Americans spend $400 billion dollars per year to comply with the tax code. Americans also dedicate 9 billion hours of labor to comply with the current tax code. Beyond costly compliance, the current tax code distorts investment and work decisions in the economy. Something needs to be done to simplify the tax code and make it pro-growth.
President Trump just released plans for a tax cut for both businesses and individuals. The plan would change how a large portion of business income in the United States is taxed. It would also support bringing home corporate profits now sitting overseas. One unfortunate effect would be a dramatic rise in the federal budget deficit and national debt.
The United States currently has the third-highest corporate tax rate in the world and the highest rate among developed nations. President Trump’s tax plan would slash the rate from 35 percent to just 15 percent. Corporations would have more money to hire workers and make capital investments. Lower corporate tax rates would make U.S. businesses more competitive in global markets and reduce the incentive to avoid paying taxes, thereby expanding the tax base.
Trump’s tax plan addresses the $2 trillion in corporate profits sitting overseas to avoid taxation. Under current tax policy, corporations face taxes on profits earned at home and abroad. This is called a worldwide tax system. Domestic corporations are given a credit for the income tax paid to the foreign country. The IRS then sends the company a bill for the difference. But a loophole allows corporations to avoid paying taxes on the profits earned overseas so long as the profits are invested abroad.
The White House proposed a switch from a worldwide tax system to a territorial tax system. A territorial system only taxes profits earned within the United States. Profits earned abroad are not taxed. The switch to a territorial system would likely stem the tide of companies moving their headquarters overseas to avoid paying taxes. This would keep jobs in the United States.
Corporations would bring home the $2 trillion in corporate profits they currently hold overseas, although the White House would impose a one-time tax on profits brought back from overseas. The impact of the corporate profit repatriation would depend on the willingness of corporations to invest and hire. Corporations could use the repatriated profits to invest in plant and equipment at home or to hire more American workers. Investment in physical and human capital would raise productivity, wages, and living standards.
On the other hand, companies could just pass the repatriated earnings on to shareholders, as with previous repatriation programs. The American Jobs Creation Act of 2004 created a corporate-profit repatriation holiday. The money brought back from overseas was mostly returned to shareholders. Another repatriation might have the same result, especially because firms are not lacking access to capital. Historically low interest rates have made many investments profitable. In the absence of profitable projects, the flood of new cash may just be funneled to shareholders.
Importantly, Trump’s tax plan does not include a border-adjustment tax. As AIER has argued time and time again, protectionist measures benefit a few domestic businesses at the expense of all consumers. The BAT would have taxed all imports. Businesses would have likely passed the tax on to consumers in the form of higher prices. Consumers can breathe a sigh of relief that higher import prices will not squeeze household budgets.
On the household side, tax rates would be lowered and the number of tax brackets would be reduced to just three: 10 percent, 25 percent, and 35 percent. The standard deduction would be doubled. This would simplify the tax code. Fewer individuals would itemize their returns. The plan would also simplify the tax code by repealing the alternative minimum tax. The AMT forces taxpayers to calculate their taxes twice. Lower personal income taxes would put more money in the hands of consumers. The estate tax would also be eliminated, which would save taxpayers countless hours of estate planning.
Some households would see their tax burden increase under Trump’s plan. Individuals who live in high-tax states would be hit hard by Trump’s plan because it would eliminate the deduction for state and local taxes. Residents of places such as New York and California would end up bearing a much larger tax burden under the plan.
President Trump has not proposed spending cuts to pay for the tax cuts. Without offsetting spending cuts, the deficit and the national debt would get larger. A larger deficit and debt would eventually crowd out private investment. A run-up in government debt would push up interest rates, curbing private-sector activity. And the larger debt would mean higher taxes in the future.
What would the tax cut cost? The conservative Committee for a Responsible Federal Budget estimates the tax cut would cost $5.5 trillion over the next ten years. On the business side, the most expensive provisions are reducing the corporate tax rate and changing the treatment of pass-through entities. On the household side, reducing the number of personal income tax brackets and doubling the standard deduction would push tax revenue lower. Eliminating major deductions, such as state and local taxes, would offset some of the cost. When interest cost is factored in, the total bill comes to $6.2 trillion.
Instead of proposing spending cuts to balance the budget, the White House estimates that tax cuts would generate enough growth to pay for themselves. Lower taxes are likely to give the economy a boost. However, it is unlikely the United States can reach the level of economic growth needed to offset the tax cut.
Under the current tax law, the Congressional Budget Office forecasts economic growth of 1.8 percent per year over the next decade. Economic growth would have to nearly double to offset the lost revenue from the tax cut. The Committee for a Responsible Federal Budget estimates that economic growth would have to average 4.5 percent to pay for the tax cut.
To get economic growth up to 4.5 percent, productivity would have to accelerate. Over the next 10 years, the CBO forecasts, productivity will grow between 0.75 percent and 1 percent per year. For economic growth to pay for the tax cut, productivity would need to accelerate to 3.8 percent. To put this in perspective, productivity would need to exceed the record 2.3 percent growth reached in the late 1960s and early 1970s. With an aging population and weak capital investment in recent years, brisk productivity growth is unrealistic.
The United States cannot afford larger deficits and a run-up in the national debt. From 1929 through today, the deficit has averaged 3.1 percent. Each year since 2001 the federal government has spent more than the tax revenue it has taken in. During the Great Recession and subsequent weak recovery, the deficit averaged 5.5 percent of GDP. Ongoing deficits have added to the national debt to the point where the debt-to-GDP ratio reached an all-time high of 105 percent at the end of 2016. Most of the increase in the national debt has happened in recent years. The national debt has nearly doubled since the start of the Great Recession.
Congress shows little inclination to support a tax cut that would increase the deficit and the debt. President Trump’s tax cut will encounter resistance from both sides of Congress. On the left, Democrats will not support the tax cut because they think it favors the wealthy. From the right, fiscally conservative Republicans will not support deficit-financed tax cuts. Senate leader Mitch McConnell has expressed desire for revenue-neutral tax reform. House Speaker Paul Ryan’s tax plan proposes tax cuts without increasing the deficit. If the failure of the plan to repeal and replace the Affordable Care Act is any indication, Trump will have difficulty rallying his own party to deficit-financed tax cuts.
President Trump’s plan trades a tax burden for a debt burden. Lower tax rates will incentivize additional capital formation and hiring. Moving to a territorial system should help keep American companies at home. Economics is all about trade-offs. The trade-off for lower taxes without spending cuts is a larger deficit and debt. At some point down the line, taxes will have to be higher to reduce the deficit and pay down the national debt.