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Trump, GOP prepare for tax code bonfire

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Trump wants to lower the top individual tax rate to 35 percent and eliminate the estate tax, making it clear that his plan is not incremental but radical. (Illustration by Bill Lesniewski)

In coming weeks and months, President Trump will attempt tax reform more sweeping, consequential and controversial than those of Presidents George W. Bush and Ronald Reagan.

He is betting that commerce and his own political fortunes will soar if he gets his supply-side ideas into the tax code. While his administration and Congress have struggled to follow through on other parts of his agenda, Trump aims to rally support for tax reform by traveling the country, hosting roundtables and bringing industry groups to the White House. He'll also lean on members of Congress hesitant about the size and scope of his ambitions.

The president doesn't have a bill yet, just a few principles. But they're enough to make clear that he agrees with Speaker Paul Ryan and House Republicans about a dramatic, conservative tax overhaul, and is looking to press for more than they are yet comfortable with.

The theory behind Trump's plan is that lower tax rates for individuals and businesses will lead to more work and investment. Combined with a simpler tax code that creates fewer distortions, this will spur fast economic growth.

One man's supply-side tax reform is another man's tax cut for the wealthy. Republican efforts are sure to meet ferocious opposition from Democrats. But others will also oppose Trump. To pay for his rate cuts, Trump will be forced to eliminate scores of tax breaks that benefit specific industries and groups. As drawn up, his plan would be a declaration of war on the housing industry, blue states and any number of other powerful interests.

Trump has only a tiny margin of error because Republicans have just 52 seats in the Senate. That slim majority will face intense pressure, given the ambition of Trump's tax reform on the one hand and the institutional constraints of the chamber on the other.

Assault on blue states, blue ideas

Trump didn't have to take this path. At the start of his tenure, other options were available.

It's not hard to imagine Democratic support for the goals laid out by Treasury Secretary Steven Mnuchin during his confirmation hearings, for instance. Mnuchin said he wanted a middle-class tax cut, a corporate tax-rate reduction and to observe what then became known as the "Mnuchin Rule": No net tax cut for high-earners. After all, former President Barack Obama also sought to lower the corporate tax rate from its current level of 35 percent, the highest among advanced economies.

When Trump advanced legislation to repeal the Obamacare taxes on high earners, however, the path for bipartisanship narrowed. By the time he released his tax principles in April, the path was closed. It's not just differences over tax policy, but generalized political opposition to Trump from Democrats.

By setting the ultra-aggressive 15 percent target rate for all businesses, the reform outline determined that legislation will have to proceed through the special procedural tool known as budget reconciliation, which allows bills to pass with only 51 votes in the Senate and thus avoid a Democratic filibuster.

Trump's plan, one page of bullet points announced by Mnuchin and economic adviser Gary Cohn, was a recommitment to his campaign tax plan, which was drafted to please Republican primary voters and developed with the help of die-hard, long-time supply-side advocates.

One of these is Stephen Moore, a scholar at the conservative think tank the Heritage Foundation, who has built a career in advocating lower taxes and lighter regulations. Before the Trump administration settled on its outline, Moore said, he and other supply-siders told them to "go back to the plan Trump ran on, won on." And they did.

Although the outline is bolder in some ways than the House Republican plan that Ryan and others introduced last June, the broad thrust is similar. "These are not huge differences," said Ken Kies, managing director of the Federal Policy Group and a prominent tax lobbyist. The White House and House Republicans plan to unite around a single measure before introducing actual legislation.

Both plans would lower the corporate tax rate, the single greatest job creation measure, the White House believes. Ryan seeks a 20 percent rate compared to Trump's 15.

Both plans would create a special new tax rate for such businesses as partnerships, sole proprietorships and S-Corporations that file taxes through the individual income tax code. This is a major and controversial innovation. While House Republicans set the rate at 25 percent for these businesses/individuals, Trump's rate is the same as the corporate rate, 15 percent.

