Tax Reform Momentum

The Senate bill improves on the House on the top rate and businesses.


Opinion Journal: Tax Reform: What They’re Saying on Capitol Hill
Opinion Journal Video: Editorial Writer Kate Bachelder Odell on the issues dividing the Republican caucus. Photo Credit: Getty Images.

Congress is now at the stage of tax reform where the details are messy and the political claims are confusing. The trick is to keep your eye on the big picture, and by that measure reform momentum is building. House Ways and Means passed its reform Thursday, and Senate Republicans released reform details that improve on the House bill in important ways.

The biggest news is that the House and Senate plans cut the top corporate tax rate to 20% from today’s 35% that is the highest in the developed world and has punished the U.S. economy. The rate cut would be permanent. Both chambers would also convert the U.S. into a territorial system, which taxes income where it’s earned. These are the crown jewels of this reform that should increase investment in the U.S. and increase wages for workers. (See Lawrence Kotlikoff nearby.)

One asterisk in the Senate version is that the 20% rate would not begin until 2019 to “save” money under the Senate’s bizarre budget rules. But 100% expensing for businesses would be immediate, and expensing is more valuable against a higher tax rate. Economists we trust say this should mitigate any harm from a one-year delay. We’d prefer the immediate cut in the House bill, but a one-year delay is better than a temporary rate cut that would complicate business decisions in the future.

The Senate bill is a notable improvement on the House in its treatment of “pass-through” businesses. These mostly smaller businesses now declare income on personal tax returns, and the House divorces the two with a top rate of 25% on businesses with a complicated formula for what income gets what rate. The Senate instead expands a deduction to allow a 17.4% discount against a top rate of 38.5% (down from 39.6%). The little guys thus do at least as well as corporations, which are taxed twice, on both income and dividends. 

The Senate’s approach is simpler, and businesses with income below the top tax rate can write off more income. This should win support from the National Federation of Independent Business, whose members are often small enterprises. (The House added a 9% bracket to get an NFIB endorsement.) Preserving the structure of the personal small-business tax rate also means that Congress could someday consider lowering the top marginal rate on individuals to spur more growth.

The Senate bill’s individual reform is both better and worse than the House version. It’s better in that it cuts the top marginal rate at least a little, to 38.5% from 39.6% on income of more than $500,000 for single filers. It also removes the House bill’s noxious “bubble rate” of 45.6% for certain high earners.

The Senate also keeps seven tax rates, rather than the House’s four, but the real simplification in tax reform comes less from fewer brackets and more from how you define income. In that sense the Senate bill is also simpler than current law because it eliminates many deductions and credits.

The big victory here is total repeal of the state and local deduction, which is a subsidy for high-tax progressive states. The House carves out an exception for property taxes to win the votes of Republicans from California and New York, and a compromise will be negotiated in conference. But note the GOP consensus that the state and local deduction is on death row. This is the price Chuck Schumer’s Democrats will pay for rejecting any reform.

Alas, the Senate repeats the House mistake of increasing the child tax credit to $1,650 ($50 more than the House) from the current $1,000. The Senate version is better in that it doesn’t include a $300 credit for each parent, but it’s worse in that it doesn’t phase out until higher levels of income. In other words, it’s a nearly universal subsidy. The House child credits cost some $640 billion over 10 years.

Add this to a dependent care credit and the adoption credit, which is back after protests from the cultural right. These do nothing for economic growth and prevent deeper rate cuts that allow all Americans, many of whom are parents, to keep more of their income.

The biggest disappointment is that the Senate won’t repeal the death tax. This is a loss for economic growth and tax fairness, and it won’t deflect Democratic charges about tax cuts for the rich. A doubled exclusion to more than $10 million of estate value is nice, but the wealthy will still duck the tax by moving their assets into trusts or foundations—or sell businesses prematurely. All of this diverts resources from the productive economy, to the benefit of accountants and lawyers.

These details matter, but the larger story is that the Senate—the cemetery for the Republican health-care bill—is joining the House with a pro-growth reform that has a real chance to pass. There are still ways the GOP could trip up: The party must bow to the Senate’s Byrd Rule that bans deficits outside the 10-year budget window, and Republicans can avoid that by repealing ObamaCare’s individual mandate and save more than $300 billion.

Still, this week’s momentum suggests that the GOP is aware that its political future depends on sticking the landing on a tax reform that can lift the economy and unleash broader prosperity.

Appeared in the November 10, 2017, print edition as ‘Tax Reform Momentum.’

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