The Trump Tax Plan Would End the Income Tax as We Know It

Beyond ignoring the most basic economic analysis, the plan also ignores recent lived experience.

On Wednesday, CEA Chair Gary Cohn and Treasury Secretary Steve Mnuchin unveiled their fourth attempt at a major tax reform plan, and it is really, really bad. So bad that even the conservative folks over at the Tax Foundation — generally fans of all things tax cut — think it’s bad. The plan would represent a massive boon to the wealthy, very little value to the middle class and, as we will explain, threatens to end employment and the income tax as we know it.

Far from a comprehensive plan, the unveiling comprised a mere list of bullet points, outlining a series of cuts even more aggressive than the already-aggressive rates proposed by the previous Republican blueprint. Now, instead of aiming to cut the passthrough rate from 39.6 to 25 percent and the corporate rate from 35 to 20 as the Brady-Ryan plan did, Trump aims to tax both corporations and passthroughs at just 15 percent.

It cannot be said in text large enough, nor in font bold enough, that this is a completely insane, unjustifiable proposal benefiting the rich. Early estimates suggest it would cost the government at least $5.5 trillion over 10 years, and based on analysis of similar plans, it is safe to assume that about three-quarters of that will go to the top 1 percent alone. That’s more than $4 trillion for roughly 3 million individuals, with less than $1.5 trillion for the remaining 327 million in this country. Such changes would yield a massive increase in income inequality and, like all other tax cuts before it, would fail to stimulate sustainable long-term growth. Both the corporate and the passthrough rate cut are really bad ideas, but it is the latter that we will focus on in this post.

“Passthrough” is a term for a business — generally a partnership, LLC, or S-Corp — that elects to be taxed at the individual level rather than the entity level. This means individuals receive their business revenue as personal income and pay the same federal income tax brackets as an employee. Many small businesses, such as your local plumber, organize as passthroughs for the sake of simplicity, but so do the vast majority of hedge funds, private equity firms, and real estate partnerships, which use the passthrough structure to write off losses and take advantage of numerous other legal tax avoidance maneuvers. These real estate and investment firms earn nearly 75 percent of all passthrough income in the United States, and therefore receive the vast majority of the benefit of passthrough rate cuts. To make matters worse, a landmark 2015 study by Treasury economists found that the top 1 percent of earners receive roughly 70 percent of the income from these firms, and that they pay an effective tax rate less than half that of U.S. corporations. In making these cuts, Republicans purport to have the plumber in mind but know who, in reality, receives passthrough income and who therefore benefits from passthrough rate cuts.

And that’s just the static impact of the plan; its far more lasting impact would be to cap income taxes at 15 percent for savvy, high-income individuals. That is, rather than pay the newly proposed 35 percent top personal income tax rate, many would seek compensation as contractors instead of employees, thus claiming their labor income as business income and benefiting from the new 15 percent rate. This tax avoidance strategy would be easiest for wealthy professionals, who would not only have an easier time convincing the IRS they are in-fact self-employed “consultants,” but who could also afford to hire clever accountants and tax planners. The result would be a flat tax at best, but in all likelihood would be even worse, as many honest workers would pay 25 or 33 percent on eligible income, while upper-income earners would pay just 15. The shifting effect would upend foundational elements of the tax code and social safety net, to say nothing of how it would amplify the plan’s impact on inequality, increase revenue losses, and raise the return to wasteful profit-seeking activities.

Beyond ignoring the most basic economic analysis, the plan also ignores recent lived experience. An even more drastic version of Trump’s cuts was recently attempted at the state level in Kansas, with disastrous effects. In 2012, Governor Sam Brownback signed legislation that ended state passthrough taxation entirely. The expectation was that businesses would flood in from neighboring states and that a previously moribund workforce would spring off the couch in a massive wave of entrepreneurship, brought on by the possibility of higher earnings resulting from lower taxes.

The failure of this plan is legendary. State revenue dropped $700 million its first year and the promised growth was nowhere to be found: Since the cuts were enacted, Kansas’s employment has grown by one-third the national rate and their 4.8 percent GDP was well under half of the country’s 12 percent expansion. Even after cutting $17 million from state university budgets, delaying $93 million in teacher pensions, and borrowing $750 million from highway improvement funds over the last four years, the Kansas state legislature was still fumbling for ways to plug its $342 million budget shortfall early this year.

Adding insult to injury, a new paper by Indiana University economists finds that even the meager growth in Kansas that followed the cuts was likely the result of the kind of income-shifting described above, rather than real economic activity.

The policy ramifications of implementing a similar plan at the national level would be even more severe, as the shift to passthrough income would undermine the payroll tax system, which sustains the Social Security trust fund, to say nothing of norms of employment and worker-firm relationships, which are also key to our already-imperiled social safety net.

Perhaps the fact that Trump offered up a half-baked tax plan that would bankrupt the country and ruin its economy is not surprising. But with just a few minutes of consideration, even someone with a passing familiarity with the U.S tax code would have noticed that this plan held disastrous implications. In light of recent Trump administration failures and initial reactions to the plan, it is tempting to laugh. But as we have learned, the problem with crazy Republican tax plans is that they become law.

Originally published at Roosevelt Institute.

Next New Deal

Roosevelt brings together thousands of thinkers and doers — from emerging leaders in every state to Nobel laureate economists. We reimagine the rules that guide our social and economic realities.

Eric Harris Bernstein

Written by

Sometimes as me, sometimes as Program Manager at the Roosevelt Institute. Most likely talking about taxes, competition policy, or worker power. @EricHBernstein

Next New Deal

Roosevelt brings together thousands of thinkers and doers — from emerging leaders in every state to Nobel laureate economists. We reimagine the rules that guide our social and economic realities.

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