The Case for a Retro Tax Code

The researchers analyzed how the TCJA’s business tax provisions have performed, with an eye to proposing adjustments that would raise the revenue needed to tame run-away deficits and fund priorities such as defense and health programs—but without choking the golden goose that is the world’s largest economy.

They treated the current system like a panel of dials: one for taxes on corporations, another for dividends, a third for estates, and so on. They then analyzed how much revenue could be raised by turning up the tax-rate dial in specific areas and estimated the likely effects on economic activity.

How the landscape has changed

To consider the merits of Zidar and Zwick’s back-to-the future proposal, consider how dramatically legislators have overhauled the federal government’s revenue-generation machine in recent decades. The TCJA revised taxes on foreign income, exempting it from the newly lowered corporate rate of 21 percent and replacing it with a worldwide system under which foreign profits are taxed only when they’re repatriated. However, arguably the most notable feature of the law was a series of business tax cuts that have changed how individuals structure their enterprises and categorize the income they earn through them.

Many Americans are familiar with C corporations, the corporate in “corporate America.” Lesser appreciated are pass-through businesses such as S corporations, partnerships, and sole proprietorships, in which profits and losses pass through to individual owners, who pay according to personal income tax rates.

C corps were the dominant business structure until the Tax Reform Act of 1986 cut individual rates and led taxpayers to shift a significant portion of business activity to minimize taxes. During the succeeding decade, pass-throughs eclipsed C corps as the primary generators of US business income, and partnership structures led the way in the most recent years, the researchers explain. “Much of the charted rise of pass-through income reflects simple recategorization: to take advantage of lower tax rates, business owners have reclassified C-corporation income as pass-through,” write Zidar and Zwick in an essay for the Aspen Institute.

These business owners are, for the most part, among the highest earners in the US workforce, according to research by the Treasury Department’s Matthew Smith, University of California at Berkeley’s Danny Yagan, Zidar, and Zwick—often doctors, lawyers, or owners of middle-market businesses such as car dealerships and drink distributors. Roughly two-thirds of every dollar currently earned by pass-throughs accrues to individuals who are already among the top 1 percent of earners, write Smith, Yagan, Zidar, and Zwick. More than 1 million business owners, each making at least $390,000 annually, reported some pass-through income as of 2014, and more than 140,000 people making at least $1.6 million annually did so. These income thresholds are likely 50–70 percent higher today, estimates Zwick. As for the number of the top earners reporting pass-through income, he and Zidar write that it far surpasses the number of executives at public companies, “who have been the focus of much public commentary about inequality.”

The TCJA tips the scales back in favor of traditional C corps by granting them larger rate cuts than pass-throughs. The law dramatically cut C corporations’ federal tax burden. Listed companies had their effective tax rates cut by 9 percentage points, Zidar and Zwick calculate. C corps saw their headline tax rates slashed from 35 percent to 21 percent. The alternative minimum tax was abolished. Among other provisions, businesses were allowed to immediately expense many equipment investments. In some cases, the tax code grants taxpayers so many deductions that they may pay little or no tax.

But the high earners who control many pass-throughs have also been big beneficiaries of a TCJA provision that cut the top marginal tax rate on personal income from 39.6 percent to 37 percent. Workers lower down the pay spectrum or in certain sectors enjoyed an even larger cut in their top marginal tax rate, from 37 percent to 29.6 percent. Many high earners still regard the pass-through structure as the more attractive option, write the researchers. And whatever business structure these owners favor, the TCJA probably delivered them a tax cut.

Grading Trump-era tax reform

The TCJA’s backers predicted the law would pay for itself, boost domestic investment, and benefit rank-and-file workers. The law’s authors took several steps to prevent it from becoming a budget buster. For example, they reduced deductions for business losses and interest expenses. They trimmed tax credits for companies that incur research and development costs. And they eliminated favorable rates previously available to domestic manufacturers, among others, under the Domestic Production Activities Deduction.

It takes time to establish how those predictions have played out—and the picture has been complicated by other factors that affected the economy in the wake of the TCJA, including the COVID pandemic and the trade war with China. Still, Zidar and Zwick are among the researchers analyzing data to paint a picture of the law’s effects.

