Key Issues in Tax Reform: The “Better Way” House Plan

Key Issues in Tax Reform: The “Better Way” House Plan

August 2, 2017
Key Issues in Tax Reform: The “Better Way” House Plan
On June 24, 2016, House Speaker Paul Ryan released the
Current effective corporate tax rates on new equity
Better Way Tax Reform Task Force Blueprint, which
investments are negative or zero for investment in
provides a revision of federal income taxes. (For an analysis
intangibles, around 24% for equipment, and up to 36% on
of the plan, see CRS Report R44823, The “Better Way”
some structures. Overall, including taxes on shareholders
House Tax Plan: An Economic Analysis, by Jane G.
and creditors, effective tax rates are around 22% for
Gravelle.) The plan does not specify all changes that might
corporate equity financed investments and a negative 44%
broaden the base or any transition rules.
on debt financed investments; the new plan would result in
rates close to zero for both. Similar narrowing of tax
Tax Revisions
differentials would occur for unincorporated businesses.
For the individual income tax, the plan would broaden the
base by disallowing itemized deductions except for
The plan’s estimated output effects appear to be limited in
mortgage interest and charitable deductions, lower the rates
size and possibly negative. The direct effect of lower
(with a top rate of 33% compared to 39.6% under current
marginal tax rates on labor supply is limited because the
law), and alter some of the elements related to family size
reduction in marginal tax rates is small and largely offset by
and structure by eliminating personal exemptions, allowing
an increased base that increases effective marginal rates.
a larger standard deduction, and adding a dependent credit.
Capital income effects are also somewhat limited even with
The current earned income credit and child credit would not
the movement to a cash-flow tax (that generally imposes a
be altered. Capital gains, dividends, and interest would be
zero rate) because the current effective tax rate is low, due
taxed at 50% of ordinary rates; currently, capital gains and
to current accelerated depreciation and the negative tax rate
dividends are subject to a top rate of 20% and interest is
on debt-financed investment. Growth effects are also
taxed at ordinary rates.
limited because most empirical evidence does not support
large savings and labor supply responses. As currently
For business income, the current income tax would be
proposed, the plan loses significant revenue which,
replaced by a cash-flow tax, with a top rate of 20% for
according to some estimates, could more than offset the
corporations and 25% for individuals’ (pass-through)
supply responses because the increased government
capital income. A cash-flow tax allows investments, such as
borrowing would crowd out private capital investment.
purchases of buildings and equipment, to be deducted when
incurred rather than through depreciation deductions over
The effect on international capital flows is ambiguous as
time and results in a zero tax rate on new investment
the cash-flow tax, while encouraging equity capital to move
returns. The cash-flow treatment would not apply to land
from abroad, would discourage inflows of debt. The plan
and apparently not to inventories. Interest would no longer
would eliminate many distortions associated with
be deducted. The tax would be border-adjusted (imports
multinational firms, including eliminating the tax treatment
taxed and exports excluded), making domestic consumption
that discourages repatriation of foreign source income to the
the tax base, although a recent announcement from
United States and the incentive for firms to invert (shift
congressional leaders and administration officials has
headquarters abroad) by merging. It would also largely
indicated that a border adjustment would be dropped in any
eliminate profit shifting to low-tax countries, although if
future tax plan. The border adjustment may not be complete
border adjustments are eliminated, the effect on profit
because it would not allow a refund of the export deduction
shifting is ambiguous. Although the disallowance of interest
when it creates an overall loss, but rather a carryover of
deductions and lower tax rates would reduce profit shifting
losses with interest. The system would also move to a
incentives, a territorial tax tends to induce more profit
territorial tax in which foreign source income (except for
shifting through transfer pricing of intangibles. Without the
easily shifted income) would not be taxed. The proposal
border adjustment, the incentive to invert would not be
would repeal the domestic production activities deduction
entirely eliminated but would be substantially reduced.
but retain the research tax credit.
Exchange rate adjustments (the dollar should appreciate by
The proposal would repeal estate and gift taxes. Although
25%) should eliminate any effect of the border adjustment
the Affordable Care Act (ACA) taxes are not repealed in
on imports and exports, although how quickly that
the Better Way tax reform proposal, ACA taxes are
adjustment would occur is uncertain. If firms cannot merge
repealed in the House-passed American Health Care Act.
or otherwise find ways to deal with the lack of refundability
of the value of the deduction for exports, the measure
Effects on Efficiency and Growth
would reduce imports.
One objective of tax reform is to increase output and
efficiency. The plan would achieve efficiency gains,
Distributional Effects
particularly in the allocation of capital by type and industry
The proposal would have effects on vertical equity
and in the even treatment of debt and equity finance.
(progressivity, or how the tax burden changes as income
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Key Issues in Tax Reform: The “Better Way” House Plan
