The Tax Cuts and Jobs Act would provide tax relief to millions of Americans, and has the potential to facilitate significant economic growth.
The proposal is pro-growth and pro-worker, but leaves much of the economy’s growth potential on the table. According to the Tax Foundation, this plan would grow the economy by about 3.9 percent over 10 years. A bolder update to the tax code could have unleashed twice that much growth.
While the tax package as a whole is certainly a positive step in the right direction, there are important ways to improve the Tax Cuts and Jobs Act to both meet the goals of pro-growth tax reform and avoid increasing marginal rates on any taxpayers.
1. Lower marginal rates at every level.
Tax reform should lower the top marginal tax rate and eliminate the new “bubble rate.”
The House plan would raise income brackets and lower marginal tax rates for all Americans making below $200,000. A significant portion of upper-income earners, however, would face higher marginal tax rates and could face higher tax bills.
The plan includes four tax brackets: 12 percent, 25 percent, 35 percent, and 39.6 percent.
The new 35 percent bracket would kick in at a lower income level than under current law, at about half its current income level. However, the proposal would also repeal other complicated provisions that currently raise taxes on these same taxpayers—the alternative minimum tax and a limitation on deductions.
The top 39.6 percent bracket is a carry-over from current tax law, but does not kick in until a new higher threshold of $500,000 for single taxpayers and $1 million for those who are married.
However, the plan would claw back the benefit of the lower marginal rates for top earners by introducing a new bubble rate, which would temporarily increase the marginal tax rate to 45.6 percent, kicking in at $1 million for individuals and $1.2 million for married couples.
After the phaseout, at a 6 percent rate, the 39.6 percent rate would kick back in. It would also potentially set these taxpayers up for a large future tax increase, making the same mistake from 1986 when the then-bubble rate of 33 percent was expanded to all income beyond the threshold.
Many pass-through businesses under the current 25 percent bracket also face a similar problem of little or no marginal rate reductions, leaving more than half the economy and 90 percent of American businesses with little tax relief.
These changes could result in significant tax increases for some upper-income taxpayers and businesses, which would negatively impact the economy by facilitating less work, saving, and investment.
2. Increase expensing.
Tax reform should allow all business expenses to be written off in the year that they are made.
The most pro-growth component of tax reform is permanent, full, and immediate expensing of all business costs. This provision alone could allow the economy to grow 5 percent larger and create 1 million jobs over the next decade.
The Tax Cuts and Jobs Act would leave most, if not all, of the benefit of this provision behind by pursuing expensing as a temporary, five-year policy and limiting it to new equipment.
Expensing, properly conceived, allows businesses to deduct the cost of investments immediately, such as the cost of new farm equipment or new factory equipment. Expensing lowers the effective tax rate on such new investments, allowing businesses to expand, creating jobs, and ultimately leading to higher wages and a larger economy.
Expensing’s lack of permanency and the omission of structures and used equipment significantly cuts into the growth potential of tax reform.
To appropriately promote the Tax Cuts and Jobs Act as significantly raising Americans’ wages and boosting economic growth, permanent full expensing should be a priority as the new tax legislation moves forward.
3. Maintain the commitment to a territorial tax system.
Tax reform should move to a territorial system that does not introduce new burdens on global business.
The proposed tax reform plan promises a territorial tax system, but then walks back many of the new territorial system’s features by imposing various new rules on international activity.
The current U.S. system of worldwide taxation attempts to tax all U.S. corporate profits, even those earned in other countries, minus a credit for taxes paid elsewhere. The tax on these overseas profits can be deferred by keeping foreign profits overseas.
This system incentivizes American firms to move their headquarters overseas through a process known as corporate inversions. Prominent examples include Burger King and Anheuser-Busch moving to Canada and Belgium, respectively.
Currently, more than $2.5 trillion of U.S. corporate profits are trapped overseas due to our arcane worldwide system.
Under a territorial tax system, additional taxes would not be collected on foreign-earned profits when distributed back to American headquarters. This seemingly simple change would allow American firms to compete abroad through foreign subsidiaries without the additional burden of U.S. taxes.
In practice, territorial systems are imperfect and require certain anti-abuse measures to keep business from gaming the system. The rules included in the first iteration of the Tax Cuts and Jobs Act were overly broad and may have entirely undermined the benefits of a territorial system.
The bill proposes two different new anti-abuse rules, one that essentially acts as a 10 percent minimum tax on foreign profits and another that levies a 20 percent excise tax on certain transactions with foreign subsidiaries.
The good news is that these provisions have already been amended to limit the damage to international business. As the process continues to move forward, Congress should further narrow these provisions, especially the 20 percent excise tax, to fully maintain the commitment to a territorial system and not undermine the potential benefits of business tax reforms.
4. Full repeal of the state and local property tax deduction.
Tax reform should fully repeal the state and local tax deductions and use the savings to lower tax rates.
The proposed tax plan makes huge strides in eliminating state and local tax deductions for income and sales taxes. The bill would cap the deduction for property taxes at $10,000.
The state and local tax deductions are detrimental to the economy. They encourage higher state and local government taxes and shift those increased burdens from high-tax, high-income Americans to low-tax, low-income folks.
Removing the state and local tax deductions must also be paired with lower marginal tax rates to avoid raising taxes. The current plan moves in this direction, but as noted above, more work is needed to further lower marginal tax rates and fully fulfill this goal.
By repealing most of the state and local deductions, the Tax Cuts and Jobs Act acknowledges the need to rid the tax code of this entire provision. Repealing the rest of the deduction is a good reform by itself, but it would also provide much-needed revenue to improve the current plan through lower marginal rates and expanded expensing.
5. Repeal the individual mandate of Obamacare.
Repealing the individual mandate would provide significant tax relief to working-class Americans who can’t afford the rising costs of Obamacare insurance.
Repealing the unpopular tax penalty for not buying insurance under Obamacare would actually benefit tax reform, as the Congressional Budget Office estimates that over 10 years the tax change would increase federal revenue by $338 billion, helping finance some of the other changes described above.
Better yet, the savings would increase in the years toward the end of the budget window, helping the Senate deal with its arcane budget rules.