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The looming fight over “tax reform,” explained

In the end, it’s about a tax cut for the rich.

Donald Trump Holds Press Conference To Announce His Tax Plan Photo by Andrew Burton/Getty Images

Donald Trump took time out of his busy schedule of disaster tourism and tweeting about the media to deliver a speech in Missouri on Wednesday about a seemingly far-less entertaining topic — comprehensive tax reform.

An overhaul of the tax code would, Trump promised, “bring back Main Street by reducing the crumbling burden on our companies and on our workers.”

Meanwhile, Paul Ryan’s been touring the nation waiving around a vaguely postcard-shaped piece of paper that he believes Americans will be able to use to file their taxes once the simplification nirvana of tax reform is enacted.

Congress is facing a crowded September full of “must pass” bills to keep the government open, replenish FEMA’s Harvey-depleted coffers, and avoid a debt ceiling crisis. But when those deadlines are in the rearview mirror, tax reform is the next Republican policy priority. And while achieving the sort of comprehensive reworking of the tax system that Trump is talking about is extremely difficult, the stars are far better aligned for Republicans to pass something than they were on the disastrous effort to replace the Affordable Care Act.

Even though neither the White House nor congressional Republicans have released legislative text or even a detailed plan for tax reform, major business lobby groups have already committed considerable sums of money to airing ads in support of the reform plan — whatever that reform plan may be.

In the fact that corporate America has decided to support tax reform without knowing what the content of tax reform is, one begins to spy the outlines of what’s to come. The tax reform push currently underway is a purely partisan affair, driven by GOP committee chairs and leadership with some input from Gary Cohn at the White House and Steve Mnuchin at the Treasury Department. And while business executives aren’t exactly sure what they’ll come up with, they are sure that they’re going to like it. Because lurking beneath the GOP’s high-minded interest in the complex policy terrain of tax reform is a rather simple and more profound belief.

Republicans believe that Americans — and especially highly-paid Americans and Americans who own businesses or shares of stock — deserve to pay less in taxes. The business community is inclined to agree. And working in tandem with unified Republican Party control of Washington, they are likely to get what they want.

What is tax reform?

In all policy areas there’s a tendency for one man’s reform to be another man’s devious scheme to destroy the country. But for the past generation or two, “tax reform” has had a reasonably well-defined meaning. It takes the bipartisan Tax Reform Act of 1986 as its model, and deems “reform” to be the act of reducing tax rates without massively reducing federal tax revenue because the losses from the rate cuts are offset by closing loopholes and eliminating or curbing deductions.

For example, the tax code currently exempts profits accrued through the sale of owner-occupied housing from capital gains tax. A tax reform could, in theory, eliminate that exemption and in exchange make capital gains tax rates slightly lower. The value of employer contributions to health insurance premiums is, similarly, exempt from taxation right now. That exclusion could be eliminated and in exchange individual income tax rates could be made a little bit lower.

The possibilities for this sort of thing are particularly large on the corporate income tax side of the ledger, where a great mass of special provisions have accumulated over the years. This ranges from giveaways lacking any sort of policy rationale (corporate jets benefit from accelerated depreciation relative to normal commercial jets) to targeted subsidies (ethanol producers get a special tax credit; NASCAR tracks have a special depreciation schedule) to efforts to use the corporate income tax to pursue large-scale social objectives (investors in affordable housing projects get a special credit).

Most of these corporate tax loopholes are small, but their aggregate weight is quite large. The statutory corporate income tax rate in the United States is fairly high at 35 percent, but in practice companies pay about 28 percent of their worldwide profits in taxes according to the Center on Budget and Policy Priorities.

That means in theory the corporate tax rate could be several percentage points lower with no reduction in federal revenue, as long as the lower tax rate was actually levied on a larger share of corporate profits.

