Tax Reform is on the Front Burner Again. Here’s Why You Should Care

 
 
As debate begins around the Republican tax reform proposal, Mihir Desai and Matt Weinzierl discuss the first significant tax legislation in 30 years.
 
 
by Sean Silverthorne
Credit: malerapaso

For as much as American politicians and their constituents complain about taxes, the truth is that tax reform packages to address those complaints are rare—the last major reform of the tax code was passed in 1986 under President Ronald Reagan. But starting this week, tax talk is back in vogue in Washington D.C.

House Republicans will start to fill in the details on a tax proposal ultimately expected to reach a thousand pages. The goal is to get the bill signed into law by President Donald Trump by the end of the year. The discussions are noticeably different from the past, perhaps as expected in a time of worldwide politicization and polarization. For one thing, Republicans are the only ones doing the talking—Democrats have not yet been invited to come to the table and likely won’t if Republican leaders can muster 50 votes for passage.

Should the average American care about tax legislation beyond concern over the amount of the check we write each April 15? Yes, very much so. Our tax policies reflect the values that the country stands for. Do we cut taxes on top earners or redistribute their wealth to help the less fortunate? Should business be rewarded for helping the environment or encouraged to drill for carbon-based fuels? How do we fund government programs such as health care and entitlements? How big should government be?

"...it would be constructive to have a discussion about what we are actually trying to achieve at a broader level and how the tax system can help us get there"

On a recent and unexpectedly warm day for a New England fall, Harvard Business School Working Knowledge sat down to discuss  tax policy in general and reform in particular with Professor Matthew C. Weinzierl and Mihir A. Desai, the Mizuho Financial Group Professor of Finance and Professor of Law, who often testifies before congress on corporate tax issues.

A brief recap of what’s under discussion. Last month Republicans and the White House issued a nine-page framework that proposed major changes in tax rates, businesses taxes, and other items:

  • Replacement of the current seven individual tax brackets with three brackets, with rates at 12 percent, 25 percent, and 35 percent.
  • A 20 percent corporate tax rate, down from 39.1 percent.
  • Establish a 25 percent rate for certain passthrough business income.
  • For businesses doing business internationally, a territorial tax system and a one-time mandatory repatriation tax.
  • Repeal of the estate tax, elimination of personal exemptions and most itemized deductions, and repeal the alternative minimum tax.

(Editor's note: The tax reform proposal has been introduced since this story was written. More details on the current plan are here.)

Transcript edited for length and clarity.

Sean Silverthorne: Why should citizens be interested in tax reform beyond what it means for their tax bill on April 15?

Matthew Weinzierl: I think of taxes as the most direct, and certainly the most important, way that we reflect some of our main values and make choices about society. Some of the biggest trade-offs we make are made when deciding tax policy.

One of the things I've been disappointed about with the talk around this particular reform is that there hasn't been much discussion of values. It's been a very mechanical discussion in a way. There isn't a lot of reference being made to principles or broader goals for the tax system, or what we're trying to do with the tax system, aside from growth. Especially in a time where you see a lot of division within the country, it would be constructive to have a discussion about what we are actually trying to achieve at a broader level and how the tax system can help us get there.

Mihir Desai: I agree completely in the sense that it's a manifestation of our values. More narrowly, it has these three really important consequences. First, we are funding the state with all it provides. Second, we redistribute to a large degree through the tax system, and that's a really important set of social decisions. Finally, we create a set of incentives for behavior and that's incredibly important.

The other way to think about why it's so important is to understand how widely and deeply the tax system impacts our lives. If you think about poverty, we now try to address it largely through the tax system via the earned income tax credit. You think about low-income housing, we do that through the tax system. If you think about health care, the ACA (Affordable Care Act) was held up because of its interpretation as a tax. If you think about the environment, you think about provisions that are associated with oil and gas, drilling, natural resource extraction. If you think about the M&A market, it's dominated by tax considerations today. The role of the tax system is very deep and wide in our society, for better or worse.

