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Two Cheers for Tax Reform

The recently announced tax reform package is one of the few serious and intelligent proposals offered by House Republicans in years. Not surprisingly, however, everyone seems to hate it. Defenders no less than critics of the plan seem incapable of thinking about tax policy outside of the simplistic framework of Reaganomics. As a result, most commentary on the proposal ignores the real issues at stake. The bill could certainly be better, but improving it would mostly mean adding provisions to strengthen the spirit of the existing proposal. At any rate, it is an improvement over the status quo.

Personal Taxes

The Right’s free market fundamentalists are appalled that the plan does not include massive personal rate cuts for the wealthy. These ideologues cling to the discredited notion that lowering marginal rates for high earners invariably produces economic expansion. They want another round of the Bush tax cuts, even though the upward wealth redistribution resulting from those policies failed to generate sustainable economic growth. In fact, Bush’s policies further incentivized (or at least did nothing to disincentivize) one of the worst misallocations of capital in history—the housing bubble—that occurred during his presidency.

To some degree, this confusion on the right may be understandable because the plan’s proponents often attempt to sell it as a conventional conservative tax cut, even trotting out the old canard that taxpayers will be able to file returns on a postcard. (Was this lame rhetorical device even compelling before the era of apps and e-file?) The most frequently touted aspects of the plan—the increased standard deduction and the expanded child tax credit—offer less of a benefit than advertised, because they are partially offset by the removal of personal and dependent exemptions. Some high-income people—especially singles in high-tax states—will face a reduction in after-tax income. The true benefits of the plan do not result from simply cutting taxes.

Meanwhile, the Democrats’ attacks mostly miss the real strengths and weaknesses of the proposal. Many of their criticisms are patently dishonest. Senator Chuck Schumer even wrote a pathetic op-ed claiming the plan was not Reaganite enough! More importantly, these opponents of the bill offer nothing to improve what is currently on the table. The existing proposal, of course, is not perfect. Legitimate criticisms can be made, as I will discuss below, but the Democrats’ total opposition to any change from the status quo betrays the party’s true motive—preserving the privileges of its own elite constituencies.

Democratic complaints fall into a few broad categories: First, the plan will add to the budget deficit. Such deficit alarmism has become a predictable prop in American political theatre. Both parties use it against their opponents’ programs and ignore it when it cuts against their own. Yet the self-proclaimed party of the Left should know better than anyone that the U.S. deficit, under the current monetary system, is not analogous to personal deficits.

House Minority Leader Nancy Pelosi has also argued that the plan “ransack[s] all the middle class benefits” and constitutes a giveaway to the wealthy “at the expense of the great middle class.” Either Pelosi is incapable of simple math, or she has no respect for her audience. The new rate schedule and increased standard deduction more than compensate for the benefits and deductions eliminated from the current code, at least for lower- and middle-income taxpayers. Anyone with an annual income of less than, say, $150,000 will almost certainly benefit, however slightly, unless they own a home that they cannot really afford even under the existing regime. One can concoct exotic scenarios, or implausibly assume that Republicans will let the child tax credit expire in 2023 with no other changes, to make the calculations look bad. But the real weaknesses of the bill have nothing to do with middle class deductions.

Objections against the removal of line-item benefits are almost entirely disingenuous. The student-loan interest deduction, for example, is worth a maximum of $625 at present and is phased out at $80,000 of income (for singles). Virtually everyone at that level of income will save more from the other changes. And subsidizing student-loan debt has already proven to be a highly counterproductive means of improving access to education, anyway. In the same vein, eliminating the medical expenses deduction could be harmful to some. But, again, the solution to this problem is adopting a sensible universal healthcare policy, not inflating medical costs through tax benefits. Removing both of these subsidies does not, in itself, solve the problems related to soaring medical and education costs. But these problems will never be solved through the tax code, and removing them from it is a step in the right direction.

The real issue is the elimination of the option to deduct state and local income taxes, and the limitations imposed on property tax and mortgage interest deductions, which constitute by far the most significant changes in the personal tax code. These changes adversely affect high-income people in high tax jurisdictions—especially single professionals in coastal megacities. These will be the real “losers” if the plan is adopted. Lower-income people in these places will probably have no problem remaining under the new deduction thresholds.

Now the fact that single urban professionals overwhelmingly vote Democratic surely did not escape the notice of the bill’s Republican designers. Yet the Democrats cannot candidly defend this constituency, which would force them to admit that they are the party of investment bankers, corporate lawyers, consultants, and executives. Hence the misdirection. For the same ideological reasons, these voters probably cannot openly advocate for their economic interests themselves. After all, they are caring progressives.

