US President Donald Trump and congressional Republicans had an opportunity – and a responsibility – to reform the US tax code to address three major economic challenges: slowing growth, rising inequality, and a looming fiscal crisis.
Sadly, they shirked their responsibility by passing a bill that squandered this opportunity.
At a time when US public debt as a share of GDP is already at a post-war
high, the legislation will add another $1.5-2.2tn to the deficit over
the next decade. At a time when income and wealth inequality is soaring,
an estimated 80% of the tax cuts will go to the top 1% by 2027. And at a
time when the economy has been growing steadily for 33 quarters and is
approaching full employment, the legislation will have only a modest
effect on growth.
To be sure, a significant cut in the corporate tax rate was long
overdue. The legislation will likely stimulate investment and encourage
domestic and foreign companies to do business in the United States. But,
by an overwhelming majority, economists predict that the increase in
the growth rate will fall far short of the annual gain of one percentage
point (or more) hyped by Trump and his economic advisers.
Moreover, there is no credible evidence to support the Trump
administration’s declaration that the trickle-down benefits of faster
growth will “increase average household income in the United States by,
very conservatively, $4,000 annually.” A large body of economic research
shows that, at most, 20-25% of the benefits of corporate tax cuts will
accrue to labour; the rest will go to shareholders, about one-third of
whom are foreign. The biggest beneficiaries will be the top 1% of
domestic households which own about half of outstanding shares.
Nor is there evidence to support the administration’s claim that the
legislation will pay for itself. As many of those who voted for it well
know, the expected gains in growth will yield at most about one-third of
lost revenues. But they are playing a cynical game. By reducing
revenues now, they will be in a position to justify cuts to services
benefiting lower- and middle-class Americans down the road – all in the
name of “fiscal responsibility” and “entitlement reform.”
Worse yet, the tax legislation is riddled with provisions that will
dramatically increase inequality and limit economic and social mobility.
By cutting the top income-tax rate, doubling the threshold at which
inheritances are taxed, and lowering taxes on pass-through businesses,
the legislation amounts to a handout for the wealthy, paid for by the
middle class and future generations.
The legislation also prioritises investment in physical and financial
capital over what the US really needs: more investment in human capital
and lifelong learning to help workers and communities cope with the
disruptive effects of automation and artificial intelligence. Instead of
expanding the earned income tax credit to encourage work, the
legislation will, for the first time in American history, impose a
higher tax rate on employment income than on income earned by
proprietors and partnerships.
In addition, the legislation is an unabashedly partisan attack on
Democratic-leaning states and cities. For example, the bill imposes an
across-the-board limit on mortgage deductions, which will have a
disproportionately adverse effect on people living in high-cost
Democratic strongholds such as New York and California. Currently, the
median price for a home in San Francisco is $1.5mn; in Kansas, a
reliably Republican state, it is $187,000.
And if that weren’t bad enough, the bill intentionally penalises
higher-tax states like California and New York, by capping the federal
deduction for state and local income and property taxes. Ironically,
this provision will hurt growth, by raising the marginal tax rate on
millions of workers in the country’s most productive locales and
industries. And it will make it harder for state and local governments
to finance necessary investments in innovation, infrastructure, and
higher education – investments that are largely the states’
responsibility but are pillars of overall US competitiveness.
A majority of Americans already recognise that the tax law is deeply
flawed and full of false promises. After failing to repeal the
Affordable Care Act (Obamacare), congressional Republicans rammed
through a complicated tax package that will please their wealthy donors,
but disappoint many of their voters. Given the tax law’s unpopularity,
it will be interesting to see what happens in the midterm congressional
elections this November.
In the meantime, progressive federalists in forward-looking states and
cities must get to work picking up the pieces of the wreckage the
federal government is leaving in its wake. Keep an eye out for the many
ways states will re-orient their tax regimes away from income taxes, and
toward property and sales taxes, including on services, which account
for more than 70% of economic activity but have traditionally been taxed
lightly at the state and local level.
In some states, there is even talk of reclassifying state taxes so that
they qualify as tax-deductible charitable contributions. Similarly, some
have proposed replacing state income taxes with payroll taxes that
employers can deduct at the federal level. Keep an eye out as well for a
sizeable increase in outcome-oriented state and local funding for
efforts to reduce homelessness and reform the criminal-justice system.
Owing to its high marginal income tax rates and constraints on
residential property taxes, California will likely be at the forefront
of fiscal innovation. Already, multiple reform proposals are
circulating, including a ballot initiative to amend Proposition 13 that
would dramatically ease existing restrictions on commercial-property
taxes. And with the Democrats in full control of the state’s government,
measures to counteract the federal law are almost certain to be
California Governor Jerry Brown, for his part, has called the
Republicans’ legislation a “tax monstrosity.” He’s right: it’s dreadful
policy. Other countries that have reduced taxes on mobile corporate
capital have paid for the cuts by increasing value-added taxes and taxes
on carbon, dividends, capital gains, and inheritances. Trump and the
Republicans, by contrast, chose to cut taxes on both businesses and
their owners, while blowing an unsustainable hole in the federal budget,
exacerbating inequality, and imposing new burdens on the most
productive parts of the country.
Still, necessity is the mother of invention. For progressive federalists
in US cities and states – the laboratories of democracy – it is now
more necessary than ever to step up and start innovating. – Project
* Laura Tyson, a former chair of the US President’s Council of Economic
Advisers, is a professor at the Haas School of Business at the
University of California, Berkeley, and a senior adviser at the Rock
Creek Group. Lenny Mendonca, Senior Fellow at the Presidio Institute, is
Senior Partner Emeritus at McKinsey & Company.