Half a Tax Reform

House Republicans released their tax bill at long last Thursday, and we wish we could say it repeats the Reagan reform of 1986. It isn’t close. The Ways and Means draft is instead a much-needed and pro-growth reform of business taxes marred by a mess on individual taxes that makes that part of the code even worse than it is now.

The good news is that the House finally grasps the nettle of corporate-tax reform that Barack Obama ducked and has hurt the U.S. economy for years. Ways and Means cuts the top corporate rate to 20% from 35%, which would make the U.S. more competitive across the globe (Ireland’s rate: 12.5%). The U.S. would move to a territorial system that taxes income where it is earned, and profits already earned overseas would be invited back at a discount: 12% for cash, 5% for illiquid assets.

This should stop the run of U.S. business “inversions” overseas, while making America more welcoming to investment. The rate cuts would be permanent, which means more certainty for business. Another growth boon is 100% business expensing for five years, which Congress would face pressure to continue in 2023.

The bill also reduces the top rate to 25% on “pass through” businesses that now pay at the individual rate of 39.6%. This is an enormous tax cut, but one large wrinkle is who qualifies to pay this rate. The draft includes complex rules to sort that out, and the trick is to treat all businesses fairly without creating a loophole that lets doctors and consultants pay the lower rate. Republicans should not want to defend Wall Street lawyers paying a lower rate than wage earners in Omaha.

The House business cuts take place immediately, but one danger is that the Senate may phase-in the rate cuts as a way to “save” money. This would give companies an incentive to delay investment until lower rates kick in, as George W. Bush learned the hard way in 2001 before he was able to fix the blunder in 2003.

And speaking of phase-ins, the House would repeal the death tax—six years from now. The bill would immediately double the exclusion to $10 million. But a 40% fee for kicking the bucket is double taxation and barely raises revenue—less than 1% of Treasury’s annual haul—in part because the megarich like George Soros put their money in family foundations that let them escape tax. Death tax repeal is among the bill’s important pro-growth planks, and we hope the Senate retains it.

The dispiriting news is on the individual side. The House would double the standard deduction to $12,000 for individuals and $24,000 for married couples. This would improve simplicity for millions, and it compensates for the bill’s elimination of the personal exemption. But nearly half of American filers already owe no income taxes, and the larger deduction would make the federal fisc even more dependent on a smaller pool of taxpayers.

This is far better than the House bill’s new “family credit,” which increases the child credit to $1,600 from $1,000 in a forlorn attempt to appease the income redistributionists of the right like Senators Mike Lee and Marco Rubio. The credit would also offer an additional $300 for each parent and another $300 for each “non-child dependent.” The credits would phase out for married couples at $230,000 of income. Does anyone think a mid-level manager at J.P. Morgan deserves a subsidy to raise children?

The House also gradually makes more of the $1,600 credit refundable. In other words, this will be a check in the mail for those who owe nothing in taxes, which discourages work. The family credits cost $640 billion over 10 years in lost revenue with zero growth payoff. To make up the difference, the House keeps the top personal rate at 39.6%, on top of the 3.8% ObamaCare surcharge that Republicans failed to repeal. This would become the fourth tax bracket and kick in at $1 million for couples—half that for individuals—with 12%, 25% and 35% brackets below.

This top rate is a surrender to Democratic class warriors, though Republicans also fear that President Trump would sandbag them. No Members want to vote for a lower top rate and then have Mr. Trump tweet that they’re “mean,” as he did on health care. This is where presidential flightiness and lack of principle have a policy cost. Ideological surrender also gets Republicans nothing politically as Democrats are still attacking the House plan as a sop to the rich.

Here and there the House plan includes some good news on individual loopholes, such as eliminating the state and local deduction. The bill carves out an exception for property taxes, capped at $10,000, to win over New York and California Republicans, if the House can hold that cap. Another good move is a $500,000 cap on mortgage interest for new homes, and no more tax breaks for second residences. The Realtors will go thermonuclear, but then they refused to support the House blueprint that left the deduction untouched.

The overall impact of the individual tax changes is little reform but more income redistribution. The long-term damage to the tax-cutting cause will also be considerable. Adding credits and deductions for individuals makes rate-cutting that much harder since the affluent pay the vast bulk of all income taxes. The divorce of “pass through” and personal income rates will also make it even harder to reduce individual tax rates below 39.6%—ever.

Kevin Brady and Paul Ryan, the chief House tax writers, understand the weaknesses in their plan. But the GOP is trapped in an iron cage of Beltway process. The party has bowed to the class-warfare crowd that says the bill cannot change the distribution of who pays taxes. The Senate’s budget procedure allows the GOP to pass the package with 51 votes, but the Byrd Rule says a bill can’t add to the deficit after 10 years. These twin realities mean the GOP has compromised with itself to water down reform.

The pro-growth business reform is still worth the effort, but this assumes the plan doesn’t get worse as it moves through the House floor and Senate. If Republicans in the upper chamber erode the growth elements with phase-ins and more redistribution, they’ll reduce the bill’s economic impact, which will mute the political benefits. If the GOP passes something called tax reform and there are no benefits to growth and incomes, Republicans will pay the political price in 2018 and 2020.