February 21st, 2018

By: Sameer Gupta


It didn’t come as a total surprise when news first broke some time ago that House Speaker Paul Ryan was contemplating retirement after the 2018 congressional elections. Reluctantly inheriting the gavel after John Boehner was forced out by a caucus revolt in the fall of 2015, it certainly hasn’t been an easy tenure for him. That said however, Ryan is probably ready to forgive and forget now that Congress has passed comprehensive tax reform that he’s fought for his entire political life.

Simplifying the tax code and slashing the effective rate while closing loopholes has been gospel amongst fiscal conservatives for some years now, and now as we enter 2018 this manifestation of those principles are now reality. Republicans are convinced that it’ll halt offshoring of capital and jobs , and the bill’s fiscal projections rely on robust domestic growth and job creation; lofty goals to be sure, but will Ryan’s promise to restore American competitiveness be fulfilled?

It may not seem readily apparent given rhetoric in the media surrounding the bill but the problems it seeks to address actually do exist, albeit to varying degrees. There’s two main issues the bill seeks to address: no differentiation between foreign and domestic profits for tax purposes, and a corporate tax rate that is amongst the highest in the world. Corporate tax evasion has been a problem long before Trump, as is the byzantine web of write-offs, credits and loopholes which comprise the American tax system. Moving to a territorial taxation system like we have here in Canada, which the bill proposes, has in fact garnered bipartisan support in the past and would help bring an end to the practice of stashing money in foreign subsidiaries indefinitely to defer pending taxes. The other pillar of the bill is the slashing of the corporate tax rate to 21% , bringing the U.S more in line with other Western economies. The bill also attempted that long-standing Republican pledge to simplify the tax code, but many of the proposed changes would fall victim to expediency as lawmakers rushed to present a final bill for President Trump to sign. But examining the reasons for its failure offers much insight into the unique challenges faced by American lawmakers attempting tax reform.

A comparison of effective international tax rates. Source: Deloitte Tax Fact Sheet

Ending Corporate America’s Tax Exile

Of the two, it’ll likely be the move away from taxing foreign profits that has the greatest ramifications for American businesses. Stories of companies like Apple storing mounds of cash in low-tax jurisdictions or Starbucks engaging in legal wrangling to pay less tax than the average person make for flashy headlines and elicit cyclical outrage, but they fail to highlight how the U.S stands increasingly alone in taxing all income earned by its citizens and companies, irrespective of where it was earned.

Doing away with this on the corporate side will certainly encourage companies currently postponing the repatriation of foreign profits to finally do so. The implication is it will finally allow the U.S to reap the other side of the economic headwinds which has sent millions of jobs overseas, as in theory at least, capital accrued abroad is injected into the economy through shareholder payouts and other investments.

The most promising component here is the alternative put forth ; instead of deferred taxation of foreign-held income at 35%, now income held in cash will be taxed at 15.5%, while non-cash income will be taxed at 8%. Companies will also be subject to a 10% base erosion tax on transactions with foreign subsidiaries. The goal here is that by reducing their overall tax burden while simultaneously increasing the cost of stashing profits overseas, companies will be incentivized to reinvest in America. In a vacuum this is a no-brainer, but there are concerns that in the absence of sufficient redistributive structures the inflow of capital will offer few tangible benefits to most Americans.

A strange episode testifying to this effect would play out back in November , suggesting that the tax plan’s assumptions may have been somewhat overly optimistic. Appearing at a gathering of business leaders in Washington, White House economic advisor Gary Cohn would ask the assembled executives if they planned on using the anticipated windfall provided by the bill to invest in growth; almost none raised a hand, prompting a dismayed Cohn to (seriously) ask “Why aren’t the other hands up?” Research conducted by Merrill Lynch/Bank of America after Trump first unveiled his tax plan in July seemed to back this sentiment, as businesses surveyed listed stock buybacks, dividends, and paying down debt amongst their greatest priorities. And to top it all off, the last time American companies were granted such a tax amnesty back in 2004 , it didn’t spur any greater job creation or a noticeable uptick in productive investment.


