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The Tax Trade-Off

by Ramesh Ponnuru

A better tax code could be worth a larger deficit

Since the late 1970s, Republicans have been the party of tax cuts. During this period, successful tax-cut proposals — those that have made it into law — have always combined two kinds of reforms. They have cut tax rates to increase incentives to work, save, and invest. And they have reduced tax bills for middle-class families, typically by granting tax relief to parents.

The tax cut advancing through Congress now, and especially its Senate version, fits within this tradition of marrying populism to supply-side economics. If it is enacted, it should yield a modest, immediate increase in take-home pay for tens of millions of people and a modest, long-term boost to growth for the whole economy.

While the current tax proposal is similar in form to previous Republican efforts, its content is different. Its principal supply-side element is a reduction in taxes on corporate profits and corporate investment rather than, as in past tax cuts, a reduction in the top tax rate on income. This change is an adaptation to new circumstances. The top income-tax rate is much lower than it was when Reagan took office, and the economic returns from bringing it down further are not very high.

The corporate tax has, by contrast, become a larger obstacle to economic growth than it once was. The corporate-tax rate in the U.S. has stayed in place for decades even as other advanced countries have reduced theirs. As a result, the U.S. has become a less attractive place for companies, both foreign and American, to invest. The Republican tax bills cut the corporate rate from 35 to 20 percent and allow companies to deduct the cost of their investments more rapidly.

One common objection to cutting corporate-tax rates — that corporations already have healthy profits and don’t need the cuts — misses the point. The policy aims to improve their incentive rather than their ability to invest. Economists in the Trump administration have asserted that this incentive will improve so much as to yield wage gains of $4,000 to $9,000 for an average family. Most economists have found that assessment extremely optimistic, but the effect should be positive.

A corporate-tax cut is not without its complications. The federal government taxes most companies under the individual rather than the corporate tax code. The tax code generally — with many exceptions, as the complexity of modern taxes makes par for the course — treats these “pass-through” businesses better than corporations. That’s because the dividends and capital gains that corporations pay to shareholders are subject to an additional layer of taxation. But the owners of pass-through businesses are an important part of the Republican coalition, and they do not want to be left out of the tax cut.

The House and Senate bills treat them in different ways. The House bill would create a new top tax rate of 25 percent on pass-through income, but also use complicated rules to make sure that owners do not game the system to cut taxes on their labor income. The Senate bill is simpler and less generous: It cuts the effective tax rate on pass-throughs to 34.9 percent. On average, they would still pay lower taxes than corporations. But the exceptions, and the fact that the proposed corporate rate of 20 percent looks lower, have generated claims that pass-throughs are getting a raw deal, especially in the Senate bill.

The House and Senate differ as well in how much they cut middle-class taxes and how they do it. Both bills cut some income-tax rates, increase the standard deduction, and expand the tax credit for children. The increased standard deduction benefits people who do not itemize their deductions and thereby encourages people not to itemize. As a result, it reduces the impact of deductions, such as the one for mortgage interest — a fact that has enraged the lobbies for realtors and home-builders and pleased most economists.

Federal entitlement programs are a worse deal for parents than for non-parents: The first group contributes more to them, since they both pay taxes and raise future contributors, but gets no extra payments in return. The child credit partly offsets this feature of the welfare state. But there’s a catch in the House bill. It expands the child credit from $1,000 to $1,600 per child. It also abolishes the personal and dependent exemption, however, and the net effect of these two changes is a wash for families in the middle of the income distribution (and a loss for those slightly above it). The Senate bill includes real tax relief for parents, especially of large families: It expands the credit to $2,000 per child.

While polls show that the child-credit expansion is the most popular element of the bills, it has generated some controversy on the right. The editors of the Wall Street Journal have long objected in principle to the existence of the child credit. They view it as a special favor to an interest group akin to giving a tax break for skiers or pet owners. They recently advised Senate Republicans to amend their bill to include a smaller child credit and larger tax-rate reductions for couples who make more than a million dollars a year. That advice carries such obvious political hazards that it will probably not be taken.

Whatever form the tax-cutting takes, it will reduce future tax revenue. Increased economic growth may shrink but cannot plausibly prevent at least some fall in revenue. Estimates of how much revenue will fall vary. Under rules Congress has adopted, before the legislation can proceed, the Joint Committee on Taxation has to find that the legislation will cause revenue to fall by no more than $1.5 trillion over the next decade.

