Big Stumbling Blocks for Business Tax Reform
The debate about overhauling and lowering business taxes now rushes to fill the congressional vacuum left by defeat of the American Health Care Act (AHCA). While not as emotional as health care, tax reform is every bit as contentious. Proposals advanced by House Speaker Paul Ryan and Ways and Means Chairman Kevin Brady, which have received generalized support from President Donald Trump, promise to ruffle many feathers. Following is a survey of the big stumbling blocks.
The central objective of business tax reform is to lift economic growth. Indeed, if it is achieved, tax reform may turn out to be the most important feature of President Trump’s agenda on growth and jobs, aimed at a 3 percent economic growth target. Infrastructure spending, which would also spur economic expansion, cannot start before the second half of 2018. Trade restrictions, if imposed, will slow growth.
But slashing business taxes offers the potential to faster growth. Basic facts are well known. The federal statutory corporate rate, at 35 percent, is almost the highest in the world, while the effective tax rate on US multinational corporations (MNCs) has exceeded 30 percent in recent years. High corporate taxes depress investment, encourage inversions, and stimulate transfer pricing abuse (for example, underpriced exports or overpriced imports) that shifts profits abroad.
The Congress generally imposes on itself a rule in budget resolutions requiring that tax cuts must be “revenue neutral” within a period of 10 years or expire. Accordingly, lawmakers must make up for lost corporate tax revenues with revenues elsewhere. Business tax cuts could in theory be slashed by eliminating deductions here and there, in the effort to ensure a revenue neutral package. But that would amount to rearranging the deck chairs, with little effect on growth.
Instead, lawmakers will be looking for new and different taxes to make up the revenue gap, provided that three central reform features make their way into law: full deduction of capital outlays when incurred, cutting the corporate rate to 20 percent (Ryan) or 15 percent (Trump), and capping the tax rate on the business income of “pass-through entities” (e.g., Subchapter S corporations and limited liability corporations) at 25 percent.
If new and different taxes cannot be found, Trump and Congress must lower their sights on the ambition of business tax reform over a 10-year horizon. Some senators would like to scrap the so-called static analysis normally used by the Congressional Budget Office (CBO) when scoring the cost of tax cuts. An alternative “dynamic analysis” that takes account of higher projected economic growth offers a more optimistic outlook and is likely to be advanced by Republicans. But for now, the CBO analysis will determine whether the business tax reform meets the goal of revenue neutrality required by the Senate budget resolution process.
The “Blueprint” proposed by Ryan and Brady addresses the revenue gap in two main ways: eliminating the business deduction for net interest payments, and adding border tax adjustments (BTA) that deny a business deduction for imports and exempt exports from the tax base. (Republicans were also counting on extra revenue from their “repeal and replace” measure on health care, but that idea is now dead). The Tax Foundation’s dynamic model suggests that eliminating the deduction for net interest payments raises $118 billion a year. Since US imports are approximately $500 billion greater than US exports, at a 20 percent tax rate the BTA raises another $100 billion a year.
Whatever its economic impact or legal ramifications—and these are controversial—at least three Republican senators have already denounced the BTA—and the number could grow. They fear that it would raise the price of imported goods, or goods with imported components, inflicting a shock on middle class consumers. Since no Democrat senators are likely to support the Republican version of business tax reform, the bill will probably need 50 Republican votes, plus Vice President Mike Pence, to pass under the budget reconciliation process. With only 52 Republican senators and 3 naysayers already voicing their concerns in the party, the arithmetic for BTA is not promising. Rather than wage an intramural battle over BTA, Republican leaders might be well-advised to drop this new tax.
That leaves the prospect of a revenue gap of more than $100 billion a year for serious business tax reform. Republicans should accept the higher budget deficit associated with business tax reform, but not compound the revenue gap by cutting personal taxes for rich Americans. Business tax reform will clearly promote economic growth. The same cannot be said for cutting taxes on the top 1 percent. While the United States imposes almost the highest tax rate on corporations, it is far from the highest on individuals. Nearly all advanced countries impose higher taxes on their rich citizens. It makes fiscal sense to offset individual tax cuts for lower bracket Americans with tax increases on the upper brackets, ensuring that individual tax reform is revenue neutral overall.
By contrast, it is worth taking a “gamble for growth” by incurring a larger deficit for business tax reform. Under Senate budget rules (devised by the late Senator Robert Byrd), the tax cuts will expire after 10 years if the CBO’s static revenue scoring shows a deficit. But if the growth gamble has paid off when 2026 rolls around, a future Congress and president will more than likely make the reforms permanent.
 The House allows dynamic scoring for tax changes that affect 0.25 percent of GDP or more, but so far the Senate has adhered to static scoring methodology. The Senate Budget Committee could potentially adopt its own version of dynamic scoring.
 Like President Obama, Democrats generally favor revenue-neutral business tax reform: in other words, raise as much revenue by closing corporate “loopholes” as might be lost by cutting rates and expensing capital outlays. This is not the Republican approach.