[Please note: The commentary was recorded on Thursday, November 30 before the final version of the bill was even released. The written expansion was created before the Senate vote. In the commentary, I assumed it would pass the Senate and be headed to a conference committee.]
I recently asked three expert economists to identify the worst element of the horrible tax bill that is going to a conference committee soon. They all agreed that the most egregious, dangerous change to the tax system contained in that bill is the lowering of taxes on pass-through business income.
I hope that when the discussions in the media turned to the details of the tax plan, your eyes did not glaze over and you gave up trying to understand it. That is what so-called experts want you to do --- they want you to believe that because you don’t speak the jargon, you cannot understand it. All so-called experts hide behind discipline specific jargon – often as a way of keeping ordinary people from thinking that they can understand what is going on and therefore opt to “leave it to the experts.” But just because economists speak in “economese” that doesn’t mean that members of the general public cannot insist on translations into plain English. So here goes
Pass through income is the income earned by a business that is not subject to a separate corporation income tax. The corporation income tax is a way of guaranteeing that when corporations make profits, that stream of profit is taxed, even if the corporation chooses not to distribute all of their profits as dividends. Unincorporated enterprises --- sole proprietorships and partnerships do not have to pay a separate business tax because all of the income accruing to the business is taxed at the individual income tax rate for the owner (or the partners). The retained earnings of corporations do not create a tax liability for shareholders whereas in a pass-through business, even if the business re-invests some of its profits the individual owners pay tax on all of it. So, if someone is subject to the 35% tax rate and one of that person’s businesses nets $200,000, it would be taxed $70,000 --- 35 percent of the $200,000.
The House version of the tax bill cuts the maximum tax rate down to 25% --- In this example, the lower tax rate would result in a tax of $50,000. That’s a cut in taxes of $20,000. The Senate version gives all such income a 17.5% deduction. With $200,000 in pass through income, this person would still pay at the 35% rate but on only $165,000 – for a tax bite of $57,750. This is not as generous as the House bill but still a $12,000 tax cut.
The reason this is such a bad policy is that it will create tremendous incentives for highly paid individuals to turn themselves into businesses. Supporters of this tax bill have been interviewed about this danger and they assure us that there will be ways to prevent the abuse of this new lower tax rate. Unfortunately, that is nonsense. All it will do is create tremendous business opportunities for accountants and lawyers to devise creative ways to re-package highly paid individuals as independent businesses.
Trump and his enablers are asserting that this bill closes loopholes in order to simplify the tax system. Well, I have tried google searches for “closing loopholes in the new tax bill” and have not seen a single example of a closed loophole in any of the reporting on the bill.
Some ridiculous changes in the bill that raise taxes on some taxpayers involve no longer being able to deduct interest on student loans, having to pay taxes on in kind benefits such as free tuition for your kids if you work at a college, no longer being able to deduct state income taxes, and others as well. However, there does not seem to be ANY effort to close business loopholes. The current statutory 35 percent rate on corporate income is not paid by any business. What we call the effective rate – the actual ratio of tax paid to net revenue (after the business takes advantage of all the deductions available) is closer to 12.6% . If the cut in the official rate is not matched by the closing of business tax loopholes, then the effective rate will be even lower.
In addition, this lower rate for pass-through income is one gigantic NEW loophole. One of the tricks that Trump and his enablers deploy to sell this tax bill is to assert over and over again that this is for the middle and working classes. It is true that there are some (temporary) tax cuts in the individual income tax, but as they phase out more and more middle class taxpayers will actually see tax increases.
In the case of the pass-through, the benefits are much less significant for lower income business owners. Suppose instead of already being rich and subject to the 35% tax rate, one was of moderate income and subject only to the 15% tax rate. In the House version, you would get no benefit whatsoever because you would already be paying the reduced rate. What about in the Senate version with its 17.5 percent deduction? If your net income were $50,000 from a business, at the 15% tax rate, your tax would be $7500 The 17.5 percent deduction would cut your taxable income to $41,750. Your tax would now be $6262.50, a tax cut of about $1200. Hedge funds with millions of dollars in income will get massive tax cuts --- truly small businesses not so much.
Contrary to the pro-worker assertions of Trump and his enablers, this bill privileges income the permanent reduction in the corporation income tax or the special deal on pass-through income. Income earned by working for wages or salaries will be taxed at a higher rate. Thus, the tax law will enshrine the superiority of income from the ownership of capital to the income earned by applying the sweat of ones brow or the power of one’s brain. The pro-worker rhetoric on display whenever Trump or one of his enablers speaks is another one of his many dangerous lies.
Addendum: The New York Times for November 30, 2017, had an interesting editorial (P. A 30) which identified three items slipped into the bill that probably would never have survived the hearing and publicity process but will probably get through the bill without too much outcry ---even though all three are quite outrageous.
The first one was what seems like a merely technical change --- changing the price index by which brackets move. Currently, the income at which one moves from, say, a 35% marginal tax rate to a 39.6% rate is adjusted upward by the last change in the Consumer Price Index. This is supposed to avoid people paying a higher tax rate even though the income increase has been caused by inflation. This indexing of the income tax has been in place since the 1980s and is quite important. The Senate bill changes the rate of adjustment to a more slow-growing index – the Chained Consumer Price Index. Over time, according to the Times, “…families would lose $134 billion by paying more in taxes and receiving fewer benefits than they would under current law.” (This will occur over the next decade – the losses will be even great afterwards as the lower rate will compound every year.)
The second one is really unbelievable. If the government collects more in corporate income tax than its accountants are projecting, the money will automatically be returned to businesses with an automatic tax cut. The Times noted wryly that “… there are no similar givebacks for individuals.”
Finally, the bill has a special tax cut for beer, wine and liquor. These taxes have not been raised since 1981 but no matter. Some deep pocketed donor no doubt whispered in the ears of some (maybe even one [!!]) Senator and there it is. It would cost “only” $4.2 billion which looks like small potatoes. But it is no less galling in a bill that is supposed to remove loopholes and special deals and SIMPLIFY the tax system.
As I write this on Friday morning, December 1, 2017, it is uncertain what goodies the Senate leadership put into the bill to “persuade” so-called deficit hawks Jeff Flake and Bob Corker to support it --- but whatever the final bill, the fact that it is an abomination that should never have even been considered given the lack of hearings and ignoring “regular order” is clear.
Let us hope that there is a groundswell of opposition to the bill that emerges from Conference. Let us hope that enough Republicans either in the House or Senate will be sufficiently nauseated by elements in this bill to reject it. It is good to see that all Democrats are united against it – for some this is a tough vote facing re-election in states that Trump carried – but it is the right thing to do and perhaps there will be some Republicans who put country above party. We shall see.
Michael Meeropol is professor emeritus of Economics at Western New England University. He is the author (with Howard Sherman) of Principles of Macroeconomics: Activist vs. Austerity Policies.
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