Tax reform is the centerpiece of Washington policymaking at the moment.
In the wake of health reform's repeated collapse, most recently with the ill-fated Graham-Cassidy bill, the Republican majority has turned its attention to rewriting the U.S. tax code. This was a major platform on which the party ran in 2016 and, among others, both the Trump administration and Speaker Paul Ryan's office have put out numerous studies on the project.
Recently Republicans published their first version of what a reform bill might actually look like. While the proposal lacks many key details, its changes include collapsing America's seven current brackets down to three and substantial cuts to corporate and other high-end tax rates.
Republicans have not yet published a proposed bill for passage and the process is ongoing. So without more information it's impossible to vet their proposals fully. Nevertheless, there are a few critical issues that anyone following along should understand. Brushing up on these subjects won't necessarily make the entire debate make sense, especially since so much of the tax code is used for and driven by political rather than economic considerations, but it will help.
Will any Democrats vote for tax reform?
Trump has long made clear that reducing the number of tax brackets is central to his vision of reform. The administration's proposal establishes three brackets (down from the current system of seven) at 12%, 25% and 35%.
Among other changes, this would reduce the top tax rate and increase the bottom tax rate. However, it's impossible to know exactly how much this would affect individual rates and government revenue, because the administration has not yet made clear where each bracket would end.
Tax bracket cutoffs are the income at which a taxpayer moves from one rate to the next. Currently, for example, the lowest bracket of 10% cuts off at $9,725 for a single individual. At $9,726 the taxpayer pays 15%, the next bracket up.
With three levels instead of seven, Trump's plan will have taxpayers make far bigger jumps when they move up or down a bracket. It's impossible to know how, exactly, this will effect individual finances and government revenue until they propose the actual cutoff rates.
Advocates for the Trump tax plan argue that reducing the tax code from seven to three brackets will simplify it. This is, practically speaking, wrong.
From a mathematical standpoint the administration is right. Reducing the number of brackets will reduce the number of calculations involved in figuring out what a citizen owes on taxable income. But taxpayers don't generally do that math. Once they've figured out their taxable income, the IRS provides an appendix that tells how much tax is owed on that amount of money.
Few, if any, taxpayers actually crunch the numbers. Instead the tax system's complexity comes in the process of actually figuring out that taxable income.
As the Tax Policy Center writes, Congress doesn't just use the tax code to raise revenue. It also uses taxes as a means of non-regulatory policymaking. Through tools like deductions, refunds and exemptions the government tries to achieve various goals. The mortgage deduction, for example, exists to encourage homeownership. Students get specific carve outs to try and convince young people to stay in school. While not necessarily a bad thing, this has created a system where figuring out what a taxpayer actually owes takes quite a lot of skill and knowledge. This is where the complexity come from.
One of the most pernicious rumors around tax reform is that there is a vast group of Americans who pay nothing in taxes. Following closely on its heels is the idea that to give high-earners a tax break, Congress has to cut taxes at the top level.
Both of these ideas are wrong.
Everyone in America pays taxes. Payroll tax takes a fixed percent from every paycheck up to $127,200. Sales, property and excise taxes cost the same no matter who pays them or how much money they make. In fact when accounting just for payroll tax, most American adults pay taxes. When you include sales tax, virtually everyone does. It's only federal income tax that not everyone pays, because many people don't earn enough money to qualify.
At the same time, everyone who pays federal income taxes starts at the bottom. Each tax bracket applies to its section of income; so, for example, all taxpayers pay 10% taxes on dollars 0 - 9,725. Then they pay 15% on dollar 9,726. As a result, reductions on the first bracket provide tax relief to every taxpayer from the very poor to multimillionaires while those on higher brackets get more selective.
The Republican majority opposes the estate tax and has proposed eliminating it altogether. Their argument is that this creates double taxation, as families will have paid first income tax to earn and then estate tax to transfer the same money. They further argue that this tax makes small businesses vulnerable to government seizure.
In general, the latter does not happen.
According to an estimate from the Center on Budget and Policy Priorities, out of 2.7 million estates in a single calendar year only 5,200, or approximately 0.2%, will owe estate taxes. Of those, only 50 (total) are small farms and businesses.
Estate taxes apply only to multimillionaire households. It takes an estate worth $5.49 million to trigger this section of the tax code, as its purpose is to dilute generational wealth and dynasties. Due to the investment patterns of wealthy individuals, more than half of the money passed down through estates comes from unrealized capital gains. In other words, as the CBPP put it, "much of the money that wealthy heirs inherit would never face any taxation were it not for the estate tax."