At the very least, then, the plan is politically astute, but does it serve any larger purpose? For my own part, I think it does. High tax states and localities are generally the wealthiest—a fact which might give conservative economic theorists pause, but that’s another story—and in my view there is no reason to use the federal tax code to subsidize wealthy people in wealthy places. If people in these areas want to reduce their tax burden, then they can elect state and local politicians to do that. But if they genuinely want more progressive taxes, rather than merely progressive signaling, then they should get what they want.

Conversely, the main beneficiaries of the personal tax code changes are affluent married couples in low-tax states. Typical Republican constituencies, like a wealthy couple in the Houston suburbs, should make out rather well—again, not a surprise. If Democrats were serious about increasing government revenue and making the affluent pay more, then they might argue for reducing the benefits to these groups. This could be achieved by bringing the proposed married couple brackets closer to the current brackets, for example. But it should be obvious that the Democrats do not really have a problem with these tax reductions; they simply do not want their own upper-middle-class donors to lose high state tax deductions in the bargain.

Finally, in my opinion, the personal tax reform proposals should be applauded mainly for their limitations on real estate deductions. Federal real estate subsidies have done little to improve housing affordability and have had many disastrous consequences. Residential real estate is one of the least productive uses of capital imaginable. Reducing the government’s role in propping up real estate values must be managed carefully, but it would likely improve long-term growth prospects and lessen inequality. Eliminating subsidies for expensive “McMansions” or fashionable urban real estate is a start.

Corporate Taxes

The changes to the corporate tax code are far more significant than any changes to personal tax rates. America’s corporate tax rate will go from one of the highest in the developed world to below average. On one hand, lower taxes obviously benefit U.S. businesses and should make the United States a more competitive investment destination. The change reduces, somewhat, the incentive to move capital overseas. The new taxes on foreign capital and some foreign earnings also make it more likely that capital will be deployed in the United States, an outcome that should be encouraged. The only question is whether these measures designed to limit shifting capital overseas are enough, but they are certainly an improvement over doing nothing.

On the other hand, Kevin Hassett’s (chairman of the Council of Economic Advisers) claim that the tax cuts would produce higher wages is as baseless as his 1999 prediction that the Dow index was in the midst of rising to 36,000. In and of itself, the tax cut is unlikely to have much of an impact on wages. Wages and corporate investment have not stagnated because corporations lack capital. Indeed, they are awash in capital, and contrary to what standard economic theory would predict, corporate investment has declined as the cost of capital has fallen in recent decades. Instead, wages and investment have stagnated because the current, financialized economic system penalizes spending on wages and investment and rewards spending on unproductive, “shareholder-friendly” measures like stock buybacks. The proposed alterations to the tax code do not do enough to change those incentives.

These problems of shareholder capitalism are immediately illustrated by comparing corporate profit growth to employee compensation and capital investment in recent years. Contrary to conservative ideology, the only things that have trickled down are recessions.

Thus the Democrats are correct to argue that the main beneficiaries of the contemplated corporate rate cuts would be large shareholders—the wealthy. It does not necessarily follow, however, that the best approach is to do nothing. Indeed, all of the problems discussed above have occurred while corporate taxes have been high. And high corporate taxes combine with shareholder capitalism in pernicious ways—increasing the incentives for offshoring, for example. In short, high corporate taxes, which only tax shareholders indirectly, are one of the least effective ways to tax capital returns or use the tax code for redistribution.

Improving the Proposal

If we are serious about increasing wages and incentivizing productive investment in America, rather than subsidizing financial engineering, then high corporate taxes are not the answer. More competitive corporate tax rates may only be part of the answer, but what else could be done? Rather than simply defend the status quo, what could be offered to make the current proposal better?

First, the main driver of inequality in recent decades is capital gains income, not earned income. I suspect one reason that politicians focus so much attention on earned income rates is because they do not really matter that much for the ultra-wealthy. Still, the House Republicans deserve considerable credit for leaving the net investment income tax—a byproduct of Obamacare—in place. An even more progressive tax on capital gains (and qualified dividends), rather than uncompetitive corporate taxes, would be the most direct way to combat inequality. The usual argument against raising capital gains rates is that it would disincentivize investment. But this is too simplistic, and assumes the government can only use the carrot and not the stick. Fundamentally, investors only have two choices: invest or hold cash, and cash effectively means risk-free instruments like treasuries. Thus, to avoid disincentivizing productive investment, meaningful increases in rates on windfall capital gains may also require greater increases in taxes on other sources of portfolio income, such as interest income, for the wealthiest capital holders.