The other reason to be engaged in it is we haven't looked at it seriously for 30 years. It's something that touches every aspect of social policy. It's a much broader and deeper reflection of our values and a much broader and deeper policy instrument than we acknowledge.

Silverthorne: If we go through American history and look at the different stages of tax evolution, broadly, how has it advanced, progressed, or changed over time?

Weinzierl: The tax system was very different throughout much of American history than it is today, in the sense that we didn't even have an income tax until 1913. It was viewed as unconstitutional and we needed an amendment to allow us to have a direct income tax. Around the same time, the corporate income tax was introduced. So, some of the key features of the tax system we all take for granted today were not present for much of American history.

That reflects a couple of things. The growth of the state has been quite dramatic, relative to the early decades of the American experience. There was, much like today, a huge concentration of wealth towards the end of the 19th century and a lot of concerns about that. The notion took hold that people at the top should pay some extra in income tax or the corporations should be asked to pay for some of the benefits that they were getting for being a part of the system. You got this advance of direct taxation of incomes and of corporate incomes. Then as the state grew in the middle of the 20th century through the Great Depression and World War Two, and the advance of entitlements, we needed to fund those things and the fiscal capacity of the state grew.

I think there's a lingering discomfort with the size of the American state, especially coming from the right. And not just the American state, but the size of modern states. Coming to terms with that is part of the debate that we're having.

Desai: In the broad sweep of history, US history can be characterized by, first, the shift from trade taxes and excise taxes to income taxes. That's the transition from the 19th century to the 20th century. The second thing to say is that the 20th century should be understood in the context of big wars, as really singular moments in the evolution of the tax structure. That's World War I, that's World War II, maybe in some ways the War on Poverty, maybe in some ways the Cold War. Maybe in some ways the “global war on terror." Those punctuated very significant periods of fiscal reorganization. That's the second piece to understanding history. Then the third piece is to recognize—and this is a gross oversimplification—that in some ways things have gotten better. Primarily due to the 1986 Act, we have lower rates and larger bases. At the first approximation that's a good thing. That's the one thing that we've learned over the last 100 years about how to design these tax systems. Which I think has been fairly important.

Silverthorne: What's different about what the current framework is trying to address than what we've seen before in tax proposals?

Desai: Well, it’s complicated because it is a framework; it's a little light on details. Broadly speaking, to its credit, it's trying to do some simplifications. That's something that we've always tried to do and should do. It's also trying to deal with a corporate tax that's out of whack with the rest of the world. Then finally, it appears to be trying to address some distributional issues, re-distributional issues. I don't think it's doing that that well, but it is attempting to speak to that.

Weinzierl: It is a proposal we could have expected from any Republican president—it doesn't feel like a Trump proposal in any unusual sense to me. In terms of the changes to the personal rate structure and some of the changes to the corporate tax, I agree with Mihir that on the distributional side they [the plan’s authors] seem to be sending signals that they don't want this to be criticized as just a tax cut that privileges people at the top. But they have some work to do. I think it's not easy to sell this as a middle-class tax cut. I don't see a great deal of evidence that that's where the benefits are likely to be concentrated.

'It is a proposal we could have expected from any Republican president—it doesn't feel like a Trump proposal in any unusual sense to me"

There's a little bit of fuzziness about whether this is a tax cut, which is relatively easy for people to get behind, or a tax reform. I think that's unfortunate. Especially with the corporate code, there is a need for reform. We haven't done reform for 30 years. Which means in part simplification and rationalization and clearing out a lot of the mess that accumulates over three decades of lobbying.

[Positioned as] tax cuts, we don't know what the costs are going to be. You don't see them, and you often don't bear them for a long time. I worry that we're going to slip into a tax-cutting mode rather than tax-reform mode.

Desai: There are certain fiscal realities that we already face that are fairly significant and challenging. Then to enact something that is, instead of tax reform, a tax cut, just flies in the face of those fiscal realities.

