What You Wished You Didn’t Need to Know About Tax Reform by David Montgomery

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I have mentioned tax reform in two columns so far, and it seems time to dig deeper into the topic. Long before the election, Paul Ryan started to develop a comprehensive proposal for tax reform. The last major tax reform package was passed in the Reagan administration, though each succeeding President has pushed taxes up (D) or down (R). Ryan’s proposal, taken up by his successor as chief tax writer in the House, Chairman Brady, would reduce personal and corporate income tax rates and fundamentally change how taxes on business are calculated and who pays them.

There are a number of reasons why this kind of tax reform is needed. Burdensome and badly designed taxation is a major contributor to the slow recovery from the recession. Since 2008 investment has fallen from its average of 4.4% of GDP between 1960 and 2008 to 2.8% of GDP last year. The United States taxes business income twice, once in the corporate income tax and then again when what is left shows up in personal investment income. This puts US taxes on investment higher than in all but four of our major economic competitors, and only two out of 173 countries have higher corporate taxes than in the U.S.

These high tax rates not only slow economic growth, in the long run they are self-defeating. We have seen this clearly as large companies move their headquarters overseas, are purchased by foreign companies, or merge with foreign companies in order to move their income to countries where taxes are lower. This not only moves jobs overseas, but erodes the base from which corporates taxes are collected.

Not only that, but when U.S. companies move overseas, they often find that their new host countries refund their taxes on the goods they manufacture overseas and sell back to the United States. Companies that remain in the USA are at a double disadvantage. They have to pay US taxes on goods they export and then find that their goods are taxed again when they arrive in the foreign country.

The Brady-Ryan plan fixes these problems. By reducing the corporate tax rate from 39.6% to 20%, it moves the US down from imposing the world’s highest taxes on business to the middle of the pack. To remove the remaining biases against manufacturing in the USA, businesses will no longer be able to deduct the cost of goods they import from their taxable income, and at the same time businesses will no longer pay any taxes on income from the goods they export. This “Border Adjustment” will give US manufacturers the same advantages in global competition that most of our competitors already give to manufacturers in their territory.

To further simplify the tax code, depreciation and all the special tax breaks that go with it will be eliminated. Investments will just be another expense to be deducted from income in the year they are incurred. Also, businesses will no longer be able to deduct interest payments. The purpose of this change is to eliminate the bias in favor of borrowing rather than going to the stock market to raise funds for investment, which has enriched banks and made many businesses much more vulnerable to bankruptcy than they would be with less debt to service.

Incentives for individuals to invest will also be increased, by exempting 50% of income from capital gains, dividends and interest income from personal income tax. Thus while businesses will not be able to deduct interest or dividends, double taxation of investment income will be greatly reduced by the combination of lower tax rates at the corporate level and exemption of 50% of investment income to individuals.

Personal income tax rates will be reduced and simplified for all incomes. Taxes will go to zero for many taxpayers now paying a 10% rate on some of their income. Going up the ladder, instead of the current 7 tax brackets there will be just three. The maximum rate in the lowest bracket will be 12% instead of the current 15%, in the next the maximum rate will be 25% instead of 28%, and the highest rate will be 33% instead of 39.6%. The obnoxious AMT that is reaching further into the middle class will be repealed.

Of particular interest to the retirees, farmers and small businesses on the Eastern Shore, the Plan will repeal the Death Tax completely and limit to 25% the maximum tax rate on small businesses that “pass through” income and expenses to their owners.

All of this will be good for the economy and good for consumers. The Tax Foundation, an independent research institution, estimates that after 10 years GDP will be 9.1% larger than it would be with the current system and that an additional 1.7 million jobs will be created. Naturally, this added growth also increases tax revenue.

The problem is how to get a major tax reform package like this passed. It would be very nice to have bipartisan agreement that we do not need to settle for lower economic growth and that tax reform is necessary – not sufficient, but still necessary – to get back to historical levels of economic performance. It would not even take much bipartisan agreement – just 8 of the 10 Democratic senators running for re-election in states that President Trump won in a landslide would be enough to overcome the roadblock of 60 votes.

However, the plan is constructed to make that unnecessary. Under the current budget process – which still exists even as the deficit balloons – a Budget Resolution is passed each year setting out overall spending and revenue targets in some detail. After the Budget Resolution is passed and Congress acts on authorizing expenditures, there is a second step to bring those actions back in line with the Budget Resolution. This “Budget Reconciliation Bill” is privileged with limited debate and requires only a majority vote for passage. It is possible to add the entire tax reform plan to the Reconciliation Bill, as long as it is “revenue neutral” – that is, any loss in revenue from one provision is balanced by an increase in revenue from another.

So far so good. This is where the devil is in the details of arguments over who benefits. Democrats describe the Plan as another example of “trickle-down” economics and claim that it short-changes or harms middle- and lower-income taxpayers. Businesses obviously favor all the provisions that reduce their taxes, but they unite with Democrats in decrying the “Border Adjustment” provisions. Companies like Walmart that import most of the goods that they sell do not like the choice of buying more expensive substitutes made in the USA or seeing their taxes go up substantially. Others worry that either of those choices will raise prices paid by consumers.

The easy solution to some of these objections would be to lower rates further in the two lowest brackets or eliminate the Border Adjustment. This is where the need to stay revenue neutral in order to avoid a 60-vote hurdle comes back to bite us. The Border Adjustment provides about $1 Trillion of revenue over 10 years and meaningful rate reductions are impossible without it.

Fortunately, it is quite likely that some of the impact of the Border Adjustment will be borne by the countries from which we import and to which we export. The argument for this very desirable outcome is that the value of the dollar will automatically adjust to get rid of any upward pressure on consumer prices.

The basis of this argument is the clearly correct observation that unless the value of the dollar goes up, the border adjustment will create a very large incentive to increase exports and a very large incentive to reduce imports. If this happened, the U.S. trade deficit would decline drastically. This is where a counter-intuitive but well-established hypothesis comes into play.

Most economists are convinced that the trade deficit has little or nothing to do with wages and taxes in the US versus China, India, Mexico or Europe. Instead, it is the magnitude of government borrowing that determines the size of the trade deficit. And in accounting terms, this is absolutely correct. If the United States is borrowing from other countries every year, that means that we are consuming more than we produce and are running up debts to pay for it. When the government spends more than it takes in, and everyone else spends all they earn and possibly a little more, we have to import more than we export in order to balance the accounts.

Remembering that the Border Adjustment is part of a Plan that is revenue neutral, it will not change the government deficit and therefore the trade deficit cannot change. This means that the dollar must appreciate by just enough to negate any incentive for more exports or less imports. If this happens, Walmart will find that the dollars it saves on buying imports will be just what it needs to pay its additional taxes due to the Border Adjustment. If that happens, there is nothing to drive consumer prices up and everyone is happy.

I doubt that everything will be quite that simple. Many European countries adopted very similar border adjustments when they adopted their Value Added Taxes, or VATs. Those countries did experience a brief period of inflation, in which some but not all of the higher taxes on imports were passed on to consumers. This produced no major disruptions or long-term problems. I think we are likely to have the same experience, as the dollar will increase but not enough to fully offset any pressure on prices. As long as wages keep up and the Federal Reserve responds appropriately, it is my opinion that the long run benefits of tax reform will outweigh these transition costs for just about everyone.

David Montgomery was formerly Senior Vice President of NERA Economic Consulting. He also served as assistant director of the US Congressional Budget Office and deputy assistant secretary for policy in the US Department of Energy. He taught economics at the California Institute of Technology and Stanford University and was a senior fellow at Resources for the Future.

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