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Republican leaders unveiled a new framework this week for fixing America’s broken tax code. It contains much more detail than the one-page document President Trump issued earlier in the year. But it still leaves many details to congressional committees, which will allow individual members to feel that their opinions have been heard and for a consensus to emerge.
Let’s hope the process bears fruit, because the current tax code, which has not been updated in over three decades, burdens Americans with large compliance costs. Its many special provisions, such as carried interest, special rules for oil and gas, and exclusion of employer-provided health insurance, distort economic behavior in harmful ways. Most important, the high corporate tax rates reduce the competitiveness of American firms and discourage domestic investment.
The new framework presents a good starting point on the corporate side. It lowers the statutory rate almost in half; from 35 percent to 20 percent. Even better, it contains strong provisions for investment. For at least the next five years, businesses will get to deduct all of their investment costs in the year they are made. The framework also preserves the research and development tax credit, which rewards companies for increasing domestic research. Over the next several months, Congress should try to make expensing permanent and increase the alternative simplified version of the credit from 14 to 20 percent.
The framework also puts domestic firms on more of an equal footing in overseas markets. First it allows U.S. companies to deduct all dividends from their foreign subsidiaries. Second, it promises a much lower, unspecified rate on profits from overseas subsidiaries. Both will dramatically lower the incentive for companies to transfer either their profits or their headquarters overseas.
There is strong academic evidence that high corporate tax rates impose a much larger deadweight burden on the economy than do individual income or consumption taxes. There is also a bipartisan consensus that current law is disadvantaging U.S. exporters and causing companies to move overseas. One could imagine a deal here that gets support from both parties.
The framework is much weaker on individual taxes, however. It contains some provisions to help the middle class by lowering statutory rates and expanding the standard deduction. It also promises to eliminate some of the more distortionary deductions in the current code. However, most of the tax benefits still benefit the wealthy.
One of the most egregious proposals is the plan to lower the individual rate for pass-through businesses, such as partnerships and S corporations. These businesses already enjoy an advantage over individual shareholders because they don’t have to pay corporate taxes. Although corporate reform will reduce their advantage over C corporations, they should benefit from the new ability to expense investments. The provision will also create a huge incentive for the richest Americans to divert their income through a pass-through shell. If Congress really wants to help these businesses, it should concentrate on simplifying the rules.
Lowering the individual rate on pass-through businesses may increase the support of some Republican supporters. But it almost surely means that few, if any Democrats will vote for it. The provision rewards the rich but does little to boost growth. Earlier this year the Tax Foundation estimated the cost over ten years of lowering rates on both types of businesses to 15 percent. The static cost on the corporate side would be $2.2 trillion but the dynamic cost (taking into account revenues from higher growth) is only $1 trillion. The static cost for pass-throughs would be $1.5 trillion but the dynamic cost is almost as high; $1.3 trillion. This alone is probably enough to doom the effort.
As mentioned before, the current framework is a good step forward. It sets out a basic plan that the congressional committees will now have to work through. It is very important that this process be allowed to work the way it is supposed to. The individual provisions of the plan ought to be open to negotiation to maximize the chances of obtaining bipartisan support for a bill that rewards investment and research. Specifically, Republicans should be open to minimizing tax cuts on the wealthy in return for significant Democratic support for lowering the corporate rate.