How to Reform Tax Reform

(Bloomberg Opinion) -- Although the White House now acknowledges that Republicans will not be able to pass a second round of tax cuts before the midterm elections, House Speaker Paul Ryan has promised a vote on so-called Tax Reform 2.0 before then. But even if the politics are unsettled, the policy shouldn’t be.

Whether Tax Reform 2.0 is the first salvo in a protracted battle over tax policy or just an election-year gambit, this is a debate that cannot be avoided. New legislation will have to be passed to make many aspects of last year’s Tax Cuts and Jobs Act permanent. (The sunset provision, under which many features of the law change or expire in several years, was a gimmick designed to lower its impact on the budget deficit.)

The Tax Cuts and Jobs Act contained three essential elements, two of which substantially strengthened the U.S. tax code and should be made permanent under any reform. The third one did not and should not.

The first two elements are the changes to the corporate and individual tax codes. America’s corporate tax rate is now commensurate with those of America’s economic peers, making the U.S. more competitive globally, and a change in the expensing of capital purchases will encourage investment. The individual tax code, meanwhile, has been simplified, and an increase in the standard deduction is essentially a tax cut for millions of Americans.

Together these two elements give U.S. businesses and taxpayers stronger incentives to save and invest. If made permanent, the Tax Foundation estimated last year, they could increase the total amount of capital invested in the U.S. economy by 12 percent.

The third element is the creation of a major new loophole in the form of large deductions for what are known as pass-through entities. These are essentially business structures, such as limited-liability corporations (LLCs), which allow the owners to avoid paying corporate taxes and instead have their corporate profits added to their individual tax liability.

This kind of structure makes sense for sole proprietorships and other small businesses. Increasingly, however, driven in part by the U.S.’s relatively high corporate tax rate, it had been used by medium-sized and large businesses. Part of the rationale for lowering the corporate rate was to remove some incentive to form pass-through entities.

Unfortunately, the Tax Cut and Jobs Act also created a whole new incentive to classify a business this way. Under the law, an individual can claim a 20 percent tax deduction for any income classified as business income. That means high earners such as celebrities, financial professionals and surgeons have an incentive to form LLCs and claim this deduction, even when their services more closely resemble those of an employee rather than an entrepreneur.

It’s not as if members of Congress couldn’t have seen this coming. When Kansas included a similar loophole in its tax reform in 2012, it saw a 20 percent increase in the number of pass-through entities. This led to a $300 million decline in revenue, and Kansas officials essentially rescinded their tax reform in 2017.

Lowering marginal tax rates and encouraging investment are worthwhile goals. But the creation of a large pass-through deduction undermines those efforts, creating a tax loophole that is largely unavailable to middle-class taxpayers. It narrows the tax base, reduces long-term revenue projections and undermines the efficiency gains from the reform if the individual tax code.

As members of Congress consider tax reform — regardless of whether they actually vote on it — they should keep these larger goals in mind: reduce complexity and encourage economic growth. The pass-through deduction does neither.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Karl W. Smith is a senior fellow at the Niskanen Center and founder of the blog Modeled Behavior.

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