A special tax rate for "pass-throughs," as these businesses are known, would be a major boon to restaurants, convenience stores, mechanics and other small businesses, which today can face a top tax rate of 44.6 percent. The Trump administration will be careful to present it as a "small business" tax cut.

It would, though, affect all kinds of businesses, and much of the benefit would accrue to large businesses and wealthy individuals. Today, pass-throughs account for the majority of business income and employment in America, and include many big businesses, such as the home improvement chain Menards and the construction giant Bechtel, along with many hedge funds and other financial firms. Trump's own business, the Trump Organization, comprises numerous pass-through businesses.

As a result, creating the special pass-through tax rate would represent a historic business tax cut, comparable in magnitude to the corporate or income tax cuts being contemplated. Over 10 years, it would lower revenues by $1 trillion, according to Goldman Sachs economists. The Treasury could lose another $1 trillion, the same economists reckoned, as C-corporations reconstituted themselves as S-Corporations and individuals set up LLCs to take advantage of the special rate.

Add to that Trump's call to lower the top individual tax rate to 35 percent and eliminate the estate tax, and it is clear that his plan is not incremental but radical.

To prevent the reform from exploding the federal deficit, it won't be enough to close a few small loopholes. Trump will have to eliminate some breaks that have been untouchable for decades.

That starts with the deduction for state and local taxes, a tax break worth $1.3 trillion over 10 years, according to the Treasury. Eliminating or scaling back the deduction would punish high-income earners in safely Democratic states, the constituency that makes up the "resistance" to Trump.

The break, which is as old as the income tax code itself, allows taxpayers to deduct state and local property taxes, along with either income or sales taxes, from their federal taxable income. It disproportionately benefits the high earners who itemize deductions. Nearly 90 percent of the benefit of the deduction flowed to taxpayers with incomes over $100,000 in 2014, according to Congress' Joint Committee on Taxation.

Because it offsets high state and local taxes, the break is an incentive to states and cities to raise their own tax rates. It's a blue-state subsidy. New York and California alone account for a third of the deduction's total value, according to the nonprofit Tax Foundation. In New York City, the average deduction is nearly $25,000.

Reagan and Bush both sought, with different amounts of effort, to eliminate the deduction, but couldn't overcome political opposition.

In the Trump administration's eyes, failing to eliminate big tax breaks would mean that the tax reform cannot be as transformational as they hope.

"If we end up negotiating back all the deductions we're trying to get rid of, it's not going to be much of a tax reform," said White House legislative affairs director Marc Short, speaking in his West Wing office.

Other breaks would be just as hard to scale back. The mighty housing industry lobby, for instance, has already mobilized to protect several of the deductions and breaks from which it benefits, erecting an early obstacle to Republican aims.

Yet the proposed battle over the state and local deduction is more noteworthy because it pits a right-wing White House against high-tax blue states at a time when those states are particularly vulnerable in Congress.

Taking away their deduction would force governors and legislatures in deeply indebted states into a quandary, noted Steven Malanga, an expert on state and local fiscal policy at the right-of-center Manhattan Institute.

Today, business executives, athletes and celebrities in California, with its 13.3 percent top income tax rate, face an incentive to move to a low-tax state such as Florida, which has no income tax. That incentive would get much stronger if residents were no longer allowed to deduct those state taxes from their taxable income, but instead forced to bear the full cost.

Ending the deduction could lead to an exodus of businesses and big taxpayers, straining the finances of California, New York and indebted cities such as Chicago. They might respond by raising taxes even higher, Malanga speculated. "It wouldn't shock me at all, because that's how they got to be high tax states in the first place," he said.

Alternatively, the states could respond by cutting spending. The tax reform could force fiscal conservatism on them.

That would be "a positive" from the perspective of the administration, said Short, even though it wouldn't be the main justification for ending the tax break.

The reasoning for axing it is the same as for the thousands of deductions, credits and preferences embedded in the tax code: they lose revenues and distort decision-making.