This basic “reform” process of lowering tax rates while broadening the tax base could, in theory, be applied only to corporate income taxes or only to individual income taxes or to both simultaneously. If it were up to Democrats the issues would probably be addressed separately, with corporate tax changes focused on “reform” in this sense while individual income tax changes would focus on ways to raise more revenue from the top 1 percent of households. But Republicans are in charge and they want to bundle the whole thing together, merging an effort to reform the corporate income tax code with a big push for individual income tax cuts.

Part of the rationale for this is that businesses that are structured as partnerships often don’t pay corporate income tax — their profits simply “pass through” onto their owners’ individual income tax reforms. But the larger reason Republicans want to tackle the whole thing at once is that Republicans are inclined to think that taxes are really, really important and that tax cuts are really, really good so they want to do as much as possible when they have the chance.

What’s good about tax reform?

The official wonky case for tax reform stems from a divergence in the way that a normal person thinks about taxes from the way that an economist — and especially an economist inclined to emphasize supply-side features of the economy over demand-side ones — thinks about taxes.

To a normal person, taxes are a necessary evil. The evil thing about them is that after you pay taxes you have less money than you had before. Most people like money, so they like the idea of getting a tax cut, and they don’t like the idea of getting a tax hike, primarily because they are focused on the impact of tax changes on their after-tax income. If Congress changed the law to cut my taxes by $500, I’d be pretty happy about that. And I wouldn’t care whether they did that by tweaking the individual exemption, tweaking the dependent exemption for my 2-year-old, making his preschool tuition tax deductible, or cutting my marginal income tax rate. At the end of the day, the point would be to get the $500.

But from a supply-side viewpoint, these are very different policies. Making the individual exemption a little bit bigger puts $500 in my pocket but it doesn’t give me any new incentives to work harder and earn more money. If anything, by making me a little more economically comfortable it reduces my incentive to work harder and earn more money. By contrast, cutting my marginal income tax rate doesn’t just put $500 in my pocket. It makes it more worth my while to try to go out and hustle up some paid speaking appearances or otherwise find ways to earn a bit more.

Tax reform is good, on this view, because it’s a way to greatly improve incentives without costing the government much in the way of revenue. The 1986 tax reform bill, for example, eliminated enough loopholes to pay for a cut in the top marginal income tax rate from 50 percent all the way down to 33 percent — drastically increasing the incentive of rich people to go out and try to become even richer.

What deductions are we talking about?

Here’s the rub. Back in the day there used to be a lot of truly ridiculous individual income tax loopholes — people were deducting country club memberships and such — but these days the vast majority of the individual income tax money is tied up in deductions that nobody has any intention of closing.

Back in 1986, for example, Congress decided that the tax code’s habit of treating income derived from dividends and capital gains more favorably than income derived from working was a loophole. Closing that loophole, if you think it’s a loophole, would raise a lot of money. But conservatives decided long ago that the Reagan administration was wrong to agree to this. House Republicans’ tax reform blueprint would peg tax rates on investment income at half the rate of taxes on normal income. What’s more, since 1986 Congress has created a lot of preferences-within-the-preference — special accounts like 401(k), IRA, ESA, 529, HSA, etc. — that let affluent people shelter much of their savings from taxation. Republicans don’t want to eliminate these accounts.

Beyond that, if you look at the Tax Policy Center’s list of the biggest tax expenditures, you’ll see that all the money is tied up in things that are distinctly nonfrivolous.

The exclusion of employer contributions to health insurance premiums, for example, is not really anyone’s idea of great public policy. But it also happens to be the cornerstone of the American system for providing health insurance to the nonelderly. Eliminating it wouldn’t just be tax policy, it would be a huge change to health care policy and would require the creation of some kind of alternative means for people to get health insurance.

Taxing imputed rent — basically the rental income that homeowners are “earning” by renting their houses to themselves — would, similarly, be a huge revolution in the American housing market. Taxing charitable contributions would be a giant blow to American cultural and educational institutions.

