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The latest tax reform proposals outlined last Wednesday by the Trump administration promise to cut corporate taxes from 35% to 15% and double the standard deduction for individuals. They also aim to encourage American corporations to bring back to the U.S. profits they hold in lower-tax foreign jurisdictions and move to a territorial tax regime where such corporations are taxed only on their U.S. revenues and not their global revenues. The hope is those and other such measures would stimulate business expansion and consumer spending, thereby expanding the tax base sufficiently to recoup the revenue loss caused by the tax cuts and incentives.
A one-page note on the White House tax plan that Treasury Secretary Steven Mnuchin and director of the National Economic Council Gary Cohn handed out last week is short on details and has no specific proposals for raising revenues elsewhere to finance the tax breaks. According to experts at Wharton, Penn Law and the University of Michigan, the upshot of such a skeletal plan is increased government borrowing to fund the revenue gap, which in turn would crowd out private investment and capital formation.
The experts predicted that the expansion of economic activity and business formation as a result of the tax cuts would fall short of the expectations of the Trump administration. The absence of details has also triggered worries about the net impact on individual taxes after the proposed elimination of deductions and a regrouping of income thresholds under fewer categories, as well as the impact on small and mid-sized businesses. The experts said that while the proposals to eliminate the estate tax and cut capital gains taxes sound good, those proposals need more clarity and alternative sources of revenue have to be identified.
Other features of the White House tax plan include: tax relief for families with child and dependent care expenses; repeal of the alternative minimum tax; repeal of the current 3.8% surtax on investment income that funds health care; and elimination of tax breaks for special interests.
“The biggest economic weakness of the Trump plan was the enormous level of debt it produced, which crowds out private capital formation.” –Kent Smetters
James Hines, Jr., research director at the Office of Tax Policy Research of the University of Michigan’s Ross School of Business, took a dim view of the White House tax overhaul plan. Many of the proposals entail “enormous tax cuts, enormous revenue loss and therefore, ballooning deficits for the federal budget,” he said.
Michael Knoll, co-director of Penn Law’s Center for Tax Law and Policy noted that the proposals have “almost nothing in terms of revenue raisers, and a lot of cuts.” However, he suggested that the administration’s move in announcing the plan was an attempt to “[get] the ball in play – just sort of a serve and beginning of negotiations.” Indeed, as Cohn said in a press briefing, “We just wanted to get [it] out and give you a broad-brush overview where we are.”
Hines and Knoll examined specific features of the tax plan on the Knowledge@Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)
Finding the Funding
“The biggest economic weakness of the Trump plan was the enormous level of debt it produced, which crowds out private capital formation,” said Kent Smetters, Wharton professor of business economics and public policy, and faculty director of the Penn Wharton Budget Model (PWBM).
“The problem is, it’s tax relief for everyone and everything in this plan, and the numbers don’t even begin to add up,” said Hines. “So it’s hard to know how seriously to take these proposals.”
Tax law is mostly about specifics, said Hines. For example, he noted that while estate taxes raise about $20 billion a year, it is possible to find alternative sources. “But abolishing estate and gift taxes is a heavy political lift,” he said. The government would need to focus on identifying an offset, or an alternative source for those monies, he explained. “In the absence of focus, it is going to be hard to get any of this stuff put forward.”
Even as the White House tax plan does not have details, the fact that it has many similarities to Trump’s campaign proposals allows some analysis. The Penn Wharton Budget Model’s tax policy simulator showed that Trump’s campaign tax plan increased debt by about 31% more than current policy by 2028, and by nearly 45% by 2040. “The increase in debt reduces private capital formation, unless international capital flows are substantially more robust than in the past. Larger spending cuts will be needed to avoid greater debt,” the PWBM said in a summary analysis on its website.
The central problem with the plan is “it doesn’t add up, and members of Congress know it,” Hines said. “They’ve tried to come up with clever ways to raise revenue in less painless methods, but the difficulty is there really is no painless way of getting revenue.”
The public seemed to welcome the proposals because “tax cuts are attractive, of course, and tax increases are the opposite,” said Hines. “But the problem is you have to pay your bills. You can run up a big credit card debt, and that’s more fun than paying it down.”
In finding solutions, the government has to decide what its priorities are, said Hines. He noted that there is bipartisan agreement that U.S. business taxes are too high relative to the rest of the developed world. Former President Barack Obama, too, wanted to lower the corporate tax rate to 28% from its current level of 35%, he pointed out. A tax cut is one way to address that, but then that revenue loss has to be recouped with “some other tax increase or spending reduction,” he added. “That’s not going to spread a lot of joy to voters, but it will make the economy more competitive.”
Funding Tax Cuts and Economic Expansion
According to Hines, the U.S. has the least competitive tax system in the world. “Every time an American company merges with or acquires a Canadian company or a British company, they become Canadian or British,” he said. “They never choose to be American if they have the choice.”
The latest tax plan aims to fix that and make the U.S. more attractive for businesses in two ways. One is by reducing the tax rate, and the second is by switching to a territorial tax system, instead of taxing businesses on their worldwide revenues, Knoll noted. The Trump administration hopes to stimulate the economy with some of its other proposals as well. “We can get back to 3% or higher GDP that is sustainable in this country,” said Mnuchin at a press briefing after handing out his one-page note on the tax plans. “The overall economic plan consists of massive tax cuts and tax reform, regulatory relief, and renegotiating trade deals. And with that, we will unlock the economic growth that’s been held back for too long in this country.” Added Cohn: “Our basic premise here is to simplify the tax system, lower rates and make it easy.
