Congress will need to pass another tax bill. Here’s what it should do.
By Ben Harris
Last December’s $1.5 trillion tax cut likely left many Americans with the impression that our tax code was settled for the time being. Then, the Trump administration recently called for a $100 billion capital gains tax cut through the indexing of investment gains. While the administration’s strategy of bypassing Congress to pass a tax cut is probably illegal, its proposal underscores the fact that our tax code is far from stable.
A new tax package is almost certainly in our near future. Whether you adore or abhor the bill, known as the Tax Cuts and Jobs Act (TCJA), what’s indisputable is that it is not a permanent solution. Without a fix, the bulk of middle-class families will see tax increases within the decade. Future business investments will be substantially more expensive than those made today. Lawmakers have discovered their international tax reforms have left gaping holes in the system. And the new plan simply does not raise enough revenue, already propelling us towards gargantuan deficits that will crowd out private investment at best and roil the financial system at worst.
These shortcomings mean that tax reform will be revisited in the next few years; maybe sooner. And when it does, Congress can boost long-run investment, stabilize revenues at adequate levels, and raise middle-class living standards by adhering to a few proven strategies. Here’s how.
Foremost, tax writers should heed the lessons from public finance research and prioritize tax breaks for new investment over windfall gains. A far underappreciated aspect of the new bill was how it spent hundreds of billions retroactively rewarding owners of capital — including in large part foreign shareholders — rather than incentivizing new investment. This shortcoming was a major reason why the Congressional Budget Office projected the TCJA would only boost national income by 0.1 percent over a decade.
A better approach is to make new investment cheaper. To be fair, the TCJA does that for a few years — but this benefit quickly fades away. Rather than permanently increasing investment, lawmakers mostly just shifted investment forward.
Along similar lines, the next tax bill should reward those who work more — especially for families with two earners and low-income workers who are particularly sensitive to how taxes affect their after-tax earnings. Economists of all stripes have long endorsed an expanded Earned Income Tax Credit, breaks for families who work, and generous benefits for child care. The next bill should take their advice.
Without a fix, the bulk of middle-class families will see tax increases within the decade.
Congress should also stop picking winners and losers among owners of capital. Our current tax code is awash with unjustified loopholes for investors: special tax breaks for owners of passthrough businesses (like partnerships), for those who hold assets until death, and for those who can squirrel away tens of millions in retirement accounts. To take one example, Americans who hold investments until death pay no capital gains taxes — costing taxpayers over $30 billion a year — while investors who sell during their lives can pay rates approaching 25 percent. A better system is to tax capital in a more uniform way.
Tax reform should also address the myriad distortions arising from poorly designed tax breaks. Taxpayers spend hundreds of billions each year subsidizing homeownership and retirement saving, but the structure of these tax breaks has been shown to be mostly ineffective. Better structuring these expenditures to achieve their purported goals should be a first-order concern for Congress.
We also need to address compliance. The U.S. has been trending toward a two-tiered tax system where wage earners pay their fair share and everyone else chooses how much income they’d like to report. Republicans in Congress exacerbated this trend by creating huge loopholes for taxpayers who receive their income through a passthrough business — which will probably accelerate a new wave of independent contractors and small partnerships. Coupled with draconian cuts to IRS enforcement, wage earners will see their relative burdens continue to rise.
And lastly, the new tax bill should bring in enough revenues to pay for government programs. In times of steep recessions, smartly designed unpaid-for tax cuts can jump start the economy — as they did in 2001 and again in 2009. But now the economy is booming, and we should be proactively saving, not running up trillion-dollar deficits.
In 1981, an overzealous administration and an accommodating Congress passed a sweeping tax cut that exploded deficits without growing the economy. Within a few short years, Congress realized its mistake and in 1986 passed one of the most pro-growth reforms since the inception of the income tax in 1913. Here’s to history repeating itself.