The tax reform bills which have recently been passed by the U.S. Senate and House of Representatives potentially introduced significant changes to U.S. tax law. This has been strongly pushed by Donald Trump. Here is a summary of the changes:
- Reduce corporate tax rate from 35% to 20%
- The highest personal tax rate has been reduced
- Inheritance taxes threshold has been raised from $11.2 million $22.4 million
- Some tax reductions which affect the middle class, but which expire in 2026
There is no doubt that the U.S. tax system needs reform. Although the corporate tax rate is 35%, in practice, the average tax rate actually paid by U.S. corporations is only 18.7% (by one estimate). The difference is due to all the deductions, exemptions and loopholes embedded in the tax code. Many of these are industry specific and are the result of years of successful lobbying by particular industries. As a result, the tax code introduces distortions in the economy which are not in the best interests of the country.
The tax reform has been sold as a needed stimulus for the economy, which will increase investment, hence increase productivity and lead to increased job creation
The reality is quite different:
- No need for a stimulus at this time
- Tax cuts for corporations will not flow into productive investment
- Changes will raise the deficit by $1.3 trillion over 10 years
- Tax cuts for individuals will not spur consumption or investment in the U.S.
- Inheritance tax threshold will have a negligible effect
I shall now expand on these in greater detail.
No need the stimulus at this time
Currently unemployment is at the lowest level since 2000 (The Times, “Booming US jobs market makes rate rise certain”, 9 Dec 2017). The gross domestic product is rising at almost 3%, which is close to the growth potential of the economy. Inflation at less than 2% is at historically low levels.
Since the economy is currently running at its potential (the result of Barack Obama’s presidency, not Donald Trump’s) there is no need for any extra stimulus.
This stimulus will accelerate the rise in interest rates and it will also lead to a rise in the value of the dollar (Ambrose Evans-Pritchet, “US tax shake-up risks a dollar shortage and a global funding shock” Daily Telegraph, 4-Dec-2017) thereby making American Products less competitive
Tax cuts for corporations will not flow into productive investment
At present there is an excess of money searching for yield. The problem is not a lack of capital, it is a lack of investment opportunities. These are associated with a lack of consumer demand.
Apple has a cash mountain of about $250 billion sitting offshore. The conventional explanation for this is that U.S. corporate taxes are so high that if Apple brought this money into the U.S. they would face a massive tax bill. While there is some truth to this, there is nothing to stop Apple building more iPhone factories with this money. However, when everyone who can afford an iPhone and wants one already has one, there is no need to ramp up production. The problem is not a lack of capital, it is a lack of consumption.
When asked what corporations will do with the extra profits the responses included:
- Increased share buybacks
- Increased dividend payouts
- Increased merger and acquisition activity
None of these have a measurable effect on the growth of the economy, increased job opportunities or decreasing inequality (Michael Moritz, “US tax reform will benefit shareholders more than workers”, Financial Times, 4 Dec. 2017).
Raising the deficit by 1.3 trillion over 10 years
These tax cuts resemble the tax cuts introduced by Ronald Reagan in the 1980s. As in this case it was argued that the tax cuts will lead to faster growth and will therefore pay for themselves. This did not happen. The budget deficit ballooned and led to a major recession which ultimately cost George H Bush the presidency.
The increased deficit will require interest rate rises, which will in turn negate any stimulative effect or rise in the GDP.
Tax cuts for individuals
These will preferentially go to high income individuals. Since such individuals already consume as much as they need or want the increased money will not spur consumption but will be saved and presumably invested. Much of the investment will be wherever the returns are highest, which means much of it will go overseas, particularly to emerging markets. This will increase production in China, creating thousands of jobs in China but not necessarily in the U.S..
Increased threshold for inheritance tax
Since the threshold is already very high in it will not have a major impact on people or on the amount of taxes collected. This is simply a sop to the ultra wealthy.
In the recent edition, the Economist (Nov. 25, “The case for taxing death”) argued that inheritance taxes are a good source of revenue for governments because, firstly they do not distort markets and secondly they reduce inequality. Note that decreasing inequality is not necessarily an end in itself. However the revenues gained from inheritance taxes can be used to reduce other taxes which can boost consumption.
A recent study from Sweden suggested that inheritance does not reduce inequality as measured by the Gini coefficient, but actually lowers the Gini coefficient. This counter intuitive finding can be explained by the inheritance being split amongst several siblings. So if there are three siblings and each gets a third of the inheritance then the Gini, coefficient goes down but in reality inequality is not reduced.
Tax Reductions for the Middle Class
There are some provisions for tax reductions for the middle and lower classes. These however are due to expire in 2026. The expiration date is designed to reduce future deficits. It has been estimated that after 2026, most middle class taxpayers will actually pay more tax than they would without the tax reform. On the other hand, the tax decreases for the ultra-wealthy are permanent.
Conclusion
The “Tax Reform” is clearly designed to enrich the already rich. This does not seem to have any real benefit for the country as a whole. A more suitable tax reform would be one that is revenue neutral but eliminates many of the distortions in the current tax code.
Ah tax reform, and the laws of untended consequences.
Tax laws in the USA and Canada are so complex that there are thousands of ‘experts’ making a living trying to interpret them. The Canada Revenue Agency inspectors generally make up rules as few citizens have the money to take on the federal (or provincial) government in court. The court process is the punishment (Mark Steyn).
There are also herds (no idea how many) of lobbyists running around DC and Ottawa throwing money at ‘legislators’ to favor the industry, union, professional group, whatever, that they represent. Note that for many of the ‘legislators’ the government job they got elected to is the best paying they have had in their lives so they are easy pickings for lobbyists. An astonishing number of ‘legislators’ retire much richer than their salary would predict.
No matter what the ‘tax reform’ that is enacted the lobbyists and the ‘legislators’ will be at the finest bars and restaurants the next day making new deals to improve the tax code.
I have not even mentioned the permanent ‘civil service’ (Trump’s swamp that needs draining). Government jobs have become much too lucrative and the insiders just do whatever makes their lives nicer. Citizen lives are not a concern.
So with respect to the new ‘tax reform’ in DC the resulting laws will be just a convoluted and enormous as what is there now and the results of the exercise will not be what has been sold to the public. The fact is that no one has a clue what the ‘tax reform’ will actually do. Congress (Parliament) must seem to be doing something. For the most part the countries would be much better served if the ‘legislators’ did very little.