The 2017 Tax Cuts and Jobs Act has been very effective so far, judging by low unemployment rates and strong rates of economic and wage growth. But why did it work?
The answer is that it closed loopholes in the tax code and lowered everyone’s tax rate. Simple tax codes with low rates are the best. As we explained at the time, the Trump tax bill changed important incentives, especially for corporations but also for individuals, that reward hard work and investment instead of rewarding clever accounting and gimmicks.
Under a warped tax code full of loopholes, corporations and, to a lesser extent, individuals have an incentive to spend their time and effort on otherwise irrational behavior, the sole purpose of which is to take advantage of tax loopholes. Because loopholes result in tax-free windfalls for firms and individuals using them, they can in some cases provide a more powerful incentive at the margin than the profit motive and its inducement toward productive business activity, risk, and investment.
In other words, where all other things are equal, a bad tax code will prompt large and small businesses to waste resources on useless tax gimmicks instead of making their businesses better and more profitable servants of public demand.
Tax reform helped improve the situation by closing loopholes and lowering tax rates for both individuals and corporations. It guaranteed that hard work and judicious risk-taking would be rewarded over manipulation of the tax code. For example, by capping the state and local tax deduction, it stopped a harmful, artificial incentive for people to move to jurisdictions with high local taxes. The new law also removed a harmful tax incentive to borrow big against home equity.
Unfortunately, though, Congress is now thinking of turning back the clock and restoring expired special-interest tax provisions. It’s not just that Democrats want higher tax rates, but also that some Republicans want to revive special-interest tax loopholes that expired at the end of 2017.
Among the provisions in question are several obvious giveaways that never should have existed in the first place: special depreciation rules for horse racing and auto racing, for example, and tax credits for railroad maintenance. Other provisions merit more sympathy, although they still should not be revived. Tax breaks on mortgage debt forgiveness and private mortgage insurance both unjustly privilege home ownership over renting. But the former goes even further, removing healthy disincentives to buying a home for those not in a position to make the payments.
Other provisions try to encourage specific economic activities, such as the production of biodiesel fuel, and attending college, which, while perfectly good things in themselves, should be governed by economics and personal choice. These activities should be their own rewards without any special tax inducements. A college education, for example, is a good thing in itself and can be regarded as an investment. But it does not merit an above-the-line tax deduction that is unavailable to workers without a college education, or entrepreneurs who skip college to avoid needless indebtedness.
Were Congress to revive these tax extenders, it would create a new $150 billion hole in the budget over 10 years, according to the Committee for a Responsible Federal Budget. Congress should not do that. But if Congress really does want to provide $150 billion in useful and fair tax relief, it should follow the example of the 2017 tax bill and cut everyone’s tax rate across the board by a corresponding amount.
When it comes to tax law, everyone already knows the formula for success. Make the tax base broad, bring down rates for everyone, and give special breaks to no one. Congress should stick with what works.
