Wharton's Kent Smetters explains how the Penn Wharton Budget Model challenges many proponents' claims regarding U.S. tax reforms.

Tax legislation speeding through Congress not only will increase the deficit and provide meager gains for most low- and middle-income groups, it may also open up huge loopholes for businesses to sidestep taxes, says Kent Smetters, Wharton professor of business economics and public policy, and faculty director of the Penn Wharton Budget Model (PWBM). “The additional growth we project is only about one-ninth of the growth that would be required for this tax plan to actually pay for itself.” And when the White House Council on Academic Advisors says that the proposed tax changes will raise yearly family income $4,000- $9,000 on average, Smetters calls such claims “political statements. No credible model produces that result.”

In this Knowledge at Wharton interview, Smetters offers a sweeping analysis of the tax proposals’ key points and how they would affect business, consumers, and income distribution and wealth, based on PWBM’s simulator. “The big winners are going to be the tax lawyers,” Smetters notes. “Right now there are just massive loopholes in the Senate version….” His biggest short-term concern is too little time before the Christmas deadline to close them. The legislation “… is basically going revert to pre-1986, where if you had serious money coming in, you could always figure out how to avoid paying taxes. Before 1986, lawyers literally advertised, ‘If you make more than a million dollars a year, we’ll figure out how to permanently defer your tax bill.’”

An edited transcript of the conversation follows.

Knowledge at Wharton: This is the biggest tax bill in 30 years. It’s been pushed through with a lot of details left out, which has been confusing for many. The public has had a tough time understanding what’s in it. What’s more, there’s a House version, a Senate version and ideas are being floated for a compromised reconciliation version. Still, some broad outlines at least are in focus. On one side, critics say that tax changes would increase the deficit — the cuts don’t pay for themselves, in other words, and would do little to increase economic growth. On the other side, the claim is the tax changes will boost economic growth, and thus family incomes, cause companies to hire more workers, and overall boost the middle class. What does the model show?

“The additional growth we project is only about one-ninth of the growth that would be required for this tax plan to actually pay for itself.”

Smetters: Overall, the Penn Wharton Budget Model predicts that the additional growth will be very small, just because of how the tax plan is designed. [The PWBM is a robust nonpartisan, online, interactive budget-modeling simulator.]

We show that by 2027, the GDP will only be about 0.3 to 0.8 percentage points larger. That’s like going from a 2% annual growth rate to a less than 2.1% percent annual growth rate. More importantly, the additional growth that we project is only about one-ninth of the growth that would be required for this tax plan to actually pay for itself. And so we’re very far away from having a tax plan that pays for itself through these macroeconomic effects.

I should point out that things can get even worse after 10 years. D.C.’s focus on this 10-year window is very misleading. When you get beyond 10 years you might think, well the tax plan has kind of kicked in a bit more, [there’s] more opportunity for it to get better. It’s actually worse after 10 years. The reason: Since it’s not paying for itself, the debt keeps building up. That debt build-up kicks in even more after 10 years. We predict by 2040 that basically the GDP is unchanged, and in fact it could be a little bit smaller than on their current policy.

Knowledge at Wharton: What’s the bottom line for business?

Smetters: There are a couple of things in there. There’s a reduction of the corporate tax rate. We’ll see what it ends up with. Right now the target is to go from 35% to 20%. It’s unclear if they are going to be able to literally keep it at 20%, because of some of the revenue issues. Especially on the Senate side, there are particular rules — the Byrd Rule — that they have to worry about. But that’s the current target.

There is an increase in what’s called expensing. That is to allow companies to depreciate their assets against their tax bill at a quicker rate than they currently are — in fact, to do it all immediately. Of those two effects, economists are much more excited about the expensing approach than cutting rates, simply because expensing focuses on new investments. With both of these plans, however, they have very limited expensing. They only focus on equipment, and then the expense supervisions are only temporary; they only last for a couple of years.

Knowledge at Wharton: And for individuals?

Smetters: It depends kind of where you are. The various tax rates will come down, there will be fewer tax brackets. There may or may not be something at the high end still that has a higher tax rate for higher income earners around what we see today. They are still debating some of that. But for most people, the tax rates are going to come down.

But there will be a loss of various deductions. On the one hand, the standard deduction is going to go up, so a lot of lower-income people are going to be helped by that. But then for a lot of people living in California, New York, New Jersey, they’re going to be losing likely at least part, if not all, local income and property deductions.

