The Trump administration released on September 27 its proposed tax plan. It was exceedingly skimpy (only nine pages long, including the title page, and with all the white space could have been presented on half that number of pages). Importantly, it was explicitly vague on many of the measures, such as what tax loopholes would be closed to partially pay for the tax cuts (simply saying they would do this somehow). One can, however, examine measures that were explicitly presented, and from these it is clear that this is primarily a plan for massive tax cuts for the rich.
It is also clear that this is not a tax reform. A tax reform would be revenue neutral. The measures proposed would not be. And a reform would focus on changes in the structure of the tax system. There is little of that here, but rather proposals to cut various tax rates (including in several cases to zero), primarily for the benefit of those who are well off.
One can see this in the way the tax plan was approached. In a true tax reform, one would start by examining the system, and whether certain deductions and tax exemptions are not warranted by good policy (but rather serve only certain vested interests). Closing such loopholes would lead to higher revenues being collected. One would then determine what the new tax rates could be (i.e. by how much they could be cut) to leave the overall level of tax collection the same.
But that was not done here. Rather, they start with specific proposals on what the new tax rates “should” be (12%, 25%, and 35% for individuals, and 20% for corporations), and then make only vague references to certain, unspecified, deductions and tax exemptions being eliminated or reduced, in order not to lose too much in revenues (they assert). They have the process backward.
And it is clear that these tax cuts, should they be enacted by Congress, would massively increase the fiscal deficit. While it is impossible to come up with a precise estimate of how much the tax plan would cost in lost revenues, due to the vagueness on the parameters and on a number of the proposals, Republicans have already factored into the long-term budget a reduction in tax revenues of $1.5 trillion over ten years. And estimates of the net cost of the Trump plan range from a low of $2.2 trillion over ten years ($2.7 trillion when additional interest is counted, as it should be), to as high as $5 trillion over ten years. No one can really say as yet, given the deliberate lack of detail.
But any of these figures on the cost are not small. The total federal debt held by the public as of the end of September, 2017, was $14.7 trillion. The cost in lost revenue could equal more than a third of this. Yet Republicans in Congress blocked the fiscal expenditures we desperately needed in the years from 2010 onwards during the Obama years, when unemployment was still high, there was excess capacity in our underutilized factories, and the country needed to rebuild its infrastructure (as we still do). The argument then was that we could not add to our national debt. But now the same politicians see no problem with adding massively to that debt to cover tax cuts that will primarily benefit the rich. The sheer hypocrisy is breath-taking.
Not surprisingly, Trump officials are saying that there will be no such cost due to a resulting spur to our economic growth. Trump himself asserted that his tax plan would lead the economy to grow at a 6% pace. No economist sees this as remotely plausible. Even Trump’s economic aides, such as Gary Cohn who was principally responsible for the plan, are far more cautious and say only that the plan will lead to growth of “substantially over 3 percent”. But even this has no basis in what has been observed historically after the Reagan and Bush tax cuts, nor what one would expect from elementary economic analysis.
The lack of specificity in many of the proposals in the tax plan issued on September 27 makes it impossible to assess it in full, as major elements are simply only alluded to. For example, it says that a number of tax deductions (both personal and corporate) will be eliminated or reduced, but does not say which (other than that they propose to keep the deductions for home mortgage interest and for charity). As another example, the plan says the number of personal income tax brackets would be reduced from seven currently to just three broad ones (at 12%, 25%, and 35%), but does not say at what income levels each would apply. Specifics were simply left out.
For a tax plan where work has been intensively underway for already the eight months of this administration (and indeed from before, as campaign proposals were developed), such vagueness must be deliberate. The possible reasons include: 1) That the specifics would be embarrassing, as they would make clear the political interests that would gain or lose under the plan; 2) That revealing the specifics would spark immediate opposition from those who would lose (or not gain as others would); 3) That revealing the specifics would make clear that they would not in fact suffice to achieve what the Trump administration is asserting (e.g. that ending certain tax deductions will make the plan progressive, or generate revenues sufficient to offset the tax rate cuts); and/or 4) That they really do not know what to do or what could be done to fix the issue.
One can, however, look at what is there, even if the overall plan is incomplete. This blog post will do that.
B. Personal Income Taxes
The proposals are (starting with those which are most clear):
a) Elimination of the Estate Tax: Only the rich pay this. It only applies to estates given to heirs of $10.98 million or more (for a married couple). This only affects the top 0.2%, most wealthy, households in the US.
b) Elimination of the Alternative Minimum Tax: This also only applies to those who are rich enough for it to apply and who benefit from a range of tax deductions and other benefits, who would otherwise pay little in tax. It would be better to end such tax deductions and other special tax benefits that primarily help this group, thus making the Alternative Minimum Tax irrelevant, than to end it even though it had remained relevant.
c) A reduction in the top income tax rate from 39.6% to 35%: This is a clear gain to those whose income is so high that they would, under the current tax brackets, owe tax at a marginal rate of 39.6%. But this bracket only kicks in for households with an adjusted gross income of $470,700 or more (in 2017). This is very close to the minimum income of those in the top 1% of the income distribution ($465,626 in 2014), and the average household income of those in that very well-off group was $1,260,508 in 2014. Thus this would be a benefit only to the top 1%, who on average earn over $1 million a year.