The alternative minimum tax is exactly what it sounds like. It's a rule that requires high-income taxpayers to pay the greater of either their regular income tax or their alternative minimum tax. In 2017 nearly five million people paid it.
It makes a very big difference in government revenue.
The AMT chiefly applies to high-income taxpayers and is specifically designed to ensure that no individual can build in enough loopholes and tax shelters to completely escape their personal liability. In 2017 nearly 30% of all households earning between $200,000 and $500,000 paid the AMT. The greatest percentage of households paying the AMT earn between $500,000 and $1 million, at 62.9%.
Under the Trump tax proposal the AMT would vanish. This would trigger a tax break for about 5 million households earning more than $130,000, taking with it an enormous amount of tax revenue.
The Trump tax proposal cuts the corporate rate to 20%, and the President has said that he'd like to cut it even lower.
The current top corporate tax rate, including average state and local taxes, is 38.9%. It is true that this is the highest in the world among the U.S.'s peer economies, although it's also true that relatively few companies actually pay the statutory rate.
There are two chief arguments for lowering corporate taxes. The first is that by cleaning up and simplifying the corporate tax code, America could make itself more competitive while also eliminating the gamesmanship that results in companies paying a very wide range of actualized rates. Second, many economists argue that cutting tax rates would incentivize companies to invest more in business expansion, because they would get to keep a greater share of any resulting profits.
Still, there are dangers in reading too much into this analysis. While companies might invest more if they could keep a greater share of the profits, cash-flush industries are declining to do so under current rates. Few analysts have produced specific evidence for why keeping 75 instead of 61.1% of profits would change corporate decision making.
The Republican tax plan will cost trillions of dollars, part of which will be paid for by eliminating the deduction for state income taxes. (Note: in recent weeks, some politicians have indicated that this deduction may be put back into future versions of tax reform.)
This deduction helps taxpayers in states that use progressive income taxes, most of which are Democratic-leaning. This deduction makes it easier for states to raise revenue through an income tax, as opposed to others which rely on sales and property taxes.
This will chiefly cause problems for low-income Americans. Income taxes fall hardest on high-earning taxpayers, while sales taxes disproportionately affect low-earners. The more the federal tax code encourages states to raise revenue by taxing a gallon of milk, the more low-income people will pay relative to their income.
Most businesses in America are pass-through entities. These are partnerships, S-corporations and sole-proprietorships where the income and losses "passes through" directly to the people in charge. In essence, a pass-through entity doesn't have any operational difference between the business and the people who run it. A freelancer who pays all her own costs and keeps her own income, for example, constitutes a pass-through business.
Under the Trump proposal, the tax rate on these businesses will fall to 25%.
To a certain degree this might help many Americans. As noted above, most small businesses constitute pass-through entities. Freelancers and the self-employed, for example, will qualify for this tax rate, as well as many small business owners.
However at the same time, for them to benefit from this tax cut they will have to owe more than 25% in personal income tax. While that's unlikely for a small business freelancer, many enormous businesses in fields like investment and real estate will have the chance to reclassify as a pass-through entity.
Republicans have proposed a tax plan that eliminates many deductions and restructures several elements of the tax code, however it preserves many popular deductions such as those for mortgage interest and charitable contributions. In told, according to reporting by the Washington Post, the plan eliminates approximately $3.6 trillion worth of deductions.
A taxpayer has to itemize his taxes to take the charitable deduction, and not all of them do so. In total less than a quarter of taxpayers claim deductions for their charitable contributions. Although households under $50,000 are responsible for about a fifth of all charitable donations in the United States, they only collect about five percent of this deduction. The overwhelming majority of it goes to the wealthy, and preserving it almost exclusively will help high-bracket taxpayers.
The Trump administration has predicted that these tax cuts will lead to explosive economic growth, potentially as high as 6% (nearly triple the national average). It is a common, if not core, part of the Republican platform that tax cuts cause economic growth.
There is no evidence to support this belief.
Historically speaking, tax cuts and the business cycle have had little relationship with each other. Cuts in the 1980s preceded growth, as did tax increases in the 1990's. Tax cuts in the early 2000s preceded the Great Recession, while the Obama-era tax increases preceded the longest period of uninterrupted job growth on record. Despite claims that a series of tax cuts will unleash explosive growth through the economy, there is simply no evidence to believe this is true.
This is not to say that tax policy is irrelevant to the national economy, nor to argue that tax increases are good for the economy. Observation simply teaches that taxes have a complex impact that can often be hard to predict.