Some predictions may have been too rosy, starting with those relating to corporate tax collections. The amount of revenue the government brought in from corporate taxes fell from about 1.8 percent of GDP to as little as 1 percent, find Zidar and Zwick. The 2022 figure of 1.3 percent was still well below pre-TCJA levels, they write.

Investment hasn’t made up for lower collections, according to Harvard’s Gabriel Chodorow-Reich, Smith, Zidar, and Zwick. In 2018, the president’s Council of Economic Advisers forecast that the TCJA would increase domestic investment in equipment and structures by 9 percent, or roughly $300 billion, and several studies indicate that C corps, including publicly listed enterprises, did substantially increase investments. Chodorow-Reich, Smith, Zidar, and Zwick find that C corps with the mean tax change, relative to those whose tax burden didn’t change, increased their domestic investment by 20 percent. But the law led corporate tax collections to fall 41 percent, and investment helped offset that by just 2 percentage points on average over 10 years, according to their calculations.

In the first quarter of 2018, 95 companies in the S&P 500 said on earnings calls that they planned to increase investment because of the TCJA, other research finds. According to an analysis by MIT’s Michelle Hanlon, University of North Carolina’s Jeffrey L. Hoopes, and University of Michigan’s Joel Slemrod, companies that expected to save the most because of the tax cuts were also most likely to announce higher investment and benefits for workers. “The business provisions of the TCJA arguably made investment more attractive by reducing the tax-adjusted cost of capital,” the researchers write.

But they also find that companies whose political action committees had donated more to Republican than Democratic candidates were likelier to announce worker benefits, which they point to as an indication that political factors, not just economic ones, may well have been at work. Companies may have sought to broadcast the news that tax cuts had widespread benefits, perhaps to fend off any potential reversals. “We also find that a corporation is marginally less likely to announce a TCJA-tied worker benefit if it is headquartered in a red state,” write Hanlon, Hoopes, and Slemrod. The benefits to workers were tracked and publicized by the Americans for Tax Reform, a right-leaning advocacy group, the researchers report.

In arguing that the Trump administration’s estimate may have overstated investment gains, Zidar and Zwick point to research—from University of California at Los Angeles’ Patrick Kennedy, the Federal Reserve Board’s Christine Dobridge, and the Joint Committee on Taxation’s Paul Landefeld and Jacob Mortenson—that used tax data to compare how similarly sized C corps and S corps responded to the cuts. C corps saw the bigger cuts, and increased investment more. On the basis of this finding, Zidar and Zwick estimate that midsize C corps invested up to $81 billion more than before. However, the tax cut removed $88 billion in corporate tax revenue from the coffers, which far exceeds the implied tax revenue gains from the higher investment for these firms.

The law may have likewise defied assertions that it would lift all boats. In 2017, administration economists predicted that the tax reform would increase average household income by at least $4,000 annually as companies shared some of the gains with workers, consumers, and shareholders. Less cash to the government would mean more cash to spread around to everyone else. Indeed, the research by Hanlon, Hoopes, and Slemrod indicates that immediately after the law passed, hundreds of companies announced plans to raise wages and salaries, issue bonuses, or hire new workers.

Kennedy, Dobridge, Landefeld, and Mortenson looked at a random sample of federal tax records for both workers and companies and find that while the TCJA did increase average C-corp payrolls (in total dollars) by 1.2 percent, these higher payrolls were largely driven by the top employees. The gains ended up adding 5 percent to the compensation of upper-income employees and executives. Nine out of 10 members of this group were men, with an average age of 53 and annual earnings of over $1 million.

Breaking down the gains in dollar terms, $55 billion went to business owners, $11 billion to executives, and $32 billion to employees in the top 10 percent of their companies’ wage distributions, according to the researchers. The TCJA provided the remaining 90 percent of the labor force with no pay hikes at all, they conclude. “Overall, the results imply that corporate tax cuts improve aggregate efficiency but exacerbate inequality,” they write.

