Rex Nutting: Trump’s tax plan would create a nation of cheaters

Republicans claim that American businesses will prosper under their tax-cut proposal. That’s debatable, but there is one sort of business that should do very well indeed: the lawyers, accountants and consultants of the tax-shelter industry.

The Republican tax plan would unleash a flood of tax-avoidance schemes — some legal, many not — that could transform the business world. And not in a good way.

As Ronald Reagan said in 1986, the last time we had a major tax reform: We want our businesses focused on creating new products and improving their services, not on unproductive tax-avoidance schemes, which would flourish under the Trump-Ryan plan.

A proposal to lower the tax rate for businesses that are organized as sole proprietorships, partnerships and S corporations would allow the wealthiest among us to avoid paying hundreds of billions of dollars in taxes without making the economy any stronger.

Creating tax-saving incentives

Any time you have two taxpayers with the same level of income paying a different tax rate, you’ve created a huge incentive for the one paying the higher rate to rearrange their affairs so they can pay the lower one. Different levels of taxes on capital and labor income — or different forms of capital income taxed at different rates because they have different legal structures — invite lots of legal and accounting games that don’t create any economic value.

That’s what the Trump-Ryan plan offers.

The Republicans are marketing their plan as simplification, but it wouldn’t be simpler for all taxpayers — just the ones who don’t pay very much.

Also read: This tax cut isn’t for the middle class, which pays little now

Most Americans dread doing their taxes. Who wants to hire an accountant, or spend money on tax software, just to make sure you don’t make a costly mistake? All the loopholes and exemptions in the code won’t save you very much money if you’re in the 10% tax bracket. Why spend hundreds of dollars to save a few bucks?

That’s why the proposal to increase the standard deduction while eliminating some itemized deductions and exemptions is so appealing: It could save a lot of people a lot of time — and a little bit of money.

But if you’re paying the 28% or 35% or 39.6% marginal tax rate, you’ll fight for every loophole, every complexity in the tax code that could give you a tax break.

Gaming the system

If you make enough money, it’s worth it to game the system to shrink your taxable income into a lower bracket. Or to load up on deductions and exemptions to lower your tax bill. If you are rich enough, you want the tax code to be very complex, so that there’s a loophole for every situation.

That’s why the proposal to lower the tax rate for pass-through businesses would be so costly. By lowering the top tax rate for some business owners to 25%, the Republican plan would give millions of highly paid workers an incentive save thousands or even millions of dollars on their taxes by converting some of their salary into profits.

Essentially, people who now work for a company for a salary would form a small business that would contract with the company to provide those same services. Everything about the job would remain the same, except for a legal and accounting fiction created to fool the IRS.

As far as the IRS was concerned, those folks would work for themselves, instead of for their company. Instead of getting a salary, these people would receive “profits” from their own company. Instead of being taxed at 28% or 39.6%, those “profits” would be taxed at a maximum of 25% on their individual income tax return.

Soft guardrails

The Trump-Ryan draft proposal promised that the final law would include strong “guardrails” to make sure that at least some of the income in a pass-through business would be taxed as earned income, subject to higher rates and to the payroll tax. But we don’t know the details. Current law requires these business owners to pay themselves a “reasonable salary.” One possibility is requiring a certain percentage or amount of income to be treated as salary.

Assuming the guardrails would be somewhat effective, the nonpartisan Tax Policy Center (TPC) estimated that this pass-through provision would save the people who own these businesses about $770 billion over the next 10 years, and nearly $1.5 trillion between 2028 and 2037.

About 20% of the tax savings — $129 billion in the first 10 years and $299 billion in the second 10 years — would come from people gaming the system by forming one of these sham companies.

Don’t laugh. When Kansas reduced its state income tax rate on pass-through income to zero, a lot of workers were able to form businesses to receive their income. Eric Toder, co-director of the TPC, said the Trump-Ryan plan “would be Kansas on steroids.”

About 86% of pass-through business owners wouldn’t benefit from shifting their earned income to business income, because they already pay at a rate of 25% or less. Almost all of the tax savings would accrue to the top 1% of taxpayers by income; 80% of the benefit would go to people with annual incomes over $1 million. The 400 taxpayers with the highest income would save an average of $300 million a year from this tax break alone.

Aggressive accounting

But wait — it’s even worse than that.

These estimates don’t account for the possibility that these newly minted pass-through businesses would engage in the same kind of aggressive accounting (often crossing far over the line of legality) that other pass-through businesses already engage in to reduce their taxes.

According to the latest IRS estimates of the tax gap, sole proprietors pay less than half of the taxes they owe to the IRS. Whether due to the complexity of the tax laws or more nefarious reasons, they only report about 37% of their true income, they deduct every possible expense, they underpay their employment taxes.

Also read: Who’s better at dodging taxes — Wall Street or Main Street?

For a worker making $250,000 in salary, the temptation would be great to write off much of their spending as “business expenses.” The car payment, the mortgage, the phone bill, the vacation, the nanny. It’s even possible to write off all of your medical expenses if you do it right. If you are creative enough, you could get that $250,000 in salary to half of that.

The average pass-through business writes off 60% or more of its gross receipts as business expenses, according to the IRS. And the best part is that there is almost no risk of being audited, especially now that the Republicans have gutted the IRS’s budget.

Another proposal in the plan would encourage multinational corporations to shelter even more of their income in off-shore tax havens, which means the Trump-Ryan tax plan would nearly gut the U.S. government’s ability to collect taxes. If this passes, in the immortal words of Trump’s chief economic adviser, Gary Cohn, only morons would pay taxes.