A 14-Point Guide to Tax Reform

November 10, 2017

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Everyone agrees the current tax system needs reform—it’s too complex, contains too many distortions, and harms the nation’s competitiveness. Unfortunately, the effort now underway in Congress is not going very well. This is largely because the current drafts in the House and Senate are built on faulty assumptions about how taxes affect economic growth. As the process proceeds, policymakers and the public should keep in mind the following points:

  1. The goal of tax reform should be to boost investment and economic growth. The country faces a large deficit between what it wants and what it is willing to pay for. This imbalance will not end well unless tax reform spurs businesses to invest more because that will spur productivity growth.
  2. Individual tax cuts will not spur growth. Republicans want to deliver a tax cut to every American. But virtually all tax cuts to individuals, including to pass-through business owners, will go to consumption, which already makes up roughly 70 percent of the economy. There is no reason to boost consumption when the economy is at full employment. We should focus on boosting investment.
  3. Tax policy should not subsidize spending on state and local government services. One of America’s strengths is the diversity of its state and local governments. Some jurisdictions choose to impose higher local taxes on their residents in return for providing public goods and services. Others choose lower taxes and provide fewer public goods and services. Federal policy should not subsidize one approach over the other.
  4. The mortgage interest deduction leads to higher-priced housing, not long-term growth. The ability to deduct interest payments encourages people to buy larger, more expensive houses. It is thus a highly regressive subsidy that mostly benefits wealthier Americans while pushing home prices out of many others’ reach. And since housing is consumption, the deduction diverts societal resources away from investments that spur long-term growth. Britain phased out its mortgage deduction over 10 years. The United States should too.
  5. The income exclusion for employer-provided health insurance distorts health care. The fact that Americans do not have to pay income tax on the value of company health insurance is largely due to historical accident rather than a conscious policy decision. It encourages workers to demand higher health benefits instead of salary raises. It also increases the cost of health care and makes it more difficult for workers to move to better jobs. And, like most other deductions, it is highly regressive, because wealthier workers tend to have more expensive insurance plans and pay higher marginal taxes on the income they would otherwise have to declare.
  6. Pass-through businesses do not need a tax cut. Sole proprietorships, partnerships, and Subchapter S corporations do not have to pay corporate taxes. As a result, they face a lower total tax burden than Subchapter C corporations. And small business already is massively subsidized by the tax code, receiving a slew of deductions and credits that large companies are not eligible for. Lowering pass-through taxes even further will exacerbate the economic distortion and lead to less growth because small firms are less dependent on capital investment. Moreover, most of the benefits will go to wealthier individuals.
  7. Tax policy should raise revenue by pricing activities that impose social costs. Congress should seek new sources of revenue to replace tax cuts on business, and the logical place to look is a carbon tax. Besides contributing to global warming, burning fossil fuels imposes significant health costs. A moderate tax on carbon emissions could easily offset the revenue costs of a corporate tax cut. It would also speed the movement toward a cleaner, more efficient energy market.
  8. Tax cuts will not create jobs on net. With unemployment at almost 4 percent and wages slowly rising, there is not much slack in the labor force. While corporate tax reform will lead to some new hiring, more pressure on wages might cause the Federal Reserve to raise interest rates, offsetting this job growth. The most important effect that reducing the effective corporate tax rate will have is boosting economy-wide innovation, productivity, and competitiveness, all of which enable workers to have better jobs and higher wages. 
  9. Corporate tax cuts will boost investment and competitiveness. There is solid scholarly evidence that corporate taxes impose a large deadweight burden on the economy. Current corporate tax law puts U.S. firms at a competitive disadvantage in foreign markets where taxes are lower. It also encourages them to leave foreign profits overseas, rather than investing in the United States or distributing them to shareholders. And it limits incentives to invest in the building blocks of growth, especially research and development, and new equipment. Reducing the statutory and effective corporate tax rates will grow the economy.
  10. U.S. companies pay higher effective rates than their overseas competitors. Those who oppose lowering the corporate tax often point out that most companies do not pay the statutory tax rate on their marginal earnings. This is correct. However, they still pay higher effective rates than companies in most other countries, partly because they face a higher statutory rate and partly because the United States offers weaker incentives for investment. A recent report by the Congressional Budget Office estimated that U.S. effective rates were the third-highest in the G20, with most developed countries being around 9 percentage points lower.
  11. Tax reform should especially lower the cost of investment. Investment, not spending by the middle class, is the main driver of increased economic growth. It also boosts worker productivity and thus pay. By lowering the after-tax cost of investment, tax reform can cause companies to increase their investment in the United States. Incentives like faster expensing of machinery and software, a higher credit for R&D spending, and an “innovation box” attempt to reduce the differential between the private rate of return from investment and the larger social returns (which economists call positive externalities) that investment generates.
  12. Tax rates have a larger impact on traded industries. Industries that are traded globally are especially sensitive to national tax rates because customers can move their purchases abroad in order to find cheaper prices. This is especially true when companies also have the option of moving some of their activity to low-tax countries. Reforms that put U.S. companies on an even footing regarding foreign competitors are especially important, such as moving toward a territorial system and increasing incentives that traded-sector firms use more, like the R&D credit.
  13. Workers and consumers will receive a large portion of any corporate tax reduction. A spirited debate has broken out regarding how much of the corporate tax is borne by workers in the form of lower wages, with some academics claiming it is 60 percent or more. Very few dispute that it is lower than 20 percent, however. Surprisingly, there is little discussion over how much cost consumers bear. Yet in competitive markets we would expect that a significant part of any reduction in production costs, including from lower taxes, will eventually get passed on to consumers, both in the United States and outside.
  14. Tax reform should seek to provide certainty. As Congress continues its efforts, it should avoid making temporary changes to the law. While it may be wise to phase certain provisions in or out, incentives to invest, like first-year expensing, have a much larger impact when they are permanent.