What Might Tax Reform Look Like?

April 19, 2017

In the wake of the Republican failure to repeal or otherwise modify the Affordable Care Act, it is increasingly likely that tax reform may be the next target on the Republican agenda. If you’ve been reading along for the last few days, I’ve been trying to lay a foundation of understanding of our current tax system that will make it easier to think about some of the plans that have been proposed to accomplish these reforms.

The TL:DR Version of the Last Two Articles

Whether you’ve been keeping up with the last couple articles or not, there are a few essential lessons that we should learn about our tax system and efforts to reform it. Reflecting on our tax system, I’ve pointed out that the U.S. has traditionally taxed a pretty consistent portion of our Gross Domestic Product (GDP), and our methods of doing so have a tendency to grow increasingly complex over time, both in terms of rates and special exemptions and deductions. At the same time, our taxation of businesses takes a very different form from most of the rest of the world.

When it comes to tax reform, it has been most consistently successful when lower rates are coupled with reduced complexity and closed loopholes. Because of the tendencies of our system to narrow the tax base over time, most reform efforts have also had the goal of broadening the tax base to impact a broader spectrum of taxpayers. Lastly, the complicated nature of our tax system and the limits of IRS capacity recommend that reform seek to simplify the tax system, particularly for individuals with primarily wage-based income.

Does the Prescription fit the Diagnosis? Evaluating the Republican Plans

Currently, there are two major plans for tax reform: the general plan sketched out by President Trump and the more comprehensive initiative proposed by House Republicans. At 4 pages compared to 35, respectively, it’s obvious which plan is more detailed, but does either plan do a good job of addressing the concerns mentioned above, and, if so, does one do so better than the other? To evaluate this issue, we need to briefly consider what each plan sets out to do.

President Trump’s plan is much more simple than the House Republican plan.  Basically, it involves a significant reduction in taxes, cutting the highest individual rate to 25% (a 14.5 percentage point drop), slashing corporate taxes to a max of 15%, and eliminating the estate tax altogether.  This is partially offset by phasing out an unspecified number of deductions for the wealthy and by a “repatriation tax” that attempts to force corporations to move foreign income back to America. Overall, this plan is a hefty cut to federal revenue, with projections estimating it will reduce receipts by $2.69.5 trillion over the next decade.1

Speaker Paul Ryan and the House Republicans have a more detailed and complicated proposal. Their plan involves more modest cuts to individual rates, with the top individual rate falling to 33% (a 6.5 percentage point drop). The corporate income tax would be cut to 20% and changed in form to a consumption-oriented tax, and this plan would also eliminate the gift and estate taxes. This plan would offset these reductions by substantially reducing the number of available deductions, eliminating the capital gains rates2 , and doing away with personal exemptions.  This plan would still reduce federal revenue, but by a more modest estimated range of $191 billion to 3.1 trillion over the next decade.

So there’s the basics of the plans.  How do they line up with the issues I’ve identified in the articles over the last two days?

The Trump Plan: (Don’t) Tax and (Still) Spend

Trump’s tax plan, as much as we can trust the outline that he produced while on the campaign trail, hits a few of the important points, but it misses many critical issues. It certainly simplifies the tax code, and it does broaden the tax base to some degree, but the plan does not address important concerns like the difference between the way the U.S. and most other nations’ tax corporations. Simply lowering the corporate rate does not necessarily eliminate the incentives for corporations to shift income overseas, and the imposed “repatriation” tax is a heavy-handed and inelegant way to address that issue.

Most significantly, however, the Trump plan is to slash revenues while continuing to spend like everything is normal. In the past year, receipts of approximately $3.3 trillion fell short of the $3.9 trillion budget. Trump’s plan cuts federal revenue by up to a third, while Trump’s proposed budget plan makes effectively no change to federal spending. Trump may proclaim himself “the king of debt,” but the country has far too much of that already. Regardless of how you feel about Trump’s tax cuts or his budget plan, it’s objectively clear that following both paths at once is a recipe for disaster.

The House GOP Plan: Too clever for its own good?

The House GOP plan does a much better job of addressing the key issues in tax reform; however, President Trump’s low tolerance for complexity may spell the doom of this plan. From my perspective, this is a bit of a shame because the GOP plan, while not reducing taxes by a huge amount3 , significantly changes how taxes are administered in a way that makes several sensible reforms.

Looking back at the last two articles, we can see how the GOP plan addresses several key tax reform ideas as they apply to individuals. Addressing the tendency for creeping complexity, the GOP plan cuts the number of tax brackets from seven to three. It also significantly reduces administrative complexity by cutting down the number of itemized deductions, removing complicated Alternative Minimum Tax (AMT) calculations, and combining a number of targeted benefits, such as those tied to families. This is capped by a proposal for a significantly simplified “postcard filing” that should make anyone who has slaved away over detailed returns breathe a sigh of relief. Similarly, elimination of the estate tax and tweaks to savings incentives will help to roll back the tendency to promote consumption that often creeps into the tax code.

