The GOP Tax Bills

Dec 28, 2017 No Comments by

As of this writing, the house and Senate have crafted their respective versions of the GOP tax proposals. After the Thanksgiving holiday, the two sides will race to reconcile and present President Trump with something tangible to sign so that they can declare “Mission Accomplished” before the calendar year expires.

The proposals are each hundreds of pages long, and so in this article I am obviously not going to give a comprehensive analysis of their particular details. Instead, I will explain the logic of supply-side “tax reform,” and will then critically analyze the current GOP proposals from that perspective. As we will see, even on their own terms, the proposals are nothing like the truly revolutionary changes to the tax code that occurred during the Reagan Administration. As obnoxious and clichéd as some of the leading Democrats are, they do have a point when they complain that the current proposals are stacked quite heavily in favor of the wealthy and do little for—or even penalize!—the middle class.

The takeaway message is simple: Don’t pin your hopes on top-down reform from Washington. If you get some tax relief and/or a big cut in the corporate income tax stimulates domestic activity, great. But either way, you should be taking steps to “secede” from the current monetary and banking system, to insulate yourself as much as possible from the coming financial storms. The stock market has been roaring since Trump’s election, but even if they end up delivering some decent reforms, that won’t fix the festering problems that the Fed has created since 2008.


The Logic of Supply-Side Tax Reform

As someone who used to work for Arthur Laffer, I want to give proper credit to the underlying logic of what the current “tax reformers” claim to be doing. So it’s not the spirit of the GOP proposals that bothers me, but rather the letter of their actual detailed plans.

The crucial insight is that there are different ways of raising revenue for the federal government, and some approaches distort the economy more than others. So we should make a distinction between a “tax cut” and “tax reform.” It’s possible for the Treasury to take in the same number of dollars in tax receipts, in a way that allows the private sector to grow faster. This is a win-win scenario that should please both conservatives and liberals.

When people are currently talking about “fundamental tax reform” and bringing up the 1986 Tax Reform Act, the fundamental idea is to lower the marginal rates of income tax, while getting rid of deductions and exemptions in order to broaden the tax base to which those rates apply.


To take a very simple example, just to make sure the reader understands the logic: Suppose initially the average household has $100,000 in pretax income, and the tax code allows it to claim $50,000 in various deductions. Further suppose that the single flat marginal tax rate is 40%. In this scenario, the household has $50,000 in adjusted income, and then pays $50,000 x 40% = $20,000 in income tax.

Now instead of this approach, instead suppose the government gets rid of all of the deductions, but lowers the single flat income tax rate to 20%. Then the household has to report its actual income of $100,000, on which it pays a tax of $100,000 x 20% = $20,000.

So at first glance, it would seem that this should be a wash: Either way, the household hands over $20,000 to the IRS. Yet most economists would argue that the second approach is superior, because of the change in incentives. In the first scenario, with the generous deductions but high marginal tax rate, the household didn’t have as much incentive to generate more income (such as through additional saving, working an extra job, or taking a more stressful but higher paying job).

For example, suppose the household in the first scenario considers cutting back on its lifestyle spending in order to save an additional $10,000 and buy corporate bonds yielding 5%. That means the following year the household would have an additional $500 of pretax income. But the amount of deductions doesn’t increase just because the household saved and invested more, and so now the household’s adjusted income is $50,500, meaning its tax bill is $50,500 x 40% = $20,200.

What has happened here? Of the extra $500 in interest income that year (earned from buying the $10,000 extra in corporate bonds), the government skims off 40% from the top. Thus, of that additional $500 in pretax income, the household only gets to keep $300 of it after the Tax Man gets his cut. (In percentage terms, the household retains only 60% of the extra income it generated through its frugality.)

In contrast, suppose we change the rules to a system with no deductions but a flat 20% tax rate. In this case, if the household decides to save and invest an additional $10,000 in corporate bonds yielding 5%, then the following year the household’s tax bill will be $100,500 x 20% = $20,100. Thus, of the additional $500 in pre-tax income, the household gets to keep $400 of it, after the Tax Man gets his cut. (In percentage terms, the household now retains 80% of the extra income it generated through its frugality.)


Does It Matter?

I chose nice round numbers for my example to keep the math simple, but I hope the reader sees the underlying logic. In either scenario, the government gets the same amount of revenue in a “static” analysis, where we assume households and businesses keep behaving the same way. In other words, the hypothetical tax reform I sketched out above would be classified as “revenue neutral.”

