– November 3, 2017

The House GOP leadership have released their much-awaited tax reform plan. Hoping to send it to President Donald Trump before year’s end, they have pinned most of their political agenda on it for next year’s mid-term elections.

The Republicans understandably want something to show voters. At the same time, their thirst for short-term political gains could end up costing the US economy in the long term. What Republicans tout as the plan’s biggest merits could turn out to be a big stumbling block.

As always, the devil is in the details of the tax plan, reported accordingly by ZeroHedge and Business Insider:

  • Lower individual tax rates; for married filing jointly: 12 percent up to $90,000; 25 percent up to $260,000; 35 percent up to $1 million; and the current 39.6 percent above $1 million;
  • increased standard deduction from $12,700 to $24,000 for married couples;
  • a new Family Credit adds $600 to the existing $1,000 Child Tax Credit;
  • cuts home mortgage interest deduction for new loans from $1 million to $500,000;
  • a lower corporate tax rate, down from 35 percent to 20 percent.

The Earned Income Tax Credit remains; together, higher deduction, the EITC, and the new Family Credit allow a two-child family to earn $44,000 without paying any federal income taxes.

Higher income earners have less to expect from the plan. All other things equal, a family of four making $100,000 would see their tax burden go down by roughly one third, from having to pay 15.2 percent of their income in taxes under today’s system, to 10.4 percent under the Republican plan. However, if the same family made $500,000 they would only see their total tax burden go down from 26 percent to 22 percent.

When the cut in the mortgage deduction is added, the net effect could be a de facto tax increase for those who earn the highest incomes.

From a macroeconomic viewpoint, this is not good. On the one hand, the tax reform fails to incentivize higher earners to be even more productive; on the other hand, it also increases the federal government’s reliance on those high-income filers for its tax revenue. Since many small business owners file their taxes as individuals, this tax plan does nothing to encourage them to grow their businesses. Similarly, it fails to give high-end professionals a reason to be more productive.

Granted, there is a fairly large segment of taxpayers below the highest incomes whose tax burden will go down. At the same time, the work disincentives that exist for the highest earners are not the only ones in this reform. The EITC, the increase in the standard deduction, and the new Family Credit coalesce into a steep marginal-tax step for low-income families.

Already today, the EITC encourages low-income families to stay where they are financially. As I demonstrate in my book The Rise of Big Government (ch. 2, pp. 16-18), the EITC can drive up the marginal tax on a $30,000 income to the same rate paid on incomes exceeding $400,000. With the higher deduction and the Family Credit, the Republican tax plan exacerbates the marginal-tax effect for low-income workers.

It is difficult to tell if the reform, on balance, will be positive or negative for economic growth. The substantial cut in corporate income taxes could be the tie breaker. At the same time, while encouraging corporations to grow and invest in the US economy, that cut also conspires with the steeper individual income-tax ladder into driving more high-income earners away from work-based income. Instead, they are encouraged to rely more on dividends and capital gains (the taxation of which is ostensibly left untouched in the new reform).

By encouraging high-income taxpayers to earn more of their living from capital-based income, as opposed to work-based, the tax plan slowly moves federal tax revenue in a more unstable direction. With 80 cents of every tax revenue dollar originating in personal income, Congress should be careful not to destabilize that substantial tax base. Yet by indirectly incentivizing a drift away from work-based earnings, and by further concentrating the tax base to high earners, the tax plan could both destabilize earnings and put a dent in economic growth.

Image: Speaker Paul Ryan.


Sven Larson, PhD

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