The Trump administration has revealed a one-page tax plan that, if implemented, could have vast consequences for the economy of the United States. The high points of that plan are simplification and repeal. The brackets go down from seven to three—10%, 15%, 35%. Corporate tax rates are slashed from 35% to 15%. The standard deduction is doubled to about $24,000, removing large numbers of low-income people from the rolls. The alternative minimum tax and the special Obamacare capital gains tax of 3.8% are eliminated, along with the estate tax. Deductions for home mortgages and charitable donations are preserved, but those for state and local taxes are eliminated. The plan has drawn enthusiastic support from conservative commentators and withering criticism from Democrats. Where does the truth lie?
Any successful system of taxation must juggle three separate ends. The first is to impose as little drag as possible on economic productivity. The second is to minimize compliance costs for both the government and taxpayers. The third is to introduce some measure of distributional equity among taxpayers in light of the diminishing marginal utility of wealth—an additional dollar of wealth produces more satisfaction for the poor than the rich. Very few people flat-out deny this last proposition. If the total production of goods and services could be held constant, virtually all people would prefer a distribution that equalizes incomes across the population.
Unfortunately, however, this is not the case, for the demand for redistribution is in deep tension with the first two ends, which tend to reinforce each other. The full analysis is complicated, moreover, because the resource effects of taxation depend not only on who is taxed, but also on how tax revenues are spent. If these taxes fund standard public goods, like defense and infrastructure, they make taxpayers better off by overcoming the problem of collective action and contributing to growth. But the highly redistributive taxes of the modern social welfare state are not sustainable. Growth suffers, which, in the long run, hurts everyone across the income spectrum.
One reason why the Democrats find it so easy to tee off on Trump’s tax plan is that they only evaluate taxes along a single dimension—redistribution from rich to poor. Why else would the New York Times’ headline scream: “Tax Overhaul Would Aid Wealthiest”? But that thinking suffers from two grave defects.
First, it assumes that the major impact of changes in the tax law is redistributive. In the words of Democratic Senate minority leader Charles Schumer, the Trump plan is “a giant giveaway to the very, very wealthy that will explode the deficit.” But his broadside ignores the incentive and allocative effects of tax changes. Lower tax rates will stimulate production by allowing innovators and workers to keep a larger fraction of what they earn. The only sensible debate asks how much growth comes from any given tax cut. So the size of the cut matters. Cut taxes down to zero and there are no public goods at all. But Schumer is also wrong to insist on some necessary link between tax cuts and deficit increases, given that it is always possible to cut expenditures, especially transfer payments and regulation, down to the levels of a decade ago.
Indeed, people are sensitive to small variations in taxes. The differential tax rates among the various states, for example, have resulted in major business and population movements across state lines from high tax/high regulation jurisdictions to low tax/low regulation ones. Thus the Trump tax cuts could help produce the economic growth he wants. Indeed, if rightly implemented, his program could make the United States a more attractive place for foreign investments, which in turn might walk Trump back from his suicidal impulse to withdraw from NAFTA and erect trade barriers.
The second major flaw in Schumer’s tax-giveaway argument is that it assumes the current rates of relative taxation are correct, no matter how steep the current ones skew. That argument thus introduces a ratchet effect, in which all tax increases on the rich are lauded, and any tax cuts in their favor are denounced, notwithstanding the general success of the Kennedy and Reagan cuts. Overtaxation of the rich, on this view, becomes a contradiction in terms. The 2001 round of Bush II tax cuts did little good because they were phased in too slowly. The 2003 round, cutting capital gains, did far better.
The correct analysis does not sanctify the status quo ante, but looks to define some independent normative baseline. I have long believed that a flat tax with a single bracket is the most socially advantageous. It eases tax administrative costs. It reduces the impulse for well-heeled people to split wealth among and within families through complex trust, partnership, and corporate arrangements. It reduces political intrigue by making it difficult for interest groups to stick their opponents with heavy taxes, like the ill-conceived special taxes on capital gains and medical devices used to fund Obamacare. And it imposes constant political pressure on Congress to lower overall expenditure rates, now that no one is exempt from taxes.
In this regard, the Trump proposal, with three separate brackets, does not go far enough. Likewise, there is a case for removing, not lowering, capital gains taxes. The capital gains tax slows down the shift in wealth from less to more productive uses. Set the capital gains rate at 20 percent, and any new investment of the gains has to receive a 25 percent higher return than the existing investment to produce the same after-tax return. Thus if the current $100 investment yields 10 percent, the new $80 investment has to yield, net of transaction costs, 25 percent more—12.5 percent. Only then does the taxpayer get the same rate of return (0.1 x 10- = 0.125 x 8)—for the switch to make sense. At the very least, a better strategy is to allow a person to escape capital gains taxes by reinvesting the gains from the earlier transaction in the market. The increase in dividends and wages should go a long way to offset the losses.
In addition, Trump is surely correct, as a matter of first principle, to ditch the estate tax. Like other wealth taxes, the estate tax is a tax on savings that discourages long-term investment. Worse still, the effect of the estate tax depends heavily on the age of death: A person who dies at 60 pays a tax well over one hundred times larger than that of a person who dies at 90, who—in addition to delaying the tax—can also use the 30 years to consume or give wealth away. Trump is also correct to keep the charitable deduction, which spurs decentralized giving with implicit matching government grants. Finally, he is right to eliminate deductions for state and local taxes, which require citizens in low-tax states to subsidize the higher level of government expenditure in high-tax jurisdictions. But he has wrongly yielded to political pressures by preserving the home mortgage deduction, which is an unwise subsidy to homeownership that invites another repetition of the 2008 mortgage meltdown.
On virtually all points, then, the Trump proposal pushes the ball in the right direction. But what about its brief form, which many find embarrassingly light on plan details, economic documentation, and phase-in rules? On balance, these shortfalls can easily be corrected in future iterations. It doesn’t matter exactly how the Trump plan draws its three brackets. Little turns on the difference between the 10 and 15 percent bracket. The 35 percent jump (which is too high) is not that critical either. Realistically, the top incomes for the first two brackets will come in around $35,000-$70,000 and $150,000-$300,000, respectively. These numbers will be of little consequence to people with taxable incomes over $1 million. Most economic documentation is largely a fog of words, given that most forecasts tend to overrate static and underrate dynamic elements.
In many ways, the really critical element is the timetable for the phase-in of the various reforms. On this score, there are two big risks in introducing any serious program of tax reform by degrees, as happened with the first round of the Bush II tax cuts. First, a plan that takes a long time to go into place will have little effect in the short run, given that the tax benefits are only realized down the road. Second, these long-term gains may never be realized at all because the next administration could easily decide to undo the reforms before they are fully in effect. The combination of these two drawbacks is not lost on private investors, who will discount the tax relief to take into account both the delay and the uncertainty. Trump’s tax plan is not perfect. But it does chart a course toward tax reduction and tax simplification, both of which are long overdue. The hard question is whether a more concrete plan will make it into law.