Magazine | May 1, 2017, Issue

The Case for Tax Reform

House Ways and Means Committee chairman Kevin Brady (R., Texas) (Chip Somodevilla/Getty Images)
Cutting rates isn’t enough

The Republican party gained control of the federal government in the 2016 election, with tax reform as one of its central policy issues. Now elected Republicans have a choice: Will they be mere tax cutters, or will they be tax reformers?

The distinction is important. A tax cut retains the framework of the current tax system but lowers rates. A tax reform is a bolder, more comprehensive change to the structure of taxes. Tax reform addresses the question of what we should tax, not just the question of how much we should tax it.

So far, congressional Republican leaders are seeking tax reform. Ways and Means Committee chairman Kevin Brady, backed by House speaker Paul Ryan, has offered a serious tax-reform plan that would overhaul corporate income taxes, remove many individual deductions, and lower rates. President Trump has also stated that he will offer his own tax-reform plan spearheaded by National Economic Council director Gary Cohn and Treasury secretary Steven Mnuchin, which would probably limit deductions and lower individual and corporate income-tax rates. Shepherding a tax-reform bill through Congress will be much more difficult than passing a tax-cut bill. However, it will also be more rewarding. The policy benefits of serious tax reform are worth the fight.

Make no mistake, it will be a fight. While “tax reform” in the abstract is popular, in the specific it is much more difficult. Tax reform is rooted in the idea that the federal tax system is currently missing out on some revenues that it should be collecting and should therefore charge higher tax rates elsewhere to make up for those uncollected revenues. Tax-reform legislation makes the trade: It adds revenue in some provisions and then uses that revenue to justify cutting the rates on some of the most harmful taxes. The idea of tax reform is largely uncontroversial — until the tax reformers begin proposing revenue-raising provisions that would offset tax cuts elsewhere. The resistance to revenue-raising provisions tends to be disproportionately organized and strident relative to the support for the cuts that they finance. Furthermore, conservative voters have a healthy suspicion of anything that looks like a tax increase.

Chairman Brady’s plan follows this framework and contains many revenue-raising provisions, all of which will create some political hurdles for the plan. A few of these are particularly notable. The removal of net-interest deductibility for businesses would mean that businesses could no longer write off the interest payments on their debts. The border adjustment on international business transactions would modify the corporate tax so that it’s based on where goods are sold, not where they are produced. Finally, the plan would remove the individual deduction for state and local taxes paid. These provisions would help generate revenue in order to lower corporate income-tax rates to 20 percent from today’s 35 percent, and they would help lower top individual income-tax rates to 33 percent from today’s 39.6 percent.

Of the revenue raisers in Brady’s plan, the strongest opposition so far has formed against the border-adjustment provision, which would apply the corporate income-tax rate to imported goods and offer rebates for exporters. A coalition of powerful corporations, including Walmart, has formed to oppose this provision because it would increase the tax paid on their imports. There are good arguments to be made that the benefits are worth the cost, and we can expect Brady to continue making them despite the opposition. But the political difficulties with border adjustment are not specific to border adjustment or to the Brady proposal. They are also likely to crop up if President Trump seeks to limit deductions as promised. In fact, big political difficulties come with every tax reform, even the successful ones that become law.

For example, the Tax Reform Act of 1986 limited several tax strategies for real-estate developers, to the fury of the industry. Real-estate developers didn’t just strongly oppose provisions of the reform at the time; they also held a grudge. In 1999, more than a decade after the act was passed, Donald Trump, then a private citizen, took to the pages of the Wall Street Journal to oppose Bill Bradley’s run for president on the grounds that Bradley, a driving force behind the 1986 reforms, had limited a key tax provision — a tax shelter known as the “passive loss” deduction — that benefited real-estate developers. Trump briefly acknowledged that the good parts of the legislation, which he attributed to President Reagan, “cut rates in half,” which was only a slight exaggeration; for businesses such as Trump’s, the top tax rate fell from 50 percent to 28 percent. Trump then attacked the revenue-raising provisions of the 1986 reform, calling them an “offense against the working man.”

