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President Trump proposed the largest tax cuts in the history of the United States during his campaigns. Politicians usually promise to deliver a better state of affairs by doing things differently from their predecessors and rival politicians. Trump as a politician embraces this virtue with the proposed tax cuts. Trump`s proposed tax cuts were part of his economic reform plan that would also include policies on immigration, government spending, and international trade. Trump campaigned his proposed tax cuts as a way to liberate Americans from the existing broken tax code. According to Trump, the tax code would be simpler, fair and pro-growth friendly which would put more money into American`s pockets due to tax cuts. His election victory and the fact that Republicans control both houses of Congress means that the proposed tax cuts mostly for the rich and businesses will be affected. Recently, the house of republicans and the white house released a tax bill that would offer huge tax cuts to both individuals and corporations (Caldwell, 2017).
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The paper attempts to analyze the potential impacts of President Trump`s revised tax proposal that would see a significant reduction in marginal tax rates for both corporations and individuals. The tax proposal would also see a repeal of personal exemptions, an increase in standard deduction amounts, cap itemized deductions, and allow businesses the flexibility of electing to expense new investment and not deduct their interest expenses. The proposal would allow for cutting of taxes across all income levels with the highest benefits in percentage and dollar amounts going to the top-income households. The policy would take a toll on the economy with the federal revenues falling by nearly six trillion dollars in the first decade of President Trump`s presidency before one accounted for the macroeconomic effects and added interest costs (Nunns, 2016). In addition to this, the federal debt would also increase to at least seven trillion dollars in the first ten years of implementation. It is estimated that the debt would rise to an astronomical twenty trillion dollars by 2036. The paper assesses the macroeconomic implications of President Trump`s revised tax plan while offering the estimated score of the plan using two new models: the Penn Wharton Budget model overlapping Generations model and TPC`s short-term Keynesian model.
A General Analysis of the Tax Plan and Its Major Macroeconomic Impacts
The tax reform plan would see a change to the individual income tax code that would see lowered marginal tax rates on wages, business incomes, and investment. The revised Trump plan will reduce the individual tax rate to thirty-three percent. Furthermore, the tax reform will widen the individual income tax base (Cole, 2016). The plan would also lower corporate income tax from the current thirty-five percent to a modest fifteen percent while also modifying the corporate income tax base. Owners of pass-through business such as partnerships, sole-proprietorships, and S corporations will get to choose to be taxed at the fifteen percent flat rate other than the regular individual income tax rates. The current preferential rate structure would guide the taxation of dividends and capital gains. The distributions from the `large` pass-through businesses that elected the fifteen percent flat rate will be taxed as dividends.
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The plan also proposes to increase the standard deduction will also adding a new deduction system that includes tax benefits for dependent and child care. The plan will also see that personal exemptions are repealed while also capping the itemized deductions (Cole, 2016). In addition to this, the plan will also eliminate the alternative minimum tax (AMT) and the net investment income tax which was enacted as part of the Affordable Care Act. The plan will also see that the gift and estate taxes are abolished while taxing capital gains at death. Corporates and pass-through businesses will be allowed to elect whether to deduct investment immediately but this will not comprise the interest expenses. In addition to this, certain business tax expenditures will be repealed according to the plan.
Various Democrats and Economists in the United States have reinstated that President Trump`s Tax cuts will only offer tax breaks to the wealthy which will harm the middle-class Americans. This assessment aligns with the paper`s findings which finds the tax plan to have several macroeconomic impacts. First, according to the Urban-brooking Tax policy center (TPC), the federal revenue will fall by nearly six trillion dollars in the first decade of Trump`s presidency. This will have an adverse impact on the budget since the government will face a budget deficit due to the lower revenue collection. According to estimates, revenue loss from the reduction in business taxes would make up three-fourths of the revenue loss (Nunns, 2016).
Major Elements of the Tax Plan Reform
The tax plan proposes to cut the corporate tax from the current thirty-five percent to fifteen percent. This tax reform will see that the owners of pass-through entities (partnerships, sole proprietorships and S corporations) have their incomes be taxed at the proposed fifteen percent flat rate. Additionally, `large` pass-through businesses that have selected the fifteen percent tax rate will have their distributions to owners be taxed as dividends (Foster, 2017). The tax plan will create an 18 percentage point differential between the pass-through business income and wage tax rate. This is projected to provide a strong incentive amongst wage earners to form pass-through entities that provide labor services to their employer other than receiving wages as compensation. The plan, however, fails to offer a threshold of the number of employees that can redefine themselves as sole proprietors so as to benefit from the fifteen percent tax rate (Foster, 2017). Even at current-law rules, enforcing the payment of payroll taxes proves difficult that results in massive payroll tax avoidance. Under the revised Trump`s plan, tax evasion will be more prevalent due to the larger rate differential.
