By Mihir Desai
(Bloomberg View) --Fiercely partisan reactions are overshadowing the accomplishments of the Republican tax proposal – as well as its misguided aspects. In reality, the plan is a mixed bag that has some good, bad and ugly parts. Here’s an early take on which reforms belong in what category.
- The dramatic changes in the corporate tax are well designed. Specifically, the combination of the lower rate, the switch to territoriality, the temporary expensing of capital investment and the repeal of the domestic production deduction simplifies the corporate system considerably and brings the corporate tax system in line with global realities. After many years of pushing on a string with monetary policy, these changes will serve as an important stimulus to the economy and will accrue to workers, though not nearly as much as claimed. This accomplishment is non-trivial and is the best part of the plan. A phase-in of the corporate rate reduction would have been preferred as the economic effects would be similar and the windfall to previous investments would have been limited.
- The new break point of $1 million for the top bracket is long overdue. The top bracket was capturing too many filers and the new break point means that the top bracket will be restored to its historic function of capturing closer to the top 0.1 percent rather than the top 1 percent of filers. A crowded top bracket led us to stealth tax rate increases in the form of deduction and exemption phase outs. I’d prefer a slightly higher rate on the top two brackets but creating that new break point is valuable.
- The number of individuals in the zero bracket will likely increase. Consider some rough math for a family with two children. Previously, the zero-bracket range was determined by a $12,700 standard deduction, total exemptions of $16,200 and two tax credits of $1,000 each. So, the zero bracket extended to those with incomes up to $48,500 ($28,900 of deductions and exemptions and $2,000 of credits grossed up at a 10 percent or 15 percent tax rate). Under the plan, the $24,000 standard deduction would combine with $3,200 of child tax credits and $600 of credits for the adults. That expands a zero bracket up to $55,666 ($24,000 plus $3,800 grossed up by the tax rate of 12 percent), representing a tax cut for the households in the middle of the income distribution that is a non-trivial accomplishment.
- Reducing the mortgage interest deduction by cutting the limit on mortgage size from $1 million to $500,000 is a progressive move that helps limit the incentives to owner-occupied housing that are already present because of the asymmetric treatment of renting and owning (as in, serving as your own landlord is tax-preferred relative to paying a landlord that is not yourself). With a median home value of lower than $200,000 nationwide, this reduction seems appropriate.
- The repeal of the state and local income tax deduction and the limit on deductibility of property taxes must be understood in combination with the repeal of the alternative minimum tax (AMT). Since state and local tax deductions (and exemptions) were the main trip wires for the AMT, this is a reasonable trade. It provides simplification and helps tax consumption rather than income -- given that state and local taxes are buying important services, of course.
- The bill does good work in taxing hidden consumption that is happening through fringe benefits and employer deductions. Specifically, the bill limits entertainment expense deductibility and the tax advantages to providing amenities like gyms at the workplace through nontaxable fringe benefits.
- The bill includes a transition tax on earnings that have accumulated abroad. The rate depends on the form that those earnings now take: 12 percent for cash, five percent for non-cash assets. This is a relatively good tax given that it approximates a lump sum tax that can’t have any adverse behavioral response. The rates are reasonably high and accord with reasonable expectations for what those earnings would have otherwise borne.
- The imperative to cut the corporate tax rate creates a problem for pass-through entities, a class of organizations that have massively grown. We’ve lived for decades with a fortunate coincidence of the top marginal rate (39.6 percent) and the corporate rate (35.0 percent). That coincidence limits the game playing of trying to obtain a lower rate on income by switching organizational forms. With corporate rates coming down (for good reasons), we have to choose between two evils: the risk of high income professionals corporatizing to get a lower rate on labor income, or creating a new, lower pass-through rate that solves that problem but creates another: people stuffing labor income into pass-through entities.
The bill chooses to do the latter, then lays out some coarse rules to distinguish between labor income that should be taxed at regular rates and capital income that is designed for pass-through vehicles. Specifically, certain industries like accounting and law that use pass-through vehicles (or partnerships) would just be presumed to have all labor income and not avail themselves of the lower pass-through rates. For individuals that are deemed to have both labor and capital income, a rough 70/30 split is used to separate income. In fact, the real beneficiaries of this are passive owners of assets held in pass-through form.
The wrong evil was chosen. We should not create a new pass-through rate and, instead, simply police the problem of individuals corporatizing. That risk is more easily policed and the difference between paying salary through a corporate dividend and simply paying oneself a salary taxed at 35 percent or 39.6 percent is not quite so bad. Finally, accommodating the siren song of “small business” in this way belies the reality that pass-through entities do not largely represent “main street” and that progressivity in corporate tax rates already accommodates true small businesses.
- The switch to territoriality is accompanied with a minimum tax. The minimum tax is sometimes characterized as a 10 percent tax on income that is not taxed somewhere else in the world in order to avoid the incentive to transfer price profits abroad. However, minimum taxes are problematic in the context of a switch to territoriality because they undo the benefits of a transition away from worldwide regimes and they keep some of the complexity of current international tax rules. And, in fact, given the treatment of tax credits, it’s closer to a 12 percent minimum tax.