Party like it’s 1997

Even if the predictions made by the TCJA’s backers are wrong, lawmakers aren’t eager to reverse the cuts. Perhaps to make the 10-year cost of the law more palatable, the TCJA’s authors established that a number of provisions, including some relating to individual tax rates, would expire in 2025. But there would be political ramifications to raising taxes on more than half of Americans, including middle- and lower-income ones.

Yet making all the individual provisions permanent for every income group would, according to the Congressional Budget Office, have a price tag of $3.5 trillion over the next decade. So what to do?

Zidar and Zwick recommend that lawmakers take a dispassionate look at each provision and decide which to keep. They also argue that as lawmakers formulate what the tax code will look like beyond next year, they should return to a 1997-style tax regime—or, as the researchers put it in their Aspen paper, “party like it’s 1997.”

In some ways, the current climate is reminiscent of that year, they point out. The late 1990s was another time of divided government: in January 1997, Bill Clinton began his second term as president while House speaker Newt Gingrich (Republican of Georgia) and Senate majority leader Trent Lott (Republican of Mississippi) oversaw Congress.

But the tax rates have markedly changed since then, even as the political battles still wage. The tax code at that time had higher rates on estates, on what top earners paid on dividends and capital gains, and on individual income. Sidestepping the politics of such proposals, the researchers looked instead at what academic literature suggests about each component.

Going back to 1997’s rates for individual incomes would raise $1.8 trillion over a decade, per the Penn Wharton Budget Model, which provides nonpartisan estimates and analysis of US legislation.

Given the many levers the affluent can use to minimize taxes, as well as the interplay between business and individual tax rates, the only way to meet the US’s pressing financial needs may be to hike the top marginal tax rates applied to income from business activity, the researchers argue. Returning to the January 1997 regime would result in high-earning married couples paying 36 cents instead of 24 cents on income above their first $300,000. For those making $500,000, the rate would go up to 39.6 percent from 35 percent. At the opposite end of the income spectrum, the researchers propose relief akin to the Making Work Pay Tax Credit that was part of the American Recovery and Reinvestment Act of 2009.

“There are a host of ways to avoid ordinary income taxes by deferring income into a form classifiable as capital gains, such as carried interest, qualified small-business stock, and incentive stock options,” write Zidar and Zwick. “In our view, these carve-outs generally allow individuals to delay compensation and enjoy a lower tax rate on what is often labor income in its underlying nature. Since much of this activity is labor income, it should not be tax-advantaged relative to that of wage earners.”

Estate taxes are another area where Zidar and Zwick favor 1997 rates. Currently, a rate of 40 percent kicks in on inheritances in excess of $13 million. But in 1997, the estate tax rate was 55 percent on inheritances in excess of a little over $1 million. This, combined with a repeal of the cost-basis “step up” that heirs currently receive—and that relieves them of paying taxes on previous gains—would raise $222 billion over 10 years, according to the Penn Wharton Budget Model.

The PWBM also calculates that changing tax rates on dividends and capital gains back to earlier levels would raise $600 billion over 10 years. Yale’s Natasha Sarin and Harvard’s Lawrence H. Summers, with Zidar and Zwick, have argued that raising capital gains rates to match ordinary-income rates could add another few hundred billion dollars to that tally. (For more, read “Could the US Raise $1 Trillion by Hiking Capital Gains Rates?”)

Zidar and Zwick acknowledge the argument that tax increases could hurt economic growth, but they note that growth was swift in the late 1990s. They also point to research by Yagan, who studied the effects of a 2003 tax cut on dividends by comparing similar enterprises that were structured as C corporations, and thus qualified for the dividend tax cut, with S corporations, which did not. (For example, Home Depot is a C corp while Menards is an S corp.) Yagan’s research finds that the dividend tax cuts had no effect on a company’s investment. So reverting to a 1997-style system of taxing dividends at the top individual tax rate would have limited effects on competitiveness and economic growth, Zidar and Zwick conclude.

As for capital gains, most Americans pay a higher tax rate on their salaries and wages than on capital gains, a policy that benefits people who own business assets, who tend to be relatively wealthy.

According to Yagan and his colleagues Emanuel Saez and Gabriel Zucman at UC Berkeley, 42 percent of unrealized capital gains take the form of private business gains. What’s more, the higher up the wealth spectrum, the bigger the share of personal assets that are held as private business equity. Among centimillionaires (worth at least $100 million), two-thirds of unrealized capital gains are in the form of private business equity.

