Tax Cuts vs. Tax Reform

The Republicans have set themselves the goal of passing tax legislation by the end of the year.  They took a major step by passing a budget resolution this past week which authorized tax legislation as long as that legislation had a net cost of less than 1.5 TRILLION over the next decade.  As such, as long as the CBO scores any legislation as complying with that cap, it is exempt from a filibuster.

That cap reflects a significant part of the current debate inside the Republican party — do they want a tax cut (reducing the overall tax burden) or tax reform (a revenue-neutral rewrite of the tax law).  This debate will be significant because the Republican approach is that those who make the most money pay the most taxes and therefore should get the most relief.  Thus, their proposals will be very top heavy on who gets the relief and the deductions most at risk will be those that benefit the middle class.

First, some Taxes 101 to set the background.  Both at the corporate level and at the personal level, calculating taxes begins with defining income.  Then there are certain authorized deductions from income that lead to a smaller income that qualifies as “taxable income.”  There are then income brackets in which you pay x% for the first $Y amount of income, than pay a slightly higher rate on the additional income above that amount (and just that additional income).  (E.g., If the top tax bracket is 40% and kicks it at $500,000, the taxpayer is only paying 40% on the income above $500,000 — so on an income of $700,000 that 40% only applies to the last $200,000 of income and the first $500,000 is taxed at a lower rate. )  After taxes are computed, the taxes can be reduced by tax credits.

For personal income tax, there are three basic types of “deductions”:  1) exemptions (a per person deduction); 2) the “standardized deduction” (a set default amount per person); and 3) “itemized deductions” (for those with enough deductions who would rather total up all of their deductions rather than using the standardized deduction).  To compensate for abuse of tax loopholes by the wealthy, there is also something called the alternative minimum tax (an alternative calculation of taxes that effectively limits the available deductions).

On the tax reform/tax simplification side of the Republican debate, the goal is to reduce the number of brackets, reduce the tax rates, and eliminate deductions.  (At its most extreme, you have the proponents of a flat tax — one rate, no deductions, no credits).  The asserted goal of some in this part of the debate is to make taxes simple enough to do on a postcard.  The key point is that, for those who want tax reform, cuts in the tax rates have to be offset by eliminating or reducing deductions and credits.

On the tax cut side, there is limited interest in simplifying the tax code.  Deductions are on the table only to the extent that the proposed tax cuts exceed the cap in the budget resolution.

The ultimate problem is that, as briefly noted, the Republicans are not really interested in a middle class tax cut.  It would be easy to draft a fair middle class tax cut — reduce the bottom two rates, increase the exemption.  Everybody benefits, and the total benefit is roughly the same in dollar amounts for both the billionaire and the person who sweeps the factory floor.  But that is not what is being discussed.  While we have not yet seen any actual bill, some of the proposed ideas make clear that the goal is to raise taxes on the middle class to cut them on the wealthy.

One idea is to double the standardized deduction.  By itself, that would not be a bad idea, but it is coupled with a proposal to eliminate the personal exemptions.  Since the exemption is about two-thirds of the standardized deduction, double the standardized deduction for a married couple is roughly equal to the current standardized deduction plus the personal exemptions for a married couple with one child.  If you have two children, you would actually be worse off under the new proposal.  Additionally, doubling the standardized deduction means that fewer will benefit from itemizing, thereby making it easier to go after some of the individual deductions such as the deductions for interest and property taxes for homeowners or for state and local income taxes.  (Even for some with one child or no children, their current itemized deduction plus the personal exemptions would exceed double the standardized deduction.)  Finally, under current law, the exemptions begin to phase out at around $250,000 of income ($310,000 for married couples).  So losing the exemption impacts middle class taxpayers but not the wealthy.

Another proposal that is floating around is to eliminate the tax deduction for contributions to some types of retirement plans.   For now, the potential targets seem to be plans that make current contributions tax deductible (but tax withdrawals during retirement).  On the other hand, Roth IRAs (in which you pay taxes now but all growth is tax-free) seem to be off the table.  Since, for middle class taxpayers, the current deduction (and exemptions for employer contributions) is necessary to make saving for retirement affordable (and there may not be enough retirement income to make taxes during retirement an issue), the deduction for current contributions is important.  On the other hand, a Roth IRA is beneficial to those who have a lot of potential retirement income and can afford to contribute to a retirement plan even if those contributions are not tax deductible.

On the other hand, while the final brackets have not yet been announced, it is pretty clear that the top rates will be reduced.  In addition, there are proposals to eliminate the alternative minimum tax which assures that even the Trump family has to pay some taxes even if it is not their fair share.  And, for those who make money from investments, there are proposals to treat capital gains even more favorably than they are under current law and to continue or expand the current favorable treatment of carried interest for the partners in investment firms.  (Of course, if you really wanted to simplify taxes, all income would be treated the same — whether earned income or income from investment.  While there are colorable arguments for some form of favorable treatment for investment income, by definition treating income from investments favorably does benefit those with the wealth to invest some of their money and requires those who do not have income to spare for investment to take a greater share of the tax burden.)

Additionally, while not part of income taxes, Republican seem to be wanting to take another run at repealing the estate (“greedy heir”) tax.  Notwithstanding Republican rhetoric, the current law on estate taxes guarantees that, when most people die, their estates are not subject to estate taxes.  Instead, it only applies to the wealthiest of families.  While for some closely-held large corporations and sole proprietorships, it theoretically might be necessary to borrow money to pay estate taxes, there is little or no evidence that estate taxes have forced the sale of a business or some of the business assets.  But the law does mean that — after having the benefit of wealthy parents paying for the best schools and either hiring them into the family business or otherwise helping them get started in business — that children and grandchildren have to give some of the family wealth back rather than simply accumulating wealth from generation to generation like some ancient aristocracy.

In short, any “reform” in the tax cut is likely to make middle class taxpayers actually pay more in taxes while having little impact on the tax burden of the wealthy.  Meanwhile the “cut” part in any tax reform/tax cut is likely to substantially reduce the tax burden on the wealthy (and particularly on those like President Trump).  Of course, we do not know how much any of these proposals will benefit President Trump because he still has not released his tax returns.

The good news, of course, is that taxes are complex.  And the more that the Republicans want to cut the top rate, the more they will need to find offsets.  And most of the deductions and credits in the tax code are there because somebody strongly benefits from them — charities like the charitable deduction, the child care industry likes the child care tax credit, state and local government like the deductibility of state and local taxes, the real estate and construction industry like the deductibility of interest payments on homes and other real estate, business like the deduction for capital investments, etc.

When a draft bill is actually introduced, it will generate opposition.  At some point, if there is enough time, that opposition will place a brake on any attempt to get things done quickly.  Of course, the Republicans have been drafting behind closed doors and deviating from normal procedure (the 1986 tax reform bill took about eighteen months from start to finish) is to make sure that the opposition to the bill does not have enough time to make the bill toxic.  Simply put, the Republican majority needs some major legislation passed to show that they can govern.  They would like to be able to tell their base that they passed a large tax cut (with the hope that the base will not realize until after the election that the tax cut actually increased their taxes).  And they would like to deliver to their donors a bill that fulfills the wish list of the Republican donor class.  If the process takes longer than five or six weeks, it will become clear that the draft bill is simply a Frankenstein monster that does not match the public statements of Republican leaders.

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