It would be preferable to deal with the problem of base erosion with an improved enforcement approach on transfer pricing rules. Fortunately, the minimum tax employed in the plan is somewhat more subtle as it averages income and taxes around the world and only obtains on foreign profits that appear artificially high. The mechanism for that is clunky -- half of the profits that correspond to returns above a “normal” seven percent return are included in income -- but effectively it combines a transfer pricing enforcement approach with a minimum tax. And that’s better than a crude minimum tax and shifting that normal return to something more like 15 percent could make it useful.
- Allowing for continued interest deductibility in combination with expensing means that tax rates on debt-financed investment will be negative. Expensing, by allowing for a full deduction of capital expenditures, makes the tax rate on new investment zero as the government is refunding a fraction of the cost up front and taxing that same fraction later. Ideally, we would have moved to expensing permanently and eliminated interest deductibility. The limits on interest deductibility in the bill are significant and also are highly complex -- in effect, firms with more than 30 percent of operating income as domestic interest or significantly higher domestic leverage than worldwide leverage will see reductions in interest deductibility.
- Repealing the deductibility of medical expenses will create a more uneven playing field that favors employer-provided health insurance. The deductibility of medical expenses contributes to a rough parity with the treatment for the self-employed and employer-provided health insurance. By further advantaging employer-provided health insurance, this leads to all the issues associated with lowered sensitivity to the costs of health care in the economy.
- The plan takes aim at universities by taxing endowment income, including research revenues as unrelated business income, and limiting their use of tax-exempt bonds. These efforts are misguided. Endowments are mischaracterized as pools of excess cash that slosh around like Apple’s hundreds of billions in Ireland. In fact, they are part of the engines of universities that allow them to excel and they also have come to serve as important means for redistributing by allowing for an expansion of need-blind admissions. It’s also a gratuitous targeting of perhaps only 50 entities given the structure of the tax with more than half of revenue coming from four institutions (Princeton, Yale, Harvard, Stanford). Given that I have a vested interest, I should mention that there are more effective ways of targeting these organizations. Specifically, the ability to deduct fair market value of appreciated assets (rather than their cost) means that lots of untaxed gains are accruing to donors and donees. Going after those rules would be a much smarter way to raise revenues from that sector and corrects a misguided rule.
- The bill phases out for a number of personal credits including the child credit at around $230 thousand. These phase-outs in combination with the limitation on state and local tax deductions and the mortgage interest deduction mean that high earners (between $200,000 and $1 million) will bear larger relative burdens and sometimes higher average tax rates relative to today while very high earners (above $1.0 million) will bear relatively less and see lower tax rates. Removing the phase-out of the credit would stop the use of stealth taxes and help rectify that imbalance.
- The bill further limits the deductibility of executive compensation for publicly-traded organizations by not allowing deductibility of performance-based contracts above $1 million and has an excise tax for salaries above $1 million for exempt organization employees. This handicaps both public companies and exempt organizations relative to private companies in the market for talent. Even worse, it attempts redistribution by denying deductibility at the entity level rather than taxing compensation directly at the individual level. Do we really think Harvard University or GE will pay their CEO/presidents less because of an excise tax or the denial of a deduction?
- The complete absence of anything for the bottom two quintiles of the population is a massive missed opportunity. The earned-income tax credit could have been expanded with a higher top marginal rate for the million-dollar plus bracket. This would serve to satisfy current redistributive preferences, help the worst off, and have the largest stimulative effects given their marginal propensity to consume. Moreover, the scoring of the bill is deceptive in that $920 billion of the cuts are associated with individuals while, in fact, most of those cuts are associated with very high-income individuals who benefit from the doubling of the estate tax exemption and the new pass-through rate. Only $310 billion is left for others through the traditional income tax. From a distributional perspective on the high end, earners between $200,000 and $1 million don’t do nearly as well as earners above $1 million.
- The doubling of the exemption amount for the estate tax is a backing away from a much better restructuring of intergenerational transfers. Specifically, eliminating the estate tax as a trade for elimination of the rule on “step-up basis at death” would have been much preferred. The step-up basis at death rule allows for large amounts of gains to never be taxed for the wealthiest and leads to a lock-in of assets. That trade is politically potent, generates offsetting revenue and fixes a structural problem -- the incentive to hold on to appreciated assets until death.
- In an effort to raise money from the corporate sector, the bill includes a 20 percent excise tax on payments to related parties that raises over $150 billion. This will both significantly distort supply chains by encouraging switches to trade with unrelated parties and, as a consequence, will likely not raise nearly as much revenue as is anticipated. This is a very crude effort to think about base erosion and will cause significant inefficiencies to global trade.
- The Tax Cuts and Jobs Act? That’s the best you can do for a name?
- Oh, yeah, and the $1.5 trillion cost is just plain fiscally irresponsible as are the acrobatics required to make it score at that level.
- And, what we really need is a reasonable consumption tax or carbon tax.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mihir Desai, a professor of finance at Harvard Business School and a professor of law at Harvard Law School, is the author of the book "The Wisdom of Finance: Discovering Humanity in the World of Risk and Return."
To contact the author of this story: Mihir Desai at [email protected] contact the editor responsible for this story: Mike Nizza at [email protected]
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