rises), horizontal equity (how the tax burden changes across
increase output, the effects would be largely offset or
families with the same ability to pay), distribution across
reversed by crowding out.
generations, and international distribution.
Administrative and Compliance Issues
Distribution Across Incomes
Many elements of the blueprint could produce
Studies find that the plan favors high-income individuals,
simplification in tax administration and compliance. For the
increasing the after-tax income of the bottom 80% of
individual income tax, a significant reduction in the share of
families by 1% or less, while increasing the income of the
itemizers, due to the disallowance of most itemized
top 20% by 1% to 4% (depending on the estimate), and the
deductions (particularly state and local taxes) and the
top 1% would have an increase of 5% to 11%.
significant increase in the standard deduction, is an
important simplification. The repeal of estate and gift taxes
Horizontal Equity
would reduce tax planning. The cash-flow treatment would
Calculations suggest that the current tax system, which
simplify business accounting although transition rules
favors families with children and lower incomes and favors
would continue depreciation deductions, potentially for
families without children at higher ones, would remain
many years. International tax planning would be simplified
essentially the same. The current pattern of marriage
and largely eliminated with a border tax adjustment.
penalties and bonuses would remain similar. Couples
without children would primarily experience bonuses
New administrative costs would arise, however. Taxing
(depending on the income shares) except at some high-
capital income of pass-through businesses (such as
income levels. Couples with children would experience a
proprietorships and partnerships) at a lower rate will require
mix of bonuses and penalties depending on who can claim
allocation of income between capital and labor income. For
the children. Some equity issues would arise from
individuals in the 33% bracket, there will be an incentive to
eliminating itemized deductions for extraordinary medical
characterize labor income as capital income.
expenses, because these families generally have a lesser
ability to pay. Disallowing itemized deductions that are
A variety of new administrative and compliance costs
appropriate to measure income, such as casualty losses and
would arise from a border tax adjustment. One tax planning
employee business expenses, may also be viewed as
issue would be addressing the inability to use the deduction
inequitable.
for exports by mergers with importers, setting up an import
brokerage business or leasing investments. Tax planning
Intergenerational Redistribution
activities to maximize the value of exports and minimize
Unlike an income tax, a cash-flow tax does not affect new
the value of imports would also complicate tax
investment but rather reduces asset values, thus shifting the
administration and compliance.
burden from younger to older generations. This asset effect
is expected to result in a fall in stock market prices and in
Other Issues
prices of used assets in general. The estimated fall in the
Several other potential issues arise with the plan. Some
stock market is limited to about 6% because the current
believe that border tax adjustments would violate rules of
corporate income tax has many cash-flow elements and the
the World Trade Organization and bilateral tax treaties. The
proposed tax does not extend cash-flow treatment to land
plan might complicate tax administration for state and local
and inventories (with full cash flow treatment, the fall
governments because most of these taxes begin with the
would be around 17%). The fall will be smaller initially if
federal base and use federal tax return information for
transition costs are allowed (such as continuing to
enforcement. The shift to a consumption tax base will
depreciate existing assets), but larger if higher statutory
eliminate federal depreciation deductions and make it
rates were used to address revenue costs.
difficult for state and local governments to continue with
income taxes. States also sometimes require conformity in
International Distribution and the Border
itemizing deductions versus taking the standard deductions,
Adjustment
which can have consequences for the number of taxpayers
The appreciation in the dollar is expected to cause current
that take state standard deductions. Complications may
foreign holders of dollar-denominated assets to gain as
occur with applying the cash-flow tax to certain types of
much as $8 trillion in value, whereas foreign holders of
firms, such as financial firms. Finally, some have argued
U.S. assets could lose as much as $5 trillion. Countries with
that the incentives to invest do not arise from a cash-flow
debt denominated in dollars would have increased burdens.
tax because financial accounting drives investment and the
cash-flow tax is a timing issue that does not affect book
Revenue Effects
profits.
Estimates indicate that the proposal would lose revenue of
$2.3 trillion over the budget horizon (assuming ACA taxes
This In Focus is part of a series of short CRS Products on
are excluded; if they are included the cost would be $3.1
tax reform. For more information, visit the “Taxes. Budget,
trillion). If the border tax adjustment were eliminated, the
& the Economy” Issue Area page at www.crs.gov.
cost would increase by an additional $1.2 trillion, although
in either case, this amount is effectively borrowed. These
Jane G. Gravelle, Senior Specialist in Economic Policy
costs are unlikely to be much altered by dynamic scoring
because, while demand stimulus and increased saving may
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Key Issues in Tax Reform: The “Better Way” House Plan

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