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US Tax Reform – a Catholicon or a Disaster?

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On November 16th, the far-reaching tax reform championed by Donald Trump got the approval with a majority of just two from the US Senate Finance Committee. This was significant legislative victory for the US President, after a string of defeats he suffered in Congress on the repeal of Obamacare. However, a fierce debate among economists and even Republican senators on the efficiency of such reforms continues. It is anything but easy to push such a dramatic slash on corporate tax rate, from 35% to 20%, even with hype made by the White House. However, some obstacles have now been removed. In fact, this plan does not need support from Democrats and with the vote for new budget, the Republican overcame the internal fighting within their own party.

Here are some points need to notice on the tax plan:

The government holds that deducting taxation on corporate income will bring more jobs and increase wages for workers – an average $4,000 per person. With fewer tax provisions, income of corporations would rise, and employees would benefit, supporters of the bill claim. According to President Trump, by targeting neither the upper nor the lower classes, closing loopholes and tax breaks, America’s middle-class miracle will re-emerge. Nevertheless, he will struggle to convince the general public of this, as many are claiming the rich are the people who will mostly take advantage of those policies. Only time can tell us whether the wealthy will be the ultimate winner.

Second, supporters argue that the lower tax rate will galvanize domestic investment, promoting the economic recovery, or, more precisely, fuel further economic growth. It is easy to understand that with the marginal product of capital decreasing in the long run, the net profits earned by companies would increase and the efficiency within the whole economy will increase as well. This can be seen from a simple economic model with the tax break being a kind of positive demand shock. Also, along with the overhaul of corporate tax, individual income tax would also be modified but somewhat less compared to the that of the corporate tax rate. Corporations normally face double taxation – one for corporate operating income and one for the dividends – and the comparison between those two tax rates would influence the patterns of dividend payments. Applying the new tax rate plan will make reinvestment of capital in the companies much cheaper, resulting from the unwillingness of shareholders to monetize their profits. Nonetheless, history always repeats itself. The statutory corporate tax rate was cut from approximate 50% in the 60s and 70s of last century to 35% in 1988, leading to only minimal additional investment. Besides, the tax ‘Holiday’ launched by former US president George W Bush was nothing but a gift to shareholders according to research. Again, it still too early to say whether the tax reform this time will be an outlier generating huge impact or will become another failure written into textbooks.

The White House asserts that a corporate tax cut would lead to corporations repatriating capital from overseas, an appealing by-product of a lower tax burden. Some economists however, think that this effect will be muted. Because the US has the largest economy in the world whose policies unquestionably influences other countries, an unfortunate result might produce a beggar-thy-neighbor effect. “Hot money” inflows from offshore is not limitless as some scholars said, as other countries might take some countermeasures to eliminate the negative effects of the capital drains.

Additionally, the US is already a notorious tax-haven for multinational companies, due to its complexity of state tax system and the existence of loopholes, such as the tax relief for debt interest costs or for mortgage interest payments. Therefore, the real meaning for capital repatriation behind the tax deduction would be far less than that has imaged. Although the government attempted to eliminate most loopholes to achieve more fairness for the middle class, no one can promise that ‘potential losers’, for example oil companies and private equity firms, do not lobby the lawmakers to change their minds.

A crucial point would be the source of financing such a significant tax cut. According to an early draft, government financing would come from three parts – tax receipts, change of government debts, and curiously, an expansion of money supply. The Senate claim that the envisaged $1.5 trillion tax cut would pay for itself by spurring economic growth almost seems laughable. Reducing expenditure may be the best way but the magnitude is too small and may existing social and welfare entitlements, a touchy issue on both sides of the political aisle.

Is this the right time to launch a new tax reform? The full effects of QE 2014 and the Federal Rate Hike in 2015 hasn’t come a full economic cycle. Further fiscal mismanagement would only serve to destabilize the global economy further. Congress should consider these issues carefully.




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