Wharton's Kent Smetters and James Hines, Jr., from the University of Michigan discuss the potential impact of proposed U.S. tax reforms.

The recent joint statement on U.S. tax reforms by Republicans in Congress and the Trump administration is clear about its goals of protecting American families, jobs and businesses, but brings little clarity to how those could be achieved. Its authors want lower taxes for households and businesses, but don’t explain how the government would recoup the revenue losses those would entail. They are clear in rejecting two proposals doing the rounds — a border adjustment tax and a consumption-based tax.

Trump’s campaign assurance that lower taxes would spur economic growth sufficiently to recoup the lost tax revenues doesn’t add up, according to Kent Smetters, Wharton professor of business economics and public policy. He is also faculty director of the Penn Wharton Budget Model, an interactive analytical tool that allows users to weigh the potential impact of individual policy proposals. Proposals to raise revenues by eliminating deductions and exemptions for individuals are tantamount to tax increases, said James Hines, Jr., professor of law and economics at the University of Michigan, and research director of the Office of Tax Policy Research at the university’s Stephen M. Ross School of Business.

Smetters and Hines dissected the various proposals to determine who will benefit the most from them on the Knowledge at Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

Here are key takeaways from their discussion:

Some Knowns, Many Unknowns

According to Smetters, Trump’s campaign pronouncements contained many specifics on corporate and individual tax reforms, but the new White House plan backed by Republicans in Congress is largely opaque. He noted that the latest White House proposal on expanding tax deductions for capital expenditure is significant, but pointed out that another proposal on individual tax brackets doesn’t specify the thresholds.

The statement’s authors are clear about the final outcomes they want. “The goal is a plan that reduces tax rates as much as possible, allows unprecedented capital expensing, places a priority on permanence, and creates a system that encourages American companies to bring back jobs and profits trapped overseas,” they wrote. They also want “a lower tax rate for small businesses so they can compete with larger ones, and lower rates for all American businesses so they can compete with foreign ones.” On the individual side, they want to “make taxes simpler, fairer, and lower for hard-working American families.”

Sadly, the math doesn’t quite work, according to Hines. “[The proposals] … lead to a huge deficit of a type that Congress would never countenance,” he said. “The more recent pronouncements are long on whose taxes are being reduced and offer virtually nothing on the side of where the money will be made up. Everybody likes tax cuts, but the problem is, you have to pay for government.”

Making the Math Work

According to Smetters, assumptions of “revenue raisers” by the Trump administration offer little respite. Those revenue raisers include the elimination of certain deductions or exemptions such as on health care premiums and select state and local tax deductions. But even with the elimination of those deductions, the government would see a 10% drop in revenue. That gap would double to 20% without the elimination of the deductions, he said, citing analysis using the Penn Wharton Budget Model.

At the same time, both Democrats and Republicans recognize that U.S. corporate taxes have to be lowered to help American companies compete more efficiently in international trade, Hines noted. But that is easier said than done. “The problem is, if you lighten the burden on business, you have to make it back somewhere,” he added. “That’s where Congress is stymied.” He noted that if corporate taxes are lowered, politicians will demand lower taxes for individuals as well.

That situation then trains the sights on government spending, which again brings little hope. “The only thing you can do is to cut government spending, but Congress has proven to be incapable of that,” said Hines. Smetters pointed out that “under the most optimistic scenario of still cutting a lot of deductions,” the government would have to find ways to cut another 20% of federal outlays excluding Social Security and Medicare, which the Trump administration has said will not face cuts.

Will the ‘Positive Dynamic Effect’ Occur?

Smetters noted that the Trump administration’s broader argument is that its proposals will have a “positive dynamic effect” on economic growth and that will grow the tax base sufficiently enough to compensate for the revenue losses from tax cuts. “But the problem is to get that effect, you can’t build up a budget debt at the same time, because that works in the opposite direction of lowering marginal tax rates,” he said.

According to Smetters, the proposal to grant more tax breaks for capital expenditure will have a salutary effect on economic growth. One proposal doing the rounds is to allow companies to elect whether or not they go through a capital expensing where they could write off their capital investments immediately. He said many economists like that proposal since it can stimulate investments and raise tax revenues progressively.

“Everybody likes tax cuts, but the problem is, you have to pay for government.” –James Hines, Jr.

Even as the latest proposals reject the introduction of a “border adjustment tax,” Smetters said it would help. “It will create more parity between the U.S. and the worldwide tax system and help U.S. businesses compete better globally,” he said. Opponents of that tax – such as Wal-Mart — have said that it would make imports costlier. The border adjustment tax proposal aims to exempt exporters’ profits from taxes and remove existing tax deductions for what importers purchase from foreign countries.

If the government chooses to eliminate some tax exemptions and deductions such as for state and local taxes or for employer-provided health benefits, such moves could prove counterproductive, Hines warned. “Those are tax increases and they discourage economic activity in the way that tax increases do,” he said, and Smetters agreed.

Economic Growth vs. Income Distribution

Which constituency should get the biggest breaks — businesses or individuals? To find answers to that question, the government has to decide which of the two it wants more — economic growth or distribution of income, said Smetters. “Often those things don’t work in the same direction; it is a classic tradeoff.”

Economic growth is typically driven by corporate tax reform, which includes both tax cuts and allowing deductions for expenses, he noted. But if those cuts are to be offset by removal of some other deductions for individuals, individuals would be hurt, said Hines. “Most of the revenue potential is in the middle class and the upper middle class, because that is where the big numbers are; the higher income people are already taxed a lot,” he said. “Taxing medical benefits will hit people hard in tough parts of the income distribution curve.” That dilemma is a tough one to crack, and “everybody is avoiding a discussion on new sources of revenue,” he added.

Slow Road Ahead

According to the joint statement, the decks are clear for the two committees charged with recommending tax reforms– the House Ways and Means Committee and the Senate Finance Committee – to begin their work. Its authors expect the necessary legislation to begin moving through the two committees this fall. However, Hines and Smetters don’t expect significant progress this year. “It’s a fantasy if you think something serious will get done in tax reform in 2017,” said Hines. Smetters agreed: “The timeline doesn’t work for any major tax reform” to see the light of day this year.