IMF Report Describes Flaws in 2017 Tax Law

The International Monetary Fund’s (IMF) recent report on America’s economy echoes many of our criticisms of December’s tax law: it’s tilted to the top rather than the bottom, loses much-needed revenue, and creates a host of opportunities to game the tax code. To address the IMF’s criticisms — in particular, to better meet “the pressing needs of the working poor” without losing even more revenue — policymakers would have to fundamentally restructure the law.

The IMF warns that the tax law:

Loses much-needed revenue. It adds $1.9 trillion  to deficits over ten years, including $194 billion in 2018. That’s fiscally unwise in both the short and long term, the IMF explains:

• The short-term revenue loss contributes to a “pro-cyclical” fiscal policy — that is, one that aggravates fluctuations in the business cycle, which is exactly the opposite of what good fiscal policy would do.  In this case, the tax law is adding stimulus (in the form of larger deficits) to an economy that already has been expanding for nine years and built up considerable momentum. Additional demand stimulus at this point risks inflation that makes the Federal Reserve’s role of moderating business-cycle fluctuations harder.  The report notes that U.S. fiscal policy is now more pro-cyclical than at any point since Lyndon Johnson was President.
• The law’s cost also adds to the nation’s long-run fiscal challenge that our debt is growing as a share of gross domestic product (GDP), which is unsustainable over time. For this and other reasons, the IMF calls for raising federal revenues as a share of GDP.

The revenue losses are especially significant given the “broad agreement that increasing federal spending on infrastructure is urgently needed,” the IMF notes.  “[T] he planned expansion in the federal deficit will leave few budget resources available to invest in a range of urgently needed supply-side reforms.”

Creates opportunities to game the tax code. The IMF notes some of the loopholes and gaming opportunities that the law provides. In particular, it criticizes the new deduction for pass-through income — income that owners of businesses such as partnerships, S corporations, and sole proprietorships report on their individual tax returns rather than pay the corporate tax — as “an important mechanism for high income individuals to reduce their tax obligations by recharacterizing personal income as pass-through income. This is counter to authorities’ objectives of increasing equity … and simplifying the system.”

The report also criticizes the law’s safeguards to prevent multinational corporations from shifting profits and investment overseas to take advantage of the new tax exemption for much of their foreign income. The IMF argues — as have we and leading tax experts — that these safeguards could actually “encourage location of tangible investments abroad.”

Tilts to the top. The law’s personal income tax changes provide “greater benefits to those in the upper deciles of the income distribution,” the IMF notes, and “are likely to exacerbate income polarization and will do little to address the pressing needs of the working poor.” The report recommends that policymakers “recalibrate the [tax] rate structure in order to concentrate tax relief to those earning close to or below the median income.” As noted above, to adopt this recommendation without making the revenue losses even worse, policymakers would have to fundamentally restructure the law.

The IMF also suggests that “the coverage and generosity of the Earned Income Tax Credit [EITC] could be increased.” This call to boost the EITC isn’t new: as we’ve written, in recent years the IMF and Organisation for Economic Co-operation and Development (OECD)  have urged the nation to increase its EITC, especially for childless workers. Unfortunately, the tax law weakens the EITC over time by changing the way it and other tax provisions are adjusted for inflation over time.

To be sure, the IMF also has some positive things to say about the 2017 tax law, such as its elimination of many itemized deductions. Nevertheless, addressing its criticisms will require much more than minor tinkering.