Media reporting on the economic consequences of the Tax Cuts and Jobs Act now in conference is short on facts and long on polemics. This is no superficial “giveaway” to the rich. Rather, the act will benefit almost 34 million businesses, the overwhelming majority of them small, and transform the United States into a globally competitive platform for investment and expansion. Active owners of these businesses and their families could easily constitute 100 million Americans.
To achieve these goals, this tax reform changes the long-term incentive structure in the tax code to equalize returns from investing in the United States with returns from investing abroad. It also provides a huge benefit to domestic companies through lower tax rates and expensing of short-lived capital investment.
These provisions will encourage business investment and new business creation. Lower tax rates on business income relative to wage income could help reverse the decline in new business creation, which has been ongoing for more than a generation.1
While there are important changes for individuals, including lower rates at most income levels, much of the benefit is offset by elimination of deductions and preferences. This reform delivers on its name by being both pro-business and pro-jobs.
It eliminates about $4.3 trillion in special preferences and reallocates those revenue dollars toward $5.8 trillion in tax rate and other tax reduction provisions. The net tax reduction will total $1.4 trillion over 10 years, averaging between $200 billion and $250 billion a year in the first years of implementation.
Lowering the corporate rate to 20 percent will have an immediate, positive impact on domestic corporations now paying the 35 percent rate and higher. (Many domestic corporations pay effective tax rates that are even higher than the federal rate when state income and gross receipts taxes are added in.)
A lower tax rate will substantially improve cash flow and investment in working capital, increase after-tax returns from investment, and help companies accumulate cash reserves necessary to survive difficult economic times.
After-tax profits are the primary source of cash and it is cash that drives a business. High tax rates on businesses siphon off cash resources and hamper companies’ ability to fund operations. Conversely, lower taxes add cash and increase business demand for a wide range of goods and services, including investing in capital and workers, particularly in the manufacturing sector.
The economic effect of cutting the corporate tax rate to 20 percent on multinational corporations is a bit more complicated.
The United States is among the most cost-competitive countries in the world. Under current law, the 35 percent tax rate acts as a surtax on U.S. investment. Were corporations to use foreign profits for investment, they would have to pay the difference between the 35 percent U.S. rate and taxes paid to foreign jurisdictions, adding significantly to the cost of capital for U.S. investment. Absent the 35 percent tax rate, companies would choose to invest here.
Foreign companies also face this surtax on U.S. activities. Although the United States remains a top choice for foreign companies investing abroad, its share of foreign direct investment has dropped from 39 percent in 2000 to 21 percent in 2014 as global competition for foreign investment has intensified.2
Many multinationals in the technology and health care sectors already pay an effective tax rate of 22 to 25 percent because they expand their production and allocate intellectual property to low-tax jurisdictions outside the United States. These companies will benefit by being able to allocate capital more efficiently globally.
High corporate tax rates, together with the high progressivity of the corporate rate structure, has prompted many businesses to shift away from corporate structures to sole proprietorships and other pass-through entities. The corporate rate is much more progressive than the individual income tax rate at income levels between about $24,000 and $335,000 (Chart 1).
My Commentary, The Business of America is Business, notes that the number of corporations in the United States has declined while the number of pass-through entities has increased. For example, there were 2.2 million corporations in 2000 vs. 1.6 million in 2013. By contrast, the number of pass-through businesses has increased from 23 million in 2000 to about 32 million today.
The United States provides exceptional opportunities for workers to turn their labor income into capital through business ownership. However, the current tax system creates a ceiling on success whereby the marginal rate on corporate versus pass-through business income can be 10 percentage points as businesses grow.
The vast majority of businesses are small. Almost 80 percent of sub-Chapter C corporations and 85 to 90 percent of all pass-through businesses have less than $1 million in revenue.3 These companies earn on average an average of $100,000, and most companies earn much less.4
Under current law, the individual tax rate rises rapidly after the high end of the 25 percent bracket (i.e., $156,000) up to 39.6 percent by $480,000 in income. A pass-through that earns profits of say $300,000 a year is likely to pay the highest individual rates when wage income is taken into account. These firms are small, indeed very small, when compared to large public companies, but they pay very high marginal tax rates as their business grows.
The proposed pass-through rate is capped at 25 percent in the current House bill, which roughly equalizes the gap between the individual tax rate and the pass-through rate.
Do pass-through businesses stay small because they don’t have any big profitable ideas? Or are they small because the marginal rate on success above $150,000 is eight to almost 15 percentage points (Chart 2)?
Despite its considerable long-term impact, the short-run benefits of tax reform are limited. For businesses, many of the revenue raisers are front-loaded. Individuals and pass-through businesses are likely to wait until the end of 2018 to understand their tax liability under the new law.
For multinationals, the immediate benefit from the lower tax rate will be offset by “deemed repatriation,” limitations on interest deductions, new permanent taxes on foreign income, and possible excise taxes on foreign transactions.
Rather than a rush of cash into stock buybacks next year, as the market expects, the very early years of tax reform for many multinationals are likely to be a wash. Moreover, foreign profits are often held in working capital that supports business operations and expansion overseas rather than in cash and cash equivalents. The taxes owed on these historic profits and other foreign entity provisions will dig into the cash benefits from tax reform.
Large multinational corporations are supporting tax reform not for the short-term benefits but because of the long-term flexibility in how they allocate capital. The stock market is overly eager to capitalize these long-term gains into current stock price valuations.
For individuals, the dollar benefit of tax reform as measured by the government’s revenue loss is less than it might seem because the lower tax rate on business pass-through income is included among the individual provisions. Setting the those cuts aside, the tax bill contains about $3.5 trillion in individual rate and other tax reductions over 10 years, offset by $3.1 trillion in lower deductions and preferences.
On balance, this is not a bill that will stimulate demand directly. The larger dollar cuts are at the high end of the income distribution because the top income quintile pays 90 percent of the individual tax liability (see Tax Cuts Will Have to Include the Rich). Speaking solely in terms of tax rates, tax reform cuts tax rates relatively more at the low end of the income spectrum (Chart 3).
As with businesses, any stimulus from the individual tax cuts will also likely be delayed. Most individuals and pass-through entities will not fully understand the impact of tax reform on their tax obligations until the end of 2018, delaying any stimulus to demand.
Moreover, the deadline to incorporate tax reform into withholding rates is long past. Changes in withholding rates will be delayed well into 2018, and many taxpayers will be over-withheld in the meantime.
In sum, the Tax Cuts and Jobs Act is intended to spur business activity and job creation. Its long-term effects depend on just how businesses, particularly small businesses, respond to the new incentive structure.
Given that the effects of tax reform won’t be felt until late 2018, Republicans will have to go into the 2018 midterm elections with promises but little to show in the way of tangible impact.
This tax bill is potentially transformational for the U.S. economy. The political question will be how voters view these benefits. A shift in congressional control from Republicans to Democrats in 2018 could undo what is a very promising deal for the future.
1 “Entrepreneurship Is on the Rise but Long-Term Startup Decline Leaves Millions of Americans Behind.” Kauffman.org, Kauffman Foundation, February 16, 2017.
2 “Foreign Direct Investment in the United States 2016 Report.” ofii.org, Organization for International Investment, February 19, 2016.
3 Estimates projected based on figures from IRS Integrated Business Data, 2003.
4 Estimates projected based on figures from IRS Integrated Business Data, 2013.
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