Another option would be to tax corporate stock repurchases as income at the corporate level. Stock buybacks effectively function as shareholder compensation; there is no reason they should not be taxed accordingly. Investors’ current preference for buybacks reduces the ability of corporations to deploy capital to more productive uses, such as capital equipment, research and development, or labor.

Of course, the U.S. government could not tax foreign corporations engaging in share buybacks. To level the playing field—or simply to incentivize investment at home—additional taxes might be levied on capital gains and portfolio income derived from foreign holdings. Under the proposed system, corporations would be taxed for shifting earnings overseas in certain circumstances; there is no reason this principle should not apply to individuals as well. Those who want to be especially aggressive could add a financial transaction tax, too.

Democrats have also complained about the elimination of the estate tax. Yet as Gary Cohn infamously said, “Only morons pay the estate tax.” For the most part, he is correct—he should know—and the Democratic opposition to repealing the existing estate tax is a charade. Surely Chuck Schumer cannot be so naïve as to think his financially sophisticated donors are paying it. An estate tax is eminently reasonable, but those who want one should not be trying to preserve the current sham system. Rather, they should design a tax that is not so easily avoided.

Republicans deserve to be criticized, however, for failing to eliminate the carried-interest loophole. Although mostly symbolic from a revenue standpoint, there is no theoretical or practical justification for it. One might think that this omission would be a major point of Democratic opposition to the plan, but that would credulously assume that their rhetoric against the financial services industry is sincere. On the other hand, if leaving it intact is enough to keep Republican private equity donors—and Chuck Schumer’s Wall Street base—on board with the broader proposal, then it is probably worth it.

Nevertheless, private equity may be hurt somewhat by the limitations on the corporate debt interest deduction. The plan should be applauded for reducing businesses’ incentives to take on too much debt (especially when much of it is used to fund share buybacks). The proposed limit of 30 percent of income—as opposed to a complete elimination—may be somewhat procyclical, however: as an over-levered company’s operating income falls (due to an economic downturn, for example), its deduction will also decrease. On the other hand, if the consequence is to increase volatility in high-yield markets, many institutional investment managers will be thrilled.

At the same time, some of their partners will benefit from reductions in passive pass-through income, but these changes simply bring pass-through entities into line with the new corporate rates. The egregious loopholes some feared were closed. Active owners of pass-through corporations are unlikely to experience any meaningful advantage or disadvantage versus the present system.

One investor class—large university endowments—is specifically penalized, however, and the tax on these endowments should be cheered. The goal should be to tax idle and unproductive capital—whether on corporate balance sheets overseas, overpriced real estate, large personal estates, or shareholder compensation through financial engineering. The wealthiest universities are no exception. There is no reason for the government to subsidize what are effectively non-profit funds of hedge funds. Universities should use their wealth to offer education to more people, hire more professors, compensate their graduate students reasonably, and invest in research facilities. To strengthen this provision, lawmakers should prevent avoidance of the tax via increasing spending on administration, luxury real estate and dormitories, and athletic stadiums.

Conclusions

In sum, the new tax proposal does not fix every economic problem—no such proposal could—but it aims in the right directions on many of them. If opponents want to strengthen the plan to further incentivize productive investment in the United States and disincentivize financial engineering, all for the better. But opposition to the plan, in toto, on behalf of the status quo is disingenuous and in some ways regressive. Whatever problems the proposed plan does not correct, the current system also fails to address, and it often makes them worse. The greatest concern should be that conservative ideologues, Democratic partisans, and real estate special interests combine to weaken the current bill. If they are going to do so, however, they should be forced to state their motivations candidly—not be allowed to hide behind “the middle class.”

For decades, the debate over tax policy has been center stage in a ridiculous melodrama. The Republicans offer a secularized version of the prosperity gospel. The Democrats promote neoliberal financialization under the guise of progressivism. The Democrats have typically been more effective, because they appeal to affluent voters’ pocket books while satisfying their moral vanity. Even today, many critics—and some advocates—of the reform proposal seem to prefer remaining within this failed paradigm. But the results—low growth combined with rising inequality—speak for themselves. Whether by accident or design, the House proposal takes steps to remedy a number of problems. It could be better, but even in the present form it deserves two cheers, which is two more than we have come to expect in recent times.

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