The Truth About The Tax Reform For Middle Class America
Let’s talk about the new corporate tax cut coming into effect. The Congressional Republicans have just passed a tax reform that will lower the corporate tax rate from 35% to 21%; the largest corporate tax cut in American history. On a theoretical level the tax cut is intended to drive the economy through job creation, wage increases, and new investments. But not only has history shown that the theory behind this tax reform does not hold up, corporations themselves have stated that this is not how they will spend their newly gifted savings. So why is this bill being passed? Who is it really benefiting? As always, let’s set aside all political opinions about President Trump and get to the bottom of what is really going on. Purely from a finance and economics perspective, here is the 411.
The specifics of the claim: “The Middle Class Miracle”
The Trump Administration claims that by lowering the corporate tax rate from 35% to 21% America will see an economic boom; a boom that will be primarily felt by the middle class. The Administration’s logic is as follows:
corporations will use the tax savings to invest in new local projects, which will increase the demand for local workers. The heightened demand for local workers will drive up the hourly working wage; higher wages means bigger take-home paychecks for the middle class American.
The Administration is reaching for an effect called trickle down economics, a theory which assumes that tax benefits to the wealthiest groups (businesses and high income earners) will trickle down to everyone else. Which is also why President Trump’s income tax cut favors the highest income earners. Supply-side theory of economics do in fact prove that reducing taxes can stimulate an economy (because when people have more money leftover at the end of the year they will spend more, and spending creates economic growth). But the problem with President Trump’s corporate tax plan is that the tax cuts are not sufficiently targeted. Corporations do not have to invest their tax savings into projects that will create jobs, the tax plan just simply assumes that they will. Money always flows down the path of least resistance, so if it is more favorable for companies to put the tax savings into banks or stock buybacks (which is likely the case), then they will.
Who is funding the tax cut?
The Administration is banking on the economic growth created by the trickle down effect to cover the $1.5 trillion deficit (over ten years) created by the tax cuts. But economists have said over and over that growth to this extent is unlikely, especially without sufficiently targeted policies on how businesses should use the tax savings. In the meantime, drastic cuts to critical programs will be made to offset some of the deficit. For instance, slashing Medicare by $25 billion is a priority in the new reform. In the long-run the income tax rates will eventually be increased again to continue to cover the deficit, as the reduction to income taxes was only made temporary, unlike the corporate tax cuts which are permanent.
Who is actually benefiting from the tax cut?
Businesses and the top 1% of income earners. In fact, approximately 80% of the overall benefits will go to these two groups; creating the largest income inequality gap out of all the developed countries.
Was the corporate tax cut even necessary?
Yes. The U.S. corporate tax rate was too high, which can encourage businesses to relocate their head offices to lower tax paying countries. But when evaluating the corporate tax rate the Congressional Republicans needed to look at the effective rate, the rate that businesses actually pay after going through all of the tax loopholes and deductions. The effective corporate tax rate is actually 27% in the United States. Without reforming the tax loopholes and deductions the effective tax rate will end up being lower than the 21% reformed rate. Which will have further implications to the deficit.
Overall, the new tax bill is simply not designed to benefit the middle class in the long-run. Some will argue that the Reagan and Bush Administrations were successful when they slashed corporate tax rates, but those policies were coupled with significant government spending and interest rate cuts (both fuel economic growth). Over the coming years we can watch where businesses start to put their money, and simply remain hopeful that local investments and projects are the most desirable courses of action.