That logic will appeal to Republicans who might otherwise fear such huge reform. To counter it, state governments will argue to members of Congress that the state and local deduction helps balance power between the federal government and states.

"The state and local deductibility right now is actually the more conservative policy," said David Parkhurst, general counsel for the National Governors Association, which is defending the break. Eliminating deductibility, he argued, would create "double taxation" of income. Income would be fully taxed by the state, and then fully taxed by the federal government. Conservative tax experts generally oppose double taxation.

Those arguments have helped states and cities hold on to their deduction, including when Reagan's administration targeted it in the mid-1980s. Then, wealthy New York Republicans such as David Rockefeller teamed with Republican New York Sen. Al D'Amato to preserve the break.

Today, though, there are no Republican senators from New York, or from California, or from any of the top nine states in which the state and local tax deduction accounts for the greatest share of income. So there are no Senate Republicans who would face re-election peril by voting to eliminate the deduction. That's a huge challenge for lobbyists trying to sway senators to keep the break. On Capitol Hill, defending the deduction "has no traction whatsoever. None," Kies said.

But governors are not the only group ready to fight. Losing the ability to write down property taxes would be a big hit to the housing industry. "That's a huge, huge item," said William Brown, president of the National Association of Realtors.

The housing sector is the most prepared of any interest group to oppose the Republican tax plan. In any broad tax reform, realtors, homebuilders and mortgage bankers stand to lose because they benefit from several of the biggest tax breaks in the code. Those also include the mortgage interest deduction, low-income housing tax credits and a break that allows real estate investors to avoid capital gains taxes when selling properties if they plow the gains back into new investments.

Resistance will be fierce. In coming months, Republicans will hear from lobbyists warning that the direction of Trump and Republicans would hurt real estate markets worse than did the 1986 tax reform. To make that case, they could rely on the words of Trump himself, who testified before the Senate Budget Committee as a real estate investor in 1991 that the reform was an "absolute catastrophe for the country, for the real estate industry." Trump would later blame that downturn for helping to push his net worth to negative $900 million.

The torrid summer months facing Washington will reveal Trump's personal willingness to defy the industry he once worked in, as well as many other special interests.

Signs from the White House suggest he's deadly serious. "He really does listen. He takes in a lot of input," Mnuchin said at an early May conference hosted by the Milken Institute, a think tank that focuses on financial issues. But, Mnuchin added, "at the end of the day he makes his own decision."

Mnuchin has projected a cavalier attitude toward the possibility of eliminating the state and local deduction, joking that he moved from New York to pay even higher taxes in California. In a television interview, he stated bluntly that "we don't think the federal government should be in the business of subsidizing the states."

One little-noticed episode may illustrate Trump's appetite for taking on deeply entrenched interests.

In an early April meeting with business executives at the White House, Trump fielded an unrelated question about New York City and answered it with a riff on the merits and shortcomings of the exclusion of municipal bond interest from taxable income, another tax break that benefits high-spending cities and states.

Trump acknowledged that the break is important for cities such as New York, but also noted that for low-spending states — he cited Indiana, home of his vice president — it looks like a "gift" to higher spending localities.

"I call it a tale of two cities," Trump quipped, revealing that he personally has given serious thoughts to the possibility of reforming the municipal bond tax break, which is projected to account for $450 billion over the next decade.

Doing so would be another major lift for Republicans, and, because it would raise borrowing costs for cities and other governments seeking to build roads, bridges hospitals and other infrastructure, would cut against some of Trump's priorities.

The president's comments were enough to attract notice from groups that back the break. Mike Nicholas, CEO of Bond Dealers of America, a trade group, noted that Trump also has supported the exclusion when talking with mayors, and that his group is active in trying to sway Congress.

Trump is thus signaling a willingness to go a long way to lower tax rates. He may be too aggressive for congressional Republicans, especially in the House.

Ryan's quest

Ryan has wanted tax reform for years, at least since he became the ranking Republican on the House Budget Committee in 2007 and during his brief tenure as chairman of the tax-writing Ways and Means Committee.