Silverthorne: What are some of the fiscal realities we are ignoring in this proposal? What are the missed opportunities?

Weinzierl: On the distributional side the proposal is pretty blunt. It basically says, let's raise the standard deduction, and it's not clear exactly where the brackets will be at the low end. There is a policy, the Earned Income Tax Credit, which is bipartisan, very popular across the aisle. Thinking creatively about how to expand the reach of the EITC and using that as a lever for achieving redistribution would potentially be more powerful and popular. It's not something that's [happening], at least from what we've got so far. I find that a little frustrating.

The other thing that we're not hearing anything about a value-added tax. We're the only developed economy that doesn't do it. We have state and local sales taxes, but we don't have any broad-based value-added tax. I think most tax economists have long thought it's a strange arrow to have kept out of our quiver. There are debates about what role it would play, whether it would supplement the tax system we have now or displace part of it. Again, not to have it as part of a big tax reform is disappointing to many of us.

Desai: I think there are several big missed opportunities structurally. The first is around not thinking more seriously about a consumption tax. The destination-based cash flow tax that was proposed in the summer was effectively that in disguise. I wasn't a terrible fan of that implementation of it, but I think there's something to be said for switching to that base. The second big missed opportunity is a carbon tax. This could be used in combination or in substitute for some kind of a consumption tax but has a variety of benefits that we should certainly explore in addition to raising revenue and has all the other benefits you'd associate with the externalities created by carbon emissions. The third missed opportunity is exploring a top bracket. A new, higher top bracket given the rise in higher incomes would be advisable. Brackets have been indexed, but high incomes have risen higher than inflation.

"There's a lot of expertise that needs to be brought to bear to make that thing work"

Significant expansion of the EITC would be the fourth big missed opportunity. Then the final one is, trying to understand better why and how so much business income has shifted to pass through entities. If anything, the framework accelerates that in really unfortunate ways. Those are really, really big missed opportunities. I appreciate the efforts, but if we wanted to really think structurally about it, I would think about all those things. Silverthorne: Let's talk a little bit about the tax as a political document, versus a document meant to create economic health or economic power for the country. Two different things. Which is this?

Weinzierl: We should stipulate that (the framework reflects) authentically held beliefs from Republicans of what we should do in the tax code. Certainly, it's part of a process, so it's a political document in some sense. Trying to set the stage for debates and setting a starting point for negotiations. But the economics are a pretty big part of that.

Desai: And I think these things are just inherently political. I don't know if today's document is more political. I think today's environment is more politically charged. We see everything in political terms, but I think the underlying issues are just as political and economic as they've always been. It's just a little bit more of a charged atmosphere than before. It's all seen in terms of where you sit on the political spectrum and whether or not that makes your idea a good idea, whether or not an idea is a good idea.

Silverthorne: The reason I raise this is because the proposal was totally designed without Democrats. It was all Republicans getting together and coming up with this framework. Was that true 30 years ago? Were there more bipartisan efforts then?

Desai: For the 1986 reform, initial efforts were drafted inside the executive branch, and they reflected the executive branch's wishes at the time. They weren't incredibly consultive with Democrats. Having said that, the overall approach was much more collaborative than what we see today. Then once it really got into the drafting mode, you had these very important players thinking in a pragmatic, bipartisan way. That was hugely important. That was really different than today because people were willing to sit down at the table and say, "Let's think about what we want to get done."

By the way, the other thing is that there is no outside expertise being provided this time around. There are no hearings. Nobody even knows what the bill looks like. It's conceivable we'll see, like, a thousand- page bill within a month. Nobody has any clue what it might look like. That is a very closed, insular process, which I don't think serves anyone terribly well. There's a lot of expertise that needs to be brought to bear to make that thing work.

Weinzierl: Just to add to that, I think that partly reflects a bit of the division even within parties at this point. One difference is that if Mitt Romney was president, I think he and Paul Ryan probably would have agreed a lot on the tax code, but it's really not clear where the President comes down on some of these key choices. I don't think we know. I'm not sure how much time before he was president he had been really thinking about those things.