The Trump plan document does include a rather odd statement that the congressional tax-writing committees could consider adding an additional, higher, tax bracket, for the very rich, but it is not at all clear what this might be. They do not say. And since the tax legislation will be written by the congressional committees, who are free to include whatever they choose, this gratuitous comment is meaningless, and was presumably added purely for political reasons.
d) A consolidation in the number of tax brackets from seven currently to just three, of 12%, 25%, and 35%: Aside from the clear benefit to those now in the 39.6% bracket, noted above, one cannot say precisely what the impact the new tax brackets would have for the other groups since the income levels at which each would kick in was left unspecified. It might have been embarrassing, or contentious, to do so. But one can say that any such consolidation would lead to less progressivity in the tax system, as each of the new brackets would apply to a broader range of incomes. Instead of the rates rising as incomes move up from one bracket to the next, there would now be a broader range at which they would be kept flat. For example, suppose the Trump plan would be for the new 25% rate to span what is now taxed at 25% or 28%. That range would then apply to household incomes (for married couples filing jointly, and in 2017) from $75,900 on the low end to $233,350 at the high end. The low-end figure is just above the household income figure of $74,869 (in 2016) for those reaching the 60th percentile of the income distribution (see Table A-2 of this Census Bureau report), while the top-end is just above the $225,251 income figure for those reaching the 95th percentile. A system is not terribly progressive when those in the middle class (at the 60th percentile) pay at the same rate as those who are quite well off (in the 95th percentile).
e) A ceiling on the tax rate paid on personal income received through “pass-through” business entities of just 25%: This would be one of the more regressive of the measures proposed in the Trump tax plan (as well as one especially beneficial to Trump himself). Under current tax law, most US businesses (95% of them) are incorporated as business entities that do not pay taxes at the corporate level, but rather pass through their incomes to their owners or partners, who then pay tax on that income at their normal, personal, rates. These so-called “pass-through” business entities include sole proprietorships, partnerships, Limited Liability Companies (LLCs), and sub-chapter S corporations (from the section in the tax code). And they are important, not only in number but also in incomes generated: In the aggregate, such pass-through business entities generate more in income than the traditional large corporations (formally C corporations) that most people refer to when saying corporation. C corporations must pay a corporate income tax (to be discussed below), while pass-through entities avoid such taxes at the company level.
The Trump tax plan would cap the tax rate on such pass-through income at 25%. This would not only create a new level of complexity (a new category of income on which a different tax is due), but would also only be of benefit to those who would otherwise owe taxes at a higher rate (the 35% bracket in the Trump plan). If one were already in the 25% bracket, or a lower one, that ceiling would make no difference at all and would be of no benefit. But for those rich enough to be in the higher bracket, the benefit would be huge.
Who would gain from this? Anyone who could organize themselves as a pass-through entity (or could do so in agreement with their employer). This would include independent consultants; other professionals such as lawyers, lobbyists, accountants, and financial advisors; financial entities and the partners investing in private-equity, venture-capital, and hedge funds; and real estate developers. Trump would personally benefit as he owns or controls over 500 LLCs, according to Federal Election Commission filings. And others could reorganize into such an entity when they have a tax incentive to do so. For example, the basketball coach at the University of Kansas did this when Kansas created such a loophole for what would otherwise be due under its state income taxes.
f) The tax cuts for middle-income groups would be small or non-existent: While the Trump tax proposal, as published, repeatedly asserts that they would reduce taxes due by the middle class, there is little to suggest in the plan that that would be the case. The primary benefit, they tout (and lead off with) is a proposal to almost double the standard deduction to $24,000 (for a married couple filing jointly). That standard deduction is currently $12,700. But the Trump plan would also eliminate the personal exemption, which is $4,050 per person in 2017. Combining the standard deduction and personal exemptions, a family of four would have $28,900 of exempt income in 2017 under current law ($12,700 for the standard deduction, and personal exemptions of four times $4,050), but only $24,000 under the Trump plan. They would not be better off, and indeed could be worse off. The Trump plan is also proposing that the child tax credit (currently a maximum of $1,000 per child, and phased out at higher incomes) should be raised (both in amount, and at the incomes at which it is phased out), but no specifics are given so one cannot say whether this would be significant.
g) Deduction for state and local taxes paid: While not stated explicitly, the plan does imply that the deduction for state and local taxes paid would be eliminated. It also has been much discussed publicly, so leaving out explicit mention was not an oversight. What the Trump plan does say is the “most itemized deductions” would be eliminated, other than the deductions for home mortgage interest and for charity.
