Just as Ronald Reagan’s landmark 1986 bipartisan tax reform increased simplicity, fairness and economic efficiency by broadening the tax base and reducing rates, today reform of the system has the potential to help American families and the economy.
Properly designed, revenue-neutral reforms could help to offset the dramatic increases in inequality that have taken place over a generation, repair a business tax system that globalisation has rendered dysfunctional, reduce uncertainty and promote growth.
Unfortunately, what we know of the intentions of the president-elect and congressional leadership suggest that they risk pushing through the most misguided set of tax changes in US history.
The proposals from the presidential campaign, reiterated last week by President-elect Donald Trump’s choice for Treasury secretary, will massively favour the top 1 per cent of income earners, threaten an explosive rise in federal debt, complicate the tax code and do little if anything to spur growth.
A core principle agreed to by all in 1986 was that reform would not reduce the tax burden on high-income taxpayers. Reagan achieved this objective while reducing top marginal rates because he raised capital gains rates, scaled back investment incentives, increased corporate tax collection, curtailed shelters and left estate and gift taxes alone. Unfortunately, neither the Trump plan, nor the one put forward by Paul Ryan, speaker of the House of Representatives, provides for nearly enough base-broadening to finance all the high-end tax cutting they include.
Steven Mnuchin, Treasury secretary-designate, asserts there will be no absolute tax cut for the upper class because deductions would be scaled back. The rub is that totally eliminating all deductions for those with incomes over $1m would not even raise enough revenue to cover reducing their marginal tax rates from 39 to 33 per cent, let alone offset their benefit from huge rate reductions on business and corporate income, and the elimination of estate and gift taxes.
Estimates of the Trump plan suggest that it will raise the average after-tax income of the 0.9 per cent of the population with incomes over $1m by 14 per cent, or more than $215,000. This contrasts with proposed tax cuts for those in the middle of the income distribution of $1,000, or about 2 per cent.
The repeal of estate and gift taxes is especially problematic because it would provide a window for the very rich to use gift and trust structures to ensure that their wealth passes without tax not just to their children but to their grandchildren and great grandchildren, regardless of subsequent legislation.
The Reagan tax reform simplified the code by eliminating the need for rules distinguishing ordinary and capital gains income, because these were taxed at the same rate, and by doing away with industry-specific shelter provisions. In contrast, the Trump proposal creates sheltering opportunities by reducing to 15 per cent the tax rate on any income that can be characterised as coming from an incorporated entity. Rather than reducing targeted subsidies, it would establish a highly dubious 82 per cent credit – the highest in the world – for financial equity investments in infrastructure.
This would mean not only disproportionate tax reductions for the upper-income group that has seen its incomes rise most rapidly over the past generation. It would also mean grave damage to federal budget projections. The envisioned Trump tax cut is about the same size relative to the economy as the 1981 Reagan tax cut. It is worth remembering that Reagan, hardly a fan of reversing course or raising taxes, found it necessary to propose significant tax increases in 1982 and 1984 (the equivalent in today’s economy of $3.5tn over a decade) due to concerns about federal debt.
Today’s budget situation is much more worrisome. The baseline involves much higher levels of debt and deficits. Then the economy was suffering from a deep recession; now it approaches full employment. If extreme tax cuts are legislated in the next months, uncertainty about the federal budget and about further tax adjustments is likely to rise. Finally, I can find no basis in either economic history or logic for Mr Mnuchin’s claim that the proposed reforms would increase the economy’s growth rate from its current 2 per cent rate to the historical 3 to 4 per cent norm. Adult population growth has slowed by nearly a percentage point, the gains generated by more women entering the workforce have been exhausted, and it is far from clear why tax reform will hugely spur productivity growth.
Indeed, because the Trump proposal would redistribute after-tax income towards those most likely to save it, push up long-term interest rates because of debt pressures, increase uncertainty and the advantages of overseas production, it is as likely to retard growth as to accelerate it.
In the 1980s, treasury secretary Don Regan said the first Reagan reform proposal was written on a word processor to signal the administration’s openness to negotiation and radical alteration. We should all hope the Trump administration follows Reagan’s approach on both tax policy principles and a commitment to bipartisan negotiation.