Main Street Hill Briefing
The Parity for Main Street Employers coalition and the S Corporation Association will host a Hill lunch briefing at noon on October 24th in the Kennedy Caucus Room (SR-325).
The briefing is open to Hill staff and tax professionals, and will focus on the pass-through sector and how it has fared under tax reform. Speakers include Senator Steve Daines (MT), Marty Sullivan with Tax Analysts, Bob Carroll with EY, and David Winston with the Winston Group. Box lunches will be provided.
You can see the official event flyer here. To RSVP, please contact us at admin@s-corp.org.
Grading the TCJA, Two Years Later
The American Enterprise Institute has a new“Trump Tax Reform Blog” series on its website. Over the next month, tax policy folks from both sides will weigh in on the reform and whether it’s working. You can read the current posts here. Our invitation to comment must have got lost in the mail, but no worries, it’s a brave new world and we can comment anyway. Here’s our report:
Has the TCJA helped American workers and businesses with additional economic growth? Such questions are impossible to answer with absolute certainty, since we will never know what the economy would have done without the TCJA’s adoption. The counter factual is an elusive beast.
That said, a solid case can be made that the TCJA has enabled our long-in-the-tooth economic expansion to continue with more energy, more investment, and higher wages, than it would have otherwise.
First, let’s start with economic growth. Jason Furman argues that the six months following the TCJAs adoption were slower than the six that preceded it. This is the wrong comparison, however. The counter factual might be elusive, but we know markets are forward looking. As soon as Trump was elected, business owners began to factor in expectations of a sizeable tax cut together with other pro-growth fiscal policies.
So the correct comparison would be the ten quarters prior to Trumps’ election verses the ten quarters that have followed it. You could include some sort of discount for the four quarters that followed the election but preceded the TCJAs adoption, since those quarters reflect an expectation of tax cuts rather than their reality, but we’re not sure that’s right. Wouldn’t investments made in the anticipation of tax cuts be just as valid as those made once it’s adopted?
So how does the correct comparison look? Pretty good for the TCJA. The pre-election average was 2.2 percent, while the post-election average is up at 2.7 percent. Half a percentage point of additional growth is significant, but the reality might be better than that. Take a look at the table below. Economic growth in the years prior to Trump’s election was a roller coaster ride of highs and lows, despite the fact that the economy was coming out of a financial crisis where you’d expect to see more consistent — and higher – growth levels. Despite coming six years into the expansion, the post-election growth numbers are more consistent, stable, and positive.
Second, let’s look at timing. Much of the economic pop of the TCJA comes from the combo platter of lower rates, full expensing, and international reforms designed to increase capital investment. But the American economy primarily is made up of consumption, so higher capital investment levels will only have a small immediate impact on the growth data. Their real contribution comes over time, as increased investments generates more jobs and higher wages. So how is Capex doing since Trump took office?
As Doug Holtz-Eakin recently wrote, it’s up consistently across the board for structures, equipment and intellectual property. Here’s the chart he used:
These higher levels of Capex promise better jobs and higher wages in the future, but just two years following adoption of the TCJA, its simply too early to see that in the economic data. We’ll just have to wait.
Third, a discussion of economic growth under Trump would be incomplete without a discussion of his trade policies. Just as the deregulation under Trump has helped spur economic activity, the trade battles he’s waged against Mexico, Canada, Europe, China – well, just about everybody – have instilled uncertainty and held back growth. CNBC had an excellent discussion of our trade challenges the other day, particularly regarding China and their recent history of stealing our intellectual property. The take-away from the conversation was that a stand-off with China was long-overdue. But the fact that our trade war with China may be justified doesn’t stop it from retarding growth and job creation, at least in the short term. Anyone reviewing the growth data over the past two years needs to take our trade policies into account when measuring the success of the tax cuts.
Our fourth observation is that the TCJA included many moving parts, with some of those provisions imposing short-term costs on the economy. A good example are the international reforms. The move from a world-wide tax system to a quasi-territorial system may be good for investment and growth in the long term, but businesses are still learning how the new rules work and many need to adjust their operations to fit the new regime. Both impose transition costs that should be taken into account. Over time, those transition costs will fade away.
