History and Pitfalls to Tax Reforms

Scissor Cutting Taxes Word on PaperOn November 16 the U.S. House of Representatives adopted HR 1, the Tax Cuts and Jobs Act, 227-205,  Thirteen Republicans joined all Democrats in opposing the measure.  Republicans opposing the measure included conservative members concerned with increasing the U.S. debt and those in congressional districts that would be significantly impacted by the inability to deduct state and local taxes.   The legislation calls for a reduction in federal revenues by $1.5 trillion over 10 years, a level just below the ($2 trillion) 1981 Economic Recovery Tax Act (ERTA a.k.a “First Reagan tax cut,” Pub. L. 97-34) in inflation-adjusted dollars.

Also on November 16, the U.S. Senate Finance Committee adopted 14-12, along party lines, their proposal for tax reforms.  The Senate will take up the measure upon their return from the Thanksgiving recess.

The Senate version is different from the House version in some significant areas.  For instance, the Senate version of tax reform keeps the student loan interest deduction and medical expense deductions.  It repeals the state and local tax deduction (as compared with the House version that maintains property tax deductions with a $10,000 cap) and maintains the estate tax with higher exemptions (as compared to the House version that repeals the estate tax after six years).

But, as history almost certainly repeats itself, like the first Reagan-era tax cuts, the 2017 proposed legislation is likely to come with potential policy & political pitfalls that will likely impact the fast-approaching 2018 mid-term elections.

Here are a few pitfalls that could happen:

History Is Not Kind To The Party of Sitting President

It is well-known that during mid-term elections, history is not kind to the party of the sitting president.  In 1980, Ronald Reagan’s presidential-victory coattails added 35 Republicans to the US House (243 Democrats, 192 Republicans) and gave Republicans control of the U.S. Senate by winning 12 seats (53 Republicans, 46 Democrats).

However, in the first mid-term election after passage of the first Reagan tax cut those Republican gains were nearly wiped out as Republicans lost 26 seats.  Moreover prior to the 1982 elections, Congress repealed most of  first Reagan-era tax cuts due to concerns over increasing the deficit with the passage of the Tax Equity and Fiscal Responsibility Act (Pub. L. 97-248).

Budget Resolution Allows More Debt For Tax Reductions

The FY 2018 budget resolution passed in both the U.S. House and Senate by narrow margins.  The U.S. House passed H. Res 71 by a vote of 216-212. Twenty Republicans joined 192 Democrats in opposing the measure.  H.Res 71, as amended, passed in the U.S. Senate 51-49, with all Republicans, excluding Rand Paul (R-KY) supporting it.

There were differences between the House version of the budget resolution and the Senate version that eventually was adopted.  The U.S. House version expedited tax reform, did not add to the U.S. debt and instructed Congress to cut federal programs by $203 billion over ten years.  Conversely, the U.S. Senate budget resolution allowed the U.S. to borrow an additional $1.5 trillion to enact the same amount in tax cuts and cut federal spending by $1 billion.  The U.S. House capitulated to the U.S. Senate version of the budget resolution, but only after fiscal conservative members in the House were promised a chance to legislatively offer significant cuts to federal programs in the FY 2019 budget process.

So, an underlying question prevails in the U.S. tax reform debate – with the U.S. already $20 trillion in debt, is it worth the U.S. assuming more debt to enact tax cuts on the chance it improves the U.S. economy from the current 2 percent annual growth rate to 3 or 4 percent growth?  The answer in 1982 was “No,” and the Tax Equity and Fiscal Responsibility Act (Pub. L. 97-248) was passed, repealing most of the first Reagan-era tax cuts.

Underlying Premise: Consumer Spending Increases

The underlying premise suggests that with additional money in their pocketbooks generated by the tax cuts, middle class Americans will consume more.  Consumer spending in the U.S. accounts for 70 percent of all economic activity.  Thus, as Americans consume more the economy expands and additional tax revenues are achieved beyond the $1.5 trillion borrowed-cost of tax reforms.

According to the non-partisan, non-profit Committee for a Responsible Federal Budget (@BudgetHawks), “While well-designed tax cuts may grow the economy (often not as much as tax reform), there is no case in which they could grow the economy enough to be self-financing. At best, tax cuts can finance a fraction of their costs through faster growth – and maybe not even that.”

The Congressional Budget Office (CBO) and many outside organizations such as Tax Foundation, Tax Policy Center and Penn-Wharton have developed tax models with varying conclusions, but few found tax cuts to be self-financing.  In their October 4 article, “Tax Cuts Don’t Pay For themselves,” @BudgetHawks pointed to a 2005 CBO evaluation of a 10 percent cut in individual marginal tax rates. CBO found that, “The budgetary impact of the economic changes was estimated to offset…(up to) 22 percent of the revenue loss from the tax cut over the first five years and….offset as much as 32 percent of it over the second five years.”

In addition, today’s economy is much different than it was when the last significant tax reforms were enacted.Businessman carrying debt  For instance, in the first quarter of 2017 the Federal Reserve of New York issued a report, “Household Debt Makes a Comeback in the U.S.” (May 17, 2017) that highlighted, “household debt in the United States had reached a new peak — $12.7 trillion.”  Household debt includes mortgages, student loans, credit cards, auto loans.

Consume More or Pay-off Existing Household Debt?

With household debt at an all-time high, will Americans consume more or will they use the extra dollars generated from tax reforms to pay off existing household debt?  After the credit bubble in 2008 Americans chose to reduce their household debt.  U.S. household debt declined through 2013.

Now, with levels of U.S. household debt reaching new high levels why would lawmakers enact tax cuts that rely significantly on consumer spending when U.S. consumers may choose to pay off existing debt?

Yes, Tax Reforms Were Eventually Enacted

Yes, thirty years ago tax reforms were eventually enacted in the 1986 Tax Reform Act.  @BudgetHawks points out that Congress enacted revenue-neutral tax reforms that “…broaden the tax base, reduce rates, reduce distortions and improve simplicity and fairness.” It “cut some tax rates almost in half but also broadened the base enough to ensure revenue neutrality. This model will do more to grow the economy – especially for future generations – than simple tax cuts.”

But, 1986 was President Reagan’s second mid-term election year, and again the party of the sitting President lost seats in the U.S. House.  Democrats picked up 4 seats (258 Democrats, 177 Republicans).  Democrats also regained control of the U.S. Senate by winning 9 seats (55 Democrats, 45 Republicans).

History shows us that during presidential mid-term election cycles adopting tax reforms does not equate to a positive electoral outcome for the party of the sitting president.

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Tim Cansler