Along with Kevin Brady, the Texan who is now chairman of the Ways and Means Committee, Ryan learned a significant lesson about institutional obstacles to tax reform in 2014, when then-chairman Dave Camp of Michigan wrote a comprehensive tax reform bill.

Camp's bill, on paper, lowered rates without adding to the deficit. But lowering the corporate tax rate to 25 percent, forced Camp to eliminate too many tax breaks and to add new taxes, such as a levy on big banks. Because it would have created too many losers, the bill was dead on arrival.

The plan that Ryan and Brady introduced last summer was designed to avoid those problems. Rather than include tax base "broadeners" that raise revenues at the expense of hurting growth, they decided to pursue a plan that, as Brady frequently says, is "built for growth." The idea was that they would find a plan that most boosts economic growth, as judged by the economic models used by budget scorekeepers, and then include the tax revenues generated from that growth in judging whether the plan maintained the current level of revenues.

After Republicans took control of the House and Senate in 2015, they worked to change congressional rules so revenues from economic growth could be included in official estimates. This is called dynamic score.

That's why Ryan's tax reform outline, for instance, allows businesses to write off new investments immediately. Economic models calculate that allowing this full expensing would boost growth strongly because it encourages companies to add more machinery, plants and equipment than they otherwise would. That's a marked difference from Camp's bill, which, to raise revenues, required businesses to write off business over a longer time frame, slowing growth.

The difference is huge. According to an estimate from the Tax Foundation last summer, the House Republican reform could generate up to $2.2 trillion over 10 years in dynamic feedback. Although Congress' in-house scorekeepers might not credit the plan with that much growth, lobbyists and members think something on that scale is achievable. One lobbyist suggested a $1.5 trillion figure was within reach. Speaking in an interview with CNBC, Sen. Rob Portman of Ohio, who has promoted dynamic scoring, suggested that a well-crafted plan could create $1 trillion of headroom.


Underlying the House Republicans' strategy is the assumption that they will have to pass tax reform through the reconciliation process. To do so, the bill can't add to the deficit beyond the 10 years for which the congressional budget is set — the budget "window," or it will be subject to a Democratic objection. If it does add to the deficit in any year after the tenth, the tax cut would have to be temporary.

There is tension between the Trump administration and House Republicans over the need to make the tax cuts permanent.

"I feel strongly the Reagan-style reforms — they were both bold and permanent, and revenue neutral — is the model for us to use," Brady said.

All of those points go together. If the reforms aren't revenue-neutral, they can't be made permanent through reconciliation. And if they don't include both businesses and individuals, support will fall apart, as demonstrated by Obama's failed effort to lower the corporate tax rate alone.

Congressional Republicans think tax reform must proceed through reconciliation. "It's pretty clear that's the only way it can happen," said Sen. Pat Toomey of Pennsylvania, a member of the Finance Committee.

That's not the only reason House Republicans see permanence as critical. They also believe a permanent tax code is crucial to generating economic growth, because it allows businesses to make plans and invest for the long term, and not be hampered by uncertainty on the horizon.

"Businesses want certainty; they want permanence," said Caroline Harris, chief tax policy counsel at the U.S. Chamber of Commerce, interviewed on Bloomberg TV after Trump rolled out his tax plan.

House Republican leaders don't want to repeat what happened with the Bush tax cuts, which were temporary and were partly reversed by Obama.

"Congress, for the last 10 years, has talked about doing big, comprehensive tax reform and any opportunity to do that is something that the Congress — I think they would just hold out" for permanent, comprehensive reform, said Marc Gerson, vice chairman of the tax department at Miller & Chevalier and a former Ways and Means staffer.

Trump team is OK with temporary

The Trump team has pointedly declined to commit to a permanent reform or to rule out something similar to the Bush tax cuts.