Eliminating the deduction for state and local taxes appears to be purely political. It would adversely affect mostly those who live in states that vote for Democrats. And it is odd to consider this tax deduction as a loophole. One has to pay your taxes (including state and local taxes), or you go to jail. It is not something you do voluntarily, in part to benefit from a tax deduction. In contrast, a deduction such as for home mortgage interest is voluntary, one benefits directly from buying and owning a nice house, and such a deduction benefits more those who are able to buy a big and expensive home and who qualify for taking out a large mortgage.
h) Importantly, there was much that was not mentioned: One must also keep in mind what was not mentioned and hence would not be changed under the Trump proposals. For example, no mention was made of the highly favorable tax rates on long-term capital gains (for assets held one year or more) of just 20%. Those with a high level of wealth, i.e. the wealthy, gain greatly from this. Nor was there any mention of such widely discussed loopholes as the “carried interest” exception (where certain investment fund managers are able to count their gains from the investment deals they work on as if it were capital gains, rather than a return on their work, as it would be for the lawyers and accountants on such deals), or the ability to be paid in stock options at the favorable capital gains rates.
C. Corporate Income Taxes
More than the tax cuts enacted under Presidents Reagan and Bush, the Trump tax plan focuses on cuts to corporate income (profit) taxes. Proposals include:
a) A cut in the corporate income tax rate from the current 35% to just 20%: This is a massive cut. But it should also be recognized that the actual corporate income tax paid is far lower than the headline rate. As noted in an earlier post on this blog, the actual average rate paid has been coming down for decades, and is now around 20%. There are many, perfectly legal, ways to circumvent this tax. But setting the rate now at 20% will not mean that taxes equal to 20% of corporate profits will be collected. Rather, unless the mechanisms used to reduce corporate tax liability from the headline rate of 35% are addressed, those mechanisms will be used to reduce the new collections from the new 20% headline rate to something far less again.
b) Allow 100% of investment expenses to be deducted from profits in the first year, while limiting “partially” interest expense on borrowing: This provision, commonly referred to as full “expensing” of investment expenditures, would reduce taxable profits by whatever is spent on investment. Investments are expected to last for a number of years, and under normal accounting the expense counted is not the full investment expenditure but rather only the estimated depreciation of that investment in the current year. However, in recent decades an acceleration in what is allowed for depreciation has been allowed in the tax code in order to provide an additional incentive to invest. The new proposal would bring that acceleration all the way to 100%, which as far as it can go.
This would provide an incentive to invest more, which is not a bad thing, although it still would also have the effect of reducing what would be collected in corporate income taxes. It would have to be paid for somehow. The Trump proposal would partially offset the cost of full expensing of investments by limiting “partially” the interest costs on borrowing that can be deducted as a cost when calculating taxable profits. The interest cost of borrowing (on loans, or bonds, or whatever) is currently counted in full as an expense, just like any other expense of running the business. How partial that limitation on interest expenses would be is not said.
But even if interest expenses were excluded in full from allowable business expenses, it is unlikely that this would come close to offsetting the reduction in tax revenues from allowing investment expenditures to be fully expensed. As a simple example, suppose a firm would make an investment of $100, in an asset that would last 10 years (and with depreciation of 10% of the original cost each year). For this investment, the firm would borrow $100, on which it pays interest at 5%. Under the current tax system, the firm in the first year would deduct from its profits the depreciation expense of $10 (10% of $100) plus the interest cost of $5, for a total of $15. Under the Trump plan, the firm would be able to count as an expense in the first year the full $100, but not the $5 of interest. That is far better for the firm. Of course, the situation would then be different in the second and subsequent years, as depreciation would no longer be counted (the investment was fully expensed in the first year), but it is always better to bring expenses forward. And there likely will be further investments in subsequent years as well, keeping what counts as taxable profits low.
c) Tax amnesty for profits held abroad: US corporations hold an estimated $2.6 trillion in assets overseas, in part because overseas earnings are not subject to the corporate income tax until they are repatriated to the US. Such a provision might have made sense decades ago, when information systems were more primitive, but does not anymore. This provision in the US tax code creates the incentive to avoid current taxes by keeping such earnings overseas. These earnings could come from regular operations such as to sell and service equipment for foreign customers, or from overseas production operations. Or such earnings could be generated through aggressive tax schemes, such as from transferring patent and trademark rights to overseas jurisdictions in low-tax or no-tax jurisdictions such as the Cayman Islands. But whichever way such profits are generated, the US tax system creates the incentive to hold them abroad by not taxing them until they are repatriated to the US.