Pass through businesses and corporations are flexible to select whether to expense their investments on structures, equipment, and inventories rather than depreciating the purchases as required by current law. However, the businesses that choose to select expensing will have to include their interest expenses (Inglehart and Morris, 2016). The plan also calls to impose a tax on the unrepatriated earnings of American firms’ foreign subsidiaries. A ten percent tax would be imposed on all earnings held in cash while other earnings attract a four percent rate. The lower tax rates would provide an incentive for firms to evade tax by recharacterizing their domestic income as foreign-sourced. The benefit of this measure is that businesses will have fewer incentives to move their tax residence overseas (Inglehart and Morris, 2016).
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Individual Income taxes
The new tax plan will see the repeal of the head of household filing status. The plan will also set the personal exemption for tax filers and dependents to a new standard that amounts to $15000 and $30000 for single and joint filers respectively. It will further consolidate the regular standard deduction with additional standard deductions that cover age or blindness. The second part of the plan is to trim the number of the individual tax brackets from the existing seven to three: twelve, twenty-five and thirty-three percent. 6.6 percentage points would cut the current 39.6 percentage rate. In addition to this, dividends and capital gains will retain the current special rate structure (Nunns, 2016). Furthermore, the plan will also include a new deduction meant to cushion against the child and dependent care expenses. Parents that do not benefit from this deduction will enjoy an increased income earned a tax credit. A new tax-favored saving account related to child and dependents care will also be introduced.
The number of fliers that itemize may decrease significantly due to the increase of standard deductions. The repealing of the head of household status and personal exemptions may cause tax increases for single parents and large families.
Estate and Gift taxes
The new tax plans proposed by President Trump and congress highlights that all federal gift, estate, and generation-skipping transfer taxes be eliminated. Under the new plan, capital gains held till death will be taxed with an exemption of five and ten million for single and married individuals. The elimination of estate tax will remove the incentive for the wealthy to make a charitable donation. Taxing capital gains of the wealthy descendants at death will allow for them to escape capital gains tax by not holding onto appreciated assets till death.
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Macroeconomic Effects of Proposed Tax Cuts
Impact on revenue collected
Nunns (2016), estimates that the reduction of taxes as a result of the tax reforms would reduce federal receipts by six trillion dollars in President Trump`s first two terms as president. This estimation is before accounting for the resulting macroeconomic feedback effects. Tax cuts on business would cause the largest loss in revenue. Corporations and pass-through businesses will pay less tax than current figures due to a reduced tax rate of fifteen percent. The reduced taxes on unrepatriated foreign income will also cause a reduction in revenue. The remainder of lost revenue will occur primarily from the net cuts in non-business individual income taxes. The reduced income tax rates and repealing of individual AMT and investment individual income tax will lead to lost revenue. Repeal of gift and estate taxes of capital gains of five million per person at death will also cause a net revenue loss.
Marginal tax rate cuts also have some beneficial attributes to the economy. The challenge arises with the increased budget deficit which calls for increased government borrowing. Lower revenues mean that the government cannot satisfy the budgetary resource requirements domestically (Jaimovich and Rebelo, 2017). A deficit occurs when the collected revenues cannot match the required budget resources requirements. Increased government borrowing to contain the budget deficit could push interest rates up which has a negative impact on crowding out private investments. In such a case, federal spending must be reduced so as to reduce the budgetary resource requirements which will offset the effect of reduced taxes on the budget deficit. Furthermore, any fiscal stimulus would force the Federal Reserve to tighten monetary policy faster in order to counter inflationary pressures in the economy that appears to operate a full employment. Trump`s proposed policy will be neutralized by the continued tightening of monetary policy (Mccaffery and Baron, 2006).
Impact on the Economy
Trump`s policies can be termed to be fiscal policies that include the manipulating tax rates and government spending. Economics lessons teach that a reduction in taxes combined with an increase in government spending which is part of President Trump`s economic reforms will result in a mixed or contractionary effect (Gravelle, 1994). If Congress approves the policies the United States economy will face an initial boost then a sharp rise in deficit and debt which will, in the long run, put upward pressure on interest rates. The higher interest rates will have an effect of crowding out private investment as capital becomes more costly to access. This will offset some of the positive gains on private investment realized due to the tax cuts. This can be mitigated by cutting federal spending to offset the effect of reduced taxes on the deficit.