"If you're able to get Congress to go along with eliminating the right deductions in a way that this can be deficit-neutral, then that's the preferred path," Short said. "But it's more important for us to protect the growth elements of the plan."

Unlike House Republicans, Trump and his advisers haven't been strategizing for several years, and they have not absorbed the same lessons as lawmakers from the temporary Bush cuts.

They see 2017 as the one big chance to get a tax bill through, while they have a Republican Congress and before other priorities start to crowd the legislative calendar in 2018.

So they have adopted the view that even a temporary tax cut would be good. Either it would immediately stoke economic growth, in which case future Congresses would extend it, or it wouldn't be worth keeping.

The White House has been influenced by old-school supply-siders. Permanence is ideal, said Moore, but the key is to get a corporate tax cut in place quickly to maintain business optimism, even if it is only temporary and loses money for the Treasury. "That's what Republicans do, they cut taxes," he said.

History suggests that, when the negotiations begin in earnest, considerations about the effect on the deficit, as estimated by budget scorekeepers, will dominate.

Convincing nervous centrists that a certain rate reduction won't cost the Treasury billions, or that ending a prized tax break worth hundreds of billions is worth it for the result it brings, will be key.

Some of those decisions must be made ahead of time if the bill ultimately is going to be passed through reconciliation for the fiscal 2017 budget. Congress will have to write that budget in the months ahead and include provisions spelling out the broad parameters of any reform.

Those discussions are taking place now behind closed doors, said Sen. Orrin Hatch, chairman of the Senate Finance Committee.

Trump will need to recognize that committing to reconciliation means he can't afford to lose more than two Republican votes in the Senate, which gives senators leverage over him. It also empowers interests, one lobbyist said, who would only need to peel off three Republicans to protect a tax break. For its part, the White House plans to send Trump to the districts and states of members of Congress whose votes are needed.

As those talks ramp up, House Republicans have been arguing that permanence is a goal worth pursuing. Brady and Peter Roskam of Illinois, chairman of the tax subcommittee, emphasized after the release of Trump's plan that they would negotiate to make the plan permanent.

They've sent the White House signals, some subtle and some not, that a temporary tax bill might not be feasible or even desirable.

Speaking at an April banking conference in Washington, George Callas, Ryan's senior tax counsel, decried the "continued survival of magic unicorns," or ideas for tax reform that are not viable. One of those ideas is that a temporary corporate tax cut could pass through reconciliation. At most, he said, only a two- or three-year corporate tax rate cut would be allowed under Senate rules.

Later, Politico published a score that Ryan's office had received from the Joint Committee on Taxation showing that a three-year reduction in the corporate tax rate to 20 percent would lower revenues beyond the 10-year budget window as companies planned to shift income from the future into that three-year window. Because it would add to deficit deficit beyond that, it couldn't pass through reconciliation. The release of that letter to the press was seen as a warning to the administration.

Republicans split

Congressional Republicans are divided over whether tax reform has to be revenue-neutral or permanent. The fault line is not, as it so often is, between conservatives and centrists, but between members on and off the committees that have been involved firsthand in past tax debates.

"There isn't a particular bias," said Bill Flores, a Texan who previously served as chairman of the Republican Study Committee, a caucus of conservatives. Because he has served on the Budget Committee and appreciates the government's fiscal situation, Flores said, he doesn't favor a tax reform that adds to the deficit, after economic growth is taken into account.

Centrist Republicans and even Democrats would be willing to consider adding to the deficit on paper, if the policy were right and permanent, suggested Tom Reed of New York, a Ways and Means member and co-chairman of the bipartisan Problem Solvers Caucus. Reed cited the 2015 bipartisan deal to make permanent $630 billion worth of temporary tax breaks that previously Congress had re-upped every year.

Rep. Roger Williams has a different perspective, based on owning an auto dealership. Although he's not on the Ways and Means Committee, Williams has put together a tax reform package aimed at boosting economic growth.

