A tax system should satisfy three criteria: it should raise sufficient revenue for the government to conduct its operations; it should minimize the economic distortions associated with taxation; and, it should minimize the costs taxpayers pay simply to comply with the tax code.
Details that have emerged from the Trump tax plan present a mixed-bag. The plan represents a step backwards in terms of raising revenue. It is estimated that the plan would cost the federal government over $2 trillion in lost revenue over a ten-year period. The federal government is currently running a $600 billion per year deficit while facing tens of trillions of dollars in future entitlement liabilities. Further reductions in tax revenue without offsetting budget cuts invites a fiscal crisis. Much of the lost revenue stems from dropping the top personal income tax bracket from 39.6 percent to 35 percent, which also occurred in the 2003 Bush tax cuts. The economic benefits of the Bush tax cuts were dubious, at best.
The Trump tax proposal takes a step in the right direction in minimizing distortions. The proposal claims to eliminate most itemized deductions, with the exception of the mortgage interest and charitable contribution deductions. Itemized deductions often serve to complicate the tax code and reward special interests without providing much economic benefit. For instance, the Trump proposal eliminates the deduction for state and local taxes. This deduction causes the federal government to subsidize high-tax state and local governments, such as California. If a taxpayer has an effective federal income tax rate of 25 percent, the deduction means that he gets 25 percent of his state income taxes back in his federal income tax return. There is no good reason for the federal government to provide this subsidy.
The Trump proposal also takes a step in the right direction in reducing compliance costs by eliminating the estate tax and reducing the corporate income tax. The nonpartisan Tax Foundation estimates that complying with the estate tax costs families $19.6 billion annually in terms of hiring lawyers, accountants, and filling out paperwork, while only raising $20 billion annually in tax revenue. Moreover, the estate tax is a tax on savings, which economists have long recognized is an inefficient way to raise revenue. The corporate income tax has compliance costs of $150 billion, while only raising $300 billion for the federal government, while distorting numerous corporate decisions.
Reducing the number of tax brackets, as the Trump proposal does, is an overrated reform. Calculating the tax owed is easy to do from a tax table, regardless of the number of brackets. Lowering the tax rate on pass-through corporations to 25 percent, as the proposal does, is a dicey proposition. Wealthy people can game the system by reorganizing their household as a pass-through corporation to take advantage of this lower rate, which increases the federal budget deficit. Given fiscal realities, a tax reform proposal that sizably increases the budget deficit presents more harm than good.