The Trump Administration’s early important steps to ease burdensome regulations has begun to improve the environment for business and job creation, but so far it has struck out in its legislative agenda that involves Congress. Progress on that front—particularly tax reform—is critically important.
The White House has relied on a variety of Administration appointments, Executive Orders and administrative rulings to take steps to unwind some of the onerous regulations that have constrained efficiencies and expansion plans in a variety of industries. This includes oil and gas drilling and pipelines, permitting processes affecting transportation systems and use of Federal lands, automobile emission standards, labor regulations and the Food and Drug Administrations. These initiatives to date have helped boost confidence. A positive follow through will contribute to stronger economic growth and better job opportunities.
On another positive note, the White House has backed off President Trump’s earlier aggressive anti-trade rhetoric, replacing it with more rational approaches to dealing with US trading partners. As examples, the Administration has backed off its earlier pledge to cite China as a currency manipulator and instead the Department of Commerce is actively negotiating with China to lower barriers that inhibit US exports of specific products; and it seeks to negotiate specific provisions of NAFTA rather than repeal it. The ardent anti-trade devotees in Trump’s inner-circle have become quieter. Such backtracking removes a big risk that threatened economic performance.
On the other hand, the effort to reform health care has been bungled and the road to meaningful tax reform, which early on seemed to be a slam-dunk, with Republicans controlling both chambers of Congress and the Presidency, has gotten very rocky and off-path. It now looks like the probability of tax reform legislation being enacted in 2017 has diminished materially. Fiscal legislation is still expected by mid-year 2018.
Things could change, and a breakthrough in the budget negotiations is possible. But for now, the dismal political realities have set in and the 2017 calendar for fiscal policymakers is getting clogged with more routine matters like dealing with negotiating the Fiscal Year 2018 budget, which involves debating the Trump Administration’s proposal to aggressively cut spending on discretionary programs, and dealing with the debt ceiling. These budgetary functions squeeze the necessary time to debate tax reform.
Poor sequencing of the fiscal agenda
The Trump Administration’s flawed attempt to repeal and replace the Affordable Care Act (ACA) before an acceptable and sufficiently detailed strategy had been established and vetted sidetracked Congress’s tax reform debate and remains an ongoing obstacle. Repeal and replace ACA has been a top priority for conservative Republicans and the intention was that health care reform would ease the budgetary constraints on tax reform and facilitate its passage. This flawed sequencing of policy rollouts failed in every way and makes enactment of tax reform more difficult.
Presently, deliberations by Republicans on health care tax reform (and other fiscal initiatives like infrastructure spending) are bogged down by substantive issues--different views on key provisions and how to finance them--driven to a large extent by budget constraints and various legislative procedures related to the budget constraints. The current health insurance and corporate tax systems are very complex. Meaningful reform of either involves changing many interacting provisions, which makes consideration of reform very difficult. On top of these issues, the political obstacles loom large, with Republicans holding a slim 52-48 majority in the Senate. Democrats are largely on the sidelines, vowing to vote against each and every piece of legislation and procedure that Republicans pursue.
Thus, enactment of almost any legislation conceivable must rely on legislative rules that require only a simple majority vote in the Senate, rather than a 60 vote majority. Hanging over the deliberations are President Trump’s ineffective and erratic leadership, a visceral hatred of the president by Democrats and a distrust by Republicans. The negative vibes in Washington DC are palpable. This is opposite from the environment in 1986, when President Reagan relied on Democratic leadership in both the House and Senate (Democrats controlled both chambers) to achieve significant tax reform.
Substantive issues on Tax Reform
The need for corporate tax reform is clear. The US marginal corporate tax rate of 35% is the highest among all OECD nations and unlike other countries, that rate is applied to all income, even overseas earnings. The system is mind-numbingly complex, which adds significantly to compliance costs and business inefficiencies. Its many deductions, deferrals, exemptions and credits greatly reduce the effective tax rate and the amount of tax receipts actually collected.
There is general agreement on the need to reduce the tax rate and address the tax treatment on income earned overseas (to reduce incentives for US corporations to move headquarters and investments overseas and to keep excess cash overseas); liberalize depreciation schedules to encourage business investment; and to simplify the system. (The Obama Administration favored corporate tax reform but never aggressively supported legislation.) But there are different views on what changes would be appropriate.
A major sticking point is the tax treatment of international income. The border adjustment tax (BAT) in the Congressional Republican Blueprint, which would disallow corporations from deducting costs of imports while excluding tax on exports, would be a major revenue generator, but has been criticized as a protectionist anti-trade measure that unduly penalizes importers. Powerful retailers that rely on imports such as Walmart and foreign suppliers that may be squeezed by a stronger US dollar that may result from the measure—and their governments--have opposed the provision.
A “territorial system” is now being considered in place of a BAT would effectively tax US corporate income earned in the US but not abroad, similar to the systems used in the UK, Germany, Japan and other OECD nations. While being a more traditional and internationally-accepted approach, when combined with a lower tax rate, it is a tax revenue loser. It also involves many complications regarding where income is actually earned. BAT-lite versions, in which a portion of import costs would be deductible, are under consideration.
Because the tax revenue implications, this issue is critical to corporate tax reform, and is a key determinant of the how much the corporate tax rate will be reduced. In reality, cutting the rate to 25%-28% as well as reducing the rate on “pass through” businesses to 25%, if accompanied by expensing of new investment and other provisions, would still be a very important tax reform.
In addition, the White House strongly supports reducing taxes of middle- and lower-middle income households through a significant increase in the child dependent exemption. In 2017, the exemption, which phases out for higher income households, is $4,050 per child. This tax relief proposal receives strong support, but it is expensive in terms of tax revenue loss, and potentially impinges on some of the key provisions of corporate tax reform.
