Don’t let a potential trade violation block tax reform
The House Ways and Means Committee is set to do its part this week in marking up the Tax Cut and Jobs Act, the long overdue overhaul of the broken tax code. It’s now 31 years since Congress last passed tax reform and the code is a complicated mess: full of distortions, facing a narrowing tax base, and plagued by higher than necessary marginal rates.
It’s apparent the code is a drag on economic growth and reform is needed badly. But as lawmakers put the final touches on the legislation, they should be cautious about one provision in particular that may violate international trade rules.
On the “dessert” side of the Republican plan, the bill makes a number of positive changes that would spur economic growth and lead to higher wages. The plan cuts the corporate tax rate to 20 percent from the current 35 percent. While still a little high—Ireland’s top marginal rate on corporate income is 12.5 percent—the move is a step in the right direction. Likewise, the plan embraces full business expensing for five years. This should be made permanent and, if enacted, Congress would face pressure at least to extend the provision when it expires in 2023.
Unlike previous tax cuts, the House Republican plan doesn’t take the easy way out and does eat its share of veggies. On the “pay for” side of the equation, the bill makes two positive changes to expand the tax base.
It caps the mortgage interest deduction at $500,000 in debt for new purchases, and the deduction would only apply to primary residences. Under the status quo, interest can be deducted on up to $1 million of a mortgage, including for a second home. While the realtors’ lobby will be howling about attempts to curtail the preferential tax treatment, the mortgage interest deduction primarily benefits upper-middle-class families living in expensive areas and encourages building “McMansions,” according to a 2014 R Street Institute study.
Another wise but politically-sensitive “pay for” is to cap the state and local tax deduction at $10,000 a year. For years, this deduction has forced low-tax states effectively to subsidize high-tax states. Totally eliminating the state and local tax deduction would have been preferable but, bowing to pressure from Republican members representing high-tax states, it was capped.
However, not all is well with the plan. One troubling aspect is its treatment of payments made by U.S. corporations to affiliates abroad in order to expand the tax base. It would essentially provide a general excise tax on all transactions with foreign affiliates. This tax could potentially have dire consequences for global supply chains that have developed in recent decades, as global economic integration has expanded.
For instance, in the case of international reinsurance, which spreads risk globally to facilitate lower insurance rates, the policy would be devastating. According to a study by the Brattle Group, an affiliate tax of this sort would decrease the supply of reinsurance available in the U.S. by 13 percent. The excise tax provision would thus exacerbate an existing supply/demand imbalance, leading to price increases. The timing of such a move could not be worse for the victims of Hurricanes Harvey, Irma and Maria, since international reinsurance is currently responsible for providing the bulk of the capital being used to rebuild those communities. Moreover, they will be no less susceptible to severe weather in future hurricane seasons.
In addition to being bad policy, the excise tax also could violate international trade rules. The World Trade Organization’s General Agreement on Trade in Services (GATS) spells out how member nations must treat trade in services. Specifically, the agreement requires that each member “accord immediately and unconditionally to services and service suppliers of any other [m]ember treatment no less favourable than it accords to like services and service suppliers of any other country.”
While there are exceptions to this general principle, including nondiscriminatory fiscal measures, there is a good chance that certain financial transactions, like those concerning risk transfer, would be treated differently at home than they would be abroad. As a result, there is at least a prima facie case to be made that the tax plan, as proposed, is in violation of international law.
For the moment, this early proposal looks like a mixed bag of the best intentions, lots of good ideas and a few stinkers. It would be a major wasted opportunity if the odd bad idea, like the affiliate tariff, derailed the entire project.
Image by Christopher Halloran