Trump vs. House GOP: Whose Plan Is More Pro-Growth?
Talk last week about President Trump’s tax reform plan had two themes: The plan is too vague, and it is too costly. In other words, we don’t know what it is, but we know what it costs.
Despite Congress and President Trump needing to fill in many blanks, it is possible to analyze the economic effects of the elements that have been announced. And it is worthwhile to compare these effects to both current law and the more detailed House Republican tax plan.
The most economically distortionary tax in the US tax code is the corporate income tax because it disadvantages American firms competing abroad and discourages investment in the United States. By this measure, Trump's proposed 15 percent corporate rate is more pro-growth than the House plan's 20 percent rate. But the headline (“statutory”) rate does not tell the whole story.
Tax reform – GOP-style, at least – is about promoting long-run economic growth through lower marginal tax rates on work and investment. With the favorable assumption that tax reform won’t make the deficit worse, a relevant metric to predict how tax reform will affect U.S. economic growth is the marginal tax rate on new investment. As that tax rate drops, domestic investment will increase, U.S. workers will become more productive, and the economy will grow.
The chart below uses AEI’s Open Source Policy Center business-tax model to calculate the effective marginal tax rate for a new equity-financed business investment under current law, the House Republican tax reform plan, and the Trump tax reform plan. The effective marginal tax rate includes the taxes paid by the stockholders as well as the corporation, and reflects other aspects of the tax system beyond the headline tax rate, such as the generosity of depreciation allowances. The good news is that for new investments by corporations and by pass-through entities like S Corps and LLCs both the House GOP plan and the Trump plan are more pro-growth than current law. Although the difference is modest, three elements of the House plan make it more pro-growth than the Trump plan.
First, the House plan slashes the average marginal individual tax rate on interest income from 31 to 14 percent while Trump nudges this rate just 5.5 percentage points lower. Second, the House plan cuts the average marginal tax rate on dividends by 5.2 percentage points while Trump cuts this rate just 3.1 points. And third, the House plan restructures the corporate income tax into a cash-flow tax, which permits an immediate write-off of new investment and disallows a deduction for net interest expense. Adoption of a cash-flow tax is a powerful reform that would move the tax code toward a consumption tax.
Ultimately, what matters most is not where the tax reform debate starts, but where it ends. President Trump’s reform principles are in many ways similar to the House GOP plan, albeit with fewer details and modestly different parameters. But unanswered questions, including lawmakers’ budgetary objective for tax reform and the base-broadening tax changes necessary to mitigate the revenue loss, abound. The sustainability of good tax policy requires that lower marginal tax rates on investment be achieved in a manner that does not worsen the long-run fiscal outlook.
