In a recent TaxVox blog, my TPC colleague Eric Toder showed that the 2017 Tax Cuts and Jobs Act (TCJA) effectively upended the key principle of the Tax Reform Act of 1986, namely that an ideal revenue system should tax a broad base of income at low rates. But then he implied the TCJA’s new “schedular” system that applies different tax rates, or schedules, to different types of income may be the best way policy makers can avoid the distortions and economic inefficiencies given the practical inability to include all income in the tax base.
It is a valid conceptual approach because it attempts to limit the benefits of behavioral responses based on differences in tax rates among similar kinds of activities. And the improved efficiencies can be a kind of tax reform. Nonetheless, I have two major reservations. First, are the hoped-for efficiency gains likely to be realized? And second, does the legislation as a whole constitute meaningful reform? I am suspicious about the likelihood of the former and downright negative about the latter.
The new law includes several drastic changes aimed at improving economic efficiency: a large reduction in the corporate tax rate, changes in the taxation of foreign-source income, and a new preferential tax regime applied to some pass-through income from partnerships, limited liability companies, and sub-Chapter S corporations. This new deduction for qualified pass-through income makes it difficult to enforce the boundaries between ordinary income and preferentially-taxed business income. It takes an act of faith to believe that the new borders will not be fully exploited, negating much of the intended efficiency gains.
Thus, on efficiency grounds, count me as an agnostic. Complex as it may have been, I preferred the highly creative approach of Alan Viard of the American Enterprise Institute and Eric Toder. They’d tax corporate-source income by including unrealized capital gains in the tax base of shareholders, thereby broadening the tax base while removing tax-induced distortions.
In addition, tax reform is about much more than efficiency. Indeed, going back to the basics we know that tax reform has traditionally consisted of trying to balance four, often-incompatible, objectives: economic efficiency or limiting tax-induced behavioral changes; equity, or fairness; simplicity, or limiting the costs of tax compliance; and revenue adequacy, or generating revenue sufficient to cover the cost of providing government services.
Start with revenue adequacy. The 1986 Act raised the same amount of revenue as the prior tax law. TCJA will add well over $1 trillion to the debt over the next decade. It is surely easier to cut tax rates, and as a consequence reduce tax-induced distortions caused by high rates, if you don’t worry about revenues.
This is perhaps the most fundamental illustration of the trade-offs among competing objectives. It is not fair to give the TCJA higher marks for improving efficiency than the Tax Reform Act of 1986 when the laws have such different revenue profiles. Show me first a revenue-neutral TCJA. The new law may still be more efficient than prior law, but the higher tax rates necessary for revenue neutrality would place more pressure on the distinctions among income types inherent in a schedular system.
Furthermore, the deficits caused by TCJA have their own negative implications for economic efficiency. Higher deficits will drive up interest rates, likely crowding out some of the investment that the TCJA was designed to encourage. Further, these fiscal deficits will surely lead to higher trade deficits
How does TCJA fare on equity and simplicity? Pretty low, in my judgment. Equity has two dimensions – horizontal equity, or treating those in the similar economic circumstances similarly; and vertical equity, or treating those in different economic circumstances appropriately differently (I acknowledge that “appropriately” taxing those with higher incomes relative to those with lower incomes is purely a value judgment).
Still, since economic distortions tend to be most pronounced with respect to business enterprise behavior, the TCJA has moved us in the direction of reducing substantially the taxation of capital income relative to labor income. As a result, high-income households, who own most capital, get bigger tax cuts as a share of after-tax income than lower-income households, in some cases, by very large margins.
On horizontal equity grounds, the distinctions introduced by TCJA can result in quite different tax treatment for those earning the same amount of income. Income from stock ownership is more lightly taxed than the same amount of labor income.
Different types of labor income are taxed differently as well. Owners of unincorporated businesses who take their labor compensation in the form of business profits pay a lower rate than high-earning professionals such as doctors, lawyers, accountants, and independent consultants. (I know, now I’m feeling sorry for lawyers.) And for no good reason, self-employed architects will pay less tax than their attorneys who make the same income. By contrast, the 1986 Act was distributionally neutral as well as revenue neutral. On either horizontal or vertical equity grounds, you can judge whether the TCJA is fair or not. I vote for not.
On simplicity, the TCJA has failed utterly. The press is full of stories about the complexity of new rules for taxing foreign-source income, the difficulty of implementing the provision for exempting 20 percent of certain income from pass-through businesses, various new phase-in and phase-out rules, and the like. Pure W-2 labor income is not much affected, but it was never a source of complexity.
One final concern. Tax policy should be predictable since people make decisions today that have implications for their future income. Many 1986 reforms, such as the taxation of realized capital gains at the same rate as ordinary income, failed to last but at least the law was intended to be permanent. By contrast, the TCJA’s individual tax cuts are designed to be impermanent since they are scheduled to expire after 2025.
It is certainly true that the TCJA is a sharp departure from the 1986 Act, both in its objectives and its specific provisions. But I don’t believe it really points the way to true tax reform. Remember, even if the efficiency gains are real, there is more to tax reform than improved economic efficiency.
