Republican Tax Plans: Key Points

KEY POINTS ON REPUBLICAN TAX PLANS, drawing on our session with Bill Gentry, Professor of Economics at Williams and expert on tax policy.                                                                    Jim Mahon 4/21/17

Background:  Tax economists think about three things when evaluating policy, while most of the rest of us think about one of these more than the other two. 

  1. What we all think about is equity between rich and poor, the way a tax system takes account of people’s (or firms’) ability to pay.  Tax policy people call this “vertical equity.” 
  2. What the rest of us  think about less is fairness between people or firms that make similar incomes but in different ways, or who use it in different ways.  Ideally, these people should face the same tax liability.  Policy wonks call this “horizontal equity.” 
  3. The other thing that mostly concerns tax economists is what they call “distortions,” which are economic decisions that people or firms make because of the tax code—beneficial projects that do not get done, or less beneficial things that do get done, because of the tax code (the general term for foregone economic activity is “deadweight loss”).   We non-economists sometimes think about this when these distortions affect economic growth, as with the related dimension of simplicity vs. complexity, most people (naturally) favoring a simple tax system that is relatively easy to deal with.
  • Under a Destination Based Cash Flow Tax (DBCFT), what is being called “Border Adjustability” in news reports, the government taxes cash flow rather than corporate income (profits). This implies that capital spending gets expensed (deducted from the taxable base) right away, rather than depreciated over time; and there is no deduction for interest paid, because in this view, interest is a cost of doing business.
  • In terms of reducing the distortions of the (corporate) tax code, Bill Gentry said that the idea of the DBCFT has a lot to recommend it. It is especially valuable during times of inflation, or when depreciation schedules are too slow for the capital goods (say, computers) a firm uses.
  • However, the bill favored by House Ways and Means Chair Kevin Brady, and Speaker Ryan, does not follow this idea consistently. One version of it preserves interest expensing, for example (something Trump is also likely to want), and does not allow firms to expense purchases of land.  It also wants to cut the rate applied to pass-through entities (such as limited partnerships), creating another loophole that firms would predictably exploit (a.k.a., a distortion in how firms organize activity).

[Here’s a decent explanation of the Ryan/ Brady plan, in cartoon form.]

  • Also, the move from an income-based corporation tax to a DBCFT would be expensive in the short term. Already-agreed tax treatment allowing interest and capital depreciation expensing would probably have to be honored while under the new rules, new capital outlays would be expensed 100 percent in their first year.  Especially if this were combined with a drop in the statutory rate from its current 35 percent to, say, 15 percent, we would have a big revenue hole in the first few years.  Given the PAYGO rules that impose a 10-year “budget window,” there would have to be a way to pay for this.  The idea now being discussed—a tax holiday, a low rate of 10 percent applied to repatriated profits (like the >$200 billion cash hoard Apple has in Ireland)—is, in Bill’s opinion, a bad one.
  • The “destination based” part of the DBCFT is also tricky. It is in the bill because the USA is now pretty much the only developed country using a worldwide, rather than territorial, base to calculate corporate tax obligations.
  • The US choice was based on a very defensible idea of fairness: if a foreign jurisdiction levies a 20 percent tax on the income of an American corporation’s operations in that country, the corporation should have to pay an additional 15 percent (to bring it up to the US rate of 35%) when those profits are returned to the firm.
  • BUT this puts US firms at a competitive disadvantage relative to a foreign company in that jurisdiction, if that company’s home country uses a territorial base, because the US firm ends up paying more. The US firm will have an incentive not to repatriate profits from that jurisdiction, retaining cash there perhaps in order to invest in that country instead of the USA.
  • Territorial taxation does make transfer pricing—the practice of setting intra-firm prices so that taxable profits are shifted to low-tax jurisdictions–a bigger problem.
  • Now, destination basing is like territorial basing except that it computes tax obligations from where a good is consumed rather than where income is earned.  Like a value-added tax (VAT), this method would have tax fall upon imported goods and services but not exports.  Unlike the VAT, businesses would be able to deduct expenses related to labor and rent, so that the taxable base now looks more like profit than value added.
  • Combining destination with cash-flow basing, you get a system that has the potential to be simpler, to encourage profit repatriation while putting US companies on even footing with competitors in foreign markets, and (depending on what happens to exchange rates), have a neutral to positive effect on the trade balance.
  • However, the politics of this ideal reform look difficult: Lots of interests are organizing against it.  It would also require tax accountants and attorneys to change the way they do their jobs.  The Senate, in particular, is likely to be hostile territory.  Orrin Hatch, Chair of Senate Finance Committee, is said to be mildly opposed, and several other important R Senators (e.g., Grassley) are more opposed.
  • When all is said and done, we are more likely to get a standard-issue Republican tax bill. My guess (Jim M.):  a corporate rate cut from 35 to 20-25; a personal top marginal rate cut from 39.6 to 35, maybe 30; an elimination of the estate tax; and some attention-getting sweetener for the “middle class” (R’s define this a households struggling on $250K- $1M).  There will be pressure on the CBO to use aggressive “dynamic scoring,” projections of the net impact that imply a big boost to economic growth.  If these don’t do the trick, expect a tax holiday for repatriated profits.
  • Going back to the three criteria noted above. The most tax-policy-wonkish Dems and Repubs could agree on minimizing distortions and horizontal equity, but they part company on vertical equity.  As the reform package evolves, unless the process is truly bipartisan (which R leaders say they welcome but will probably not follow in practice), this difference means that Dems and resistance groups would be right to distrust legislators whose philosophical guide is Ayn Rand.

[And here’s a recent take on the politics.]



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