This is an issue, and could be addressed directly by changing the law to make overseas earnings subject to tax in the year the earnings are generated. The tax on what has been accumulated in the past could perhaps be spread out equally over some time period, to reduce the shock, such as say over five years. The Trump plan would in fact start to do this, but only partially as the tax on such accumulated earnings would be set at some special (and unannounced) low rates. All it says is that while both rates would be low, there would be a lower rate applied if the foreign earnings are held in “illiquid” assets than in liquid ones. Precisely how this distinction would be defined and enforced is not stated.
This would in essence be a partial amnesty for capital earnings held abroad. Companies that have held their profits abroad (to avoid US taxes) would be rewarded with a huge windfall from that special low tax rate (or rates), totalling in the hundreds of billions of dollars, with the precise gain on that $2.6 trillion held overseas dependant on how low the Trump plan would set the tax rates on those earnings.
It is not surprising that US corporations have acted this way. There was an earlier partial amnesty, and it was reasonable for them to assume there would be future ones (as the Trump tax plan is indeed now proposing). In one of the worst pieces of tax policy implemented in the George W. Bush administration, an amnesty approved in 2004 allowed US corporations with accumulated earnings abroad to repatriate that capital at a special, low, tax rate of just 5.25%. It was not surprising that the corporations would assume this would happen again, and hence they had every incentive to keep earnings abroad whenever possible, leading directly to the $2.6 trillion now held abroad.
Furthermore, the argument was made that the 2004 amnesty would lead the firms to undertake additional investment in the US, with additional employment, using the repatriated funds. But analyses undertaken later found no evidence that that happened. Indeed, subsequent employment fell at the firms that repatriated accumulated overseas earnings. Rather, the funds repatriated largely went to share repurchases and increased dividends. This should not, however, have been surprising. Firms will invest if they have what they see to be a profitable opportunity. If they need funds, they can borrow, and such multinational corporations generally have no problem in doing so. Indeed, they can use their accumulated overseas earnings as collateral on such loans (as Apple has done) to get especially low rates on such loans. Yet the Trump administration asserts, with no evidence and indeed in contradiction to the earlier experience, that their proposed amnesty on earnings held abroad will this time lead to more investment and jobs by these firms in the US.
d) Cut to zero corporate taxes on future overseas earnings: The amnesty discussed above would apply to the current stock of accumulated earnings held by US corporations abroad. Going forward, the Trump administration proposes that earnings of overseas subsidiaries (with ownership of as little as 10% in those firms) would be fully exempt from US taxes. While it is true that there then would be no incentive to accumulate earnings abroad, the same would be the case if those earnings would simply be made subject to the same current year corporate income taxes as the US parent is liable for, and not taxable only when those earnings are repatriated.
It is also not at all clear to me how exempting these overseas earnings from any US taxes would lead to more investment and more jobs in the US. Indeed, the incentive would appear to me to be the opposite. If a plant is sited in the US and used to sell product in the US market or to export it to Europe or Asia, say, earnings from those operations would be subject to the regular US corporate income taxes (at a 20% rate in the Trump proposals). However, if the plant is sited in Mexico, with the production then sold in the US market or exported from there to Europe or Asia, earnings from those operations would not be subject to any US tax. Mexico might charge some tax, but if the firm can negotiate a good deal (much as firms from overseas have negotiated such deals with various states in the US to site their plants in those states), the Trump proposal would create an incentive to move investment and jobs to foreign locations.
The Trump administration’s tax plan is extremely skimpy on the specifics. As one commentator (Allan Sloan) noted, it looks like it was “written in a bar one evening over a batch of beers for a Tax 101 class rather than by serious people who spent weeks working with tax issues”.
It is, of course, still just a proposal. The congressional committees will be the ones who will draft the specific law, and who will then of necessity fill in the details. The final product could look quite different from what has been presented here. But the Trump administration proposal has been worked out during many months of discussions with the key Republican leaders in the House and the Senate who will be involved. Indeed, the plan has been presented in the media not always as the Trump administration plan, but rather the plan of the “Big Six”, where the Big Six is made up of House Speaker Paul Ryan, Senate Majority Leader Mitch McConnell, House Ways and Means Committee Chairman Kevin Brady, Senate Finance Committee Chairman Orrin Hatch, plus National Economic Council Director Gary Cohn and Treasury Secretary Steven Mnuchin of the Trump administration. If this group is indeed fully behind it, then one can expect the final version to be voted on will be very similar to what was outlined here.
But skimpy as it is, one can say with some certainty that the tax plan:
a) Will be expensive, with a ten-year cost in the trillions of dollars;
b) Is not in fact a tax reform, but rather a set of very large tax cuts;
and c) Overwhelmingly benefits the rich.