A Most Complex Code

R educing the base tax rate is also a good idea in a vacuum, as it’s true that the country’s tax rate is amongst the highest in the world. But with that said, if the American economy is uncompetitive, it’s probably not because of that base rate. By cultivating relationships in Washington, just about every industry has managed to coax sympathetic legislators into quietly slipping a whole raft of exemptions, credits and subsidies into budget bills, to the point where very few companies actually pay the oft-bemoaned 35% rate. A survey by the Institute on Tax and Economic Policy of Fortune 500 companies from 2008–2015 revealed that over half paid an effective rate of 21.2%, in line with the proposed changes in the bill, and significantly lower than Japan, Canada and Germany. 48 companies paid an effective rate of less than 10%, and 18 paid nothing whatsoever during this period despite reporting pre-tax profits each year. Most intriguing however, was the survey’s finding that amongst companies with significant overseas operations, more than half paid a higher tax rate to the governments where they operated than that paid on domestic earnings.

So companies aren’t necessarily being taxed more at home than abroad, but the problem may lie in the fact that paying taxes is markedly more expensive in America. The IRS estimates that tax compliance cost $195 billion in 2015, a whopping 10% of total tax receipts that year. While much has been written on the advantage this system offers to companies and wealthy individuals who can afford the accountants and lawyers necessary to squeeze every ounce of savings from the tax code, the reality is that having a lower tax rate and eliminating loopholes would reduce the costs American businesses face while having little tangible effect on government revenues.

This “Cut & Close” system was espoused by every Republican in the party’s 2016 primary, and its roots in modern conservatism date back to the Reagan administration. When legislators set out to craft the bill, Paul Ryan declared that taxes could be completed “on a postcard” ; and President Trump promised that Americans would file on “ a single, little, beautiful sheet of paper .” So long has the GOP supported such a move that when the first draft bill was unveiled in November, tax preparation firm H&R Block saw its stock plummet as shareholders fled a business they were convinced was about to be rendered obsolete. It’s telling however, that when the final bill was passed on December 20th the stock had jumped roughly 20% from its panic-induced losses the month prior.

Ryan’s ‘Tax Postcard’ . Source: House Ways and Means Committee

The problem was twofold; on one hand, Republicans found themselves attacked by industries such as real estate, construction and green energy who were on the verge of losing favourable tax credits. On the other, their slim majority in the Senate meant that vulnerable Republicans the party was leaning on to vote “yes” were faced with a serious dilemma in the face of widespread media coverage and protests in their districts denouncing the bill as a giveaway to corporations and the wealthy. As mentioned, the GOP’s reasoning for cutting the corporate rate and lowering the foreign income rate further still were hardly nefarious; the elimination of loopholes and revenue from newly repatriated foreign income was supposed to help offset the enormous cost of the bill (along with repealing the ACA’s individual mandate).

Opposition to the bill amongst deficit hawks and Republicans in blue states led to numerous concessions, as both the optics and demands of donors saw hastily redrawn configurations of the bill, each retaining more of the existing tax regime. Deductions previously set to be eliminated in the draft bill are now merely reduced , while other commonly used deductions for student loans, IRA/401k contributions and charitable donations are preserved entirely, amongst others. Tax breaks for clean energy investments and carried interest are amongst those aimed at businesses and the wealthy that carry over.

The end result is not quite what Republicans likely envisioned six months ago. Reflected by renewed investor confidence in H&R Block, the final bill does not put forth a slimmed down and comprehensive tax code. While the base tax rate has been slashed, this is largely symbolic in light of the rate most companies actually pay. New rules on foreign income offer further complications ; for example, the discrepancy between foreign and domestic rates allows companies with an international footprint to borrow money abroad, deducting interest against gains in that country in order to take advantage of favourable tax schemes elsewhere. The tax plan does reduce costs for American businesses, but it does so in an incredibly convoluted manner. Other jurisdictions will likely keep pace despite having marginally higher base rates in part because their systems contrast favourably with the GOP’s loophole-rife tax bill, but also because policies aimed at attracting foreign investment to these countries extend far beyond taxation.


The Plan’s Hidden Costs

S ome experts argue that simplifying the American tax code is uniquely impossible, in part due to lobbying but also because policymakers largely eschew direct spending on social policy in favour of tax credits. It contributed to the ballooning cost of the final bill, as Republicans rushed to backtrack and cram a whole raft of deductions and credits into the deeply unpopular bill. According to the Joint Committee on Taxation, tax cuts are projected to generate roughly $451 billion in revenue on account of new growth, so that the bill’s net cost will be in the neighbourhood of $1.1 trillion over the same period. But if personal credits and cuts currently scheduled to expire in 2025 are extended like promised, the Committee for a Responsible Federal Budget places the final cost of the tax plan closer to $2 trillion.