Yet in reality, most economists would agree that the second approach was more “efficient” (where that term has a precise technical meaning that is not simply “desirable”). In the aggregate, with millions upon millions of households making saving and work decisions “on the margin,” it really does add up when you magnify the after-tax return on additional pretax income.

To repeat: With our numbers, the household got to keep 80% of its additional earnings with the tax reform, as opposed to the original scenario of only keeping 60%. That might not make much of a difference for any one household, but over the entire economy, year after year, that change in incentives could have an enormous impact on how much is saved and invested. The increased investment then fuels the construction of more tools and equipment, so that workers have a higher productivity and earn higher wages.


Different Tax Types

In addition to studying the impact of rate reductions, economists also analyze the form of the tax. I do not have the space to dwell on it in this article, but the takeaway conclusion is that (other things equal) taxes on capital are the most destructive to economic growth, whereas taxes on consumption are less distortionary than taxes on income. This is why so many economists favor (at least in principle) things like a Value Added Tax or a sales tax in order to raise revenue, and argue that a capital gains tax or the corporate income tax is counterproductive.

For our purposes here, let me give the intuition behind the preference for a “consumption tax” as opposed to an “income tax.” If the government levies (say) a 10% tax rate on all consumption, then that distorts the economy. It makes a worker less eager to sell his labor hours for wages, since anything he buys (such as food, fancy clothes, or apartment rental) will have a 10% tax going to the government. On the margin, the worker will want to enjoy more leisure, and not work as many hours, because of the 10% tax on consumption.

However, it would distort things even more if the government were to raise the same amount of revenue by imposing a flat tax rate on income (rather than consumption). Not only does an income tax make the worker less likely to sell his labor hours for wages (since the wages get hit with the income tax), but it also distorts the worker’s decision about how much to save out of his after-tax paycheck. When a worker saves, the benefit to him accrues in the form of interest, dividends, or capital gains in the future, and these are all different types of “income” that will be hit by the income tax.

So to sum up, textbook discussions of tax theory typically favor a consumption tax (such as a sales tax or a Value Added Tax) over an income tax, because the income tax has a double whammy: Not only does it screw up the decision of how much to work each period, but it also penalizes saving in an extra way. In contrast, a consumption tax discourages work effort too, but once you’ve earned the income, a consumption tax doesn’t give an artificial advantage to spending the money today rather than next year.


Tax “Efficiency” versus “Equity” (or Fairness)

Thus far I’ve summarized some of the standard points in the economic analysis of taxation. However, I should be clear that even economists recognize that “efficiency” is not the only criterion. Cold-blooded economists also appreciate that there are other things to consider, such as the impact on the poor.

To give one simple example: One of the least distortionary taxes is a “head tax,” in which each person in the country owes a flat dollar amount to the government. This is pretty attractive from the perspective of economic efficiency, since it doesn’t alter incentives very much. (The only decision it really distorts is to make people less likely to have children.)

However, even though a flat head fee would constitute a very small “drag” on the economy, depending on its size it might be monstrously unfair. Imagine that the government insists that every citizen owes, say, a flat $7,000 each year to the IRS. This would take in some $2 trillion in total revenue, while unshackling the most productive citizens to earn boatloads more of income, and also it would give a huge boost to saving and investment.

But on the other hand, think of how unfair it would be to suddenly tell a single mother with three little kids that she now has to cough up $28,000 per year in the head tax, while telling a bachelor hedge fund manager that he only owes $7,000 per year.

So as this extreme example illustrates, even the standard economic analysis appreciates that raw “efficiency” is not the only thing to consider when discussing the “ideal” way to raise revenue.


The Real World versus Textbook Theory

Now that I’ve sketched out some of the main results in the standard economics literature, let me hasten to add that I am NOT endorsing such thinking. There are many pitfalls in a naïve application of the principles we’ve considered so far in this article.

For example, we need to ask why the tax code gets so distorted in the first place, if it’s so obviously inefficient? The reason of course is that legislators don’t craft the tax code in order to satisfy a group of technocratic PhDs, but instead they aim to curry favor with their donors. If they put in a clause that allows manufacturers in Baton Rouge to fully deduct expenditures on new trucks so long as they are red and carry radio parts at least six months of the year, then that is a quirk that won’t affect most people but could be very lucrative to certain companies. Such a specific measure would presumably be inserted into the tax code by a representative whose constituents are based in Baton Rouge.