According to the Penn Wharton Budget Model’s tax policy simulator, Trump’s campaign tax plan could stimulate the economy in the short run by about 1.35% of GDP, but would leave the economy unchanged within just 10 years. “Thereafter, the economy does worse than under current law, due to growing debt,” the PWBM predicted. “By 2040, the U.S. GDP would be 8.49% smaller than under current law, even after accounting for the dynamic impact on the economy.” Further harm awaits the economy if Trump renegotiates the North American Free Trade Agreement, and that move reduces trade flows and cross-border capital flows and enhances the negative effects of growing debt, it added.
Higher consumer spending would provide a broader tax base to offset the revenue loss caused by lower taxes to some extent, said Hines. “But it doesn’t alleviate anywhere near enough of it,” he added. Smart tax cuts for both individuals and corporations would of course stimulate the economy and lead to business expansion, he said. “But is it enough to pay for itself? Absolutely not.”
The proposal to double the standard deduction for personal income tax would certainly help lower- and middle-income people, said Hines. The tax plan proposes to reduce the number of brackets for personal income tax from the current seven to three, with rates of 10%, 25% and 35%. Individual tax payers will face higher or lower rates, depending upon the category they fall in.
“The rhetoric that we will grow out of [the tax cuts] becomes dangerous and appealing.” –Michael Knoll
Hines placed the current proposals against the backdrop of a tax cut for individuals that the Bush administration implemented in 2001. The Obama administration then subsequently extended it for all groups except high-income people. “To layer a tax cut on top of that is really a lot of cutting,” he said. The problem for the Trump administration is that “the American tax payer has gotten used to enjoying the low tax rates that they got courtesy of the 2001 tax cut, and now it’s hard to cut them further.”
Knoll agreed that Americans have become comfortable with the idea of lower taxes. “The rhetoric that we will grow out of it becomes dangerous and appealing,” he said. “No one seriously believes that these cuts – even smart cuts – will grow [the economy] enough to pay for [themselves].”
Territorial Tax System
The proposal to switch to a territorial tax system from the current worldwide system used by the U.S. will be helpful, according to the Penn Wharton Budget Model’s analysis of the new tax plan. It explained the implications of that shift: In a worldwide tax system, U.S. firms owe U.S. taxes regardless of where in the world they sell their goods and services, although they do receive a tax credit for foreign taxes paid. In a territorial system, by contrast, firms would pay U.S. taxes only for goods and services sold in the U.S.
Since a territorial system is commonly used by the U.S.’s large trading partners, it promotes more tax harmonization, according to the analysis. But it pointed out that such a switch could produce “other side effects” in that such corporate tax reform “is large in scope and may have significant costs; and the reaction of foreign governments may have an impact on corporate tax policy reform outcomes.”
However, with the proposed 15% corporate tax rate, “the net impact from moving to a territorial system alone is much smaller than it would have been at the existing tax rate,” the analysis said. “Indeed, at a 15% corporate tax rate, many U.S. firms selling abroad would receive enough foreign tax credits to eliminate their U.S. tax bill, even under a worldwide tax system.”
Problems of Execution
Hines said smart tax systems could also help small and mid-sized businesses. But he noted that most American businesses are LLCs (limited liability corporations), sub-chapter S corporations or partnerships and they are taxed under the individual income tax system. Therefore, in order to provide them with a more friendly tax regime, individual income tax rates have to be cut, he argued. However, there is little clarity on what exactly the government plans on that front, he added.
Hines pointed out that Mnuchin and Cohn did talk about creating a separate regime for LLCs, sub-chapter S corporations and partnerships. However, the details haven’t been released of how exactly that will be accomplished, he said. Any meaningful discussion on those proposals would be possible only after members of the administration “roll up their sleeves and do the hard work.”
“If [we] make the business tax system more competitive, maybe you won’t get laid off from your job. Maybe you would get a better job, or a higher wage.” –James Hines, Jr.
The incentive for individuals to treat themselves as businesses in the eyes of tax law would also bring difficulties in ensuring compliance and monitoring. “When you draw lines and create big differences on small margins, there is a strong incentive to move across those margins,” Knoll said. People would be tempted to take more out as profit and less as wages by treating their income as business income, he explained. The pressure for such switching will increase as corporate tax rates drop from the current 35% to 15%, he said. “That will be a tough line to police. Unless somebody has a very creative solution, it is going to be very fact-specific.”
The Trump administration is aware of that potential for abuse. “We will make sure that there are rules in place so that wealthy people can’t create pass-throughs and use those as a mechanism to avoid paying the tax rate that they should be on the personal side,” said Mnuchin in his press briefing.
Some features of the plan are unambiguously helpful for taxpayers, such as its protection of retirement accounts without disturbing the deductions for contributions into those, Knoll noted. However, removing deductions for health care would create problems, especially when the government has yet to bring a workable alternative to the existing health insurance system, he added.
Also, trying to find ways to bridge the revenue gaps by eliminating deductions may not make sense, according to Hines. He noted that several deductions are in place for good reasons. “Do you want to eliminate the casualty loss deduction, [or the] excess medical expense deduction?” he asked. “They’re proposing, implicitly, to eliminate popular deductions, and they’re still not getting anywhere close to recouping the revenue.”
The Road Ahead
Hines said that by putting “the ball in play,” the Trump administration at least indicates that it is “reasonably serious” about implementing its campaign promises. Airing the proposals also puts some pressure on Congress to support them, he noted. “But there are going to be a lot of disappointed tax payers out there, because you can’t do much more than a fraction of what they are talking about without crazy deficits,” he said. “And Congress is not going to go for the crazy deficits.”
More broadly, Hines suggested a holistic approach. “If [we] make the business tax system more competitive, maybe you won’t get laid off your job. Maybe you would get a better job, or a higher wage,” he said. “If you make the tax system better, it actually helps people, and conversely, if you make it worse, it hurts people.”