Which brings us to our fifth observation – permanence. One item that popped from our member survey earlier this year is how many S corporations decided not to convert to C this year because they didn’t have confidence the 21 percent corporate rate was going to be around for long. This feedback was slightly ironic, as it’s the Section 199A pass-through deduction that’s temporary, not the lower corporate rate. It is counter intuitive that companies would choose to stick with the temporary policies because they don’t believe the “permanent” rates will survive long. Businesses don’t make long-term plans based on temporary tax policies. If Congress wants to see the full benefit of the TCJA, they need to convince the business community that these policies are going to be around for a while. The right first step in that direction would be to make the 199A permanent.
Perception v. Reality on Tax Rates
Here’s a conundrum. A recent poll revealed that 76 percent of Americans support increasing taxes on the “wealthy,” while sixty-one percent support the wealth tax proposed by Senator Elizabeth Warren, which is like an income tax, only at ridiculously high rates.
But polls also show Americans consistently oppose high tax rates, even on the wealthy. This summer, for example, the Winston Group asked registered voters: “For each of the following, what is the maximum rate at which you think they should be taxed?” …[T]he average responses were all consistently low, ranging from a high of 31 percent for the wealthy down to just 17 percent for small and family-owned businesses.
First published in The Hill. Read the entire post here.
Failure of High Marginal Rates
Earlier this year, the Congressional Budget Office produced a report reviewing tax rates on labor income since 1962 that includes some important lessons for tax policy folks.
The first lesson is that nothing replaces a really cool chart. Take this heat map, for example. What a great way to convey a lot of information all at once. If you’re a taxpayer, the simple way to view it is lighter colors good, darker colors baaad.
Our second lesson is how much more progressive the tax code has become since the 1960s. Back then, nearly everybody paid statutory rates between 16 and 28 percent. Today, those rates are limited to the top quarter of taxpayers. Around three-quarters pay lower rates ranging between 0 and 15 percent. This vast improvement in how we tax the middle class is completely lost in today’s political discourse.
A third lesson is the dramatic impact inflation had on tax burdens. See how thin those dark lines are prior to 1970? Marginal rates were really high back then, but few taxpayers paid them and they didn’t raise a lot of revenue. Then came the high-inflation 1970s. As the CBO notes:
Throughout the 1960s, fewer than 0.5 percent of tax filers faced a statutory rate of 50 percent or more, and the number of tax filers facing rates higher than 28 percent fluctuated between 2 percent and 4 percent. In the 1970s, the share of tax filers in high rate brackets began to grow rapidly. By 1981, 1.5 percent of returns fell into tax brackets with tax rates of 50 percent and higher, and almost one-quarter fell into brackets with rates higher than 28 percent. The rapid increase occurred despite stability in the tax law because the tax system was not indexed for inflation and rapid inflation in the 1970s pushed many taxpayers up the rate schedule.
We hear lots lately about how high top tax rates were in the 1950s and 1960s (91 percent) and how those high rates didn’t seem to hurt the economy, but this chart puts the lie to those claims. It’s hard for high rates to hurt the economy when nobody pays them. It was only when inflation pushed increasing numbers of taxpayers into the upper brackets that they began to have any relevance. Apparently, taxpayers can plan around high rates, but they can’t plan around inflation.
How exactly did high income taxpayers avoid the ridiculously high rates of the 50s and 60s? In many cases, they paid taxes (if they paid taxes at all) using other rates. This table from a 2009 paper by economists Slemrod, Saez and Giertz shows the top tax rates for different forms of income dating back to 1952. As you can see, taxpayers back then had a choice to pay marginal rates of 91 percent on their wage and salary income, 52 percent on their corporate income, or 25 percent on their capital gains income. The paper’s key finding is that recognizing earnings shifted from one form of income to another is a key to accurately measuring taxpayer responses to rate changes.
Using corporations as tax avoidance vehicles was a popular choice back then, and it stayed popular right up until the 1986 Tax Reform Act. The pre-86 corporate rates were lower and the deduction opportunities bigger. With the new rate structure and greater deduction opportunities for corporations under the TCJA, it’s likely to be popular again real soon.
Our final observation is how consistent actual tax burdens are. Top tax rates varied wildly in the past sixty years, but the above chart shows the average rate has been remarkably solid at around 20 percent throughout it all. It spiked with inflation in the late 1970s, and it rises a few points with each market bubble, but that’s about it. And, as we noted above, this steadiness occurred over a time when top tax rates were cut in half and the tax code became more progressive.
