What Tax Reform 2.0 Should Look Like

What Tax Reform 2.0 Should Look Like

With the 2018 midterm elections only a few months away, congressional Republicans are refocusing on their largest legislative accomplishment since President Trump’s election: tax reform. Instead of working on Obamacare repeal or comprehensive immigration reform, the GOP has decided to focus on adjustments and expansions to the Tax Cuts and Jobs Act (TCJA). The effort has been dubbed “Tax Cuts 2.0.

The TCJA made some important reforms, such as lowering the corporate tax rate to 21 percent. But it also expanded the budget deficit and featured many temporary provisions, such as the reduction in personal income tax rates. Tax Cuts 2.0 should focus on making those provisions permanent while not further increasing the deficit.

Making TCJA provisions permanent is the best way to generate long-term economic growth from another round of tax reform. Temporary tax cuts do not significantly grow the economy because they don’t change long-run incentives to supply capital or labor. Making the individual income tax provisions of the TCJA permanent — both the lower marginal income tax rates and the more limited deductions — would raise long-run GDP by 2.2 percent and lead to 1.5 percent higher after-tax incomes across the income spectrum.

On the corporate side, the best way to stimulate economic growth is to implement full expensing — that is, to allow businesses to fully deduct the cost of their capital investments immediately. Economically, full expensing functions as a tax cut exclusively on new investment, whereas a corporate rate reduction is a tax cut on the returns to both old and new capital. This difference means that full expensing generates the most economic growth for every dollar of tax revenue lost.

The TCJA introduced full expensing for some short-term capital investments, but only over the next five years. In order to maximize long-term economic growth, Tax Cuts 2.0 should make full expensing permanent, and allow businesses to fully expense all forms of capital investment. Thanks to this rise in capital investment, and subsequent increase in productivity, full expensing would lead to 5.3 percent higher wages for the average American in the long run.

A second round of tax reform should curb more tax expenditures: tax code preferences that lower particular taxpayers’ tax burdens. The TCJA limited some distortionary expenditures, such as the deductions for mortgage interest and state and local taxes, but left others, such as the exclusion for employer-sponsored health insurance untouched. This exclusion distorts the health-care market, as it favors in-kind compensation in the form of health insurance over monetary compensation. This bias leads consumers to choose overly comprehensive insurance plans that help obscure the health-care price system and lead to the overconsumption of health care. That exclusion will cost the government $1.57 trillion dollars over the next decade: Capping or repealing that exclusion would make the tax code treat monetary and non-monetary compensation more equally and raise revenue.

On the flipside, another round of tax reform should avoid creating new, distortionary deductions. The TCJA, for example, created a new 20 percent deduction for some types of pass-through business income, which favors some types of earnings and industries over others while significantly reducing revenue. On a smaller scale, the House Ways and Means Committee recently advanced a new preference for fitness expenses. Whether large or small, new tax breaks should be foregone. Similarly, the current tax treatment of savings is a mess: Some forms of savings are taxed twice, some once, and some are not taxed at all. Reforming the tax treatment of retirement savings by only taxing returns would reduce complexity and increase saving. 

While making full expensing and individual rate cuts permanent would bring long-term economic growth, architects of the new tax reform should make sure not to further increase the deficit. The national debt is now over $21 trillion dollars, and soon the federal government will be running annual trillion-dollar deficits, despite an economic boom. Interest payments on the debt will take up a larger share of the federal budget, and higher government borrowing may lead to higher interest rates that could crowd out private investment.

Both the omnibus spending bill and the TCJA increased the deficit significantly, even after accounting for long-run economic growth. Revenue-neutral tax reform can help grow the economy by lowering taxes that heavily disincentivize economic activity and eliminating deductions that lead to little growth. This would significantly improve long-run growth prospects. But lawmakers should avoid making our debt problem even worse.

Alex Muresianu is a writer for Young Voices, and his work has been featured in The Federalist and the Washington Examiner. He can be found on Twitter @ahardtospell.

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