Headlines are buzzing about what’s in the plan to overhaul the tax code that the Trump administration is set to release today -- a huge business rate cut, much larger standard deductions, a new child care tax credit. Notably absent from those headlines, though, was any mention of how the president and his advisors plan to pay for what would amount to a massive cut in federal revenues.
The most dramatic element of the proposal, expected to be released in general form today, would be how business income is treated. The president’s plan would cut the corporate tax rate by more than half, from 35 percent to 15 percent. That cut is expected to apply not only to large public companies, but also to smaller businesses structured as “pass-throughs,” in which the earnings from a business venture are taxed on the owner’s individual income tax filing.
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This, all by itself, would be extraordinarily expensive. Reducing the tax rate on large companies would cost the Treasury between $2 trillion and $2.5 trillion over a decade. Extending that break to pass-throughs would add another $1 trillion to $2 trillion to that total.
Without a plan to offset those losses -- and Trump isn’t expected to offer one -- the federal government would have to borrow that money to fund normal government spending. On top of what is expected to be a rising interest rate environment for the next several years anyway, that would drive rates even higher, meaning that the cost of government borrowing will also increase.
The standard argument in favor of proposing such a dramatic rate cut without any offsets is that tax cuts pay for themselves by increasing economic growth. The idea is that a larger economy generates more corporate profits, and hence increased tax revenue to offset the losses from the cuts.
But while that is held as an article of faith by some on the political right, the numbers simply do not bear it out. On Tuesday, the conservative-leaning Tax Foundation published an analysis of what it would take for the business tax cut to pay for itself over a ten-year window. It concluded that it would require the economy to grow at an average rate that is 0.9 percent per year higher than currently expected.
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But according to Tax Foundation economist Alan Cole, the numbers don’t add up when fed into his organization’s model -- a model that is generally optimistic about the economic effects that tax cuts have on economic growth.
“Tax Foundation’s Taxes and Growth model would not predict 0.9 percent added growth over the budget window from a corporate rate cut to 15 percent,” Cole wrote. “The model predicts something more like 0.4 percent over the budget window: a sustained period of 2.3 percent growth instead of 1.9 percent growth, until the economy is eventually about 4 percent larger.”
That, to put it plainly, means that the Trump tax plan would blow a hole in the federal budget that would have to be plugged by more borrowing.
And that only accounts for the business rate cut, not the other tax cuts the White House is expected to propose today.
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The plan also reportedly contains a proposal for dramatically increasing the standard deduction, which is taken by people who don’t itemize their tax returns. The standard deduction is currently $6,300 for individuals and $12,600 for families. It is unclear exactly what the administration will propose today, but during his campaign for the presidency, Trump repeatedly suggested more than doubling both -- raising the individual deduction to $15,000 and the family deduction to $30,000.
The effect of such a change would be a substantial windfall for many taxpayers. Considering a family with a top marginal tax rate of 25 percent, the change could wipe out $17,400 of taxable income, translating into a $4,350 tax cut.
In general, the higher taxpayers go up the ladder of marginal income tax rates, which currently top out at 39.6 percent, the more likely they are to itemize their returns, allowing them to take advantage of things like the mortgage interest deduction and the charitable giving deduction. The sharp increase in the standard deduction would make itemization less attractive for many taxpayers, resulting in a much simpler tax filing process for some.
As with the business tax cut, the increase in the standard deduction would be another blow to government revenues that would likely have to be offset by increased government borrowing. The same is true for whatever the administration proposes to do with its child and dependent care tax credit.
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In the end, what the Trump administration seems to be doing, as the president approaches his 100th day in office, is proposing some of the easy parts of tax reform -- rate cuts, larger deductions, more credit -- while avoiding the difficult work of explaining how to pay for them.
Moving forward, this could go in two different ways.
The proposal unveiled today could be the starting point for what morphs into a serious discussion of major tax reform, with the administration and lawmakers sitting down to negotiations over how to pay for the cuts being proposed. Generally, economists look for cuts to be offset with “broadening” of the tax base. That is, the fiscal effect of rates being driven down can be offset by eliminating tax deductions that insulate some income from taxes altogether.
Or, the White House and lawmakers could take the eat-dessert-first route, passing a package of politically popular tax cuts and worrying about the fiscal impact later. They may simply stick to the idea that the cuts will ultimately pay for themselves and not worry about it at all.
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In either case, the result will be wholly owned by the Republican Party. Not only does the GOP control both houses of Congress and the White House, but the party’s leaders have indicated that they intend to use the budget reconciliation process to pass their tax reform proposal, allowing them to ram the legislation through Congress without any Democratic votes.
The reconciliation process, though, while it makes it simpler for the GOP to assure that its priorities are written into the bill, has one major limitation: Legislation passed using it cannot add to the federal deficit outside a ten-year window.
That means that the eat-dessert-first option would have to come with a sunset provision, making some or all of its effects temporary.
