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The Four Challenges of Tax Reform

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The Four Challenges of Tax Reform

Washington Examiner April 7, 2017
EconomicsTax

After failing to repeal Obamacare, House Republicans are moving on to the supposedly easier task of tax reform. Tax reform is long overdue given our high tax rates, countless loopholes, and archaic international tax system that is driving corporations and income out of the country. At the same time, tax reform has not happened since 1986 (and has occurred only three times since World War II) because it is extraordinarily complicated, and creates a politically perilous number of winners and losers.

Congress has been quietly negotiating tax reform for the past six years. Having participated in some of these negotiations while working in the Senate, I see four major issues that must be resolved to get tax reform over the finish line.

The largest issue is whether to stop at corporate tax reform, or to also overhaul the individual tax code. Conservatives recognize that both sides of the tax code require the same rate reduction and base broadening – and that reforming the individual income tax can bring families into the reform constituency.

Additionally, reducing both the corporate and individual tax rates together can ensure much-needed tax rate parity. By contrast, cutting the corporate tax rate to 25 percent while leaving the individual income tax rate as high as 39.6 percent would face suffocating opposition from the millions of small businesses that file through the individual income tax code. One proposed solution – creating a separate, lower small business tax rate – has been criticized because families could simply redefine themselves as small businesses.

The challenge for Republicans is that, while most Democrats broadly accept the corporate tax reform framework of lower rates and fewer deductions, they absolutely reject any reduction in the 39.6 percent top tax rate on the individual side (especially after spending a decade fighting to restore that rate after President George W. Bush cut it to 35 percent). Such proposals would turn tax reform into a more partisan exercise that, like ObamaCare reform, could be held hostage by any House or Senate GOP faction, as well as demagogued by energized liberals. Republican unity would be key.

The second issue is cost. Democrats insist that tax reform be revenue-neutral – or even revenue-raising – while Republican plans likely reduce revenues. Today's corporate tax code provides the worst of both worlds by strangling jobs and incomes with the second-highest tax rate in the world, yet raising just 9 percent of all federal revenues. Thus, lower rates could increase economic growth that would in turn minimize any revenue loss (which should be accounted for with dynamic scoring).

There is also the practical challenge that lower tax rates are quite popular, yet nearly all tax offsets are extraordinarily unpopular (and in some cases economically damaging).

On the other hand, voters may sympathize with Democratic opposition to reducing tax revenues while budget deficits head back towards $1 trillion (never mind the stream of Democrat spending proposals that also are not paid for). It is worth noting that the entire coming deficit increase will result from soaring entitlement spending that will outpace even a historic surge in tax revenues. The deficit problem is a spending problem.

Still, even a small revenue loss could poison the well for entitlement reform. Voters will never accept balance-budget demands to cut Medicare or Food Stamps from lawmakers who had recently added red ink with business tax cuts.

The third issue is the international corporate tax code. The U.S remains one of the last remaining countries that taxes active profits abroad. So while American, German, and French subsidiaries each pay the 19 percent British corporate tax rate on goods sold in Great Britain, the United States uniquely charges its British subsidiary an additional 16 percent tax. Disadvantaged American companies have responded by either keeping these profits abroad indefinitely (to escape the second tax), or inverting and moving to another country with lower tax rates.

The obvious solution is to join the 21st century and implement a territorial tax system, combined with base erosion reforms that prevent companies from moving money across countries to game the system. Here, Congressional Republicans are mostly united for reform while Democrats are split. Many Democrats privately concede that a territorial system is needed, while publicly pummeling Republicans for wanting to "give tax breaks to multinationals who send jobs abroad." Although the anti-abuse negotiations have been challenging, the ease with which this issue can be demagogued may be the main barrier to a bipartisan consensus.

Speaking of international implications, the House's proposed border adjustment tax (which would tax imports but not exports) has received substantial attention. However, its outlook is bleak given likely World Trade Organization (WTO) challenges as well as the potentially catastrophic effect it could have on importers such as retailers, car-makers, and oil refiners if consumer prices jump because exchange rates do not fully adjust to the new system. The concept is too unpredictable, and creates too many potential losers to be politically viable.

The final issue is politics. Americans will support tax reform that is portrayed as promoting competitiveness, simplification, and job growth – not as a deficit-busting giveaway to the rich. Bipartisanship, for all its questionable policy compromises, can build legislation that is less controversial, more likely to pass, and more likely to endure. Can the parties cooperate in good faith?

This piece originally appeared on the Washington Examiner

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Brian M. Riedl is a senior fellow at the Manhattan Institute. Follow him on Twitter here

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