Every single loophole in the tax code has a ferocious defender, a fact that has scared off all the recent administrations from attempting tax reform.
The Republican Health Care bill failed because it was a bad bill that had almost no authentic public support. It took benefits away from tens of millions of vulnerable people to give tax breaks to the rich few.
When Republicans turn to tax reform, they will start on much stronger ground. The Republican plans, at least in their broad conceptions, are built solidly on the two frameworks that have shaped recent tax-reform discussions.
The first is simplification, the idea that a cleaner tax code, with fewer loopholes and lower rates, would foster economic growth. The second is substitution, the idea that the overall rate of taxation is less important than what you tax. The current code taxes income heavily and barely taxes consumption. To increase dynamism and growth, we should substitute taxes on investment with taxes on spending.
The first framework shaped the tax reform of 1986 and is locked in many people’s brains today. But my impression is that economists have come to see the second framework as more important.
The research shows that cutting top marginal rates does not produce as much growth as the supply siders expected. Meanwhile, research by the Organization for Economic Cooperation and Development and others has found that corporate income taxes have a more negative effect on growth than income, payroll or consumption taxes. It’s more important to cut those.
Most rich nations today combine consumption taxes and a low corporate rate. As Kevin Hassett, who’s been mentioned as President Donald Trump’s likely Council of Economic Advisers chairman, has noted, 34 out of the 35 OECD nations have VAT or VAT-like consumption taxes. The United States is the only outlier.
The House Republican tax reform bill embraces both frameworks, but it leans on the substitution framework more heavily.
The most exhaustive look at the Republican tax plan I’ve seen was written by David A. Weisbach of the University of Chicago Law School. He notes that the Republican plan would simplify the rates and close a lot of loopholes — the simplification framework — but it wouldn’t radically reshape the taxation of individuals.
Business taxes, meanwhile, would be transformed. The Republican plan cuts corporate rates, allows the immediate expensing of investments and eliminates the taxation of income from sales in foreign countries while raising an import tax, which functions sort of like a VAT. “These changes would go a long way toward shifting the tax system to taxing consumption rather than income,” Weisbach writes.
Moreover, the Republican plan bears some family resemblance to the X Tax, David Bradford’s version of a consumption tax that isn’t necessarily regressive.
So the basic GOP framework is good. There are at least three main problems.
The consumption tax rates are too low to raise enough revenue, the whole thing is much more regressive than it needs to be, and the current political climate is probably going to make the bill much, much worse, not much, much better.
After the health care debacle, Republicans desperately need a win. Moreover, they are massively underestimating how hard tax reform is going to be.
Every single loophole in the tax code has a ferocious defender, a fact that has scared off all the recent administrations from attempting tax reform. So even just the loophole closing piece is going to be like Guadalcanal. Raising consumption taxes on top of that — against the ferocious opposition of the retail sector — will be Guadalcanal on stilts.
The Republicans are going into this process from a position of extreme weakness. The first temptation will be to do the easy stuff, which is cutting the taxes, while skipping the hard stuff — closing loopholes and finding substitute revenue sources. The second temptation will be to scale back the whole enterprise so that you can declare victory with a much smaller bill. The third temptation will be to can the border tax, which is associated with Paul Ryan and which the Freedom Caucus already opposes.
By the time legislation is crafted, probably in early summer, the good basic framework could transmogrify into something completely ugly — a bill that explodes the national debt while handing massive benefits to the rich. Then we’d be back where we were with health care reform, with a bill that benefits very few and which no one likes.
Tax reform probably won’t survive if the Republicans try to do it the way they tried to do health care — staying within the lines of Republican orthodoxy while veering over to the extreme right in the hopes of winning the Freedom Caucus. Tax reform will probably only pass with bipartisan buy-in, if there are enough potential yes votes that you can afford to lose some off on the extremes.
Tax reform is one of the few issues where Republican and Democratic thinking overlaps. It’s one of the few ways to significantly boost growth. If Republicans can learn from their errors, they can get this done. If, on the other hand, tax reform fails, the GOP majority is forfeit and Washington will descend to utter dysfunction.