Even within the Democratic Party, you have a real challenge from the left with the [Bernie] Sanders movement, which would be very upset if leading Democrats compromised and gave Republicans a lot of what they wanted in the tax reform. I think you have a very charged political atmosphere in which you might end up getting this very insular process to protect against the chaos that would come if we brought it out in the open. I agree that it's not going to lead to a great outcome if we do it all just from one side.

Silverthorne: Let's talk about businesses. As business owners and leaders look at this, what should they be thinking about? Some are small businesses, some are big corporations, some are multinationals. Is this package a win for business in general?

Desai: Yes, I think broadly you could characterize it as a win. The basic features they should be focused on are, one, a considerably lower rate for C corporations which I think is a good idea. Second, we would shift to territoriality, which is a change in the international tax regime that is also welcome. Third, we have a shift to expensing, which is a very important piece of what has been proposed. Some ambiguity about interest deductibility, which is going to have some important interactions with expensing. That is the fourth piece they should pay attention to. The fifth piece is the change in the structure of passthrough taxation which is really quite revolutionary.

Weinzierl: There's been some talk about a one-time lower rate under repatriation of all the money that's sitting offshore. That's obviously relevant to business people as well.

There's a pretty fundamental question about why we tax corporate income at all. Economists will tell you that corporations don't pay taxes, some person pays taxes, whether it's the owners or the workers or the consumers of the corporation's products. I think the lowering of the rate partly reflects that. And we are out of step with a lot of other rich countries.

Desai: I think this interaction with the individual side is something really important. In the modern income tax, you have these boundaries between individuals and companies that people can go back and forth between. That creates some really, really interesting tensions. I think that's really one of the most important stumbling blocks today given the imperative to cut corporate tax rates. In addition, there just aren't that many revenue raisers. Tax expenditures, which are also sometimes labeled loopholes, have become highly concentrated in certain areas, namely, employer-provided health insurance, the state and local tax deduction, the mortgage interest deduction, all of which are sometimes called loopholes but are in fact very serious consequential policy choices. That makes reform really, really hard. That makes it all the more important to think about new revenue sources like consumption taxes or carbon taxes.

Weinzierl: Exactly. One other thing that occurs to me when you ask is this a win for corporations is that it's hard not to talk about the deficit implications of this. Again, this is a real revenue-negative plan. We think there will be negative consequences of running much larger deficits, but exactly how we will reconcile the budget constraint is not clear. Will we cut entitlements? Will we end up raising other taxes later? Forcing whoever's proposing this to say something more concrete about how they would like to resolve that would be healthy for all of us, including corporations, who could end up bearing the costs somewhere down the line.

Desai: I think the detachment of the current debate from fiscal realities is really disturbing. It's gotten just unanchored from any notion of what fiscal realities are.

Weinzierl: Given the emphasis on fiscal discipline that was coming from the Republican Congress in the past decade, it is a bit surprising. There hasn't been any notion that we need to tie this to entitlement reform or any other spending reform. I would have thought Republicans would have taken the opportunity to bundle all of this stuff into a more comprehensive package that would have addressed some of these concerns. Maybe not in a way that would have been politically popular in both parties, but at least it would have offset some of the fiscal stuff that we've talked about.

Desai: This is a kind of culmination of 30 to 40 years of the demonization of what governments do. The tax system has become a political foil just as there is increased appetite for government to do more things. All these trends are accelerating, which just leads to a larger and larger detachment from fiscal reality. That's highly problematic and there's going to be a comeuppance at some point. Or there has to be some kind of economic reconciliation that has to happen.

Silverthorne: This brings me to my next question, which is what are the risks involved in this framework if it's passed in the form that we know it as of now?

Desai: Well, the first is the one we just mentioned, which is the fiscal consequence of the reforms. The second is, the way they think about passthroughs is really, really important. I think that could end up blowing a hole in revenues in ways we don't fully understand. The third big risk is probably that these pieces of legislation are very hard to pass. This could be a once in a 30-year opportunity. As a result, there's a real problem with making this a tax cut instead of a tax reform. That goes back to the conversation we had about revenue raisers and broader tax reforms.