Once we realize that there are political reasons that the current tax code ended up the way it did, we should be skeptical of promises to “reform” the code by taking away so-called loopholes in exchange for lowering marginal rates. Those rates will no doubt rise in the future, and other loopholes will be inserted down the road. This cycle repeats again and again.

Another major problem with the standard approach to “tax reform” is that it raises taxes on some people in order to make the “simplification” possible. This is unavoidable if the objective is a “revenue neutral” reform that lowers rates while eliminating deductions and credits, because different people take advantage of these quirks differently.

Finally, introducing a new type of tax—such as a European-style Value Added Tax or a national sales tax or a carbon tax—is particularly dangerous, since it warms the American people up to a new form of bilking.

The only safe way to reduce the tax burden without hurting anybody is to keep the structure of the code that way it is, while merely lowering the rates.

The Reagan Revolution

After our lengthy discussion of the theory (and pitfalls) underlying the tax reform discussion, we can appreciate just how significant the changes to the federal income tax really were back in the 1980s. Table 1 shows the marginal tax rates for the various income brackets, at the start of the Reagan years and then at the end. (Note that the changes started when he first came in, and then additional changes were implemented in stages after the sweeping 1986 Tax Reform Act. There was not one sudden year in which the code completely transformed.)

As Table 1 indicates, Ronald Reagan came into office facing a federal personal income tax code with seventeen brackets, and a top marginal rate of 70 percent. After the various reforms were phased in, seven years later the federal personal income tax had only two brackets with a top marginal rate of 28 percent. Thus you can see why some people look so fondly on the supply-side achievements during the Reagan years, as the turnaround was pretty remarkable on this front.

Before moving on to the current GOP tax proposals, let me address one pernicious myth about the Reagan fiscal record. It is certainly true that the federal budget deficit mushroomed on his watch, causing a massive expansion in the federal debt, whether measured in absolute dollars or even as a percentage of GDP.

Table 1: Federal Personal Income Tax Brackets and Rates, Single Filer, 1981 vs. 1988

However, the problem here wasn’t revenue, it was spending. Specifically, in Fiscal Year 1981 total federal receipts were $599 billion, while total outlays were $678 billion. By Fiscal Year 1989, total receipts had grown to $991 billion, but spending had grown to $1,144 billion. 2 Thus, over the eight years that could be attributed to the fiscal policies of Congress working with President Reagan, federal receipts increased by 65 percent, while spending increased 69 percent.

Moreover, except for one year early on (during the worst recession since the Great Depression at that point), tax receipts went up every year during Reagan’s two terms. So he critics of “tax cuts for the rich” can’t even claim that there was a huge hole that was only filled by the end of his tenure. No, it is simply a myth of American politics that the Reagan years involved “starving the government” of revenue. Reagan was a disappointment from the perspective of fiscal conservatism, but it was due to lack of discipline in spending restraint, not because of reckless tax cutting.


The Current GOP Proposals

As of this writing, both the House and Senate have offered tax reform packages. The good news is that they involve massive cuts (on net) rather than simply rearranging the burden of the tax code. Indeed, the media accounts report that the Republicans in Congress are pushing through the largest reduction in receipts (relative to the projected status quo baseline) that is allowed by the rules, to still be able to avoid a Democratic filibuster. Specifically, the plans are projected to “cost” the federal government $1.5 trillion over ten years in lost revenue.

Let’s be sure we understand this terminology. When the media reports that either of the Republican tax plans will “cost” $1.5 trillion, what that means is that the IRS will let Americans keep $1.5 trillion more of the income they earned.

Another shared feature of both the House and Senate proposals is a reduction in the corporate income tax rate from 35 percent down to 20 percent. By itself, this is a beneficial change that is long overdue. Even though the personal income tax in the United States is not outrageous by global standards, the corporate income tax is the 4th highest on planet Earth as of 2017. (The three highest are the United Arab Emirates, Comoros, and Puerto Rico.)

The corporate income tax is particularly insidious, because it penalizes—and hence discourages investments in business growth. (After all, the benefit of investing more in a company is that it hopefully generates higher net income down the road.) Reduced investment is bad not only for shareholders, but also for American workers.