Budgetary and budget procedural issues
If the US budget were in good shape and government debt was low, the debate about corporate tax reform—or for that matter, health care or other spending programs—would be less constrained. But that’s not the case. Gross government debt is 106% of GDP and under current law is projected to rise significantly further, driven largely by increased spending on Social Security, Medicare and Medicaid, plus higher debt service costs. The government’s unfunded liability is estimated to be between $80-$100 trillion, depending on assumptions on longevity, medical prices, real wages, etc. In present value terms, this translates into a budget gap of approximately 5%-6% of GDP per year, too large to be materially reduced through stronger growth.
While economists and policymakers express concerns about the longer-run economic and financial implications, the reality is that the high Federal debt is already impinging on economic performance and virtually every debate about spending and tax policy. The composition of Federal spending—a key determinant of the allocation of national resources—is already affected by the rapid growth of entitlement program spending and rising debt. Witness the insufficient government spending on infrastructure, considered “discretionary” spending, which indirectly reflects the squeeze from the rapidly growing entitlement programs.
These budget realities accentuate the political debate on all fiscal matters and clearly are driving the tax reform deliberations. Also, the many arcane procedures that now drive congressional budgeting have stemmed from political disagreements on what to spend on, how much to tax and how much deficit spending is acceptable.
In the tax reform debate, deficit neutrality may not be absolutely binding and there are many ways to get around it, but budget estimates control what is considered acceptable. This forces a tradeoff among the various tax provisions. The budget scorekeeping estimates provided by Congressional Budget Office (CBO) and the Joint Committee on Taxation (JCT) dominate the deliberations on corporate tax reform, while important potential efficiencies and economic improvement are forced to secondary consideration. Currently, advocates of tax reform argue that the CBO’s and JCT’s models do not adequately capture the positive macroeconomic impacts of the tax reform proposals and thrust toward deregulation. This nuanced debate about the economic growth projections are critical to the estimated projections of tax receipts and deficits—and what tax provisions will be in the final legislation.
Continuing resolutions, reconciliation, the Byrd Rule and the filibuster issue
All of the messy budgetary processes, set deadlines, and threats of government shutdowns, the various deficit constraints, as well as what spending programs are considered “mandatory” and “discretionary” are artificial constructs erected by the budgeteers who quarrel over fiscal legislation and tend to only get things done when facing artificial deadlines. Even the 10-year budget projection is arbitrary—it could be changed. The filibuster issue is much more serious.
The budget battle is now being waged on several fronts. Congress must deliberate on the Fiscal 2018 budget before it begins October 1. President Trump’s proposes large cuts in spending for discretionary programs and Medicaid, with no cuts in Social Security and Medicare and increases in defense appropriations. These proposals are contentious. The current Fiscal Year 2017 has been operating under several continuous concurrent resolutions, the last one agreed upon end of April, which avoided a government shutdown. It is noteworthy that continuing resolutions allow appropriations for discretionary spending programs, while the largest portion of Federal outlays are for entitlements and debt service, which are considered “mandatory” and as such are on automatic pilot. Congress is very unlikely to be able to compromise on a Fiscal Year 2018 budget so once again the new fiscal year would begin operating under a continuing resolution.
Around the beginning of FY2018, the gross government debt is expected to bump against the $19.8 trillion debt ceiling. The White House will be seeking clean legislation to increase it, but its efforts may be opposed from different angles. The conservative Republican Freedom Caucus may bargain for cuts in mandatory spending programs while Democrats may try to force Republicans to back down on some of President Trump’s proposed large budget cuts. The debt ceiling debate is certain to elicit political grandstanding and unproductive budgetary brinksmanship. Threats of government shutdown and debt default are not to be taken literally. In the several actual government shutdowns in the past, the government has always serviced its debt and most government operations have continued; they have resulted in minor, temporary inefficiencies, and resulted in a paid vacations for most government employees. They have, however, harmed the government’s credibility.
The Republican’s slim majority in the Senate and party-line votes on virtually everything suggests that enactment of tax reform must rely on the use of reconciliation. This legislative process, created by the Congressional Budget Act of 1974, allows passage of a budget bill with a simple majority vote and disallows filibuster. The reconciliation process is commonly used on significant legislation, but there are limitations on the types of legislation resolution can use used. Of course, history is full of bending of those limitations.
The Byrd Rule (introduced in 1990) allows reconciliation to be used on spending and tax legislation and debt ceiling adjustments, but prevents its use for bills that include language “extraneous” to the budget. The Byrd Rule requires that the budget impact of the legislation must be deficit neutral over the projection period. Again, history shows a tendency to bend the Byrd Rule. Currently, it is noteworthy that the Byrd Rule does not stipulate a 10-year budget projection period. Another ruling that may be imposed by the Senate involves suspending or outlawing filibuster. But such a move involves potentially large and uncertain costs, including damaging the democratic process.
Budget fights are nothing new, but presently they distract debate about pending legislation and fill up the calendars of leading congressional committees that must deliberate on tax reforms. This includes the House Ways and Means Committee, the House and Senate Budget Committees and the Senate Finance Committee. Accordingly, the debate on tax reform looks like it will be carried over into 2018.
With all of these obstacles, why do I continue to anticipate enactment of tax reform in 2018? Because Republicans know that approaching the mid-term elections in November 2018 without tax reform would be political suicide, and dealmakers in the Trump Administration and the Republican leaders in Congress will reach a compromise.
Mickey Levy is the chief economist for the Americas and Asia of Berenberg Capital Markets, LLC, and member, Shadow Open Market Committee. The views expressed in this column are the author’s own and do not reflect those of Berenberg Capital Markets, LLC.
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