The biggest change, however, comes with the complete overhaul of corporate taxation. As I mentioned previously, the rest of the world primarily taxes businesses based on the value that they add at each stage of production. That is, you pay taxes on the goods you buy, then you can take a credit on those taxes paid as you pass those goods down the chain of production.4 The GOP plan tweaks several features of the corporate tax to transform it into what is essentially a value-added tax that allows for the deductibility of wages. While this plan faces issues in passing muster with the World Trade Organization, it has several features to recommend it, including removing incentives to move corporate assets offshore and encouraging capital investments while no longer distorting decisions between debt and equity financing. The changes are substantial and complex, but this total overhaul in the way America taxes businesses is probably one of the most important and needed features of the tax reform plan.

So what do you think? Looking back at our consideration of tax reform and the American tax system over the past few days, what changes do you think are most important? Does tax reform seem necessary to you? Let us know what you think in the comments below.

About the Author
  • Donald Roth serves as Associate Professor of Criminal Justice, Co-Director of the Kuyper Honors Program, and Director of the Master of Public Administration Program at Dordt University.

  1. The large range on the estimates is due to both right- and left-leaning analysis as well as whether the number accounts for macroeconomic growth due to lower taxes.  

  2. The plan taxes investment income as ordinary income, but it does allow exclusion of half of the profit received, effectively halving the tax paid on this type of income.  

  3. Projections run from around 10% down to less than a 1% reduction, depending on macroeconomic effects.  

  4. If this still sounds complicated, see William Gales’ excellent simplified example based on buying a loaf of bread.  

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  1. None TL!

    Broadening the tax base and simplifying the tax code: who could be against either idea? Very few in principle but almost everyone when it comes to implementation. Ethanol subsidies? The home mortgage interest deduction? Raise your hand if you’re in favor of eliminating either. (And don’t bother running for elective office.)

    Even if a revenue-neutral overhaul of the tax code gets through Congress–a big if–it will do nothing to solve the problem of embedded government spending on (mostly middle class) entitlements and defense. Not to mention looming demographic issues (i.e., we’re not growing the tax base). (Dare you to write about those, Donald.)

    All of this suggests to me that the current reasonably comfortable steady state of affairs is going to come to a hard end. Which should remind us that our ultimate hope is in the heaven-initiated consummation of all things.

    1. Thanks, Scott.

      I think that’s where reform might need to be more all-encompassing. If we were to more thoroughly rework and reinstate the tax code, it might be possible to remove some of these special carve outs because we choose not to put them in to something new, rather than removing them from something old. That said, I think you’re right, it’s political suicide to advocate the end to some of these benefits, and that’s not good economic news.

      Time will tell if the demographic issues come to bear as hard for the U.S. as they are in other jurisdictions. Despite some contrary leanings, we have been more open to immigration than some other developed countries (esp. countries like Japan, who are facing some of the worst challenges). While our own population isn’t replacing itself all the time, immigrants are, and other cultures are. In some ways, the future is the Mormons, the Catholics, and other groups who have historically favored larger families. As of right now, millenials outnumber baby boomers, so, while you’re right that demographic shift to an older average age will cause issues for entitlement spending, that crisis is relatively far off yet.

  2. Thank you Donald for your work and research on the Fed tax structure. Your articles have been helpful. What a tangled web has been weaved over the years. We need people like you to help untangle the web. What ever happened to the old simple formula–income must equal output?? Or why can’t we be satisfied with a balanced budget? Are we beyond the point of no return and someday our taxes will have to go up??

    1. I’m glad you’ve found the series helpful, Marion.

      This is an area where the federal government could perhaps learn from states, who have to run a balanced budget in many cases. Overall, more awareness of what our receipts are and a willingness to peg expenditures to average collections would be helpful. In years of higher receipts, we could (now) pay down debt or (later) build a rainy day fund, then in down years, we wouldn’t have to slash spending because of built surpluses. Monetary policy does get more complicated in ways that allows fudging the system more than this, but I think we’re pushing the outer limits of that fudge factor.

      Sadly, even Trump, running on a platform of austerity-type cuts to much of the government, chose to propose a colossal increase to defense spending that undoes any budgetary restraint that was gained elsewhere. So no one, political insider or outsider, seems willing to address our spending concerns while they can yet be fixed, and I do fear we’ll need to be on a fiscal cliff before there is political will to be serious about this issue.