By Ryan Ellis
President Trump’s key advisers this week released an outline of his vision for tax reform. All told, it would be a very pro-growth change from current law. Tax rates would be lower across the board, especially for businesses who now face rates higher than their competition around the world. The system would be far simpler for families, most of whom would no longer have to keep track of itemized deductions.
Indeed, the headline 15% business tax rate (on both corporations and pass-through business income) is the crown jewel of this package. It’s also positive that the plan explicitly endorses the repeal of the net investment income tax (NIIT) of 3.8%, calls for death tax repeal, and moves to a simplified three bracket system for households (with a lower top rate of 35%). Treasury Secretary Mnuchin, NEC Director Cohn, and their staff are to be commended for a good starting document here.
However, there are serious drawbacks to the tax base the plan envisions, drawbacks which should be addressed in tax reform. There are three tax base issues that need more work:
The Trump plan should adopt full business expensing. Under our current tax code, all but the smallest firms are not allowed to deduct capital expenditures like computers, machinery, and factories. Rather, they must slowly deduct the cost in pieces over many years in a process called “depreciation.” Computers take five years. Furniture takes seven years. Buildings take 39 years, unless they are rental properties in which case they take twenty-seven and one-half. These maddening figures were set by Congress, not by economic good sense.
The proper tax treatment of capital expenditures is to let businesses deduct them in full under a cash flow system. If a business pays $1000 for a computer, it should be deducted in full that very year. It should not be deducted $200 at a time for five years.
The Tax Foundation says moving from depreciation to full business expensing of capital purchases would grow the economy by 5.4% and create over 1 million American jobs. Sixty percent of the static revenue costs would be recovered in the first ten years with this higher economic growth. Over time, full expensing doesn’t reduce tax revenues at all since the change amounts to a timing shift only.
The Trump plan should eliminate the double taxation of savings. The plan as released makes some very good progress here. Killing the economically destructive death tax and the NIIT counts for a lot when it comes to taxing all savings once and only once. But the Trump plan still leaves in place a 20% double tax on capital gains and dividends.
Why a double tax?
If a company issues a dividend, that dividend is not deductible to the company–it is paid with after tax (15% under the Trump plan) corporate profits. Then, when an investor receives the dividend, he has to pay the 20% dividend tax. Put that together, and you end up with a 32% cascaded tax rate on the dividend.
The same is true of capital gains. If a company retains earnings after paying the 15% corporate income tax, the value of the company rises and share prices go up. Our investor who then sells his share of the company has to pay a 20% capital gains tax on his profit–profit which was caused by the post-tax retention of corporate earnings. It’s a lot less straightforward, but the 32% cascaded tax works here, too.
Ideally, savings would be taxed once and only once–at the corporate level. Once the 15% tax is paid there, investors should not have to face any further exposure to taxes on their savings. This is known as a “yield exempt” system.
The Tax Foundation says that moving to such a system would grow the economy by 2.7% and create 544,000 new jobs.
Politically, it is difficult to do this without giving the appearance of “cutting taxes for the rich.” That’s why a pragmatic middle ground here might be to mirror what the House GOP blueprint does–allow people to exclude half the value of their capital gains and dividends from taxation. Under the Trump plan, that would mean a capital gains and dividends cut from 23.8% today to 17.5%–still too high, but a good down payment on further reform.
The Trump plan should reduce the current tax bias in favor of debt and opposed to equity. A final base issue the Trump tax plan should look at as it’s refined and built out is the tax code’s bias in favor of debt and against equity.
A company that wants to borrow can do so in a fully tax-neutral way. Any interest they pay on loans is fully deductible from their tax base, with virtually no limit.
However, if that same company wanted to raise cash by finding investors, they would have to do so using the cascaded double-tax regime described above. Interest is deductible, but dividends and retained corporate earnings are not. That creates clear tax code bias in favor of raising money via debt rather than raising money via borrowing.
There are several ways to address this: lower the cascaded double tax on corporate equity as described above; create a corporate deduction for dividends issued; limit or eliminate the corporate deduction for interest. A plan could mix and match all of these to create a kind of rough justice.
The Trump tax plan is a very good framework in many ways–it tacks in the direction of a system which is more competitive internationally, simpler for families, and is more pro-growth than today. But getting the tax base right is vitally important in making sure that the new tax system delivers the higher economic growth we all hope it will.
Read more here.