Picking the Right Budgetary Offsets Key to Tax Reform Success

In a perilous economic and fiscal environment, with instability created by Trump’s trade war and publicly held debt on track to surpass the highest levels ever recorded within five years, a lot rides on how Republicans navigate taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. and spending reforms in reconciliation. As lawmakers review options to balance their goals for pro-growth and fiscally responsible tax and spending cuts, we have three guidelines they should follow.

First, because choosing the wrong offsets could wipe out the pro-growth effects of the bill, lawmakers should reduce spending as their main offset to avoid unduly harming the economy.

Under current law projections, federal spending will average 23.9 percent of GDP over the next decade, which exceeds spending in any decade since World War II and is far higher than the federal government has ever collected in tax revenue. Any realistic chance of putting the fiscal trajectory on a sustainable course depends on returning spending to more normal levels, i.e., something closer to the 19.8 percent of GDP that the federal government has spent on average since World War II.

Spending reductions are generally less damaging to the economy than are tax increases, according to many studies including by the Congressional Budget Office. Reducing transfer payments and social spending has little impact on long-run economic growth, whereas taxes that reduce incentives to work, save, and invest or are otherwise distortionary present a significant drag on the economy.

While the House budget resolution allows deficits to rise by $2.8 trillion over the next decade, it incentivizes some spending reductions by requiring spending cuts for every dollar of tax cuts above a threshold. For instance, if lawmakers want to cut taxes by $4.5 trillion, they will have to reduce net spending by $1.7 trillion. A larger tax cut of $5 trillion would require a spending cut of $2.2 trillion so that the allowable deficit increase would remain at $2.8 trillion, before accounting for economic growth or changes in interest costs.

While these are big numbers, they are small in comparison to the federal budget: a $1.7 trillion spending cut amounts to about a 2 percent reduction in projected spending of $86 trillion over the next decade. Even on its own, a $1.7 trillion spending reduction would be insufficient to prevent debt as a share of GDP from rising to record levels within the next decade, but of course, the overall impact of the budget resolution is to increase deficits.

Second, to reduce the cost of the bill and fit within the budget resolution’s cap on net tax cuts, lawmakers should pursue tax offsets but avoid tax increases that cause undue economic damage.

For example, we recently highlighted precautions for new limits on corporate state and local tax (C-SALT) deductions. Though C-SALT limitations could raise substantial revenue, they would raise effective corporate tax rates, reducing economic output, investment, and wages. The corporate tax is a tax on profits, net of expenses, meaning that the costs of doing business should be fully deductible.

Likewise, businesses should be able to fully deduct labor compensation, yet lawmakers might consider expanding a rule that limits deductions for corporate executive compensation. First enacted in 1993, Section 162(m) disallows deductions above $1 million for compensation of top executives of publicly traded companies. The Tax Cuts and Jobs Act (TCJA) expanded Section 162(m) in 2017 and the American Rescue Plan Act further expanded it in 2021. The Biden administration proposed expanding it to include all employees of C corporations who earn more than $1 million. Section 162(m) is extremely non-neutral, increasing the tax burden on the compensation of a select group of workers. Rather than expanding it, lawmakers should repeal it entirely.

Along the same lines, lawmakers should avoid rolling back deductions for capital costs. The TCJA took this approach by requiring amortization of research and development (R&D) expenses as a pay-for, which resulted in reduced R&D spending and a cash crunch for small businesses in particular. Leading up to TCJA, many proposals suggested lengthening write-off periods for various business assets as a pay-for, which would have overstated income, penalized investment, and reduced economic growth. One idea that may return is amortizing advertising costs; another idea is lengthening the write-off period for intangible property. Instead, lawmakers should move in the direction of full expensing for all investment, including R&D, on a permanent basis.

Lawmakers may turn toward tax increase ideas proposed by the Biden administration, such as expanding the InflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. Reduction Act’s (IRA) stock buyback tax or the corporate alternative minimum tax. Both taxes should be repealed rather than expanded, as they introduce complicated extra layers of tax on corporate income that reduce economic growth.

Third, tax offsets should further the goals of tax reform by reducing distortionary preferences.

Lawmakers can find a multitude of actual loopholes and tax subsidies in the lists of tax expenditures maintained by the Treasury Department and the Joint Committee on Taxation. However, it is important to focus on actual loopholes and costly subsidies versus features of the tax code that support economic growth and improve neutrality.

While both lists include items that broadly reduce double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. of saving and investment, such as expensing for investment that should be left alone, they also identify several provisions that narrowly carve out special treatment for certain industries or taxpayers.

Among the largest corporate tax subsidies are the several green energy tax credits created or expanded as part of the IRA, which Treasury estimates will reduce corporate tax revenue by more than $700 billion over the next decade. Including impacts on individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. revenue and outlays, the credits will add about $1.2 trillion to deficits over the next decade.

Other corporate tax subsidies or loopholes worth scrutiny include the credit for low-income housing investments (estimated to cost $167 billion over the next decade), the exemption of credit union income ($32 billion), the new markets tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income rather than the taxpayer’s tax bill directly. ($8 billion), and special tax benefits for Blue Cross/Blue Shield ($6 billion).

Some of the largest loopholes and subsidies are directed at individual consumption of health care. Treasury estimates the exclusion of employer-sponsored health insurance will add $5.9 trillion to deficits over the next decade, including payroll and income tax effects. This distortionary loophole has grown for decades, causing employers to reduce cash compensation in favor of this untaxed fringe benefit, such that the average annual premiums for employer-sponsored family health coverage now exceeds $25,000.

The Affordable Care Act’s health insurance premium tax credits will add $1 trillion to deficits over the next decade, $897 billion of which is outlays. Other tax expenditures that encourage health-care consumption include health savings accounts (estimated to cost $197 billion) and the deductibility of medical expenses ($254 billion).

Crafting a tax and spending cut package that boosts economic growth and is fiscally responsible will require lawmakers to abide by these three guidelines to meet their deficit targets: rely on spending cuts for most offsets, avoid economically harmful tax offsets that would increase the tax burden on saving and investment, and clean up special provisions and spending in the tax code.

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