Tax cuts can't go far enough because Congress won't tackle entitlement abuse

The Senate has passed its version of the annual budget resolution, which would permit a simple majority to pass a 10-year tax cut of $1.5 trillion. That’s a modest amount – only about three-quarters of 1 percent of our nation’s gross domestic product. But it will prove a heavy lift for Congress to pass because of concerns about multibillion-dollar budget deficits.

Factoring in some revenue gains from increased economic growth, the tax cut that would be permitted in the budget resolution would increase the U.S. budget deficit by no more than one-fifth – likely much less.  The basic problem is that tax cuts can’t go farther, owing to legitimate worries about budget deficits. Entitlements are on track to exceed 100 percent of federal revenue within a decade, forcing the government to borrow just to fund day-to-day operations.

The GOP majority in Congress – especially senators like Susan Collins, Shelley Moore Capito and Lisa Murkowski from entitlement-dependent states like Maine, West Virginia and Alaska – refuses to tackle entitlement abuse, putting the borrowing capacity of the U.S. Treasury near its limit.

Consequently, tax cuts are expected to be limited to about $150 billion a year – approximately divided between corporate and personal tax relief, including ending the estate tax, which garners about $17 billion a year. That is not nearly enough money to soothe those whose oxen would be gored by efforts to simplify America’s painfully complex tax code.

Such reforms require eliminating cherished deductions, like those for state and local taxes or domestic manufacturing, to make possible lower rates overall. Keeping the exercise revenue-neutral would create about as many losers as winners.  For example, eliminating the deductibility of state and local taxes would benefit individuals in low-tax states like Florida and Texas, but raise taxes paid by those in high-tax states likes New York and California. 

To make tax simplification politically palatable, the overall revenue take must be reduced more significantly to lower rates more dramatically, or the losers will apply pressure on Congress to kill the reforms. Spreading around $150 billion in additional rate reductions – less $17 billion to axe the estate tax – is not nearly enough.

For example, the deduction for medical expenses exceeding 10 percent of income is likely to be eliminated, and the elderly suffering from Alzheimer’s and other expensive to treat chronic illnesses could face hefty tax increases.

On the business side, cutting the federal tax rate from 35 to 20 percent appears to be a big tax reduction and for many it will be. But eliminating or curtailing interest deductions and special benefits for manufacturers will likely leave many credit-dependent businesses that sell products competing with Chinese imports more disadvantaged than before.

Overall, what matters are the actual taxes paid, and slicing $75 billion off the annual federal corporate taxes would reduce the effective rate by about only one-fifth. Studies by European Union and other tax experts indicate that would still leave U.S. effective tax rates significantly higher than those in other industrialized countries.

Significant incentives would remain for pharmaceutical companies and other businesses earning substantial patent income to flee to Ireland by changing the nationality of their corporate registration via so-called tax inversions.

In fact, by moving to a territorial system – namely taxing the profits earned by U.S. companies on the basis of where those are earned – a significant tax avoidance business could emerge from simply moving research and development activities to locations like Ireland and domiciling patent ownership there if companies can get enough scientists to move.

For many companies, the tax plan would still make it more attractive to locate production and jobs in the United States. That should boost growth a few tenths of a percentage point. However, given the negatives mentioned above, Trump administration claims that the tax cuts would pay for themselves with more private investment and stronger growth are straight out of Alice in Wonderland.

The same goes for tax simplification. The administration proposes to apply a special 25 percent personal rate to limited liability companies (LLCs). For example, the rate would apply to architectural and construction firms organized as LLCs that put up shopping malls and apartment buildings – but not to independent architects and engineers who do smaller projects by subcontracting with various specialty companies. 

The same goes for the large real estate holding companies with multiple LLCs for individual properties – but not the home-based real estate investor with 10 units, or the individual who loses his job and creates employment for himself and vendors by setting up a home-based consultancy.

Somehow it would seem that big LLCs – such as JP Morgan Securities or Koch Industries – create jobs, but many smaller businesses are viewed as parasites to be taxed excessively.

And for the latter, the IRS compliance and enforcement apparatus will add a new level of complexity and harassment.

All of this can be accommodated in the inevitable negotiations and compromising that will follow the Trump administration’s initial proposals, but realism must prevail.

Only so much tax relief and simplification can be squeezed out of $150 billion a year.

Peter Morici served as Chief Economist at the U.S. International Trade Commission from 1993 to 1995. He is an economist and professor at the Smith School of Business, University of Maryland.