Thursday, March 28, 2019
David Kamin (NYU) presents The Tax Rate Ratchet (with Ari Glogower (Ohio State)) at Duke today as part of its Tax Policy Workshop Series hosted by Lawrence Zelenak:
The 2017 tax legislation introduced significant preferences for business income and ushered in a new conversation on tax reform. The legislation cut the corporate rate and introduced the new Section 199A deduction for “pass-through” income. Many commentators criticized the design of the pass-through deduction and the legislation’s generally regressive effects but tacitly accepted or applauded the corporate rate cut as desirable response to international pressures. Then in early 2019, recently elected Representative Alexandria Ocasio-Cortez initiated a separate debate on progressive tax reform, by proposing a 70% top individual rate on taxpayers with the highest incomes. Leading progressive thinkers defended the proposal, arguing that a higher rate in this range would maximize revenues from those at the top of the income distribution and address economic inequality.
This Article bridges these conversations on the 2017 legislation’s new preferences for business income and the future of progressive tax reform,and introduces a theoretical framework for understanding their interaction.
The “tax rate ratchet” describes a path dependence in the structure of the tax system, whereby a new preference for certain portions of the tax base can generate downward rate pressure on other portions of the tax base. This Article first describes conceptually the circumstances under which a new tax preference can either mitigate or compound the ratchet resulting from an initial preference, depending on the legal rules defining the new preference.
This framework suggests an alternative understanding of the 2017 tax legislation and explains how both the corporate rate reduction and the Section 199A pass-through deduction were poorly targeted responses to the initial problem of international profit shifting, which are likely to compound the ratchet’s effect and obstruct rate increases on other portions of the tax base. This framework also suggests the deeper distributional consequences from the 2017 legislation beyond its immediate benefits to the highest income taxpayers. Efficiently raising more revenue from the highest earners through future tax reforms will first require “breaking the ratchet.” The Article concludes by evaluating different options to break the ratchet and explains why a reversion to the rate dynamic under prior law—with a relative corporate penalty—is likely the most effective way to facilitate future progressive reforms absent more fundamental changes to the rules governing business entities.