Impact on income distribution
While the proposed tax cuts suggest that all groups within the income distribution will enjoy reduced average taxes, some filers will face increased taxes. The overall taxes would reduce by an average of $2940 that represents 4.1% of after-tax income (Nunns, 2016). It is expected that based on dollar and income percentages, the highest-income households would receive the largest tax cuts. These households will receive tax cuts that are equivalent to fourteen-percent of the after-tax incomes as compared to an average of four percent for all other income groups. In dollar amounts, this would mean that the top 0.1 percent American receive tax cuts approaching 1.1 million dollars compared to $1010 for middle-income households. The tax cuts hence would only widen the income inequality and disparity that plagues the American society. Income redistribution is not guaranteed in this plan.
Impact on Aggregate Demand and Output
The tax cuts would result in increased aggregate demand which results in final output in the following in two major ways. First, the reduction of household`s tax rates would increase their taxable incomes. The improved disposable income will allow the household to spend the extra income gained which will, in turn, boost aggregate demand. The effect will, however, be attenuated since most tax benefits will accrue to the highest-income earning household that will represent a sporadic increase in spending levels. Second, the tax plan`s provision that allows businesses to select the option of expensing investment which results in sustained incentive for the organizations to increase their investment spending (Kevalramani, 2017). These further increases aggregate demand which has an effect of raising output levels until the Required Reserve by the federal institutions use monetary policy to try the economy at an equilibrium which forms it potential in the long run. According to Nunns (2016), the model developed by Keynesians theorists can take into account how fiscal policies on tax and spending alter demand of goods and services in an economy including if the economy is operating at full capacity.
The proposed tax cuts would result in a long term effects on possible output. The incentives to work, save and invest will be altered and at the same time the deficit on the budget would also be affected. The PWBM model, in this case, assumes that households adjust their savings and labor supply behavior while businesses also adjust their investment choices in response to the changes in fiscal policy. In addition to this, the PWBM model also assumes that the policy makers can stabilize public debt by cutting government spending.
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Impact on savings and investment
Trump`s tax cuts promise the many middle-class Americans of a better future by guaranteeing them higher paying jobs and high wages as a result of the tax cuts. Reduced taxes have an effect of altering positively the inducements to invest and save at the same time (Mccaffery and Baron, 2006). In this scenario, savers will have increased after-tax returns due to reduced income tax rate, the reduced tax rate on business, lower rates charged on interest income and lower the ideal marginal tax returns on the long run capital gains. If interest rates are assumed to be constant and tax rates are financed with ways that do not undermine the incentive to save and invest, the amount of investment and savings would increase in the United States. This is, however, a hypothetical case which bases its facts from macroeconomics assumptions of constant interest rates and external funding of debt.
Marginal effective tax rates on new investments can be used to showcase the effect of the tax cuts on the incentive to save and invest (Caldwell, 2017). Marginal effective tax rates are forward-looking policies that assess the effect of the proposed tax system on the return rates of an ideal profitable investment project. In Trump`s proposed tax code amendments, businesses will be allowed to elect whether to expense their investments in depreciable assets other than structures. This would lead to a reduced average tax rate level for individuals on dividends, income gains, and interest. The marginal effective tax rates would decrease considerably. Businesses that elected expensing would have to incur high marginal tax rates since rates associated to deductions would be disallowed (Inglehart and Morris, 2016). Moreover, debt-financed business investments may cost businesses high levels of tax rates as compared to current policy as businesses do not have the power to deduct the interest. The overall result is that, the strategy will lower the marginal effective tax rates which will make savings and investment enticing.
Tax cuts are on the surface popular and presidential candidates can use them as a compelling case to gain political mileage over other political rivals. The challenge of this policy arises on how to pay for it. This raises a serious debate on the credibility of the proposed tax cuts and its impact on business, budget deficit and the economy. It is estimated that the tax cuts will result in a debt of about six trillion dollars in the first decade. This will lead to a steep rise in the deficit, and if the government borrows to mitigate on this effect, the resulting debt places upward pressure on the interest rates. Trump`s tax cuts would result in the short-run boost the incentives to work, save and invest due to increased disposable incomes. The plan in such a case would be to ensure the reduction of the marginal effective tax rate on new investment that would allow for increased investments in the United States. The increased investment can have a ripple effect of raising labour productivity as well as wages due to the increased capital per worker. The challenge lies on how to ensure constant interest rates and maintaining reduced levels of government spending.
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