Can Trump and Congress Solve the Rubik’s Cube of Tax Reform?
As Congress and the Trump administration turn their sights on overhauling the tax code, it’s a good time to think about the great three-dimensional brain twister of the 1980s, the Rubik’s Cube.
That’s partly because the first and last time there was a comprehensive rewrite of the tax code, it was 1986. But there is more than that.
What makes trying to solve a Rubik’s Cube so exasperating is that every rotation you make to align the colors on one side messes up something on one of the other sides. Nothing moves in isolation; everything affects everything else, and rarely for the better.
The 1986 tax overhaul took two years. Despite bipartisan backing from the Reagan administration and congressional Democrats, it had many false starts and reversals in its voyage to becoming a law.
“There are thousands of moving pieces in full-blown tax reform,” said Jeffrey Birnbaum, an author of a book about the passage of that legislation, “Showdown at Gucci Gulch,” and now a public affairs strategist at BGR Group. “Every entity and interest you can think of has a stake, and there are inevitably winners and losers. And if you’re a loser, you know it.”
Add in a more polarized political environment, an administration that has been light on policy expertise, and a Republican congressional contingent that hasn’t shown much ability to pass complex legislation in more than a decade, and the puzzle looks all the more complicated.
Congress and the Trump administration will solve tax reform only by navigating difficult trade-offs. Think of these trade-offs as the six sides of a Rubik’s cube, each of which needs to match up perfectly — but each of which can foul up the others.
Bipartisan support vs. conservative goals. The Republican majority in the Senate is narrow: It takes only three Republican senators (out of 52) to vote against a measure to ensure its failure, should Democrats stay united in opposition. The G.O.P. majority in the House is not as narrow, but it might as well be because of ideological divisions.
That means Republican tax writers need a bill to keep party members on board, or one that could attract significant Democratic support and allow more room for Republican defections.
In theory at least, there’s room for common ground with Democrats on the corporate income tax. President Obama proposed corporate tax changes that would have lowered the rate on businesses to 28 percent from its current 35 percent while changing its structure.
But to gain any hope of meaningful Democratic support, some key conservative goals would almost certainly need to be cast aside. Say goodbye to lowering the top rate on individuals’ income or other changes that primarily benefit the wealthy, or to anything that decreases the amount of revenue the government will collect in the years ahead. Even if those concessions are made, Democrats will be resistant to giving President Trump a big policy win — meaning it may take more concessions than it would a less polarized political moment to get even a few Democrats to the table.
Republicans, who showed their internal divisions during the health bill debate, need to stay united or to give up on some of the longstanding priorities of the conservative movement (and of Republican donors).
Lower taxes vs. higher deficits. Republicans widely agree that tax rates should be lower. If you want to cut them, though, the budget deficit will rise, increasing the national debt — absent cuts to spending or eliminations of tax deductions for individuals and businesses.
Even economists who believe tax cuts generate growth do not believe that faster growth is enough to prevent lower taxes from increasing the deficit. For example, the conservative-leaning Tax Foundation estimated that President Trump’s campaign tax plan would increase the deficit by $2.6 trillion to $3.9 trillion over the next decade, even after accounting for these “dynamic” effects.
Bigger deficits could send interest rates higher and crowd out private-sector investment, particularly as the United States economy approaches full employment. Consider that the last time there was a major tax cut, in 2003, the national debt was 33 percent of economic output. Today, it is 76 percent.
Instead of increasing deficits and debt, Congress could offset lower rates by eliminating deductions with the overall result that American individuals and companies would still pay as much to the government. But this tactic runs into its own problems. Namely:
Concentrated losers vs. diffuse winners. Eliminating tax deductions and credits to pay for lower tax rates is a strategy that sends economists’ hearts aflutter. They call it lowering the rate, broadening the base.
But the distress of a relatively small group that loses some favorable tax treatment can be a lot louder than the gratitude of masses of people benefiting from a lower rate. Trying to take away deductions or other tax advantages from one group tends to stir the passions of that group, which might then fight the entire reform effort.
For example, the House Republican tax plan introduced last year would pay for tax rate cuts in part by eliminating the tax deduction for state and local income taxes. That is a tremendously valuable deduction for people in high-tax states like California and New York.
