Likeliest Outcome of Tax Reform is a Deficit-Financed Tax Cut for the Rich That Will Expire in a Decade

Undeterred by their failure to repeal the Affordable Care Act (ACA), Republicans look set to move on to the next item in Paul Ryan's "Better Way" agenda--tax reform. This post helps set the stage for the upcoming tax reform debate and explains why "tax reform" will in the end likely just become a deficit-financed tax cut for the rich and corporations that expires in 10 years--a decade of free money for groups that don't really need it and a problem for policymakers to deal with in the future.

Understanding why this deficit-financed, 10-year tax cut is the most likely outcome requires some understanding of the "budget reconciliation" process (apologies). Budget reconciliation allows the Republicans to avoid the Senate's 60-vote threshold for a filibuster, and hence will almost surely be needed to pass any tax cut. To begin the reconciliation process, Congress first passes a budget resolution with topline spending numbers that includes reconciliation instructions. These instruct the relevant committees to make changes to mandatory spending or revenues in order to achieve some budgetary target--for instance, decreasing revenues or the deficit by so-many billion over a specified time period.

Here, Republicans in Congress face a choice. They originally planned to use the fiscal year 2017 budget to repeal the ACA, and so wrote reconciliation instructions that were basically deficit neutral over the 10-year budget window. They could do this because, although repealing the ACA would mean large tax cuts for the top 1 percent, these could be paid-for with cuts to Medicaid and subsidies that helped people afford insurance in the ACA marketplace exchanges. If Republicans wanted revenue-neutral tax reform--perhaps following through on the popular mantra of "broaden the base, lower the rates"--they could simply repurpose those instructions. But this is unlikely to work for them.

Last year's "Better Way" tax reform proposal will likely form at least the skeleton of the upcoming Republican plan. The Tax Policy Center (TPC) estimates that this plan would increase federal debt by $3 trillion over just the first decade. This plan included the tax cuts that were part of ACA repeal, but the cuts to ACA Medicaid and premium subsidies which were supposed to help pay for them have for now been left behind in the failed attempt to repeal the ACA. So in order for their desired tax cuts to make it through the reconciliation process, the GOP will have to find another way to pay for them.

They could just propose cutting Medicaid again, but that didn't work for them before, so why would it work now? Or they could drop the repeal of the ACA's taxes from the "Better Way" plan, making their plan $800 billion cheaper (and hence easier to pay for). But this would be a point of contention, since directing a lot of money towards the top 1 percent is a very desired feature in Republican tax plans, and it would still leave them about $2 trillion away from deficit neutral.

So how could these cuts be made deficit-neutral? What we are likely to see are claims that the cost will be covered by economic growth. This isn't true. TPC already used so called "dynamic scoring" to take into account the limited growth impacts of cutting taxes--their $3 trillion number includes these dynamic effects. More importantly, the Congressional Budget Office and Joint Committee on Taxation probably won't agree that tax cuts will pay for themselves with faster growth either.

It gets even worse for crafting a deficit-neutral version of the Better Way plan: TPC's estimate already assumes a number of pay-fors that are far from a sure thing.

First, the TPC estimate includes the "destination-based cash-flow tax" (DBCFT), sometimes referred to as the "border adjustment tax" (BAT), which would raise $1.2 trillion in revenue. Reliance on the DBCFT to finance the Better Way plan creates two main problems, one political and one budgetary.

The budgetary problem is that if Republicans plan to use revenues from the DBCFT to pay for their tax cuts, they'll need that revenue to come in not just for 10 years, but longer (remember, tax cuts passed through reconciliation can only remain permanent and not phase-out after 10 years if they are paid for in the long run, not just in the first decade). However, since the DBCFT taxes imports and gives rebates on exports, it only raises money so long as the United States runs large trade deficits. Are the official tax scorers willing to assume that the United States will run large trade deficits for more than a decade?

The political problem is simply that it creates winners and losers. The economics are complicated and contested, but suffice it to say that exporters are convinced they'll win and importers are convinced they'll lose. And some key importers have a lot of sway. To put it really bluntly, the Koch brothers and Wal-Mart already hate this idea. Indeed, Wal-Mart's home state Senator Tom Cotton (R-Ark.) already described it by saying "some ideas are so stupid only an intellectual could believe them." Given the political headache that the DBCFT is, we'll likely see it dropped as a revenue raiser.

Besides the DBCFT, TPC's estimates assume that the Republican tax plan will raise around $4 trillion from repealing itemized deductions (other than charitable and mortgage interest) and closing other tax expenditures. Take one example: TPC assumes the Better Way plan will eliminate the exclusion from capital gains taxes on sales of principal residences. That is, currently if you sell your house, you're allowed to exclude the first $500,000 of capital gains from income taxes (if you're married filing jointly). The TPC score assumes this (along with literally dozens of other potentially popular tax breaks) are eliminated. Sound realistic?

So deficit-neutral tax reform is pretty hard, but there's an easier option if your goal is to cut taxes for the rich--follow the lead of the 2001-03 Bush tax cuts and finance them with debt. To do this, Republicans would give up on the fiscal year 2017 budget and pass a fiscal year 2018 budget resolution which included reconciliation instructions telling the relevant committees to simply lose some revenue.

To pass that resolution, they're going to have to agree on topline spending numbers for 2018 (remember, they have already agreed for 2017). The fractious Republican caucus could make this awfully hard, however. Remember that about this time last year, the fiscal year 2017 budget resolution made it out of committee on a party-line vote, but then couldn't be passed. Amazingly, it couldn't reach a majority in the Republican-controlled House because the severe spending cuts were not severe enough. What will happen if President Trump insists on money for infrastructure being smuggled into the tax reform plan? However dubious we might think the Trump infrastructure plans to date have been, they do add, not subtract, to the budgetary cost of any package.

Republicans managed to pass the 2017 budget resolution only after a carrot was added for the Freedom Caucus--starting the process for repealing the ACA. Now that the repeal of the ACA has been abandoned, it is not immediately clear that Republicans can reach the consensus they need on topline spending numbers to pass the fiscal year 2018 budget.

Finally, even if they pass this hurdle, any deficit-increasing tax reform automatically expires in 10 years. This is because the Senate's "Byrd Rule" forbids reconciliation bills from increasing the deficit outside the ten-year budget window. So if this year's tax reform is debt financed, there will be a "sunset" provision that snaps back the tax cuts at the end of the budget window (just like the Bush tax cuts--though only the highest-end ones were eventually allowed to die permanently).

The outcome of tax reform seems pretty clear: deficit-financed, regressive tax cuts that get crammed through the reconciliation process but expire in 10 years, creating another "fiscal cliff" for future policymakers to deal with. It could be worse--the Republicans could take another run at gutting Medicaid, for example--but it could certainly be better.