How much would raising capital gains rates damage economic activity? Tax fights in the 1990s featured dueling research findings on this, recount Princeton PhD student Ole Agersnap and Zidar. “This issue has reemerged in every presidential administration since 1990 and plays a key role in ongoing tax reform plans. For instance, this elasticity is the central parameter governing the revenue scores of President Joe Biden’s plan to increase capital gains rates as well as President Trump’s proposal reducing capital gains taxes,” they write. For their part, Agersnap and Zidar looked at state-level data to estimate how state capital gains tax changes affected where wealthy Americans lived and how they realized their capital gains. They then built a framework to estimate how the patterns would play out nationally and find that the economic response of capital gains realizations to changes in capital gains is likely modest, on the order of between -0.3 and -0.5 over 10 years. (Thus, for every 1 percent rise in the rate, realizations fall by 0.3 to 0.5 percent.) For context, the researchers cite other research estimates that range from -3.8 to -0.22.

Zidar and Zwick are also nostalgic for 1997 when it comes to funding for the Internal Revenue Service. The IRS budget as a share of GDP was almost 0.09 percent in 2002 but closer to half that in 2020—with a corresponding decline in audit rates.

Even deeper in the weeds of tax policy, Zidar and Zwick point to additional changes that could yield big benefits for the Treasury. These include repealing the so-called Gingrich-Edwards loophole, which allows taxpayers to characterize income from consulting and speaking fees as business profits rather than wages. Per the Treasury Department, this would raise $306 billion over 10 years.

Another option: allow the TCJA’s Qualified Business Income Deduction to expire. This deduction has lowered tax rates on many pass-throughs, and scrapping it would raise $373 billion over 10 years without a big effect on investment or growth, the PWBM estimates. Zidar and Zwick offer other recommendations, as well, all of which they say add up to $4.7 trillion.

The politics of taxes

Predictably, not everyone is on board. For one thing, Zidar and Zwick aim to increase tax progressivity. Democrats tend to focus on sharing the economic pie equally by implementing “progressive” policies, while Republicans are more focused on expanding the pie through policies they believe will spark economic activity. One thing both sides agree on is that their policies are the best way to benefit rank-and-file workers and their families.

John Cochrane, a senior fellow at the Hoover Institution, says he’d take an entirely different approach. It would include eliminating corporate taxes altogether, and replacing levies on incomes and estates with a broad-based consumption tax. (Read more in “It’s Time the US Abolished the Income Tax.”)

The US regime is already one of the most progressive in the world, says Hoopes, who is research director of the UNC Tax Center. He notes that while the US was ratcheting down income tax rates for high earners in recent decades, Americans at the other end of the spectrum were benefiting from provisions including the Earned Income Tax Credit and the Child Tax Credit. The result is that about half of all earners pay no federal income taxes at all, although they do pay payroll taxes. What’s more, says Hoopes, no matter how Washington hikes taxes on top earners, it can’t tame its deficit problems without coming up with other revenue sources or spending cuts.

The politics of this discussion are even more complicated than the math. President Barack Obama proposed some of the same corporate tax changes that were ultimately passed under Trump, and while some Democrats supported Obama’s proposals, they disparaged them when advanced by his successor, Hoopes recalls. However, he also says that with divided government, Congress may be forced to forge practical solutions that have enough support to pass and that provide the longevity the private sector needs to operate efficiently.

Tax policy is sure to remain politically contentious. This polarization is epitomized by a pair of opinion columns from this spring. One in the left-leaning New York Times blames low taxes for expanding America’s wealth gap and the ranks of its billionaire class. Another in the conservative Wall Street Journal declares that “The U.S. Already Soaks the Rich,” citing a study that indicates the top 1 percent of earners already pay close to half the nation’s income taxes.

The 2025 deadline written into the TCJA makes another tax fight practically unavoidable, and the outcome will be crucial to the federal government’s solvency. To raise revenue, it isn’t necessary for lawmakers to tear up the tax code and start over, Zidar and Zwick argue. A return to 1997 could be the answer.