Republicans are not looking to create giant angry constituencies to mobilize against them or force enormous disruptive change on the public. Consequently, they have promised not to touch any of this stuff. But that’s left them promising not to actually raise much money through loophole closing. The biggest thing they are talking about going after is number 9 on the list, the deduction for state and local taxes. This is an idea that appeals to ideological conservatives because they see it as essentially encouraging state governments to raise taxes. And it’s a fairly popular idea among Republican Party senators, because few of them represent high tax states.

But there are a fair number of House Republicans representing upscale suburban districts in New York, New Jersey, California, and other high-tax blue states whose constituents would be hammered by this change. It’s also a provision that benefits a lot of people who are personally friends with Donald Trump and key aides like Gary Cohn and Jared Kushner. So it’s far from clear that this will actually make it into final legislation. On the corporate side there are no untouchable sacred cows — but every special provision has its own little corps of dedicated lobbyists. To get the rate down to 20 percent would require a lot of loophole closing, and Trump’s promise of 15 percent is almost certainly impossible.

But more broadly, Republicans simply aren’t looking at loophole closing that will pay for very much in the way of rate cutting. At the same time, they are promising a lot of rate cutting.

What are Republicans promising on rates?

Donald Trump offered three different tax plans as a candidate, all subtly different from one another, and then on April 26 his top economic policy aides released a framework that was slightly different from the campaign plans. In a speech on August 30 dedicated to outlining his principles for tax reform, he remarkably managed to get less specific than he’d been in any of his earlier plans.

House Republicans, meanwhile, have their own proposal that is somewhat different from Trump’s plan. It will probably be hardest in the Senate to scrounge up the votes for whatever it is Republicans end up deciding to do, and neither Mitch McConnell nor Finance Committee Chair Orrin Hatch has released a plan.

All that said, the different proposals out there have a few things in common:

  • Collapse the current system of seven tax brackets to just three brackets, and cut the top marginal income tax rate from its current 39.6 percent to either 35 percent (Trump) or 33 percent (Ryan).
  • Cut the corporate income tax rate steeply from its current 35 percent to either 15 percent (Trump) or 20 percent (Ryan).
  • Stop trying to tax American corporations’ foreign profits.
  • Eliminate the estate tax.
  • Eliminate the Affordable Care Act’s 3.8 percent tax on rich people’s investment income.
  • Eliminate the Alternative Minimum Tax.

In addition, Trump’s plan calls for allowing business owners’ “pass through” income to be taxed at the 15 percent corporate rate rather than the 35 percent individual income tax rate.

These proposals would, collectively, be extraordinarily costly. The Tax Policy Center believes the Trump version would reduce federal revenue by $7.8 trillion over 10 years. Depending on the specifics, some of that could be made up for by closing loopholes. But according to TPC’s analysis, if you maintain the deductions Trump has promised to maintain, even maximum loophole closing would still leave you with $3.4 trillion in lost revenue.

This is also a plan that’s destined to be extremely regressive in its fiscal impact. Cutting middle-class brackets helps middle-class taxpayers, but it also helps rich ones. Cutting the top bracket only helps rich people. Eliminating the ACA tax only helps rich people. Eliminating the estate tax exclusively helps very rich people. And the corporate tax cuts mostly benefit stock owners, i.e., rich people.

So for all the talk of tax reform and middle-class relief, Republicans are bundling those notions with what amounts to an enormous deficit-increasing tax cut for the rich. Whether Republicans actually can — or even want to — plow ahead with a bill costing revenue on that scale is a matter of both economics and also the arcana of congressional procedure.

Is this going to be about the Byrd Rule?

In a world where Republican majorities want to pass major legislation on a partisan basis while holding only 52 senate seats, everything is on some level about the Byrd Rule, which governs what can and can’t be done in a nonfilibusterable budget reconciliation bill. This came up a lot during the Obamacare repeal debate due to the complexities of what kind of legislation does and does not qualify as having a substantial budgetary effect. In the world of tax reform, that’s not an issue, since pretty much anything you might want to do is going to have a substantial budgetary effect. Instead, the key issue is something else.

