Nov 12, 2017 6 min read

The overriding theme of the tax plan hatched by President Trump and Republicans on Capitol Hill is cutting taxes on the wealthy, with a willingness to drive up the deficit in order to do so. The primary elements of the plan are reducing the rate on the highest wage earners and the corporate rate, eliminating the estate tax, and allowing owners of privately held businesses to pay a lower rate.

Reducing the tax rate on the wealthiest taxpayers from 39.6 percent to 35 percent, while increasing the tax on the poorest taxpayers, from 10 percent to 12 percent, exacerbates income inequality. While poor taxpayers may not actually pay more in tax, because the automatic deduction was doubled, raising the amount of income that is tax-free, those with more dependents will pay more, because the Republicans also proposed eliminating the personal exemption.

One thing is clear – the wealthy will pay a lot less.

Businesses are generally organized as sole or joint proprietors, partnerships, limited liability corporations (LLC), or corporations. The first three are essentially “pass through” entities, which means the profits of the entity are passed through the entity to the owner, without being taxed, so the owner pays taxes on those profits at the owner’s regular income tax rate. Trump wants to reduce the taxes these business owners pay to 25 percent, which is a reduction of almost half their tax bill for wealthy owners, with the idea that if these business owners have more money, they will invest in their business, creating jobs and growing the economy.

While there is some sense to this, it is a very indirect relationship; it would only be true for businesses that see a business opportunity but lack the capital to act on it, and the extra cash provided by the tax reduction were sufficient to make the investment. Businesses invest because they see an opportunity, not because the tax rate on their potential profits is reduced. The opportunity to profit is much more important than tax savings on those profits. While some owners might invest their tax savings in their business, they are not obligated to do so, and many would not.

To cite an example, Sam Brownback was elected governor of Kansas as part of the Tea Party Republican wave in 2010. Along with a Republican legislature eager to demonstrate the economic vibrancy a low-tax business environment, Brownback and his fellow lawmakers cut state taxes and eliminated the state tax on pass-through business income, as the Trump plan does. It was a disaster. The economic growth never materialized: Kansas grew more slowly than neighboring states, as well as the nation as a whole; state tax revenues fell dramatically, with a loss of $700 million in the first year; and many businesses changed their organization structure to take advantage of the lower pass-through rates, without investing in their enterprises.

Instead of helping struggling small businesses, much of the savings in Kansas went to large law firms and oil exploration companies. Nationally, many hedge fund and venture capital organizations, as well as the Trump organization, are pass-through business entities, so they are the ones who will benefit the most from the new tax rate. It would not help struggling mom-and-pop businesses as much as it would vulture capitalists. This year, the Republican controlled legislature in Kansas raised taxes to plug the hole in the state’s budget, overriding the governor’s veto.

Corporations, on the other hand, pay a tax on their profits, then distribute their profits as dividends, or retain them for investment. The president claims that U.S. corporations are taxed at the highest rate in the world; while the nominal rate is high, at 35 percent, most corporations do not pay that rate – the effective rate is 18 percent. Many large corporations actually pay little or no tax, and some even get refunds. But this is an area where there is room for improvement; lowering the nominal rate while eliminating the loopholes would be an appropriate reform. But this should be revenue neutral, not a tax cut.

In 1952, during the era that President Trump seems to think America was last great, and economic growth was an impressive 3.9 percent during the 1950s, the corporate tax rate was over 50 percent and brought in 32.1 percent of the federal government’s revenue. In 2013, at 35 percent, it only accounted for 9.9 percent of revenue, and recently, economic growth has been around 2 percent annually. Another aspect of a corporate tax cut that might be important to Trump supporters, is that approximately one-third of all stock in American corporations is held by people outside the United States, so a large portion of any reduction in corporate tax revenue will go to wealthy foreigners, with revenue shortfalls being made up by U.S. taxpayers.

Critics who want to lower the corporate rate argue that it drives corporations to earn their profits overseas, and they have a point. Not that companies actually move overseas, but that they exploit a loophole and use accounting tricks to move their profits overseas, to places like Ireland, which has a relatively low tax rate. The U.S. tax code allows corporations to pay taxes on their overseas profits when they bring those profits back to the United States, rather than when they are earned.

Republicans argue giving these corporations a “tax holiday” to bring those profits back to the United States would boost the economy and create jobs. But when this happened in 2004, most of the corporate profits were not reinvested, but instead were used to buy back company stock. This raises stock prices, but does not create more jobs. To fix this problem, Republicans propose a “territorial” corporate tax, which means the United States would collect no revenue from corporate profits “earned” overseas, which is like “solving” the problem of theft by making it legal.

Next week, I will look at other aspects of the tax proposal made by President Trump and Republicans, including the elimination of the estate tax and the doing away with the deductibility of state and local taxes.