The Senate and House produced tax reform bills in the last few weeks, similar in important ways, but different enough that they could be lethal to the tax reform efforts. The House passed its version and we are waiting on the Senate to either pass or reject their own version.
Before breaking down these proposals, it is worth remembering that our current system is horribly complicated, making compliance costs exorbitant. It is incredibly unfair, extending privileges to some at the expense of others. There is no equality before the taxman.
Genuine tax reform would expand and simplify the tax base by getting rid of the thousands of loopholes to special interest groups. It would lower the top marginal rates and end the double taxation on saving and investment. It should restore some horizontal equity (two people making the same income paying the same taxes). It would also make as many provisions permanent—and predictable—as possible.
Good tax reform would require the federal government to make adjustments in spending, the way states and the District of Columbia operate, so the amount of tax collected more or less covers spending for a given year.
The Simpler Tax Code
The House version goes after a large number of tax exemptions, breaks, credits and deductions that make our code so complicated and unfair. It takes some significant steps to reduce the mortgage interest deduction. It also gets rid of most—with the exception of a $10,000 deduction—of the state and local tax deduction (SALT). Pretty impressive moves considering ending tax deductions is usually where tax reform goes to die.
The House plan doubles the standard deduction, meaning dramatically fewer taxpayers will itemize their taxes.
The Senate plan also doubles the standard deduction. (an estimated 90 percent of filers making under $200K would now claim the standard deduction). It gets rid of SALT entirely, but is more timid on the mortgage interest deductions. Moreover, it preserves many of the tax breaks with which the House dispenses. And rather than making the tax changes permanent, it includes a sunset date of 2025 reverting the standard deduction, the estate tax, the child tax credit, SALT, the pass-through deduction, and individual tax rates to 2017 levels.
Middle Class Tax Cuts
President Trump's intention to give a real tax break to the middle class is counter-productive considering the middle class barely shoulders any of the income tax as it is. The top 10 percent of income earners—households making $133K, not $1 million as most assume—currently pay more than 70 percent of all income tax revenue. The middle quintile pays, on average, 2.6 percent of the federal income tax.
And yet, in both the House and Senate plans the middle class receives the largest tax relief by reducing their marginal tax rates, increasing the child tax credit and doubling the standard deduction. The result is fewer taxpayers would be paying income tax at all, problematic from a small government perspective. It also means a more progressive income tax code than it already is.
The House plan also effectively jacks up the top marginal rate for some high earners by using a 39.6 percent bubble rate on the first $90K earned by single taxpayers making $1 million and married taxpayers making $1.2 million and a 12 percent rate like everyone else. This is a perfect example of Republicans caving in to political pressure and implementing bad policies. Not that it will stop Democrats from calling it a tax cut for the rich.
Lack of Spending Cuts
Senate and House tax writers have been trying to pour two pounds of sugar into a one-pound bag to comply with reconciliation rules. Budget rules require that tax reform not cost more than $1.5 trillion over ten years and be deficit neutral outside of that time window. Because the $1.5 trillion tax reform is scored on a static basis and assuming that many current tax breaks and spending provision will sunset in a few years, the Senate has much more room than it seems. A little economic growth could go a long way (though far from going all the way) to help pay for this. This still imposes a real budget constraint on the tax writers.
They could, of course, have made their lives much easier by cutting government spending. But they refuse. Our current public debt is $14.6 trillion or 78 percent of our GDP and moving at a pace to be 102 percent of GDP by 2033 according to CBO. This massive debt, which will be paid for in higher taxes and slower growth by future generations, was apparently not enough to convince them to be fiscally responsible.
As a result, lawmakers rely heavily on revenue raisers (some good, like the elimination of SALT, and some bad, like base erosion provisions or taxing endowments of private universities) and budget gimmicks (like sunsetting dozens of provisions that will likely be extended in 2025). It is fiscally irresponsible and doesn't address the most important aspects of tax reform: simplicity, transparency and stability.
Cutting the Corporate Tax Rate
Both plans cut the corporate income tax rate from its current 35 percent level to 20 percent. The Senate version implements the cut in 2019, the House version in 2018. Both have the good sense to make the change permanent. This is the most pro-growth/wage change. This is a measure worth passing to make the country's tax environment more competitive.
Two questions I most often get are: Will tax reform be considered before the 2018 elections, and are either of the plans worth supporting? The honest answer to both questions is I don't know.
This is no libertarian tax reform. Far from it. Many aspects of either bill are awful (lack of fiscal responsibility, increased progressivity, enhanced child tax credit, sunset provisions just to name a few). But there are also provisions I really like, the corporate tax cuts, the elimination of SALT and other loophole terminations. Plus, it will be pro-growth (how much is the question) and certainly beats the alternative.
Not a ringing endorsement, but that's all I've got.