Background: President Donald Trump, Speaker Paul Ryan and Senate Majority Leader Mitch McConnell made it clear before the November 2016 election that pro-growth tax reform would be a major legislative priority for Republicans in 2017 if they were given the chance to govern. Now that the American people gave Republicans control of the House, Senate and White House, there is a real opportunity to achieve comprehensive, pro-growth tax reform. A rewrite of the tax code couldn’t come soon enough. It has been far too long since Congress made major updates to the tax code. In fact, the last major reform of our nation’s tax code was under the Reagan administration in 1986, and every major effort since then has failed. After three decades of no major changes to the tax code and a stagnant economy, the time for tax reform is now.
Problem: Over the past few decades, the U.S. tax code has become a significant obstacle to economic growth, job creation and higher wages for American workers. This is due to a number of reasons.
1.) Our tax code suppresses business creation, expansion and reinvestment here in America due to high rates, double taxation, and how foreign profits are taxed. At an average of 39.1 percent, the U.S. corporate tax rate is the highest in the industrialized world making Americans companies uncompetitive with their foreign counterparts. Small businesses, who mostly file taxes through the individual income tax code as pass-through entities, also have a difficult time competing as they experience an average top marginal income tax rate of 47.2 percent. High tax rates encourage businesses to raise prices, decrease wages for workers, or even leave the country altogether.
If this wasn’t enough, the tax code inherently punishes saving and investment, the lifeblood of economic growth. Income that is saved or invested is often taxed two, three, or more times. The same dollar can be hit by individual income taxes, again by the corporate income tax, and yet again by the capital gains and dividends tax. After all this, before your family can inherit your small business or farm, the government levies a final death tax. These forms of double taxation discourage saving and investment, the most essential components of economic growth.
In addition, the U.S. is one of a very few countries that operate under a worldwide tax system rather than a territorial one. This means domestic companies are double taxed on profits they earn overseas – once by the foreign country they earn profits in, and once again when they bring those profits back to the U.S. This system encourages domestic companies to keep their profits out of the country, preventing more than $2.6 trillion in profit from being reinvested here at home.
2.) Our tax code is far too complex for the average citizen. In 1913, the tax code was a reasonable 400 pages long, but by 2013 it grew to over 74,000 pages. Americans spend nearly 9 billion hours complying with the tax code every year costing our economy over $400 billion in foregone economic growth. The complexity of the tax code allows individuals and businesses with the best lawyers and accountants to game the system and pay the least amount of taxes possible.
3.) Our tax system is full of cronyism that allows a few well-connected actors to game the system over hard-working taxpayers. The combination of tax credits, deductions and carve outs littered throughout the tax code due to special interest lobbying allow the most powerful and established individuals and businesses to pay low taxes while suppressing their competition.
Solution: Congress must pass comprehensive, pro-growth tax reform that lowers rates for individuals and businesses, simplifies the tax code, ends cronyism, and encourages domestic business creation, expansion, and investment. To do this, tax reform should include the following principles:
1.) Lower and simplify individual tax rates: This can be accomplished by increasing the standard deduction for low-income earners and lowering rates for high-income earners and small businesses that use the individual code. The current standard deduction, which is the fixed amount of income not taxable, is $6,350 for an individual and $12,700 for a married couple. Lowering and simplifying rates will allow hard-working taxpayers to keep more of their money while encouraging small business owners to expand their companies and create more jobs.
2.) Lower the corporate tax rate: Taxes on businesses should be cut as much as possible to encourage job creation and higher wages for workers who end up paying more than 70 percent of all business taxes through lower wages. The federal corporate tax rate is 35 percent plus the state corporate income tax rate. The average U.S. combined federal and state rate is the highest among developed countries and is making American companies uncompetitive.
3.) Full expensing: Allow all businesses to deduct the full cost of capital investments from their taxable income, replacing the current system of depreciation, a convoluted multi-year accounting system that only allows a partial deduction. Full expensing would encourage new business investment, job creation and wage growth.
4.) Establish a territorial tax system: A territorial tax system only taxes U.S. companies on the profits they earn in America. This will encourage foreign business investment here in America and help bring back more than $2.6 trillion in profits currently locked out of the U.S. by our broken and outdated tax system.
5.) End cronyism: This includes all the special interest handouts, tax credits, deductions, and exemptions in exchange for lower tax rates across the board. For businesses this includes getting rid of tax subsidies to green energy, special economic development zones, nuclear power, and every other preference in the tax code. For individuals, tax reform should remove as many special deductions and exemptions as possible, including the state and local tax deduction which subsidizes high tax states at the expense of fiscally responsible states. Removing tax preferences must be paired with lower rates, so average Americans receive a tax cut.
According to recent analysis, this kind of pro-growth tax reform has the potential to grow the economy by 10 percent over the next 10 years and increase the average American family’s wages by more than 7 percent or about $4,000 for someone earning $50,000 a year.
Conclusion: In order to bypass a Democrat-led filibuster in the Senate, Republicans intend to use a powerful tool called budget reconciliation to pass tax reform. While this path allows Congress to fast-track tax reform in the Senate, it prohibits the consideration of legislation that increases the federal deficit outside the adopted budget window. Although somewhat restrictive, Congress can use this as an opportunity to pair tax reform with spending cuts in order to comply with the rules of budget reconciliation and maximize the economic benefits of tax reform. After all, the federal government has a spending problem, not a revenue problem. Federal revenues are expected to rise to 20 percent of the economy by 2021, a dangerous level seen only once since the end of World War II. Reducing federal spending alongside tax reform would ensure tax reform is permanent; whereas simply cutting taxes through the budget reconciliation process would result in the expiration of those tax cuts in 10 years. Regardless of the approach taken, by enacting pro-growth tax reform Republicans can fulfill their promise to create jobs, increase wages, and restore our stagnant economy back to sustainable long-term growth.