As they devise a strategy to place a tax bill on President Trump’s desk, Republicans in Congress are grappling with thorny issues: What can pass the Senate? How much should they add to the deficit? How will tax changes play with voters in 2018?
These are delicate political calculations, but there’s a simpler and better yardstick for measuring their efforts to rework the broken U.S. tax code: What will help the economy the most? That obvious question tends to get lost amid Washington’s daily political knife fights.
During the week of September 25, the White House and congressional Republicans are scheduled to release details of their tax plan, the result of months of closed-door negotiations. This could produce the first major legislative victory of the Trump presidency and the biggest change to tax policy in more than 30 years.
Discussion so far has centered on who would benefit from the numerous policy changes on the table, including repealing the estate tax, eliminating the alternative minimum tax, and slashing the capital gains tax. Would the changes—gasp—make the rich richer?
The purpose of tax reform isn’t to ignite or temper class warfare but to spur the economy. The revenue models that we’ll hear plenty about in the coming weeks are little more than educated guesses based on many different and competing factors. If you talk to economists, though, what’s clear is that of all the possible tax-policy choices facing lawmakers, the one with the biggest potential economic pop is cutting tax rates on business income.
“If the goal is to increase economic growth—and I think I’m in a group of a majority of economists—then changing the corporate tax rate would be the most beneficial,” says Michael Walden, an economist at North Carolina State University. “If you look at the studies, and there have certainly been scores of them over decades about what elements of the tax code increase economic growth the most, it’s the corporate tax rate.”
The federal government taxes corporations at a rate of 35 percent of their income. Add an average of 5 percent for state taxes, and the typical U.S. corporation pays 40 percent in taxes. Because of loopholes and deductions, the actual percentage is often less, of course, but the statutory figure is more than any other country except the United Arab Emirates, according to a survey by tax consultancy KPMG. The Scandinavian nations, long considered models of humane socialism, have corporate tax rates that average 22 percent.
The economic rationale for lowering the corporate tax rate is straightforward: Cut taxes and companies have more money to pay workers, return to shareholders, and invest—all of which have rapid economic benefits.
The Trump administration has proposed lowering the federal rate to 15 percent. Even with the upsides to the economy from such a cut, federal revenues would be expected to decline. House speaker Paul Ryan said this month that it would be “hard” to cut the rate so much. Trump “obviously wants to push this as low as possible,” Ryan told the New York Times. “I completely support doing that but at the end of the day we’ve got to make these numbers work. Our goal is to be at or below the industrialized world average—and that’s 22.5 [percent]. So our goal is to get in the mid to low 20s. And we think that’s an achievable goal.”
Not all companies pay taxes using the corporate rate. Many small-business owners pay their taxes on the individual form, which has a top rate of 39.6 percent. Trump has proposed lowering that rate to 35 percent, and lowering and condensing the other rates as well. Treasury Secretary Steven Mnuchin has suggested letting more of these “pass-through businesses” pay at 15 percent, the same as the proposed rate for corporations.
Walden thinks reducing those rates would result in economic benefits, too. “Simple logic says that if you increase the benefit from working and earning, you’ll get more working and earning,” the economist says.
Mark Vitner, senior economist at Wells Fargo, says it’s beyond time to update the tax code to reflect the global economy. Since the last major reform, in 1986, Washington has made piecemeal tax changes, which have distorted incentives for companies, and Vitner thinks the code should be more efficient and logical. But, “The number one thing would be to reduce the corporate rate,” he says. “It’s important to reduce the corporate rate and the individual rate so we have fair treatment for large and small businesses. That, more than anything else, will help the vast majority of businesses.”
The tax debate is playing out against a backdrop of a stable economy. Unemployment is near a 16-year low, growth is steady, and the stock market continues to hit record highs. Those successes remove some of the urgency of passing tax reform. If the numbers were worse, Republicans could pitch the proposals as a financial rescue plan, as President Obama did with the $800 billion stimulus package of spending and tax incentives in 2009. Trump has faster economic growth as a top goal. He has said he’d like to see annual growth of at least 3 percent, which would be about double the rate in the Obama years. Tax policy could play a big role in getting there.
Interestingly, while the bipartisan 1986 tax reform under the Reagan administration was widely praised for simplifying the tax code, many economists believe it did little for growth. Designed to be revenue-neutral, it lowered corporate and individual rates and closed loopholes, including some that increased taxes on investments. The Tax Foundation found in a later study that the tax package actually reduced gross domestic product by 0.2 percent. The part of the 1986 reform that resulted in the largest GDP growth was slicing the corporate tax from 46 percent to 34 percent, the study found, but that growth was offset by removing deductions and credits. In contrast, the 1981 tax bill signed by Reagan, consisting mostly of big cuts on individual rates, led much more directly to economic growth.
Some of the economy’s recent gains are due to the expectation of policy changes in Washington. Since Trump’s election, business owners have been more optimistic about the economy—largely due to the tax cuts and decreased federal regulation in the offing. In December 2016, a month after the election, the National Federation of Independent Business’s Small Business Optimism Index shot up 10 points to its highest level since 2004. In 2017, the organization’s surveys show small businesses have increased their spending on equipment and modestly stepped up hiring, both signs of optimism.
Bill Dunkelberg, chief economist for the NFIB, thinks this is all because of the “change in the management team” in Washington. “One that was just a crazy regulatory team was changed to one much more interested in growth and cutting the tax and regulatory burden,” he says. Small businesses “didn’t know what Trump was going to do with taxes, but they figured whatever he did was better than what they have been dealing with in the last 10 years.”
If he had to name one change that would help the economy, “what stands out for our members would stand out for everybody, and that would be tax rates,” Dunkelberg says. “Tax rates would be the big, big deal.”
There are plenty of other tax measures, big and small, that could help the economy, from changing the tax rules on depreciation of equipment to an ultra-low tax holiday that would encourage multinational firms to bring foreign profits back to the United States. Even if Congress adopts some of those policies, its effort could still feel small compared with revolutionary reform ideas floated in presidential campaigns of years gone by—like Steve Forbes’s flat tax (1996), Mike Huckabee’s fair tax (2008), and Herman Cain’s 9-9-9 plan (2012).
That’s where financial reform bumps into political reality. Republicans lack the Senate votes for sweeping tax change, just as they have lacked them for repealing Obamacare. Even the White House is sensitive to Democratic charges that its tax reforms will benefit “the wealthy.” The Washington Post reported on September 19 that Republicans were considering backing off of repealing the estate tax, a longtime GOP goal, in order to underline the tax package’s appeal to the middle class.
What seems likely to emerge is a plan that carefully balances the economic and the political: Cut tax rates on corporate and individual taxes as much as deficit hawks will allow. Offset some of the hit to federal revenue by limiting certain deductions. Highlight the appeal to the middle class. Argue that the hit to the federal fisc is less than Democrats and congressional budget gnomes project. And proclaim the whole package “the most sweeping tax reform in more than 30 years.”
The reality is more likely a rate cut with window dressing. If that leaves longtime Republican tax talking points unaddressed, it will still answer the most crucial question by boosting the U.S. economy.
Tony Mecia is a senior writer at The Weekly Standard.
