The Corner

Politics & Policy

Puzzling Moves on Tax Reform

The good news is that Republicans are in a position to finally pass some sort of tax reform. They are certainly talking about it as if it is happening.

But it won’t be easy. If they want to pass tax reform with a simple majority in the Senate, they have to live by the rules of “reconciliation.” These are real constraints that tie the Republicans’ hands as they figure out what goes — and doesn’t go — into a tax-reform package.

Unfortunately, some of their decisions are undermining their ability to enact a really good plan.

First, I have said it before but it’s worth saying it again: Republicans won’t cut spending — or even restrain spending — so they have much less leeway to adopt a tax-reform package that includes a big tax cut. It also means that no matter what they end up doing, if it is not paid for with enough economic growth, spending restraint, and/or the elimination of enough deductions, they are effectively shifting the burden onto future generations and simultaneously jeopardizing the long-term survival of their tax cuts, not to mention that large deficits could have an impact on the growth potential.

Second, there is the insistence of some Republicans and conservatives that the tax reform should enact a substantial increase in the child tax credit. Unfortunately, the darling of conservatives and Democrats alike, it is social engineering (i.e., spending through the tax code), unfair to those without kids, and it does nothing for growth. Moreover, it uses up a lot of money that could be used for tax cuts that actually lead to higher incomes by boosting work, saving, and investment. It is also not the best way to achieve the administration priority “that American families can thrive,” as Ivanka Trump claimed yesterday. Creating economic growth and jobs, many jobs, through tax reform that reduces the incentives to engage in productive activities. And it’s not as if we don’t already have a generous tax child tax credit and are starting from scratch.

I know, I know, you’re going to say that it is politically important. But is it more important than simplifying the tax code and getting rid of special handouts to preferred groups? And is it more important than cutting the corporate tax rate as much as we can? Many scholars agree the growth dividend increases as the rate gets lower. In the long run, that will boost take-home pay for everyone by more than an expanded child credit. And if cuts to middle-class taxes are necessary politically, which I understand, we should do it by lowering tax rates rather than by granting tax credits. Also, while I am not crazy about doubling the standard deduction because it removes many people from the tax rolls — as does an expansion of the child tax credit — it has the merit of simplify the code without discriminating against those without children.

Third, the pressure from the real-estate lobby and lawmakers from high-tax states are such that there is a real threat that the state and local tax deductions won’t be eliminated or seriously limited. As a result, the policy and political worlds are working hard to offer possible compromises: Keep the deduction for property taxes only, have a credit worth between 8 and 20 percent of property taxes, means testing the deduction, income caps, or some combination of these ideas. So much for making the code simpler and fairer.

The rationale for compromising is that it may be the only way to get tax reform. But make no mistake, what it means that some Republicans are holding tax reform hostage so that high income earners from high-tax states continue to be spared some of the burden of their state and local taxes and so that lawmakers in these high-tax states are never held accountable for the policies they put in place. (See Dan Mitchell, here.)

A compromise on SALT, no spending cuts, and fewer taxpayers on the tax rolls, among other things, means that the House Ways and Means Committee will need more revenue from other sources to make the math work. So let’s take a look at where we are hearing they may go for that extra revenue.

First, they want to maintain the top marginal tax rate for taxpayers making above $1 million. Now, you will get between $300 and $400 billion in revenue this way while we wouldn’t get much growth by cutting marginal tax rates from 39.6 percent to 35 percent, but there would be some benefit. The top tax rate includes a lot of professionals who have a lot of control over the timing and level of their income.

Moreover, a GOP surrender on the top tax rate is politically sloppy. It would have been one thing if they had announced four rates — 39.6, 35, 25, and 12 percent. But instead they announced three rates, and then they backpedaled, in fear of the class-warfare rhetoric that will happen no matter what they do. So now it looks as if 1) they are slapping a surtax on millionaires and 2) they seem to be agreeing with the Left, which believes that millionaires should be penalized some more for their high incomes. It’s worth noting that the average OECD top personal rate is 44 percent. Between the federal rate and the state and local ones, the U.S. average top rate is around 46 percent.

The bottom line is that Republicans can defend themselves as much as they want and say that the tax rate is no higher than it already was — but the way it was done makes it look like a policy straight out of the Democrats’ playbook.

Now you can say that at the 39.6 percent level, it won’t matter. But it will when it interacts with other elements of the tax reform. The higher the top personal rate, the more tension you are putting on the 25 percent pass-through tax. Also, this rate will start to matter as soon as the rate goes up when Democrats are in power and hungry for revenue. The slippery-slope argument isn’t appealing to many. And yet, this is how we get so many of the bad policies we have today.

By the way, if Republicans want to show that their tax reform doesn’t benefit the rich, there are no better ways than to get rid of SALT and eliminate completely the tax exemption for municipal bonds.

Second, Ways and Means apparently is still considering scaling back significantly the tax deductions for 401(k)s. The idea would be to curtail the 401(k) deduction to $2,400 with the rest going into Roth IRAs. This would allow the committee to claim tax revenue today as opposed to tomorrow. Roth IRAs, like 401(k)s, are a good way to avoid double taxation of saving income. One allows you to save after-tax income but commits that the income from that savings will be tax free, and the other allows you to save tax-free today but it will tax you tomorrow when you consume the income from your savings.

Some claims that the fear surrounding the policy change is overblown because it only moves the time of taxation and preserves the promise to not be double taxed. However, it is hard to imagine that shifting away from a tax-free savings today to Roth-type savings doesn’t carry the risk of reducing the incentives to save today, especially when not done in the context of vastly expanding these savings vehicles. Raise your hand if the prospect of reducing your tax base in the current year isn’t appealing, probably more appealing than the promise of no taxes tomorrow. Also, raise your hand if you firmly believe that there is no risk that government officials down the road will change their minds about taxing your Roth IRAs saving.

Also, Social Security is heading to bankruptcy and many scholars and experts are complaining that Americans don’t save enough. So it doesn’t seem like a good idea to get rid of a policy that is actually successfully encouraging people to save money for their retirement. Also, while it may not affect lower-income savers that much, it will most affect those Americans who are the most likely to lose during the inevitable compromise that would have to take place when the Social Security Trust Fund dries out. Shouldn’t they be given all the possible incentives to save today for when that time comes?

Now, I do support Roth IRAs in the current form — in fact, I support super-boosting them in the form of universal savings accounts, but that’s different than what we are talking about here. This is a budget gimmick, and it will only hurt retirement savings.

Last but not least, I hear that their need for revenue may lead to Republicans actually phasing in the corporate income tax cut. If true, that’s foolish. Cutting the corporate rate as low as we can is one of the most important elements of the tax reform. If you phase in the cut, you delay the economic growth. As Republicans revise their revenue outlook based on this proposal, will they review their growth projections too? Oh and when their growth outlook changes, they should also change the benefits to the middle class and to workers projected in the recent CEA report, which found that cutting the corporate tax rate from 35 percent to 20 percent would raise the wage income of an American household by an average of $4,000 over ten years.

To be honest, I am in awe of how self-destructive Republicans can be. I promise that I want to help them pass tax reform but instead, I keep being distracted by the latest news of their latest idea to find revenue.

Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.

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