For him, revenue neutrality is inadvisable, because it means "every bone you give the taxpayer is a bone you're going to take away." Instead, he'd favor lowering taxes to aid business growth, then cutting federal spending to prevent the debt from rising. And although he'd favor a permanent change to the tax code, as a businessman, he'd cut a deal to make a temporary one if necessary.

As the healthcare debate showed, buy-in from the House Freedom Caucus will be essential. There, too, the politics are not straightforward. While conservatives in the caucus generally are top opponents of adding to debt, they see tax cuts differently. Some would likely favor a tax reform package that adds to the deficit to one that doesn't.

Freedom Caucus member Rep. Andy Biggs of Arizona suggested he'd be willing to bet that reform would pay for itself through economic growth even if it didn't do so on paper, noting that official budget scorekeepers "tend to be overly cautious" about the positive impact of improving the tax code.

Some Republican quarters still want to "starve the beast," cutting taxes and thus forcing cuts to spending as well. Rand Paul, the libertarian-leaning senator from Kentucky, summed up that view in an op-ed for Breitbart headlined "Real Men Cut Taxes."

Different methods

Mnuchin has suggested that there are different "levers" for implementing tax reform through reconciliation. There are ways to game the Senate rules relating to reconciliation, ranging from clever workarounds to brazen defiance.

Inevitably, Trump will be tempted to use one or more of them.

One option, advocated by Toomey, would be to write a budget for 20 or 30 years. Although 10 years is the standard for a budget timeframe, there is no law requiring that it be that length. With a multi-decade budget window, Republicans could pass a "temporary" revenue-losing tax reform through reconciliation that would be functionally permanent, because 20 or 30 years is effectively forever in terms of tax law.

Another, advanced by CNBC commentator, former Reagan budget official, and hardcore supply-sider Larry Kudlow, would be simply to force the budget scorers to assume a certain rate of economic growth in future years, making the plan revenue-neutral. That would be the diciest option, and the one that flouts Senate conventions the most.

More conventionally, the administration could simply convince Congress to go along with any number of gimmicks. One example, offered by Dean Zerbe, a former Finance Committee tax counsel and national managing director for Alliantgroup, would be to include some major revenue-raiser, such as the import tax favored by House Republicans, in the reconciliation bill, and then simply repeal or delay it separately. That would be analogous to the "Cadillac Tax" on generous healthcare plans included in Obamacare, which helped the bill's fiscal score but has since been delayed.

None of the options is great, though, and none will help Trump avoid tension with House Republicans. "We can see this train wreck coming over the budget deficit," said Dan Clifton, head of policy research at Strategas Research Partners and a former tax lobbyist who worked on the Bush tax cuts.

If the administration really has the ability to massage scores from the Congressional Budget Office, Clifton noted, they would have found a way to avoid the score of the Obamacare replacement bill that found that it would cause 24 million people to lose insurance.

Institutional knowledge

For scoring purposes, the administration's relative lack of institutional knowledge is a factor.

Mnuchin's career has been at Goldman Sachs and as a regional banker and financier. Gary Cohn, the National Economic Council director, was the president of Goldman Sachs. The top-ranking official with congressional experience on taxes and familiarity with members of Congress is Shahira Knight, Cohn's deputy who served as a Ways and Means staffer and tax lobbyist.

While members of Congress were absorbing the lessons of the Bush tax cuts and gaming out the possibilities for scoring tax reform, Trump's team was involved in business. Some involved in writing legislation think that they might be at a disadvantage because of their lack of hands-on tax experience.

Hatch gave a vote of confidence in the ability of Mnuchin and Cohn to navigate the congressional process. "These are bright guys," he said. "They're very, very bright and they know it's going to be tough whatever they want to do, and I give them credit for being willing to try."

Yet being smart is not a complete substitute for experience, said one tax lobbyist. "If you had brain cancer and I said, 'I've hired 5 guys from Goldman Sachs and they're brilliant, and that they're going to spend the next five weeks reading up on brain cancer, can they perform the surgery?' You'd say, 'f—k no.' "