The Trump Tax Plan Would End the Income Tax as We Know It

April 27, 2017

On Wednesday, CEA Chair Gary Cohn and Treasury Secretary Steve Mnuchin unveiled their fourth attempt at a major tax reform plan, and it is really, really bad. So bad that even the conservative folks over at the Tax Foundation—generally fans of all things tax cut—think it’s a bad idea. The plan would represent a massive boon to the wealthy, very little value to the middle class and, as we will explain, threatens to end employment and the income tax as we know it.

Far from a comprehensive plan, the unveiling comprised a mere list of bullet points, outlining a series of cuts even more aggressive than the already-aggressive rates proposed by the previous Republican blueprint. Now, instead of aiming to cut the passthrough rate from 39.6 to 25 percent and the corporate rate from 35 to 20 as the Brady-Ryan plan did, Trump aims to tax both corporations and passthroughs at just 15 percent.

It cannot be said in text large enough, nor in font bold enough, that this is a completely insane, unjustifiable proposal benefiting the rich. Early estimates suggest it would cost the government at least $5.5 trillion over 10 years. Based on analysis of similar plans, it is safe to assume that about three-quarters of that will go to the top 1 percent alone. That’s more than $4 trillion spread out among roughly 3 million individuals, with less than $1.5 trillion for the remaining 327 million in this country. This would lead to a massive increase in income inequality and, like all other tax cuts before it, would fail to stimulate sustainable long-term growth. Both the corporate and the passthrough rate cut are really bad ideas, but it is the latter that we will focus on in this post.

“Passthrough” is a term for a business—generally a partnership, LLC, or S-Corp—that elects to be taxed at the individual level rather than the entity level. This means individuals receive their business revenue as personal income and pay the same federal income tax brackets as a full-time employee. Many small businesses, such as your local plumber, organize as passthroughs for the sake of simplicity, but so do the vast majority of hedge funds, private equity firms, and real estate partnerships, which use the passthrough structure to write off losses and take advantage of numerous other legal tax avoidance maneuvers. These real estate and investment firms earn nearly 75 percent of all passthrough income in the United States, and therefore receive the vast majority of the benefit of passthrough rate cuts. To make matters worse, a landmark 2015 study by Treasury economists found that the top 1 percent of earners receive roughly 70 percent of the income from these firms, which already pay an effective tax rate less than half that of U.S. corporations. In making these cuts, Republicans purport to have the plumber in mind but know, in reality, who owns passthroughs and who benefits from passthrough rate cuts.

But this analysis just covers the static revenue and distributional impacts of the plan; its far more lasting impact would be to cap income taxes at 15 percent for savvy, high-income individuals. Rather than pay the newly proposed 35 percent top personal income tax rate, many workers would seek compensation as contractors, thus claiming their labor income as business income and benefiting from the new 15 percent rate. This tax avoidance strategy would be easiest for wealthy professionals, who would not only have an easier time convincing the IRS they were in-fact self-employed “consultants,” but could also afford to hire clever accountants and tax planners. At best the result would be a flat tax, and in all likelihood many honest workers would pay 25 or 33 percent on eligible income, while upper-income earners would pay just 15. This would upend foundational elements of the tax code and social safety net, to say nothing of how it would amplify the plan’s impact on inequality, increase revenue losses, and raise the return to wasteful profit-seeking activities.

Beyond ignoring the most basic economic analysis, the plan also ignores recent lived experience; an even more drastic version of Trump’s cuts was recently attempted at the state level in Kansas, with disastrous effects. In 2012, Governor Sam Brownback signed legislation that ended state passthrough taxation entirely. The expectation was that businesses would flood in from neighboring states and that a previously moribund workforce would spring off the couch in a massive wave of entrepreneurship, brought on by the possibility of higher earnings resulting from lower taxes.

The failure of this plan is legendary: Annual Kansas state revenue dropped about $700 million immediately; Kansas’s employment grew by just 2.6 percent, compared to 6.5 percent nationally, and their GDP grew by just 4.8 percent compared to nearly 12 percent nationally. Even after $17 million in cuts to state university budgets, the delay of $93 million in teacher pensions, and borrowing $750 million from highway improvement funds over the last several years, the Kansas state legislature was still fumbling for ways to plug its $342 million budget shortfall early this year. Even the conservative Tax Foundation panned the cuts as costly and without merit.

Adding insult to injury, according to a new paper by Indiana University economists, even the meager growth in business income that Kansas has witnessed since the cuts was likely the result of the income-shifting described above, rather than real economic activity.

The policy ramifications at the national level would be even more severe, as the shift to passthrough income would undermine the payroll tax system, which sustains the Social Security trust fund, to say nothing of norms of employment and worker-firm relationships, which are also key to our already-imperiled social safety net.

Perhaps the fact that Trump offered up a half-baked tax plan that would bankrupt the country and ruin its economy is not surprising. But with just a few minutes of consideration, even someone with a passing familiarity with the U.S tax code would have noticed that this plan held disastrous implications. In light of recent Trump administration failures and initial reactions to the plan, it is tempting to laugh. But as we have learned, the problem with crazy Republican tax plans is that they become law.