On Tuesday, I had the chance to testify before the Senate Finance Committee on business tax reform. Here are my opening remarks. They are a bit on the glum side, emphasizing challenges and constraints lawmakers face. Moving from optimistic rhetoric about tax reform to legislative reality is hard. You can find my full testimony here.
America’s business tax system is needlessly complex and economically harmful. Thoughtful reform can make our tax code simpler. It can boost American competitiveness. It can create better jobs. And it can promote shared prosperity.
But tax reform is hard. Meaningful reforms create winners and losers. And you likely hear more complaints from the latter than praise from the former. I feel your pain. At the risk of adding to it, my testimony makes eight points about business tax reform.
- Thoughtful reform can promote economic growth, but we should be realistic about how much.
More and better investment boosts economic activity over time. The largest effects will occur beyond the 10-year budget window. If reform is revenue neutral, revenue raisers may temper future growth. If reform turns into tax cuts, deficits may crowd out private investment. Either way, the boost to near-term growth may be modest. Dynamic scoring will thus play only a small role in paying for tax reform.
- The corporate income tax makes our tax system more progressive.
The corporate income tax falls on shareholders, investors more generally, and workers. Economists debate how much each group bears. Workers are the most economically diverse. But they include highly paid executives, professionals, and managers as well as rank-and-file employees. The bulk of the corporate tax burden thus falls on people with high incomes even if workers bear a substantial portion.
- Workers would benefit from reforms that encourage more and better investment in the United States.
In the long run, wages, salaries, and benefits depend on worker productivity. Reforms that encourage investment and boost productivity would thus do more to help workers than those that merely increase shareholder profits.
- Taxing pass-through business income at preferential rates would inspire new tax avoidance.
When taxpayers can switch from a high tax rate to a lower one, they often do. Kansans did so when their state stopped taxing pass-through income. Professionals use S corporations to avoid payroll taxes. Investment managers convert labor income into long-term capital gains. Congress and the IRS can try to limit tax avoidance. But the cost will be new complexities, arbitrary distinctions, and new administrative burdens.
- Capping the top rate on pass-through business income would benefit only high-income people.
To benefit, taxpayers must have qualifying business income and be in a high tax bracket. Creating a complete schedule of pass-through rates could reduce this inequity. But it would expand the pool of taxpayers tempted by tax avoidance.
- Taxing pass-through business income at the corporate rate would not create a level playing field.
Pass-through income faces one layer of tax. But corporate income faces two, at the company and again at taxable shareholders. Taxing pass-throughs and corporations at the same rate would favor pass-throughs over corporations. To get true tax parity, you could apply a higher tax rate on pass-through business income. You could levy a new tax on pass-through distributions. Or you could get rid of shareholder taxes.
- It is difficult to pay for large cuts in business tax rates by limiting business tax breaks and deductions.
Eliminating all corporate tax expenditures except for deferral, for example, could get the corporate rate down to 26 percent. You could try to go lower by cutting other business deductions, such as interest payments. But deductions lose their value as tax rates fall. To pay for large rate reductions, you will need to raise other taxes or introduce new ones. Options include raising taxes on shareholders, a value-added tax or close variant like the destination-based cash flow tax, or a carbon tax.
- Finally, making business tax cuts retroactive to January 1, 2017 would not promote growth.
Retroactive tax cuts would give a windfall to profitable businesses. That does little or nothing to encourage productive investment. Indeed, it could weaken growth by leaving less budget room for more pro-growth reforms. Another downside is that all the benefits would go to shareholders, not workers.