Op-Ed Contributor: The G.O.P.’s 20th-Century Tax Plan
The Republican proposals promise a needed update, but instead will just leave America in the past.
With this week’s House floor vote and a Senate Finance Committee markup, the Republican tax plan is hurtling toward passage by year’s end — a timeline that is frenzied compared to that of previous tax reform efforts, which took years and extensive debate. Many people in both parties believe the tax code needs to be modernized, especially regarding how businesses are taxed. Yet the policy choices Republicans have pursued in their grand reformation of business taxation reflect a pre-digital, pre-global economy. With their bill, they may well ensure that the United States economy is left behind once and for all.
Republicans have promised simplification of the tax system. Instead, they have introduced even more complexity. This results, in part, from their choice to favor certain business activities over others, substituting congressional judgment for market pressures. And the privileged sectors are precisely those that are in decline.
Take the bills’ treatment of pass-through business income. In the House bill, such income is taxed at a maximum 25 percent rate, down from as high as 39.6 percent today, with a 9 percent rate for the first $75,000 of small-business income. As of Tuesday evening, the Senate plan would create a new deduction for a portion of such income, effectively capping the rate at around 32 percent. In both plans, these tax incentives are substantially smaller for businesses involving personal services — accountants, for example, or yoga instructors.
In September, Treasury Secretary Steven Mnuchin justified the exclusion of personal services from the tax cut by arguing that other industries, like manufacturing, created jobs. But manufacturing’s share of the economy is only 13 percent, a share that is shrinking because of technology and outsourcing. Meanwhile, the service industry has grown significantly in the last several decades, and now employs about 10 times as many workers.
What’s more, under the House bill, the pass-through rate has a bias for owners of capital over laborers, a choice that is out of step in a world of rising inequality. Passive investors in active businesses would be able to obtain the low rate on all of their income from those businesses, whereas people who work for a living largely would get the low rate for only 30 percent of their business income.
Even more perversely, taxpayers can raise this 30 percent threshold by making more capital investments — for example by purchasing robots and machinery to replace employees. This is apparently part of an overall scheme to punish workers: the evisceration of the estate tax, the reduction in the corporate rate and the increased tax burdens on education all allocate precious government resources to financial, rather than human, capital.
Another pressing goal of tax reform is to reduce the incentives for companies to move their operations overseas. But again, the bill does the opposite.
The House bill proposes an international tax system that would subject income of high-profit foreign subsidiaries to a 10 percent minimum tax. Senate Republicans have also proposed a minimum tax on foreign earnings, at a 12.5 percent rate on income from intangible assets, such as patents and copyrights.
This new international tax system is a compromise between a territorial system, which would exempt foreign income altogether, and a worldwide system, which would tax all income, foreign or domestic, on basis at the same rate. This quasi-territorial approach would create a system unlike any other in the world today, applying different tax rates depending on where the income is earned.
Faced with a 20 percent rate at home and a 12.5 percent (or less) effective rate on income earned abroad, companies would still be encouraged to move jobs and profits offshore. The Senate plan attempts to deal with this problem, at least in the case of intangible assets, by also granting a 12.5 percent rate on an American company’s domestic intangible income. But as I have argued elsewhere, this plank likely violates our obligations under the World Trade Organization agreementsm because the amount of income that receives the benefit of the lower rate is directly linked to the amount of income from exports, thereby qualifying as an unlawful export subsidy. The W.T.O. has ruled against several similar measures that Congress has passed, and the issue was thought to have been put to rest when Congress repealed the last such measure in 2004. The legal instability surrounding this part of the Senate plan will significantly reduce a company’s ability to rely on it in the future. Accordingly, corporations will continue to locate intellectual property overseas.
Other dynamics worsen the shifting problem. Because of the mechanics of the formula for calculating the minimum tax, the tax can be reduced by moving assets overseas. Additionally, because the minimum tax is essentially calculated on a global basis, rather than per country, this further encourages companies to shift investment offshore in order to blend low- or zero-taxed income from tax havens with income from higher-tax foreign countries. So, rather than paying 20 percent or even 12.5 percent on income earned in the United States, companies will move investment offshore to a tax haven until the global foreign tax rate is blended down to the minimum rate, avoiding paying American taxes altogether. In other words, the United States loses out on revenues and investment.
In fact, both plans largely maintain pressures for companies to locate corporate residency abroad, despite their claim to reduce taxes on corporate income. After all, a company that moves its residency to a tax haven can often achieve zero taxation, rather than being taxed at the American minimum rate, however low. Both plans have safeguards against this by increasing the tax burden on certain inbound investments, but these can be avoided by selling through independent distributors rather than related parties, among other strategies. And even then, business lobbying has already caused the House to scale back on its original proposal — a dynamic that does not bode well for the Senate’s counterpart measure.
Rather than revising the definition of corporate residency to account for factors such as the location of a company’s headquarters or shareholders, the House and Senate plans retain the place of incorporation as the sole determinant of corporate residency, a notoriously artificial definition that has become disconnected from economic reality. They also largely subscribe to the fiction that one can identify a specific geographic locale where income is produced.
Instead of modernizing the taxation of business income, Republicans have doubled down on outdated concepts like corporate residence and origin of income that have become meaningless in a global and digital economy, while also attempting to preserve dying industries. The result is a dizzyingly complex system that will interfere with market forces.
Other countries have increasingly relied on consumption taxes as pro-growth alternatives to traditional business income taxes. The United States, however, remains wedded by politics and ideology to an inefficient, easily manipulated and antiquated tax policy. Rather than driving the United States to be a competitive force in the 21st century, the Republicans’ plans hold the United States back in the last one