It looks like under the current agreement they will be able to still deduct their first $10,000 worth of [taxes], but if you are actually in California or New Jersey or New York, which by the way are blue states that the administration is less sympathetic with — they are going to definitely be paying more.

“Unfortunately in this tax-reform debate, the big picture is how good analysis has taken a back seat.”

Knowledge at Wharton: For lower- and middle-income groups, the tax brackets will drop a little bit, and they might save a little bit. Is it a material increase and will it matter either to them or to the economy at large?

Smetters: No, we’re finding very little impact on the economy at a large — and when we talk about what’s the impact on the person, it really comes down to: Who is that individual? The Wall Street Journal today just launched a simplified version of our tax model. You can go to the Wall Street Journal website. Our actual tax model has hundreds of inputs, but it’s boiled down to just nine inputs in the Wall Street Journal so obviously this is an approximation, it’s simplified.

Nonetheless, it captures the salient features of things like state and local deductions, child credit — which is a big one — and things like that. You can go on there and get a guesstimate of what your taxes are today, and what they will be, at least under the House plan right now, and then we’ll do it again with the reconciled bill.

Knowledge at Wharton: Some analysts suggest that the tax rule changes strongly favor the top 1% of earners, and especially the top 0.1%. One analysis even notes that in 2027, when individual tax cuts fall away, more than half of the benefits would have gone to the top 1% of income earners.

At the same time, the PWBM model shows that under the new tax regime there would be no significant change to the level of progressivity of the tax code. Those earning the most will pay a percentage of total taxes very similar to what they pay today — and for those earning at other levels, it would also be similar. So how does all of that fit together?

Smetters: That’s the big issue of trying to convey this to a media that wants sound bites. Generally speaking, unfortunately, in this tax-reform debate, the big picture is how good analysis has taken a back seat. Proponents of tax reform — I used to call them conservatives, but conservatives used to believe in fiscal discipline, that you actually pay for tax cuts like we did in 1986 — are basically making up growth numbers.

No legitimate model says, when it’s calibrated to the actual tax plan, that this tax cut is going to pay for itself. But the opponents, I think it’s still safe to call them … liberals, they’re basically also making up numbers. I call it click bait when it comes to distributional impact. Whether it’s the 1% or the top 10%, they’ll talk about how these guys make more from this tax plan than the bottom 50%. But this of course ignores the fact that the richest 10% in the country are already paying more than 60% of the country’s tax bill to begin with.

So when you start with a very progressive tax system, even a proportional change is going to look like it’s the top people that are making out. Well that’s because they, in fact, paid most of it to begin with. What happens is that for the left, the click bait is who actually gets most of the benefit from this tax bill, ignoring who actually pays the taxes to begin with. And we just don’t think that’s a legitimate analysis.

One simplified number that’s still legitimate to look at is tax shares. And for that you simply ask: What is the share of taxes that are being paid by these different income groups, and how does that change? Well, one of the important findings of our model is the share of taxes paid by the top 1%, which is more than a quarter of the nation’s taxes right now, and the top 10%, which pays more than 60% of the nation’s taxes — those shares even under current law will go up over time. And the reason why is the different features of the tax code known as “real bracket creep” and some other features that will actually increase their shares over time.

For the most part, what this tax plan does on the distributional side, it kind of resets it, such that by 2040 the top 1%, the top 10% are going to basically have the tax shares that they have today. Yes they will win for a little bit — it’s not going to be perfectly smooth — but for the most part, it’s just basically preserving the tax shares over time.

Knowledge at Wharton: For those who thought this might do something for the issue of income inequality, it doesn’t change it one way or the other.

Smetters: Yes, this is basically a tax plan where the growth numbers aren’t great … those are embellished by the proponents, and the distributional impacts are greatly embellished by the opponents. This is an embellished debate on both sides.

Knowledge at Wharton: Does the model look at wealth measurements?

Smetters: Yes. For the most part the increase in wealth by people is fairly proportional to their progress via the tax code. And so it’s not surprising that if you look at the percentage change in wealth, for low income households, 50% of households in the United States have no meaningful savings outside of Social Security for retirement, for example. And so there is very little nudge going on with them; when you give them a tax cut, they immediately spend the money. They are what we called borrowing constrained. So it’s not surprising that those who are not borrowing constrained are going to save more of that money and invest it and so forth. So you definitely get what looks like increase in wealth inequality, but again we’re talking about a smidgen — it’s not a big one.

