Taxes

These Are No Reagan Tax Cuts

Contrasting the reforms of '81 and '86 with Trump's self-serving plan.

It was a simpler time.

Source: Keystone/Hulton Archive/Getty Images

The Trump tax plan is out, and it is grand in scope, though scanty on key detail. The number of tax brackets will be collapsed to three -- with rates of 12 percent, 25 percent and 35 percent -- and the standard deduction will be increased. Corporate taxes will be eased, and estate taxes will be eliminated. Naturally, such ambitious tax-cuttery has invited comparisons to Reagan.

All very well, but to which Reagan are we comparing him? The man who oversaw swashbuckling supply-side rate decreases in 1981? Or the steward of the good-government, technocratic reforms of 1986, which reduced the tax code to two low brackets, while eliminating so many deductions that tax collections didn’t even fall?

At first glance, we seem to be looking at Reagan II. Like in 1986, this plan promises to reduce both the number of brackets and the number of deductions. And yet, the 1986 tax reform was largely revenue neutral, and indeed, raised the amount that corporations paid. This new plan, on the other hand, seems to be wildly tilted in favor of corporations, at the expense of folks who work for a living.

We can't be exactly sure who will come out ahead, and who behind, from this bill. Too many provisions have asterisks where there ought to be numbers. Nonetheless, we can sketch out a few winners and losers. On the losing side: some of the lowest-income Americans, who get an increase in the standard deduction that turns out to be underwhelming, and in return see their marginal tax rate rise by two percentage points. Also upper-middle-class professionals in blue states, who get creamed by the loss of their deduction for state and local taxes, and probably won’t see much improvement in their effective tax rate.

And maybe that’s a price worth paying for a simpler tax code. But where’s the simplicity? Not only do the mortgage and charitable deductions stay, but “The framework retains tax benefits that encourage work, higher education and retirement security.” Go down the list of the tax breaks that actually cost the government serious money, and it looks like state and local tax deductibility is the only major tax benefit on the chopping block. 1

We should end the deductibility of state and local taxes, which effectively forces people living in low-tax states to subsidize higher spending elsewhere. But getting rid of one deduction does not a simplification make. And on the corporate tax side, it actually introduces a new, highly distortionary giveaway to business owners.

That would be the new, special 25 percent tax rate for “pass-through” income. In the U.S., certain kinds of closely held corporations are organized as S corps (so named for the subchapter of the tax code that created them). These corporations pay no corporate income tax. Instead, the corporation’s income “passes through” to the individual’s tax return, and is taxed at their personal income tax rate. 2 Under the Trump plan, however, it will be taxed instead at a special 25 percent rate, as will income from partnerships and sole proprietorships.

Since the 25 percent rate is the same as the plan’s middle tax bracket, this provides no benefit for middle-income business owners (and will actually disadvantage any lower-income taxpayers who happen to have a stake in an S corp). Rich owners, on the other hand, get 10 percentage points shaved off their tax bill.

I can’t help but notice that our president is an extremely rich guy who has a lot of pass-through income. And who will be passing on much of that income tax free to his heirs under this plan, which also eliminates the estate tax.

Oh, there are other cuts on the corporation side -- a slash in the rates, and a switch to territorial taxation, rather than attempting to tax global income, as the U.S. now does. But these things at least have plausible economic rationales: The corporate income tax results in double taxation (because shareholders then also pay taxes on dividends or capital gains), and extra-territorial taxation is an administrative headache that distorts corporate decision-making.

But I have spent years struggling to think of an economic rationale for special tax treatment of pass-through income, and still can’t. For young businesses, struggling businesses, or modestly profitable businesses, the new tax regime does nothing; for people who are already rich, it makes pass-through income a better tax deal than anything except muni bonds. Might this provide some incentive to work hard and build a business? Perhaps. But on what logic do we want to encourage starting a convenience store or founding a car wash more than we encourage, say, working hard and building yourself into a cardiac surgeon or a CIO?

Nor will this simply reward people who are building businesses and creating lots of jobs. As we’ve already seen in Kansas, the first thing that grows from this sort of special treatment is a fertile industry of tax specialists helping the wealthy to reconfigure as much of their income as possible in the form of pass-through earnings. 3 And a series of absurd scenarios in which people who earn the same amount of income are paying dramatically different rates on what they earn. This is exactly the opposite of what the 1986 reform aimed to do: reduce the structuring opportunities and make everyone at the same income level pay roughly equal taxes. So it doesn't look much like Reagan II.

But neither is this a Reagan I proposal, with its dramatic supply-side cuts for all income levels. In fairness, Trump simply hasn’t as much scope for reduction as Reagan did, since the top rate in 1980 was almost double what it is now. But of course, that scope gave Reagan reason to believe (or at least to hope) that rate cuts would expand the economy and thereby help pay for themselves.

It’s hard to argue that we’re going to achieve substantially higher growth rates by lowering the top rate by four percentage points, and ditching the deduction for state and local taxes. Or that the special rate for pass-through entities is going to generate explosive growth, outside of the already-booming field of tax law.

Whatever Reagan’s failings, his administration had a clear vision for how the tax code should work: low rates to encourage work, and equal treatment for taxpayers with equal incomes. Perhaps his party heirs still share that vision. If so, they’ve badly marred it with provisions that will inevitably give voters quite a different vision: of a party that has stopped even pretending to care about tax cuts for anyone but the rich, and of a president making a generous gift to himself.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

  1. Okay, yes, that list also contains “exclusion of net imputed rental income. And what is that in plain English? Well, tax specialists argue that in a fairer world, you’d pay taxes on the “income” you get from living in your own house rather than having to pay rent. There is really very little chance that a tax on such “income” is going to end up in any final tax bill, partly because it would be a hellacious nightmare to administer, and partly because the whole notion is crazy. Imputed rental income is basically dorm-room-bull-session-level philosophizing about the mysteriously slippery concept called “income”, made into absurdly serious policy arguments by people who should really know better.

  2. Those interested in the gory details can read this primer.

  3. “The framework,” intones the document, “contemplates that the committees will adopt measures to prevent the recharacterization of personal income into business income to prevent wealthy individuals from avoiding the top personal tax rate.” I am willing to bet a considerable sum that tax lawyers will spend far more hours contemplating how to get around these rules than any committee will put into writing them.

To contact the author of this story:
Megan McArdle at mmcardle3@bloomberg.net

To contact the editor responsible for this story:
Philip Gray at philipgray@bloomberg.net

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