There are countless such tripwires in reforming the corporate tax code, and every large company and trade association is watching carefully for its own interests. For example, eliminating the tax deductibility of interest payments, a feature of the House Republicans’ plan last year that helped enable a much lower tax rate for all corporations, is stridently opposed by real estate and private equity industries that rely heavily on borrowed money.
Those in danger of losing a valuable deduction will lobby to preserve it, which collectively makes it hard to make that lower-rate/broader-base ideal possible.
Boost growth vs. spread the benefits. Not all tax cuts are created equal in their potential to spur faster growth. Economic models generally predict that tax cuts that encourage business investment are likelier to lead to decisions by companies that result in higher productivity, more jobs and higher incomes over time.
That can include cuts to the corporate income tax or cuts on income-tax rates for top earners. By contrast, tax cuts meant to leave more income in people’s pockets have less impact. Tax cuts on wages, “whether they are at the top or the bottom, tend to have very very modest impacts on the economy,” said Kyle Pomerleau, director of federal projects at the Tax Foundation.
That presents a political problem for Republicans: The changes they believe will create the strongest pro-growth effects would offer few direct benefits to middle-class Americans. It’s hard to make a populist pitch for a tax cut that gives the biggest benefits to millionaires and large corporations, but that is what the House Republican plan does.
In 2001 and 2003, the George W. Bush administration took the “both-and” approach to its tax bills, layering both substantial tax cuts for the middle class and for investment income and the wealthy. Trying to do that again today would get right back to the issue of increasing the deficit.
Permanent vs. temporary. This has less to do with the underlying political economy of taxes and more to do with details of congressional rules.
For the Senate to pass a tax bill with a simple majority vote, as opposed to a 60-vote supermajority, it will need to do so under “reconciliation,” a legislative process with its own set of rules.
Among them: A bill passed through reconciliation cannot be projected to increase the budget deficit beyond a 10-year period. That gives the engineers of a tax bill a choice: Either devise changes that don’t increase long-term deficits (which limits how much you can cut taxes) or cut taxes with abandon but with the possibility that they’ll expire after 10 years.
The George W. Bush administration took the latter strategy, betting that future Congresses would be unwilling to allow taxes to rise, effectively making them permanent. Wrong. The Obama administration was able to raise taxes on the wealthy at the end of 2013 essentially by doing nothing.
Cleverness vs. uncertainty. In the plan that House Republicans introduced last year, they advocated a novel approach to solve many of these trade-offs. They proposed something called a destination-based cash flow tax with border adjustment.
You can read more details here, but the idea is to tax imported goods but not exports. Because the United States runs a trade deficit, the tax would raise lots of money, which in turn could be used to reduce the corporate income tax rate, perhaps to 20 percent from its current 35 percent. The tax system would cause fewer distortions, because companies would have less incentive to relocate operations to low-tax jurisdictions.
Economists believe that imposing this tax would cause the value of the dollar to rise on currency markets, which would offset the tax on imports, and so consumer prices wouldn’t rise. In theory, at least, no one would be worse off.
It looks like the holy grail of tax reform: It allows lowering tax rates without increasing the deficit, without creating powerful losers, and creating a more efficient economy for the long run.
But the very cleverness of the proposal — it is an idea that has been tossed around in academic circles for a decade but never adopted in any country — is what makes border adjustment so fraught.
Retailers, among others, are not confident that currency adjustments will happen the way economists predict, and are running advertisements warning that the “border adjustment tax” will tax “your car, your food, your gas, your medicine, your clothes.”
Economists are gaming out how the tax would reshape currency markets; oil and other commodity industries; and businesses that rely heavily on borrowed money. And they’re looking at the unpredictable ripple effects the tax could create. Legal scholars worry that it would violate World Trade Organization rules and fuel a prolonged legal battle or even a trade war.
In effect, the elegant, clever solution to many of the other trade-offs involving taxes introduces a level of complexity and uncertainty that may doom an otherwise promising approach.
As they seek to resolve these interrelated tensions, tax writers in Congress will face pressure from hometown industries, constituents as well as practically every business lobbyist in Washington — and will also confront the inherent political challenge of getting to a majority.
There are videos online that show how to solve a Rubik’s Cube in a few minutes. The engineers of tax reform should be so lucky.