Friday, December 01, 2017

What could a reasonable Republican-ish tax reform have looked like?

Now that the tax bill is temporarily paused due to deficit issues - although I'm still expecting it to go through, and probably sooner rather than later - it's a good time to ask, not so much what went wrong as what could have gone right, at least in an alternative universe where our political system was better-functioning. And in particular, I'm thinking of an alternative universe in which, say, the beliefs of reputable conservative economists, rather than reputable liberal economists, had particular influence with policymakers. (I say this due to a number of legitimate disputes about good policy that I will mention without trying to resolve here.)

The lesson of the actual process, alas, is that bad people with bad motivations, acting in haste to avoid deliberation and accountability, are going to do bad things. Also, being ignorant seems to have some disadvantages. But even so, some of the ideas they started with, and which are to a degree in the proposed legislation, would have at least arguable merit if done differently.

One more bit of throat-clearing here: I think we academics have learned something about business tax reform - or. to avoid that loaded and misused term "tax reform," desirable business tax changes that respond positively to changed circumstances since 1986.

My sense of the predominant consensus among us several years ago is that it viewed the corporate (or business) and individual levels as too intertwined for one to be changed significantly without also addressing the other.  But then some of us got impatient. The business level of current U.S. income taxation is so bad, the view grew, that can't we do something about it without waiting for the whole thing to improve?

In principle, this view could be either right or wrong. It's a judgment call. Obviously addressing the whole thing would be better, but might it still be worth trying to hit a double instead of a homer?

I am thinking that the answer has turned out to be: No. A key problem I (and others) had with the destination-based tax was that doing it apart from addressing the individual side threatened to cause real problems. But politics has also strengthened the case for No.

The movement for a lower pass-through rate, which (as I've argued in earlier blog posts) might end up being the single worst structural change in the history of the U.S. federal income tax, shows how politically intertwined the corporate/business and individual levels are. But in an earlier version of the problem, people came to realize that paying for lower corporate rates through income tax-style base-broadening would hand the pass-through sector a huge tax increase that, whether or not it was good policy, was certain to be politically unfeasible. Same problem from the opposite angle.

OK, getting at last to this blogpost's title, what could a reasonable Republican-ish tax reform have looked like? Here are some main points:

1) Lower corporate headline rate, with base-broadening offsets. But note two different types of offsets: those that simply get rid of industry-specific tax breaks, and those that make our system more of an income tax and less of a consumption tax. It's easier to reach intellectual consensus in favor of the former than the latter. But doing just the former wouldn't pay for much of a rate cut at all, on a revenue-neutral basis that ought to have remained the target given long-term fiscal issues.

Lower still, thus losing revenue? Maybe, if there are alternative revenues sources - e.g., VAT or carbon tax. (The key to the destination-based tax, of course, is that it tried to smuggle in a VAT by calling it something else.) But if the corporate or business rate is lower than the individual rate, and you still have an income tax at the individual level, a bunch of further steps are desirable. One is to try to limit the extent to which the benefits of the lower rate reach old investment. It should just be for new investment. But the politics on this are backwards - inefficient transition gain is exactly what the donors want.

Also, if the corporate or business rate is lower than the individual rate, one should think about shifting more taxes to the owner/shareholder level, and also about addressing the use of corporations as a tax shelter via the underpayment of taxable compensation to owner-employees. (The lower passthrough rate gets this completely backwards - extending preferential rates to labor income of owner-employees, despite the supposed guardrails, and despite the second level of corporate tax, and thereby inflicting punitive relative treatment on employees plus insoluble line-drawing problems.)

2) Move towards expensing - Once again, there is dispute about this. E.g., just limiting it to my past or future Tax Policy Colloquium co-teachers, Alan Auerbach vs. Lily Batchelder. But there is a case for expensing, so long as it's accompanied by sufficiently addressing interest deductibility, so taxpayers can't get a net subsidy by combining consumption tax treatment of the outlay with income treatment of the interest expense.

But implementation of expensing, when there is still an income tax at the individual level, requires further thought about the coordination between business and individual taxes. Plus it causes big problems when tax rates change.

I've been pointing this out with reference to the idiotic Senate Republican proposal to start expensing in 2018 and the lower corporate rate in 2019. (Hence, deducting $100 in 2018 at the 35% rate, in order to earn $90 in 2019 at the 20% rate, makes money after-tax.) But it's a much broader and more general problem. Indeed, I gather that the Senate Republicans are struggling with the other side of it right now, as businesses have complained to them (making a conceptually correct point) that they would lose from expensing outlays at a 20% rate and then including the returns at, say, a 22% rate.

3) International - Here there is actually a bit of free money available, in an efficiency sense. (Not free politically or distributionally, however.) Two aspects of it. First, deferral makes no sense whatsoever. I have long called it a "ceasefire in place" between the warring pro-worldwide and pro-territorial viewpoints. No one with any sense favors deferral; the issue is "compared to what." Immediately taxing US companies on their foreign profits at the "correct" rate is unambiguously better than deferring the tax, which would then ultimately depend on the tax rate in the repatriation year plus the value of foreign tax credits.

But what is the correct rate? Oops, that's the hard part, and I certainly don't mean to rule out the possibility that, at least in some instances, it might be zero. Due to the complex nature of the underlying issues, which I've tried to unpack (without resolving definitively) in a number of academic articles, we don't know what the correct rate is, or how it should vary with particular details of the foreign source income that is at issue. (E.g., what is reported as tax haven vs. other income.) A further problem is that there's no clear consensus about the optimal amount of profit-shifting by US and foreign companies that are operating in the US. It's not necessarily zero, since they may be more mobile than other businesses. That undermines figuring out how rigorous the anti-profit-shifting rules should be, especially if some of our tools work better against US than non-US companies but we don't inherently want to treat the two differently.

Still, the problems with international deferral means that something better ought to be possible. Plus, it is clear that a deemed repatriation of past earnings that US companies have stashed abroad would not only raise revenue (within the budget window, no less) but be desirable in efficiency terms. E.g., it reflects past decisions, and might reduce the anticipatory incentive to engage in further future profit-shifting that exceeds what we determine is the optimum.

So that's in a sense free money in budgetary terms, except that the rate imposed could in principle be too high, plus the companies aren't going to like it unless the rate is very low.  (If too low, it's in effect another repatriation holiday even if mandatory. After all, a mandatory deemed repatriation is equivalent to a voluntary holiday for anyone who would have taken advantage of the holiday anyway.)

Obviously this falls far short of saying what a principled Republican-ish tax reform could have looked like. But it could have had a lower corporate rate, properly addressing the difference between corporate and individual rates, a new revenue source,, something more like expensing but with reduced interest deductibility and due sensitivity to tax rate changes, and something in international, where there are reform plans out there that could have been consulted.

Sounds pretty vague, I know, but with good people who cared about governance, a year or two of bipartisan deliberations might have led to something that principled conservative economists could endorse without descending to dishonest hackery, and that principled liberal economists could agree had significant merits even if they would do some of it differently.

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