The vague tax reform promises that Donald Trump put forward during his presidential campaign have finally been turned into concrete measures. Republican senators and their House counterparts recently released their respective proposals to simplify the cumbersome American tax system. Once both bills are passed, a conference committee will be assembled to work out a final piece of legislation.
This procedure, which might seem a mere formality due to the majority that Republicans hold in both chambers, will face some challenges along the way. First, it doesn’t seem likely that a final bill will be ready by the end of the year as promised by President Trump. After all, the House and Senate proposals differ substantially and reaching an agreement will be a complex and lengthy task. In addition, the so-called Byrd Rule prevents senators from passing legislation that increases the budget deficit by more than $1.5 trillion over a 10-year period, and the estimates undertaken so far seem to exceed this number.
There’s little doubt that either one of these bills would entail significant change to America’s taxation structure. However, the differences between the House and the Senate bills are still big enough to be notable. The House legislation heralds a more radical overhaul of the income tax system, reducing the number of tax brackets from seven to four. Yet this reduction would result in a higher rate for low-income families, which in turn would be partly alleviated by a greater tax credit per child and a higher standard deduction ($12,000 for individuals and $24,000 for joint filers).
Elsewhere, the Senate and House bills are very similar. Both propose repealing deductions for state and local taxes, including income and sales taxes, which could be devastating for pricey blue states like New York and California. A discrepancy is found on property taxes: the Senate bill eliminates all deductions whereas the House bill caps them at $10,000.
Medical expense deductions will be maintained should the Senate bill prevail over the House bill, which would fully eliminate them. The House also abolishes mortgage interest deductions, which would affect newly purchased homes over $500,000. Yet two important tax credits will be maintained, at least in the House version: the one applying to R&D investments and the one applying to lower-income housing investments.
The flagship proposal of this tax reform doesn’t affect individuals but businesses. Both the House and Senate bills contain a drastic cut in the top marginal corporate tax from 35 percent to a 20 percent flat rate. Effective rates wouldn’t be reduced by that much, however, since most of the deductions would be removed.
Pass-through businesses will also be affected by this reform. This type of business structure was originally aimed at eliminating the effects of double taxation. Pass-through businesses, which account for 95 percent of all U.S. enterprises and provide the majority of business tax revenue, don’t pay corporate taxes. Instead, benefits that flow from businesses to shareholders are taxed at income tax rates. The House bill introduces a 25 percent flat rate for pass-through businesses, which is considerably more than what most firms pay under the current system. As a result, the tax burden for most enterprises that were created under this legal structure will be increased.
All this amounts to a significant overhaul of America’s byzantine taxation structure. Yet an overall assessment is necessary if we want to measure the impact of the reform on government finances. In terms of the cost, the Congressional Budget Office has estimated that the House bill will increase the budget deficit by $1.7 trillion over the next 10 years, which is in line with economic theory and, more specifically, with the Laffer Curve.
The Laffer Curve relates changes in tax rates with government revenue. On some occasions, tax cuts can boost the economy and offset a fall in revenues. However, as pointed out by Center for Freedom and Prosperity economist Dan Mitchell, not all tax cuts pay for themselves. And this seems to be one of those cases: no matter how much the economy grows in the coming years, this tax reform law will make a hole in the federal government’s finances.
What is the alternative? Any serious tax reform must go hand in hand with a budget cut proposal that guarantees tax cuts won’t have a negative impact on government accounts. Let’s remember that there’s no such a thing as a free lunch. Increasing deficits result in increasing debt that will eventually be paid off by taxpayers (let alone the potential consequences that excessive government debt could have for the American economy in the long term).
Should taxes be lowered? Of course. In fact, Trump’s tax reform lacks ambition: there’s room for slashing rates even beyond what he’s proposing. However, the idea of cutting taxes without trimming the budget is just another form of pandering populism. It is, as the saying goes, “feast today, famine tomorrow.”
Luis Pablo de la Horra holds a MSc in Finance. He’s currently doing a Master of Research in Business Economics, prerequisite to start a Ph.D. in the same field in 2018. He has been published by CapX, Speak Freely, and the Foundation for Economic Education, among others.