If in fact Congress were really concerned about this, there’s a so-called twofer here in terms of economic growth and even distributional wealth. And that is: Focus less on rate cuts on the corporate side and focus a lot more on expensing of new investment. Cutting rates doesn’t just reward new investment; it rewards all the investments that have already been made and that will be subject to tax. Focusing your deficit dollars much more narrowly on the expensing rewards purely new investment.

Expensing is more of a stimulus, and it’s less of a reward to current shareholders.

“Proponents are basically making up growth numbers.”

Knowledge at Wharton: Business taxes are to be reduced from 35% to 20%. Will companies bring home a lot of the $2.5 trillion they have kept overseas and take advantage of these lower rates? And if so, how much might they bring home? What are they going to do with it? Are they going to invest it? Are they going to pay down debt, give most of it to shareholders, buy back their own shares, hire more workers?

Smetters: It’s unlikely in the long run that we’re going to see big changes. What we’re talking about is more temporary changes. Under both the House and the Senate version of the bill right now, all of those foreign earnings — that $2.5 trillion sitting offshore — would be considered to be automatically repatriated. What that means is tax is due. But it’s a tax due at a special rate; it’s going to be due at 10%. And even then it can be paid over many years — it’s not all going to be due at once.

So under current law the big issue is that those earnings are not subject to the U.S. corporate tax until they are repatriated and brought back into the country. And there are some Clinton-era loopholes that allowed for that exploitation. So these plans were basically to say all of that is now repatriated automatically regardless of where it is. You pay a 10% rate, we would give you many years — likely a decade to pay that 10% rate. So we will see some money coming back that artificially was sitting offshore.

What will happen with that money? That is a big debate that’s going on now. But it’s likely that some of it will be paid out in higher dividends, some of it will be paid out in stock repurchases and some of it will likely be invested. We don’t think the investment channel is going to be nearly as big as some people will say, and the reason why is that there are already some ways of clever financing.

For example, Microsoft and a lot of the other companies that have a lot of big money offshore, they’re smart, and they don’t pay a dividend with that offshore money because that would be tax inefficient. They actually float new debt to pay a dividend already today. And so they’re not really constrained right now in making the investments that they otherwise would want to make in the United States. So for the most part, this repatriation — most of that money is going to go to shareholders in the form of dividends and repurchases.

The real issue is: What’s going to happen in the long run? In the long run, after this one-time reset, you’re still going to have the same problem. Yes, the U.S. corporate rate will be lower. But it’s not going to be low enough to stop this problem on new money earned offshore because it’s still going to be cheaper to do the double Irish /Dutch sandwich inversion and all of the other fancy techniques.

And by the way, these tax bills as currently written have enormous loopholes, tax-avoidance schemes. They are kind of aware of it. They’re trying to rush and fix some of these things, but it’s almost impossible to figure this all out before the end of the year. You really need months of talking with tax attorneys to figure out all of these things.

Knowledge at Wharton: So it could be law easily before we really have any serious idea of what the results will be?

Smetters: That’s right.

Knowledge at Wharton: Two questions about what we’re talking about there. One is: Corporate debt levels are pretty high right now. Do you think this will lead to a pay down of some of that debt since they won’t be financing themselves in quite the same way?

“The growth numbers aren’t great … those are embellished by the proponents, and the distributional impacts are greatly embellished by the opponents. This is an embellished debate on both sides.”

Smetters: Corporate debt levels are high in countries like ours that allow you to deduct the interest on that debt. It’s completely tax arbitrage. It’s not that companies are suffering for capital to invest and so forth. Sometimes you hear about debt being cheaper than equity. That’s kind of loose language; it’s cheaper because it’s more tax efficient.

And so we have this big skew towards debt in the United States. A lot of people don’t realize the corporate debt market in the United States is bigger than the stock market — it’s a huge, huge market — because with over-the-counter trading, it’s not as visible. You don’t see the index like you do the Dow on your newsfeed and so forth.

These bills are going to limit some of the interest deductibility — but again that, as I read the tea leaves, will likely be temporary. And so it’s also not completely eliminated. It’s just some limitation. So you should start to see some skew away from debt just for that reason, but I don’t think it’s going to be dramatically connected to the repatriation issue.

Knowledge at Wharton: So in general, do you see a big change in corporate strategy or tactics for these big multinationals and how they manage their far-flung empires, because in the end this tax change will be a wash?

