Why President Trump’s Promise of Tax Reform May Be Dead on Arrival

Mar 28, 2017

If you thought health care was tough to conquer, achieving American tax reform is like slaying a savage beast in a dark labyrinth and then navigating the maze to safety. Donald Trump’s labyrinth is a promised revenue-raiser that probably won't happen, while the beast is towering, murderous budget deficits. Greek mythology hero Theseus was able to slay the Minotaur and emerge from his labyrinth a hero, guided by Ariadne's magical thread. But the idea that Trump will steer his agenda safely past his own twin perils is more fantasy than myth.

Following the failure of the Republican health care initiative last week, the Trump administration is spinning tax reform as a far lighter lift and the vehicle that will restore momentum for the president's pro-growth, business-boosting agenda. On March 26, Chief of Staff Reince Priebus predicted that "Democrats are going to come on board" to enact "one of the biggest middle class tax cuts in the history of this country."

The Trumpian optimism is misplaced. The House health care bill was a close call. But radically reshaping America's tax code so that families have more cash to save and spend, while companies clinch higher returns on each dollar of investment—though a great idea—is frankly looking dead on arrival.

The reason is threefold. First, passing tax reform is extremely difficult even in the best of times. "It's really hard to get reform done with one political party, as in this case," says Eric Toder of the non-partisan Tax Policy Center. "You're not talking about cutting spending, but raising one person's and one company's taxes and cutting another's." In other words, for every winner there's a perceived loser.

Second, previous overhauls have occurred when the outlook for debt and deficits were much more favorable. "When they did the George W. Bush tax cuts in 2001, we were looking at a future of big surpluses," says Toder. Today, the fiscal picture is far bleaker, clouded by trillion-dollar deficits that could hit as early as 2021.

Third, the only major blueprint that, given the most favorable assumptions, doesn't disastrously swell future deficits––the House Republican plan––relies on new taxes that are extremely controversial and probably won't be enacted. Chief among them is the complex, VAT-like Border Adjustment Tax, what is likely a dead-end tunnel in the maze of tax reform.

Given the problems with growing deficits and unpopular revenue-raisers, the Trump administration may be forced to gut the deepest, most growth-enhancing reforms. So let's examine how the two major plans will at best deliver a pale version of the tax-slashing revolution advertised by Trump.

The Trump Plan Doesn't Remotely Pay for Itself

As the leading candidate in mid-September, Trump unveiled a daring tax reform manifesto. To be fair, it’s still a campaign platform; his administration hasn't updated it as yet, and whatever it does propose will need to be a lot more fiscally prudent that the opening salvo.

Still, it's instructive to study the Trump campaign plan to understand how deep cuts would burden future budgets. The proposal would more than halve the corporate tax rate from 35% to 15%, and on the personal side, consolidate today's seven brackets to three, with a maximum rate of 33%, vs. today's 39.6%.

The reductions would cause a multitrillion loss of revenue over the next decade. The Tax Foundation, a free market-leaning think tank, estimated those losses as well as savings that modestly narrow the gap. The Tax Foundation reckons that the Trump plan would greatly increase employment and wages, generating a windfall in payroll taxes of $520 billion from 2017 to 2026. The plan also gives companies the option of either expensing capex immediately or foregoing all deductions for current and future interest payments on debt. On balance, the Tax Foundation forecasts that the Treasury would collect an additional $213 billion, because companies will post higher taxable earnings by nixing their interest deduction.

Still, the offsets would be relatively small. According to the Tax Foundation, the proposal would cost a net of $2.6 trillion over 10 years, and that's assuming that it substantially lifts economic growth. Nor does that forecast include the extra interest on the growing debt. By Fortune's reckoning, the plan would raise deficits by average of around $310 billion a year over the next decade. The Congressional Budget Office is already projecting deficits of $684 billion in 2020. The Trump campaign plan would lift those shortfalls to around $1 trillion. By 2025, deficits would reach $1.6 trillion.

"It's very unlikely that Congress would support a big tax cut with those kind of deficit concerns," says Steve Entin of the Tax Foundation.

That $1.6 trillion deficit would amount to 26% of all spending. So the Trump plan is really a non-starter. If rejiggered to erase future deficits, the plan would need to eliminate all but 15% of the corporate and personal tax cuts. The budget Minotaur will prevail.

The House Republican Plan: Better for the Budget, But the New Taxes Probably Won't Happen

The House Republican plan, designed by Speaker Paul Ryan, is slightly less ambitious, and a lot cheaper, in its approach to lowering taxes. Its blueprint for individuals is similar to Trump's (three brackets at a max of 33%), but it advocates lowering corporate taxes to 20% rather than 15%. But the big difference is the size of the money-saving offsets. The Ryan proposal would eliminate all itemized deductions except for mortgage interest and charitable donations. That change alone broadens the tax base so dramatically that, along with a push from extra growth, it would raise income tax collections by an astounding $2.2 trillion over 10 years.

Whereas companies have the option of either expensing capex or foregoing the interest deduction under the Trump plan, the Ryan proposal eliminates the interest deduction on new loans. That's the price companies must pay for immediate expensing of their investments. That plank saves almost $1.2 trillion.

A third major base-broadener is the Border Adjustment Tax, a measure that would allow exporters to sell U.S.-made products abroad free of corporate taxes, while forcing importers to pay far-higher levies, based on total revenue instead of profits, on goods shipped to the U.S. Since the U.S. imports a lot more than it exports, the BAT would be a huge money-spinner, raising an estimated $940 billion over the next decade.

So although the cuts otherwise lower revenue by over $4.5 trillion, the offsets are almost as big. And thanks to these elastically expanding base, the House plan would add only a tiny $191 billion to the deficit through 2026.

But here's the problem. Two of the pay-fors, and maybe more, probably won't happen. Start with the forced elimination of the interest deduction. The real estate industry is mortally opposed, and Trump as a major developer, may be sympathetic to their pleas.

Nor has Trump backed the BAT. He's waffled on the levy, at times calling it too complicated, and at others praising its potential for raising extra cash. Six senators are reportedly opposed to the BAT, though their identities haven't been fully reported, and Republican Orrin Hatch, chairman of the Senate Finance Committee, predicts that the BAT will not be included in the final tax reform bill.

So subtract the $940 billion in savings from the BAT and the $1.2 trillion from eliminating deductibility of interest on new loans, and future deficits balloon to around $230 billion a year. That's not as bad as under the Trump plan, but it will never win the support of the Congressional deficit hawks.

And the shortfalls could be even worse. "The elimination of itemized deductions means that instead of having 35 million people itemizing each year, about 20% of those would itemize," says Toder of the Tax Policy Center. He predicts that folks who would otherwise itemize and give money to charity for the extra tax break may donate a lot less, since it makes more sense to simply take the expanded standard deduction. It's probable that foundations, colleges, and other institutions depending on donations will fight the plan.

Once again, if just the BAT and interest savings were eliminated, the Ryan plan, to remain deficit-neutral, would need to junk about half of its tax cuts. The tunnels to nowhere in the tax labyrinth are those savings that won't happen.

To be sure, the Republicans could close the gap by raising taxes elsewhere. For example, they could remove the income caps on payroll taxes. But what's the point? That's an anti-growth, anti-job measure that negates what they're trying to accomplish, which is boost growth and jobs. The best bet is that we get token reform at best, and the best of the proposals die in the labyrinth.

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