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The Challenges of Tax Reform

Financial markets are not noted for sentimentality, but potential tax reform seems to be an exception. Investors appear to hold high hopes for the recent Trump tax plan, with expectations exceeding the reality of the likely results of the reform process. The U. S. tax system is justly criticized for its complexity with statues and regulations amounting to thousands of pages that can only be interpreted by accountants and lawyers. In contrast, the Trump plan is a one-page bullet-point document only slightly longer than his usual 140-character tweets.

Despite its brevity, the plan is ambitious both in the size of the proposed tax cuts and the structural changes proposed. While conciseness may be a sign of careful planning with the distillation of key ideas, this does not seem to be the case here where the Trump plan was issued with no background or clarifying material and without apparent Congressional support. Contrast this with the last major successful tax reform in 1986. This process began with a massive three-volume background analysis of the existing tax system that eventually resulted in detailed reform plans. In 1986, there was engagement with both Democratic and Republican leaders in Congress. The reform was also undertaken with considerable discipline where revenue was to be held constant with tax reductions offset by other increases.

The challenges of the Trump reform plan begin in the memo's subheading that touts it as "The Biggest Individual and Business Tax Cut in American History." While tax cuts can be used to promote economic growth, the U. S. economy now is near full employment while generating an annual half-trillion deficit that would likely double if the Trump plan were enacted, leading to a potentially unsustainable growth in public debt. While the cuts might stimulate faster economic growth, research suggests that such growth would not offset the revenue losses from lower rates.

Despite these negatives, the Trump plan does contain good ideas that have considerable support, most notably in the area of business tax reform. The U. S. corporate tax rate (along with state corporate rates) is the highest in the world, not because the U. S. has increased its rates, but because other nations have cut theirs. In addition, U. S. laws unlike most of the rest of the world make it costly for U. S. companies to repatriate their foreign profits. Such corporate changes may not accrue just to upper income taxpayers because of the complexity of the incidence of the corporate tax.

Unfortunately, the Trump tax plan does not stop with corporate changes as it also proposes a top business tax rate for non-corporate businesses that is less than one-half the proposed 35 percent top income tax rate for other income. This creates a huge potential loophole where businesses could rearrange their affairs by reclassifying labor earnings as profit with a halving of the tax rate. For example, service providers who own their own business such as lawyers, architects, engineers, accountants, doctors, and dentists would be encouraged to lower their own salaries thus converting labor income into business profit to capture the 15 percent business rate. A young physician employed at a clinic might well be taxed at a higher rate than older owners of the clinic.

The Trump plan proposes the elimination of some tax subsidies such as the deductibility of state and local taxes, but would continue the deductibility of mortgage interest and charitable donations. These remaining preferences would accrue largely to high income taxpayers who have high marginal tax rates.

Given these problems, tax reform is far from certain. As demonstrated with the efforts to eliminate the Affordable Care Act, it is not enough to have a majority who are unhappy with the current system. Assembling a majority in favor of the replacement is much more difficult.