In this example, one can see many of the political problems with tax reform, starting with the politics of concentrated interests. Most Americans did not think much about passive losses, because they were used mostly by investors in rental properties rather than by ordinary individuals. Americans may have appreciated the rate reduction to 28 percent, but they probably did not think much about the passive-loss provision’s being axed in order to get to that rate. In contrast, real-estate developers clearly thought about passive loss a great deal, and they acted as a bloc and put considerable effort into attacking the legislation and protecting their interests. Whether or not this particular policy choice was ultimately a good one, the episode shows that a small number of motivated people can have an outsize role in public debate, especially when an issue is narrow in focus.

The 1986 reforms also demonstrate how “loss aversion” affects political decisions: Because our feelings about losses tend to be stronger than our feelings about gains, we prioritize political choices that will prevent loss. Trump’s 1999 Wall Street Journal op-ed shows how the negative aspects of a trade-off often stick in people’s minds longer and more strongly than the positive ones do.

This is the environment that tax reformers often must navigate: They hear general support for their rate-lowering efforts, and they hear general support for making the code fairer and limiting deductions or tax-avoidance strategies; then they are stymied by strong opposition to specific measures.

In contrast to tax reform, tax cuts are simple. They have an easy, straightforward appeal; a voter can be assured that his financial situation will improve. If Republicans are looking for a legislative win, then, why not just lower everyone’s rates across the board and call it a day? Why is tax reform worth it?

Tax reform is worth it because limiting oneself to rate-cutting is a capitulation; it cedes control of the tax structure to the opposition. In February, Karl Smith of the Niskanen Center nicely explained why Republicans should aim for tax reform and why revenue-raising provisions should be part of their toolkit. If libertarians and conservatives “oppose any and all tax increases on principle, only capitulating when they lack the political power to stop them,” it means that “all tax increases will come when libertarians, and economic conservatives in general, have the least power to influence policy design,” he argues. “It cedes any control over the tax structure, which is at least as important as the tax rate.”

Tax reform is worth it also because budget deficits matter. They matter as both a policy and a procedural concern. A larger deficit is a policy concern because it might require higher taxes or spending cuts later, and so far this presidential administration has not proposed cutting spending overall; its proposed non-defense budget cuts are matched by an increase in the defense budget. George W. Bush cut taxes without any real offsets, but he did so during a time when the budget deficit was relatively under control. President Trump inherited a different situation, requiring a different strategy.

A deficit in a tax-reform bill is a procedural concern because, under Senate rules, the Republicans will not be able to pass a permanent deficit-increasing tax cut. The Bush administration’s tax cuts hit this procedural hurdle and therefore had to expire after ten years; only some of them were preserved. If Republicans want to pass a more lasting reform, they should include some revenue-raising provisions in the bill.

Tax reform is worth it also because Republicans have promised many times to reduce the complexity of the tax code for individuals, curb corporate-tax avoidance, make the code fairer for all, and limit carve-outs for special interests. Campaigning on these issues over the past 30 years has helped Republicans win many races, so it is a matter of integrity to get to work on them, now that the GOP has obtained unified control of the government.

Finally, tax reform is worth it because the tax code and the economy have real problems that only tax reform can address. One such problem is the avoidance of international corporate taxes, or “base erosion.” In our current tax regime, multinational businesses find a way to report a disproportionate share of their income in low-tax jurisdictions such as Ireland and Bermuda. It’s a good thing when countries lower their tax rates to attract investors — that’s healthy competition. In practice, though, the current rules on corporations do more to incentivize financial engineering than competition for investment. This can become particularly apparent when a corporation has much of its physical presence in the United States but reports much of its income elsewhere.

