This week, the president outlined his plan to reform and replace the tax code. But it is just an outline. The hard work will be in the details, which requires specifying the winners and losers of the changes. And that means the battles will be fierce.
To begin with, Congress must decide between making tax cuts or actually reforming the code. There are major differences between the two: Cuts add to growth only in the short term while reform has the potential to create a more efficient, faster growing economy in the long term.
So, what is the difference between tax reform and tax cuts?
Tax cuts are simple: You lower the rate or create additional ways to reduce the amount of corporate or personal income that is taxed. Loophole closing is not a primary concern.
Tax cuts are the equivalent to a sugar high. You get more money and you spend it, but what do you do next year and the year after? You need another dose of the drug or you keep doing the same thing.
Tax reform, however, is the restructuring of the code.
Special tax breaks are eliminated in order to make the code simpler and fairer. Loopholes that add little to growth or create inefficiencies are eliminated.
For example, all personal income could be taxed similarly, regardless of the source. For businesses, loopholes would be closed so no matter what the industry or source of income or costs, all firms are taxed the same.
The goal of tax reform is to take taxes out of the household and business decision process.
Firms should focus on economics, not tax benefits. Households should spend on what is most important, not on what might give them a tax break. And investors should invest in firms that grow faster, not those that profit from tax gimmicks.
The current tax structure warps economic decisions by creating misplaced incentives to spend, produce, and invest. Tax reform that corrects those problems would make the economy more efficient, allowing it to potentially grow faster for an extended period.
That has enormous implications.
First, it means that Congress should focus on the special tax breaks, not on the rates. The top corporate tax rate of 35 percent doesn’t matter if you don’t pay it.
The average corporate rate is closer to 28 percent, and while some firms pay above the average, many pay much less. The code creates tax winners and losers, rather than the economy, and that is wrong.
Reforming this monstrosity, however, will not be easy.
If you change the law, some businesses and households would pay more, and they will not give up their advantages without a huge fight.
Businesses will be pitted against businesses and individuals against individuals — through their elected representatives and lobbyists, of course.
And let’s not forget that changes in the code will affect revenues and the budget deficit.
Understand this: There is essentially no evidence that tax cuts pay for themselves. Initial estimates are that the administration’s plan increases the deficit anywhere from $2 trillion to $3 trillion.
Politicians who have positioned themselves as deficit hawks have two choices. They can accept rising deficits (doubtful). Or, more likely, they will use unrealistic growth estimates that most economists dismiss out of hand, to show their plan doesn’t increase the deficit. That is already happening.
Meanwhile, politicians who could care less about deficits in the past are demanding that tax changes be “revenue neutral.”
What a strange political world we live in.
Finally, the issues of economic impacts and fairness will be raised.
The effects on growth of tax changes depend upon who benefits and who loses. The more that tax benefits accrue to higher-income households or slower-growing companies and sectors, the lower the impact on the economy.
Will politicians, as they have promised, not cut upper-income households taxes? Or will they do as they have done in the past, which is reduce everyone’s taxes but concentrate the gains in higher-income groups?
Will the tax breaks/loopholes that have little or no economic value be repealed?
Will companies and individuals who pay little or no taxes because of special tax breaks or accounting gimmicks be made to shoulder their fair share of the burden?
And if spending is to be cut to balance the budget, who will lose?
Tax reform, unlike tax cuts, requires pain sharing. And because politicians don’t like to inflict pain, I fear there will be much more tax cuts than real tax reform in whatever package is finally passed.