The Next Step in Tax Reform Is Tax Repair - Bloomberg

The Next Step in Tax Reform Is Tax Repair

Republicans knew the flaws in the bill and passed it anyway. It will be up to Democrats to fix the mess.

By Noah Smith

December 28, 2017, 9:00 PM GMT+11

The job isn't finished.

The Tax Cut and Jobs Act of 2017 -- commonly known as the Republican tax reform bill -- has a number of good things in it. My Bloomberg View colleague Justin Fox has an excellent rundown. The corporate-tax rate cut was something that needed to happen for a long time, and mainly just follows the example set by other developed nations. Limits on the mortgage-interest deduction and the tax deductibility of interest payments will discourage companies and households from taking on too much debt. The limiting of deductions for state and local income taxes, although probably intended as a cynical move to tax residents of high-tax blue states like California and New York, could also be progressive in its impact.

But overall, the tax bill is a mess. Since it was rushed through Congress without extensive debate, there are probably tons of loopholes and perverse incentives in the law that will be discovered in the years to come by clever tax accountants and lawyers. These loopholes and bad incentives will need to be closed -- if not by the Republicans, then the next time the Democrats are in power.

Already, though, the broad contours of many problems are apparent. Since the GOP Congress knew about many likely problems in advance, and yet chose to pass them anyway, it’s likely that the task of fixing them will fall to the Democrats. In other words, Democratic politicians and policy advisers should already be thinking about tax repair.

The biggest problem with the bill is also one of its centerpieces -- a 20 percent deduction for pass-through business income. S corporations, limited-liability corporations, partnerships and sole proprietorships will now be taxed at a much lower rate than ordinary personal income. That opens the door for all kinds of tax avoidance. Instead of having a job, just set up a shell company and become an independent contractor; your income will now flow through the shell company, instantly lowering your tax rate without any substantive change in what you do. Of course, your employer will have to go along with the scheme, but many will, especially for highly paid employees. Already, less than half of pass-through income comes from traditional business activities, and this fraction can be expected to decrease with the new rate cut.

This amounts to a substantial income tax cut for the rich. Not only will it make the tax system less progressive, but it will create large deficits -- high earners pay an outsized share of the income taxes that make up the U.S. government’s main revenue source. Instead of focusing on cutting the top income tax rate, as in previous tax cut plans, Republicans have simply offered rich people a way around it. Big deficits will put pressure on the Federal Reserve to keep interest rates very low, in order to save the government from having to make large interest payments on its debt. That could distort the economy in ways that are poorly understood, or -- in the most extreme case -- even put the country in danger of a hyperinflation somewhere down the road.

A second problem with the tax bill involves the shift to a territorial tax system for corporations. Under the previous system, companies had an incentive to use various accounting tricks to shift profits to overseas subsidiaries in low-tax nations and hold them there for long periods of time. For a while, Congress flirted with an idea to tax profits based on where actual sales were located, which would have put an end to many such shenanigans. But instead, the final bill switched the U.S. to a system that makes the shenanigans even more harmful. Under the new system, some experts believe a company will be able to move its real operations -- factories, offices and research centers -- to another country, then book the profits in a tax haven, and end up paying almost no taxes. Not only will that reduce corporate tax revenue and increase deficits further, it will probably result in the offshoring of more U.S. jobs -- exactly the kind of thing President Donald Trump promised to halt.

A third big problem with the bill is a big cut to the estate tax. From 2018 until 2026, wealthy individuals will be able to pass on $11 million -- or $22 million for couples -- tax-free. That’s exactly the opposite of the direction that the country needs to go. The staggering rise in wealth inequality means the country needs more inheritance taxation, not less. And estate taxes are a good way of transferring money away from heirs toward people who will invest it more productively. Instead, the estate tax cut moves the U.S. even further toward a less mobile, less productive and more ossified society with rigid class divisions.

The final big problem with the tax reform bill is the repeal of the individual health-insurance mandate, a key part of the Obamacare system that has substantially increased the number of Americans with health insurance. The mandate imposed a penalty on those who failed to buy insurance, helping to bring down premium costs for those with coverage. Ending this will allow more healthy people to exit the health insurance market entirely, raising prices for everyone else.

So even before all the other loopholes and bad incentives in the tax reform bill make themselves apparent, Democrats should be thinking about fixing these four big problems. The pass-through tax rate should be raised back to the individual tax rate level. The territorial tax system should be modified so that companies can’t catch a break by shifting jobs overseas. The estate tax should be expanded, and the individual health-insurance mandate reinstated. Tax reform is a reality, but the quest for tax repair has just begun.