Smetters: For the first decade it’s going to look like big changes because of this one-time repatriation. But over time, if you are a larger firm, you are still going to be pretty smart in keeping that money offshore. And the reason why that happens is because of this decision that was made to move towards what’s called a territorial tax.

And the problem with that is there are some advantages relative to our current tax system — which is known as the worldwide tax system, but it’s not as integrated with the rest of the world the way what’s called a destination tax is integrated, which was part of the 2016 House GOP bill. That destination tax would have created much more integration and removed those distortions for the most part.

That was not very popular with Walmart and some other companies that were basically claiming that imports would become more expensive and so forth. There was a lot of misunderstood economics — that’s a debate that economists lost because we didn’t articulate it very well, but nonetheless because of that lack of integration there will still be good tax arbitrage for companies locating offshore.

Knowledge at Wharton: What items does the model suggest bring the most benefits to companies and to the economy overall?

Smetters: For the most part it is the small move toward expensing on just capital equipment – that did [increase] the speed at which you can do depreciation, but it’s not full expensing. Those are the things that tend to give you the most kick. The reduction in rates is actually much smaller, because hypothetically, if we went to full expensing, then the reduction in rates actually does nothing for new investment, because you’ve already essentially eliminated the tax on new investment.

The reduction in rates only rewards existing investments. It’s a complete wealth giveaway at that point. The big power comes from expensing. Those are the big lessons from our model, and these lessons weren’t adhered to. If you really were trying to have a very pro-growth result, you can get big growth if you just went to full expensing of all tangible and intangible capital expenditures — that means capital equipment, structures and so forth.

“No legitimate model says, when it’s calibrated to the actual tax plan, that this tax cut is going to pay for itself.”

If you went to a really integrated international tax system like a destination-based tax, and you actually — like in 1986 [when the last major tax reform occurred] — paid for the tax reform, you made it basically revenue-neutral on a static basis, that means that on a dynamic basis net of growth you’re actually going to have more revenue. Now why do you actually want to have more revenue? Because we’ve got this massive amount of debt, and this debt is increasing as far as the eye can see.

We’re almost approaching World War II levels of debt. We’re not quite there yet, but we’re getting there. But with World War II that debt came way down afterwards — the war was over, the economy had grown, we were rebuilding the world, and so forth. Now, as far as the eye can see, we’re on this escalating debt path.

And by being able to pay some of that down, using the dynamic effects to pay some of that down, that’s where you get a nice big kick as well to stimulate capital investment. So those are the real three main ingredients: full expensing, integrated international tax with a destination-based tax, and then being revenue-neutral on a static basis and using the additional growth to pay down debt.

Knowledge at Wharton: None of which are in the current legislation.

Smetters: Well, a smidgen of the expensing, but not the other stuff, that’s right.

Knowledge at Wharton: The White House Council of Economic Advisors says that corporate tax reform will increase the average family income $4,000-$9,000 a year. The PWBM suggests only a small amount of increase in labor income and GDP. How do you see the two reconciling or not reconciling?

Smetters: Let me put it this way: No model out there, even models that I disagree with, or that are being made by [Republican] proponents of the tax reform [show that]. Keep in mind, I am a Republican who was appointed in the Bush administration — this is not some liberal guy talking to you here. [Smetters was policy coordinator — deputy assistant secretary — for the U.S. Treasury under President George W. Bush.]

In fact, my previous academic work is some of the most cited for these pro-growth effects of tax reform. But all of those models are looking at very stylized tax changes that are revenue-neutral, that incorporate those things that I just talked about, that are very pro-growth. Any model that has actually looked at this current tax bill, not some stylized example of this academic work that’s been done in the past, has not found anything close to it paying for itself. Even models I disagree with, that ignore the debt effects, have not found that impact.

And so when the Council of Economic Advisors [projected] a $4,000-$9,000 increase, that is based on — it turns out — not just really stylized models, but also some studies that weren’t even focused on the federal tax system. They were focused on arbitrage between some state tax systems. And so they are political statements; no credible model produces that result.

Knowledge at Wharton: What are some of the most important things for businesses to know about this, and for consumers to know about all of this?

Smetters: The bottom line is, don’t get too excited. The growth effects are going to be modest. For consumers, individual tax payers, it really comes down to your details. Where do you live? And what is your income range? How many kids you have?

For businesses — yes, you’re going to have lower rates; you will have this one-time repatriation, especially for the larger businesses. [There will be] some exploitation of — I mean that in a positive way — increasing investment through expensing and so forth.