A lower U.S. corporate income tax rate will attract more investment, both from American and foreign savers, which will increase the accumulation of machines, tools, and other equipment in the United States. This means U.S. workers will enjoy faster productivity growth, so that their wages and salaries will grow faster than they otherwise would have.


“Closing Loopholes” and Crashing Asset Prices

On the downside, the House and Senate plans reduce or eliminate many of the deductions and credits that people can currently claim. Earlier in this article I explained the logic behind such a move.

But even though “closing loopholes” may sound elegant in theory, in practice it can crash entire markets. For example, the famous 1986 Tax Reform Act eliminated the real estate “tax shelters” that had become very popular. As investors responded to the change, the real estate market had the worst crash since the 1930s, and the stock market crash of 1987 was literally the worst one-day fall in history. (The Dow Jones lost 22.6% in a single day!) 4

We can hope that there is nothing as dramatic brewing in the current proposals, but the House version does limit the mortgage interest deduction on new purchases to the first $500,000. (The current cap is $1 million.) The Senate version has no such change to the rules. Both homebuyers and the housing sector are of course anxiously awaiting the reconciliation process to see the ultimate fate of this politically popular element of the tax code.


Watch the Thresholds, Not Just the Rates

As my final bit of complaining in this article, let me illustrate how relatively modest the personal income tax rate reductions are in the Senate proposal. But on top of that, look at how the bracket thresholds change as well. It means that some households might see the top tax rate increase, in addition to losing some of their deductions.

Table 2. Senate Income Tax Proposal, Single Filer, 2018 Tax Year

To reiterate, the proposed changes in Table 2 are a pittance compared to the massive overhaul documented in Table 1. Those comparing the current GOP proposals to the “Reagan Revolution” are being overly dramatic.

Yet beyond the fact that the personal income tax rates are only tweaked—and even here, the lowest and second-highest bracket rates stay the same, at 10% and 35% respectively—look at the expansion in the income ranges of the brackets. Even disregarding the elimination of certain deductions, we can see that some taxpayers will suffer a hike in their marginal income tax rate! (However, note that the standard deduction will increase, which will counterbalance some of the problem, though it won’t address the incentive issue.)

Let’s take two examples, based on the information in Table 2. First, suppose you earn $160,000. Under current law, if you had the ability to generate up to $35,450 in additional income, you would face a marginal income tax rate of 28% on that extra income.

However, under the latest version of the Senate bill, if you earn $160,000 right now, then the next $40,000 of additional income you might generate faces a marginal tax rate of 32%.

Let’s consider a second example. Suppose you currently earn $200,000. Under current law, you can generate up to $224,950 in additional income, and face a marginal tax rate of 33 percent on it.

However, under the latest version of the Senate bill, if you earn $200,000 right now, then the next $300,000 in additional income you might generate faces a marginal tax rate of 35 percent.

Not only is this annoying to millions of high-income people who may have thought they were getting a reduction in income tax rates, but it also undercuts the whole point of a supply-side tax reform. Namely, millions of upper-middle class professionals and small business owners (depending on how they file—there are tax breaks given to pass-through income) are facing a tax rate hike on the extra income they might plausibly generate over the next several years. If Republicans think the supply-side tax cuts of the 1980s were responsible for stimulating saving, investment, and job growth, then they should realize that the current Senate proposal will do the opposite, at least for a large segment of the most productive Americans.



The current House and Senate tax proposals are enormous documents, containing not only the items we’ve touched on above, but also changes to the treatment of pass- through business income and possible repeal of the ObamaCare mandate and estate tax. Here at the LMR, I’ll wait until final legislation is passed before offering more commentary on specifics.

Even at this stage, however, we can warn our readers that the promised supply-side boom from the GOP proposals is likely to underwhelm. This is at least one episode where the standard Democratic complaints about a “giveaway to the rich” are somewhat justified.

To be sure, from our perspective we have no problem with tax cuts for the wealthiest Americans. But the problem is that millions of other households are facing an imminent hike in their taxes, both through the bracket expansion and because of the elimination of deductions (such as those for state and local taxes).


Julie Ann Hepburn, National Private Client Group – Lara-Murphy Report

Knowledge is Power, Taxes & Taxation

About the author

Julie Ann Hepburn, is a Private Banking Expert and Financial Coach. She is the founder and principal of National Private Client Group, LLC , a Chicago based financial consulting group. Ms. Hepburn is a licensed finance professional, and serves as an agent and consultant for several major mutual insurance carriers. For full bio, please see:
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