So what is the overall lesson? The report demonstrates that really high tax rates don’t work as advertised. Taxpayers actively avoid them, so they leak revenue, distort behavior, and hurt the economy. When inflation in the 1970s surprised taxpayers and forced a meaningful number of them into those high rates, the economy suffered. Remember President Carter’s “Malaise” speech? We weren’t suffering from a “crisis of confidence”, we were suffering from a massive, inflation-caused tax hike. Taxpayers revolted, Reagan got elected, and rates came down (and were indexed for inflation too).
Treasury on 199A Guardrails
Remember this JCT chart from earlier this year? It garnered lots of attention and called into question how the 199A pass-through deduction was structured. If only 9 percent of all pass-through income was disqualified from getting the deduction, what was the point of having all those complicated rules?
We wondered about the estimate at the time, as it didn’t comport with our member’s experience. In our S-CORP survey this year, only half of our members expected to get the full deduction, while rest expected just a partial deduction or no deduction at all. How was it possible the excluded income of all those firms is only 9 percent of the total?
A Treasury paper from May suggests that our members might be right. According to Treasury, the amount of pass-through income disqualified by the Section 199A limitations could be 40 percent, not 9 percent. While Treasury makes clear the mechanics of their estimate differs from the JCT’s, that’s still a big difference. Somebody is off by a factor of four! Here’s the table from the Treasury report:
As you can see, far from having little impact, the limitations significantly reduce the amount of income eligible for the deduction, particularly the exclusion of specified services businesses and wage guardrail.
Why is this important? Lots of reasons. First, it makes a difference on revenue estimates and parity. Here’s Treasury on their estimate and the Joint Committee’s:
Our baseline estimate, reported in the sixth row of Table 2, is that taxpayers would have claimed $156 billion in deductions in the absence of behavioral responses, yielding total tax savings of $34.5 billion. These estimates are adjusted for inflation to 2018 dollars, as are all dollar values in this section, unless otherwise indicated. For comparison, the Joint Committee on Taxation estimates that the 2019 fiscal year cost (which includes portions of the 2018 and 2019 tax year costs) of the 199A deduction is $47.1 billion (Joint Committee on Taxation, 2017; not adjusted for inflation). The Joint Committee’s 2018 fiscal year estimate of $27.7 billion is also informative. It includes only a portion of the 2018 tax year cost and therefore places a lower bound on the 2018 revenue effect (Joint Committee on Taxation, 2017). We note that the Joint Committee’s estimates include forecasts of behavioral responses to the deduction, which tend to increase its cost, and their estimates include a richer interaction with other TCJA changes. Furthermore, their estimates include the effects of the Section199A deductions for qualified Real Estate Investment Trust dividends, qualified publicly traded partnership income, and certain income from co-operatives; our estimate does not.
Different methods might explain some of the gap between $34 billion and $47 billion, but not all. If Treasury is right about the Section 199A guardrails, then the JCT significantly overestimated the value of the Section 199A deduction to pass-through businesses.
Meanwhile, it looks like the JCT vastly underestimated the corporate tax relief in the TCJA. The JCT initially predicted corporate revenues would be $243 billion in 2018. Despite rising earnings, actual revenues were just $205 billion and they are tracking at similar levels for 2019. In the balancing act between corporate and pass-through tax treatment, there is growing evidence the JCT’s tax reform estimates were tilted against the pass-through sector.
Second, since the disqualification of specified services business income and other guardrails only apply to business owners with incomes exceeding $315,000, underestimating their effectiveness will greatly impact the JCT’s distribution tables. The media had a field day with the JCT estimate that two-thirds of the Section 199A benefit goes to taxpayers over the income threshold. The Treasury analysis suggests that estimate is too high.
Finally, contrary to the implication that the Section 199A’s guardrails are ineffective, the reality on the ground is that they have real teeth, particularly the wage guardrail. It’s difficult to fake W-2s and wages paid are a reasonable, easily measured proxy for other factors that make up a real business. That’s why the wage guardrail was proposed by our business coalition in the run-up to tax reform. There’s a certain populist attraction to it too – if you want the deduction, create some jobs.
Some corporate CEOs recently floated the idea that they should focus more on jobs and less on profits. It’s a worthy sentiment, but their actual statements lacked any real substance. It’s one thing to say you’re going to focus more on job creation, it’s another to do it. The wage limitation on the pass-through deduction, on the other hand, is real. For business owners above the threshold, the surest way to get the pass-through deduction is to go out and create some jobs. Maybe those corporate CEOs would support applying the wage guardrail to the 21-percent corporate rate too? That would be consistent with their recent press, but we’re not holding our breath.