Weinzierl: One of the big risks is that we actually haven't had a constructive conversation, getting back to your very first question about what we're trying to accomplish with this tax system. I mean, one way to see that concretely is the distributional implications if passed as is, with no extra top bracket and pass-through at 25 percent. We all know inequality has been rising and it's high. There's recent research showing a substantial share of that is due to passthrough activities growing so dramatically. Now, if you cut the tax rate on passthroughs from 39.6 to 25, and you cut top rates... the vast majority of this tax cut goes to people in the top 1 percent. We can have debates about whether that's the right thing to do or not, but we aren't having that debate as part of this tax-reform process. I think that's a real missed opportunity.

Personally, I would suggest having a discussion about who's benefited from the economic system that we've been having over the last several decades and how we want that to be reflected in the tax system. Getting away a bit from the demonization of government. Saying, "Look, government does important things. We need to pay for it. Who wants to pay for it, or who should be expected to pay for it and what would be a fair way to do that?" Those are the sorts of discussions I think we should be having. If we don't have them and instead we have a proposal that seems to lean pretty heavily in one direction distributionally, I think there is going to be a further loss of confidence or buy-in with how the system is working.

"I think the detachment of the current debate from fiscal realities is really disturbing"

Desai: I think this is a really important point that we haven't hit on. The backdrop of the income inequality debate is the shadow over the whole debate. I'm sympathetic to the concerns in the income inequality debate, but it has become such a dominant frame on the way that we think about everything that I think it's actually starting to screw things up a little bit. We understand things to be far worse than they actually are. As a consequence, we are contemplating doing some really stupid policy things on trade and immigration, because we've convinced ourselves that we're falling apart. The reality is more nuanced. If anything, we lived through a very exceptional period where wages rose very quickly. As a consequence, we’re living through, as de Tocqueville called it, a revolution of rising expectations. Expectations have gotten out of whack. A revolution of rising expectations is really difficult to deal with. I'm not saying that people aren't upset for good reasons. I'm just saying that we’ve lost perspective over how bad things are and therefore we are contemplating really bad ideas that will only serve to exacerbate the woes of the people who we think we’re helping.

Silverthorne: Candidate Trump ran as a “business president.” As such, it seems he ought to be influential on tax policy that affects business. Are there any signs of his fingerprints in this tax reform proposal separate from what Republican belief is? Do we see Donald Trump in there somewhere?

(Editor's note: Trump on Monday, after this interview took place, waded into the discussion by opposing how the proposal would change the treatment of certain retirement funds.)

Weinzierl: I don't see anything particularly that bears his fingerprints.

Silverthorne: Is that presidential hands-off approach unusual compared with past tax reforms?

Desai: Reagan was very involved. He had a real point of view about it. Clinton spoke about it eloquently. Both Bushes managed to speak about it. Obama was a little more detached. This time is also different in that we're in a setting where there are very significant policy debates happening. Immigration, health care, tax reform, shifting foreign policy agendas are all percolating about. As a result, tax reform has not been the focus of anything or anyone. So, it's harder to get a sense of what the president’s real priorities are.

Weinzierl: I might even be willing to go further. I'm surprised how little of his fingerprints seem to be on this in the sense that unlike maybe more traditional Republican candidates, he really made his hay fighting for working-class Americans. Romney was criticized precisely for not paying much attention to that demographic. I don't see a lot in this proposal that is appealing to those Trump voters.

Desai: The other aspect you might have expected to see his fingerprints on is not in terms of the agenda but in terms of the process. Part of the Trump promise was negotiation and deal-making. That may turn out to be true, but it hasn't been manifest yet. That was in a way one of the important promises; I know how to get things done. That is the promise of any kind of business president. That has yet to be realized in any way. But, hope springs eternal.

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