US tax reform – is it all smoke and mirrors?

It is a fact that Reaganomics in the 1980s had flourished as a result of massive tax cuts which generated a four per cent GDP growth in American.

Will the success story be echoed given that last year, the US Senate approved the $1.5 trillion tax bill, which includes permanent tax breaks for corporations and temporary tax cuts for individuals, by a slim vote of 51-48. The Act includes tax cuts for individuals and families of all income levels, with the largest benefit going to the wealthiest Americans. Paul Ryan, the House Speaker thinks it is one of the most important pieces of legislation that Congress has passed in decades to help the American worker grow the American economy. Critics disagree saying that tax cuts are not the only way to incentivise a sluggish economy and create new jobs.

In fact, some economists argue that when companies receive tax rebates they often prefer to invest the surplus overseas or increase shareholder dividends but do not invest in higher R&D or increase wages. They will not run a new recruitment drive. This may be a harsh assessment of the US tax reform. Certainly, in the medium term, companies do relish higher productivity and invest in smarter research innovation which may also lead to creation of better-paid jobs. Critics of Trump’s recent tax reform understate the importance of the reform which lowers the maximum corporate tax rate from 35 per cent to 21 per cent. This rate is the lowest since 1939 and compares well with a number of Europe countries having equivalent rates. Once fully functional, such corporate tax cuts will trickle down to shareholders and investors and will generate larger returns particularly to retirees who make their money from investment earnings.

It is no secret that US capital has long started to leave the US to seek more productive shelters in foreign countries. Economists tell us this is a symptom but it is not an unpatriotic act and is caused by high state and federal tax systems. These have deteriorated in effectiveness ever since the 1980s when Ronald Reagan had slashed taxes. Observers complain that the US tax code is the toughest one in the industrialized world. Under the Trump plan, America will compete with the world and win back investment by cutting the corporate tax rate to 21 per cent, taking the rate from one of the worst to one of the best. Without this reform, one notices how start-ups, SMEs and sole proprietors are taxed at the comparatively high personal income tax rates which stifles small businesses, and in the Obama years a significant number of brands and innovative start-ups leaving America.

The reform is a complex one but one can comment about a number of unique steps in Trump’s plan. These include the phasing out of the tax exemption on life insurance interest for high-income earners, while curtailing the current tax treatment of “carried forward” interest for speculative partnerships that do result in enhanced business potential and traditionally are highly geared so they are not risking their own capital. Of special mention is the onetime deemed repatriation of corporate cash held overseas charged at a significantly discounted 10 per cent tax rate. Under this plan, companies can elect to bring their funds home and invest it in America while benefitting from the reduced corporate tax rate. Furthermore, reducing or eliminating some corporate loopholes that previously catered for special interests, as well as removing deductions made unnecessary or redundant by the new lower tax rate will bring more equity and justice to the fiscal system. There will also be a 30 per cent cap on the deductibility of business interest expenses which matches the same rules prevailing in most OECD countries. Again, one may play down the significance of such tax cuts for corporates and criticise that such windfalls will not incentivise major companies to raise wages or invest in new plant especially when one notes that we are already living in a world awash in capital.

It is a fallacy to say that a shortage of capital supply is the problem holding back investment. In fact, one is aware that US companies have been active to transfer their intellectual property assets abroad to gain from favourable fiscal incentives in such countries. It is reported that major American businesses have siphoned around $3 trillion overseas as part of their tax strategies over the years. For this reason, the Trump reform tries to encourage repatriation of such a massive capital hoard by introducing participation exemption (provided the US parent has at least 10 per cent shareholding in the foreign investment). This move is estimated to cost the US treasury about $500 billion. Critics disagree. They say this rewards companies for tax-avoidance strategies without guaranteeing an economic dividend.

This tax reform has been criticised by Democrats saying that it fails to help the lower classes or encourage more investment needed to combat climate change. Addressing climate change is not a top priority for the Trump’s administration but in reality, if more investment is directed in this sector there will be more sustainable green jobs created. US workers are feeling the brunt from disruptive technology mainly arising from the shift away from traditional manufacturing and closure of companies burning dirty fossil fuels. Another anomaly is the trimming of mortgage interest payment allowance for existing housing tax benefits. It caps them at $500,000 for new home purchases which means homebuyers in expensive markets will effectively lose out.

In conclusion, one must carefully and dispassionately assess how the US tax reform will impact Europe and other Asian counties. Is this a coverup for more protectionism to buttress the US economy? According to the Financial Times, “there is some concern in Europe that the Trump administration will use tax reform as a route to promote ‘America first’ trade discrimination, escalating tensions that have already risen in other policy areas like the environment and Middle East peace“. It certainly looks that the Trump’s policy is keen to attract capital that has fled the US and once repatriated it hopes this will be a harbinger for jobs growth. The moral of the story is that in a year or two one can witness the effectiveness of the US tax reform especially on GDP growth.

In the meantime, Europe faces a sluggish growth with an ageing work force combined with a low-fertility rate that exacerbates the cost of maintaining the burgeoning welfare state cost. Could this sound the clarion call for a systematic tax reform in Brussels?