A reconciliation bill can increase the short-term budget deficit, but cannot increase deficits beyond the 10-year CBO scoring window. That leaves Republicans with a few options:

  1. Write a bipartisan bill that can get 60 votes by adhering to Democratic demands to not do an enormous deficit-increasing tax cut for the rich.
  2. Emulate George W. Bush and do an enormous deficit-increasing tax cut for the rich but schedule it to expire after 10 years so it doesn’t technically raise the long-term deficit.
  3. Apply “dynamic scoring” to claim that your tax cuts won’t actually cost revenue because they will increase economic growth.
  4. Genuinely restrain your tax cutting to the amount of tax cutting that can be paid for through loophole closing — or at least dynamically scored loophole closing.
  5. Change the rules to expand the scoring window to 20 or even 30 years and thus make your temporary tax cut more-or-less permanent.

Nobody seems to have given any considerations to option one. Conversely, it’s pretty clear that option three will be deployed to some extent. But there’s a real question of how much dynamic scoring even a Republican-appointed CBO director can be persuaded to do. That leaves some combination of two, four, and five on the table. But while there’s been a fair amount of discussion of these options, the discussion has overwhelmingly come from House Republicans.

Ways and Means Committee chair Kevin Brady has seemed quite serious about preferring some mashup of three and four, while conservative firebrands are most jazzed up about two or five. Trump himself has tweeted frequently that the filibuster should be eliminated entirely, which would render this issue moot.

The real question, however, is what will Senate Republicans go for. The GOP senate caucus contains a couple of vulnerable incumbents (Dean Heller and Jeff Flake), one moderate (Susan Collins), some cranky people who don’t like Trump (John McCain and Lisa Murkowski), and the Senate is always marked by a certain amount of small-c conservative reluctance to monkey with the rules.

Republicans can only lose two votes on their bill, so ultimately they’ll be constrained by what the marginal members of the senate caucus will agree to, not to what Trump or Brady or Ryan want. And so far neither House leadership nor marginal senators have really even clearly said what they want. So it’s extraordinarily unclear what can actually pass. But unlike with health care, it’s extremely likely that something or other will pass.

The fundamentals favor passing something

There are three main reasons why it would be fairly extraordinary for Republicans to not end up passing some kind of tax cut.

One is just that cutting taxes is what Republicans do. As the late columnist Robert Novak memorably put it, “God put the Republican Party on earth to cut taxes.” The GOP may not be able to agree on huge amounts of loophole closing, but they can surely find some. And with interest rates objectively low, there’s no real problem with increasing the budget deficit by some amount. To close some loopholes and borrow some money and cut some taxes is basically a no-brainer for a tax cutting party, and the GOP is definitely a tax-cutting party.

The other is that tax cutting has no equivalent of the masses of disabled protestors swarming the Capitol to warn that GOP bills were threatening their lives. Paying for tax cuts is hard political work that creates losers and generates opposition. But a deficit-financed tax cut is hard to mobilize opposition to. Cutting taxes on the rich isn’t popular, but it also doesn’t negatively impact middle-class people’s lives in a direct or obvious way.

Last and most importantly, least common denominator tax policy works just fine.

When Republican senators couldn’t agree on a replacement plan for the Affordable Care Act, they hit upon the idea of “skinny repeal” that simply included core ideas they did all agree with. But skinny repeal was a terrible piece of legislation that senators told themselves they were only voting for to spark a conference committee. The problem is that the health care system is a complicated web of interconnected parts, and you can’t just change some aspects of it without impacting the others.

Tax policy isn’t really like that. You can make it complicated if you want to. But a very simple tax bill that just takes a couple of numbers and makes them lower is completely workable. Political concerns and economic prudence may limit the size of the tax cut. And procedural issues may force it to be wholly or partially temporary. And Republicans would, ideally, like to do something grander and more conceptually ambitious. But at the end of the day, if Republicans want to cut taxes — and they all say that they do — nobody can stop them, so they probably will.

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