The fiscal freewheeling hasn’t gone unnoticed by the more deficit-minded elements of the party, even as they voted for it. As Sen. Bob Corker noted, “Most of the drive upward has not been on the Democratic side, which is disheartening.” The tax bill represents the signature policy achievement of the now year-old Trump administration, and in the interest of allowing it every chance to succeed it’s unlikely (as of now) that deficit hawks will force the temporary cuts to expire; instead, savings will have to come from elsewhere.

That ‘elsewhere’ is likely entitlement spending. Paul Ryan signalled back in December that the House would look to take up entitlement reform this year in the hopes of reigning in a ballooning budget deficit. “Frankly, it’s the health-care entitlements that are the big drivers of our debt, so we spend more time on the health-care entitlements — because that’s really where the problem lies, fiscally speaking.”

It’s true that healthcare has been a massive pillar of government spending since the 60s, but only because so many Americans depend on it. Medicare and Medicaid programs assist over 100 million, providing essential services to enrollees such as flu shots, annual check-ups and dental care for low-income families. Ryan and other conservatives frequently assail healthcare’s perceived high cost, and yet in doing so they often ignore the economic benefits universal coverage offers.

A report on healthcare policy from American University argued that extending healthcare coverage to more Americans would be a boon rather than a drag on the economy; while this may seem counterintuitive, it mirrors research published by the IMF which confirms that excessive income inequality like we see in America today actually has a depressive effect on economic growth.

As the wealthy have a significantly higher propensity to save, inequity forces consumption-oriented economies to ease the flow of credit to poorer households during times of economic hardship, saddling them with unsustainable debt loads. If applied in moderation, redistributive programs like social security, subsidies for higher education and medicare have been shown to reduce this dependence by increasing social mobility, improving worker productivity and can thus increase the income share of the middle class by attracting high quality jobs and potentially even decreasing the costs companies incur doing business in America. The scale and nature of such redistributive measures remains an open question , but Republicans’ determination to not only ignore the issue but actively worsen it, both through the tax bill and beyond it, is unquestionably bad policy.

But even beyond these baseline programs, the Trump White House’s budgetary “wish list” for 2017–2018 included dramatic cuts to education as well as funding across numerous departments for research and innovation. Given the fiscal implications of the tax plan President Trump’s conception of a pared down federal government suddenly doesn’t seem quite so far fetched anymore; and yet scaling back government investments would be the wrong move.


Parting Throughts

T he country is experiencing full employment, and with interest rates at near historic lows, corporations need little incentive to invest. The recent highs seen in the stock market reflect the profitability of the biggest American companies; according to the broad metrics, the economy seems to be doing well, and businesses seem to be reaping the benefits. To say that however, would be providing only part of the picture; the labour participation rate remains low, underemployment remains an issue and climbing healthcare costs continue to plague American households. Boom times have arrived, but half of America didn’t get the memo.

The tax bill is estimated to generate only an additional 0.1% annually to the economy, as it’s widely believed that the anticipated influx of capital into the country will force the Fed to accelerate its timeline for raising interest rates. Stagnant wages since the last recession amidst a bull market reflect how Wall Street gained during the recovery at the expense of Main Street; it’s problematic that the real purchasing power of consumers sits around 2007 levels , with the simple reality being that American workers are not competitive with their global peers. While legislators are often quick to bemoan the “cumbersome regulations” imposed in other advanced economies, they usually ignore that the countries which have strong protections for their workers also invest heavily in them and find other novel ways to gain a competitive advantage without sacrificing their standard of living.

Washington has been handed a prime opportunity to enact generational change thanks to a booming economy but instead their response is an exercise in redundancy; it takes some small steps forward, but it’s the wrong answer to the right question. Investments in education, healthcare and infrastructure (social and otherwise) make livable communities and spur innovation, attracting the sort of workers companies need and cannot necessarily up and find in a tax haven. And yet Republicans are doing the opposite, gutting public education funding and repeatedly taking aim at efforts to extend healthcare coverage. In doing so, they’re losing the forest for the trees; as one tax expert at Columbia Law School put it, any definition of competitiveness where the ultimate goal isn’t a rising standard of living is pointless.