t change accessibility for poor families at all. Rather, they want to increase the income level at which the credit starts phasing out for rich people (currently $75,000 for single parents, $110,000 for married couples). That makes the credit less targeted at the needy, not more.
Many Democrats and liberals would prefer a full-on child allowance, which all families would receive regardless of income. That would do more to fight poverty than the existing credit. Stein and other reformocons tend to oppose this, partly because they think handing out money with no strings discourages work. Stein has said his plan for expanding the credit is “not designed to encourage fertility in the poor over and above what we already do.”
There are parts of the plan I can’t explain
That’s hardly a comprehensive summary of all the parts of the package. While the top rate for individuals isn’t specified, it will almost certainly be lower than the current 39.6 percent rate; conservatives, as always, argue that this encourages high earners to work more and promotes economic growth, to the consternation of liberals who argue there’s no empirical evidence this is true.
More baffling is the decision to include a new, lower 25 percent rate for “pass-through businesses.” Those are companies that don’t pay corporate income taxes currently, giving them a sizable tax advantage relative to other companies. Instead, they pay normal personal income tax rates when their profits are distributed to owners. The plan would expand the existing advantage these companies get.
It would also cause a massive loophole for rich individuals, who would have a strong reason to incorporate as a sole proprietorship or LLC and contract with their employers, rather than taking a normal wage. That way, they could pay the low 25 percent rate rather than normal income tax rates. Sure enough, when Kansas adopted a rule like this, it led to massive tax evasion rather than economic growth.
I know of no honest, good-faith rationale for helping pass-throughs like this. These aren’t small businesses; tellingly, the Trump Organization is organized as a group of pass-throughs. Most lobbying shops are also pass-throughs. So there are plenty of cynical explanations for why this provision was included, but it’s hard to understand what genuine public interest it serves.