The biggest concern, generally, that I have on the business side is the big winners of this are going to be tax lawyers. Right now there are just massive loopholes in the Senate version, which literally is part handwritten. You can see the bill, and there are parts of it that was voted on that were handwritten, to get some votes at the last minute.

“The reduction in rates only rewards existing investments. It’s a complete wealth giveaway….”

So, it has huge problems that even the Republicans acknowledge – big problems and big loopholes. The biggest immediate concern I have is that between now and Christmas, we’re trying to give a Christmas gift to the White House of getting this tax bill done, and it is just not enough time to figure out all of these loopholes. And so there might be enormous unintended consequences.

The corporate AMT [alternative minimum tax] is an example here. It wipes out all of the value of the development and research credit, and some other credits. It’s just a mistake. Republicans acknowledged it was a mistake in the Senate bill. And then there’s all of this tax arbitrage – tax-avoidance schemes, tax-abuse schemes, and so forth.

Knowledge at Wharton: Examples?

Smetters: There are transactions that you can do, this gets really in the weeds, but using what’s called foreign related parties, which are basically not necessarily a fully owned subsidiary, but anything that you have a 25% or more interest in. There are ways of basically making payments to them and they give you a loan back, and it’s going to avoid the potential for what’s called base erosion in these schemes.

Don’t get me wrong, I’m not a tax lawyer, but I’m listening to the tax lawyers, and they’re basically saying there are enormous opportunities here. And they say it, by the way, not giddily — they’re not excited about this. They’re saying, “Holy cow, there are just big tax base erosion schemes here.”

And normally how this works is, like in 1986, you get all of the tax lawyers, all of the experts  — you have a process incorporating all of that…. Just the fast-tracked [nature] of this is what is very perplexing for everybody.

Knowledge at Wharton: It sounds, based on these potential enormous loopholes that you mentioned, that if anything your estimates for the deficit could be much higher?

Smetters: We incorporate pretty sizeable, what’s called income shifting and reclassification. Those are the big ones where some empirical studies have calculated what’s called elasticity, to figure out how much of that is going on. We have those in our estimates; in fact, the PWBM score for the Senate plan, when the JCT [Congress’s nonpartisan Joint Committee on Taxation] came out with their dynamic score a couple of weeks later, only differed by $3 billion over 10 years. We’re talking about a $3 trillion annual [revenue]; we’re talking about revenue loss of more than a trillion dollars over 10 years.

We got there in different ways. But on the House side we differed quite a bit, and the reason why is because we believe that the base erosion is much bigger than what the JCT has accounted for. They also allow for what is called income shift, and that’s across periods, that income reclassification, that exploits differences in tax rates even within a period. They allow for that — we believe they undercounted it.

At the PWBM we have the person who was the [Treasury Department’s] Office of Tax Analysis’s expert on income shifting and pass-throughs and income reclassification — he’s now with us full time. He’s generally considered the leading expert in this area. And we believe that the official Congressional numbers on this are underestimating that.

Back to your point: If anything we are still underestimating [the amount of deficit increase] because we are just talking about income shift and reclassification. There are potentially even much bigger schemes here that just take that stuff, put them on steroids — clever schemes that lawyers will figure out that we haven’t even incorporated yet.

“Just the fast-tracked [nature] of this is what is very perplexing for everybody.”

Knowledge at Wharton: So the unknowns are probably going to result in an even higher deficit?

Smetters: Yes. If anything, all of the assumptions that we make are pro-growth. That’s the irony about it. I could go into a whole list of assumptions that we’re making, that if anything bias us upwards in terms of growth. But nonetheless, the downsides are basically a much bigger potential for deficits.

There is nothing in there where we say, okay maybe that will just eat away at the deficit that will have the unintended consequence in the positive direction. We just don’t. Tax lawyers are good at figuring out how to reduce your tax bill, not figuring out how they increase their voluntary tax bill. The irony about this is that the 1986 reform — which economists left and right, across the political spectrum … all basically agree was a good tax act — broadened the base, got rid of a lot of loopholes…. We all pretty much agree that 1986 was a class model kind of tax reform. It simplified a lot of things, was pro-growth, revenue-neutral on a static basis, so you got your growth really kicking in.

What this is going to do, at least as currently written … is basically revert to pre-1986, where if you had serious money coming in, you could always figure out how to avoid paying taxes. Before 1986, lawyers literally advertised, “If you make more than a million dollars a year, we’ll figure out how to permanently defer your tax bill.”