If the legislation hits that mark, its size will be in the vicinity of the tax cut that President George W. Bush signed in 2001. The economy was smaller back then, so it might be said that Republicans have gotten a little more restrained in their tax-cutting over time. Perhaps the imminent increase in federal debt owing to Baby Boomer retirements is inhibiting them. Republicans are certainly more restrained than their presidential candidates were during the primaries. They touted plans that they claimed would cut revenues by $4 trillion, $6 trillion, and even $11 trillion.

Republicans still want to cut taxes by a lot more than $1.5 trillion. They are using three methods to fit large tax cuts into their revenue target. The first is to raise some taxes. They are abolishing the personal and dependent exemption, as noted earlier. Most controversially, they are going after the deduction for state and local taxes. The House bill would shrink that deduction, the Senate bill end it altogether. Conservatives have often criticized that deduction for encouraging states to have higher taxes than they otherwise would. Since the chief beneficiaries of the deduction live in high-tax states with a lot of Democratic governments and voters, Republicans consider ending it an attractive way to raise money.

A second method, found in the Senate bill, is to end the “individual mandate” feature of Obamacare. The Congressional Budget Office has long believed that fines for people without insurance are a powerful inducement for people to sign up for it. That’s the main reason the CBO found that Republican health-care bills from earlier this year would have caused large losses of coverage — a finding that did a lot to sink those bills. Senate Republicans decided that this time they would make the CBO’s views work in their favor. The CBO thinks that without the fines, fewer people will join Medicaid or seek tax credits to buy policies on Obamacare’s exchanges. The net effect, in the CBO’s model, is to save the federal government $318 billion over ten years.

A third method is to phase in some tax cuts and make others temporary. The Senate bill phases in the reduction in the corporate-tax rate but makes it permanent. Changes to the individual tax code would expire. Republicans are getting dinged for this feature of their bill, with critics saying it proves they care more about corporations than people. (The bill’s kinder treatment of investment write-offs is also temporary, but the critics dwell less on that.) Republicans designed their bill this way, though, largely because they think that their tax cuts for individuals will prove popular enough that future Congresses will be very likely to extend them.

Methods two and three fall into a bipartisan tradition of budget gimmicks that mask the fiscal impact of legislation. If the CBO’s faith in the power of the individual mandate is exaggerated, as it likely is, the savings will be much smaller than Republicans are now claiming. Counting on the extension of temporary tax cuts amounts to making future Congresses pay the political price for today’s promises, or to letting revenues fall further than advertised.

The major Democratic complaints about the bills are, as always with Republican tax cuts, that they would swell the deficit and disproportionately benefit the rich. Many of the bills’ provisions would directly benefit the highest earners. Both bills go after the estate tax, which is unpopular and has long been a target of supply-siders: The House bill abolishes it, the Senate one raises its already-high exemption levels. Both bills would abolish the alternative minimum tax. Both bills cut tax rates on income between $470,000 and $1 million (for couples). The Senate bill slightly reduces tax rates for even higher incomes. Cutting corporate taxes will very likely benefit high earners disproportionately, although how disproportionately is hotly disputed.

Democrats have not been above exaggerating how skewed the Republican bills are. Senate Republicans helped them exaggerate it when they put an end to the Obamacare fines in their bill. If people with low and moderate incomes go without health insurance once they can do so without being fined, they will not get tax credits; and that shows up in some official projections as a tax increase. Thus Democrats can say that the estimates show that millions of middle-class families will face a tax increase while owners of large estates see their taxes slashed.

By some measures, the Senate bill would actually make the tax code more progressive: The Joint Committee on Taxation finds that millionaires would be paying a larger share of the tax burden. But the Democratic criticisms are not entirely baseless. The bills would raise more revenue, tilt less toward the rich, and sacrifice almost nothing in terms of economic growth if they refrained from cutting tax rates for people earning in the high six figures. People in that income range would still, in most cases, benefit from the business-tax cuts. For that matter, the business-tax cuts could themselves be smaller while still being a pro-growth step. Allowing the child credit to apply against payroll taxes would yield more middle-class tax relief, especially for those in the lower middle class.

But the concerns about the deficit ought to be put in the context of a federal government that is projected to take in $43 trillion over the next ten years and that will have to reform entitlement programs if it is to keep its debts manageable. If the final legislation looks like the Senate bill — which improves the tax structure so that the burden of the federal government falls less on both business and parental investment, and so that state and local governments are less encouraged to create burdens — then the trade-off of a higher deficit will be worth it.

It will, indeed, be the biggest conservative legislative victory in D.C. in more than a decade. As sad as it is to say so.

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