Staggering quantities of legal and accounting resources, for example, are devoted to a field known as transfer pricing, or the handling of cross-border transactions within a multinational firm. Transfer-pricing strategies allow firms to shift the tax location of their profits without making real changes to their business model. The IRS often issues new regulations to curb excessive use of these strategies, and talented lawyers spend their time defending their clients from IRS lawyers. All of these resources could be better employed otherwise.

Chairman Brady’s border-adjustment provision essentially removes transfer pricing altogether from the tax code; international transactions no longer matter in the calculation of taxable income, so many current issues involving them would dissolve. But border adjustment would mean a tax increase on some firms, and it therefore faces substantial opposition. Border adjustment is not the only means to curb the problem of transfer pricing, but any other solution would also face vociferous opposition from those who would fare better under the current system.

Tax reform isn’t limited to solving tax issues, though. It could help solve problems in the larger economy as well. Many Americans are increasingly concerned that the economy isn’t working well for them. Conservatives sometimes hesitate to acknowledge such anxiety, because doing so can lead to calls for more-centralized control of the economy. But people’s concerns about the economy have some merit.

In the past few decades, ordinary returns on both work and savings have grown only modestly while the returns on a few investments have been spectacular. Snap Inc., one of the country’s most recent initial public offerings, is a good illustration of what is going on in the economy: It reached a market value of almost $30 billion from the sale of shares on its first day of trading but it employs fewer than 2,000 people. It created a large fortune for its early backers but relatively little income for others.

Recent research from Simcha Barkai at the University of Chicago shows that a rising share of our national income goes neither to labor nor to physical capital, but to what he calls “markups.” Other phrases for this might be “returns on brand value,” or “economic rents.” The idea, essentially, is that much of our GDP growth is going to people who catch lightning-in-a-bottle ideas and achieve extraordinarily high returns on their investment; in other words, it goes to people such as the early investors in Snap.

The current tax code doesn’t handle this development very well; low capital-gains taxes are good for growth and for the average retiree with an ordinary brokerage account, but they end up applying to Silicon Valley–style super-high returns as well. We can derive more tax revenues from these wealthy individuals without substantially reducing their incentive to invest in the first place.

The solution is to leave initial investments deductible while taxing the returns — essentially, use the structure of a traditional IRA. It preserves the appropriate incentives to invest; unlike other parts of the tax code, it doesn’t make any profitable investments turn unprofitable or vice versa. But it also makes sure that those who achieve spectacular investment returns will pay the same rates as others who weren’t as fortunate.

There are variations of this idea at the individual, corporate, and small-business levels. To implement this approach for corporate businesses, a tax reform could allow them to fully and immediately deduct capital expenditures, and then the government could make up the lost revenue by limiting or eliminating their other deductions. Chairman Brady’s plan follows this general outline. At the individual level, conservatives could consider taxing labor and investment income at the same rate while greatly increasing the use of tax-deferred universal savings accounts. Ted Cruz’s tax plan as a presidential candidate took this approach.

Like all serious tax-reform plans, Brady’s necessarily involves trade-offs, and it has vocal opponents; it might not become law exactly as originally outlined. Border adjustment, in particular, has proven to be a big challenge for the congressman. It is likely that President Trump will choose a somewhat different approach in his own plan. But let us hope that it is a reform plan dedicated to solving problems, not just a tax cut. Government isn’t just about finding the path of least political resistance. It’s also about delivering genuinely good outcomes for the country as a whole, even if that means asking for sacrifices from some. Elected representatives with genuine conviction are willing to navigate those trade-offs and spend political capital to do what is right for their constituents. We should applaud Chairman Brady, Speaker Ryan, and the other serious tax reformers in the Republican party for having that conviction.

– Mr. Cole is an economist at the Tax Foundation, a nonpartisan public-policy research group. He has advised members of Congress and presidential candidates on tax policy.

Alan Cole — Mr. Cole is an MBA candidate at the Wharton School and a former economist at the Tax Foundation.

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