Personal Finance

The Fatal Flaw in the GOP Tax Plan Has Nothing to Do With the Middle Class

A person holding a binder labeled tax reform.

Following nearly 10 months in the Oval Office, President Trump and the Republican Congress appear to be on the verge of moving forward with one of the biggest overhauls to the U.S. individual and corporate tax code that we've witnessed in a long time. This past Thursday, the House voted 227 to 205 to advance the Tax Cuts and Jobs Act that was unveiled just weeks ago. Not surprisingly, all Democrats opposed the bill, along with 13 dissenting Republicans. Now that the bill's passed, it'll move to the Senate for debate and changes.

The Senate has also been crafting a bill of its own, though it's unclear if it has the support from the 52 GOP Senators to pass. Republicans can only afford to lose two votes in the Senate and still have tax reform pass, since Vice President Mike Pence's vote can break a 50-50 tie.

A person holding a binder labeled tax reform.

Image source: Getty Images.

Despite their differences, the House and Senate tax plans share a similar goal

When compared, the House and Senate bills do bear differences. For instance, the Senate bill includes a provision that would eliminate the individual mandate tied to Obamacare (officially the Affordable Care Act). Doing so would save an estimated $338 billion over the next decade, per the Congressional Budget Office.

However, both GOP tax plans have a very similar mission: cut taxes on the middle-class and corporations. They'd both simplify the individual tax code by reducing the number of tax brackets and eliminating a slew of credits and deductions in the process. They'd make up for it by nearly doubling the standard deduction and noticeably lifting the Child Tax Credit.

On the corporate side of the equation, peak marginal income-tax rates would fall from 35%, one of the highest in the world, to 20%. Republicans believe that putting more money into the hands of corporations will lead to more hiring and higher wages, and that an increase in disposable income as a result of lower effective tax rates and higher wages will encourage consumers to spend more on a sustainable basis. That's how, according to the GOP, 3% gross domestic product (GDP) growth is attainable and sustainable.

A middle-class father sitting on the couch next to his two kids.

Image source: Getty Images.

Concerns persist regarding its potential impact on the middle class

Yet, the Republican tax plan has faced a sea of criticism. In particular, there have been concerns raised over what it might do to the middle class.

For example, the elimination of the personal exemption , the removal of student loan and tuition and fee deductibility, and the elimination of state and local tax deductions (with the exception of up to $10,000 in local property taxes), could wind up taking a big bite out of the middle class. While the boost in standard deduction may offset some of these lost deductions and credits, not all middle-class individuals and families are expected to come out ahead. Those in states like California and New York, where sales and property tax bills are well above the national average, could be hit particularly hard.

An analysis of the Tax Cuts and Jobs Act by the Joint Committee on Taxation and Senate Budget Committee seemed to confer that the wealthy and upper-middle-class are the real beneficiaries. By 2027, more than one out of five folks making $40,000 to $50,000 a year would actually see their taxes increase under the GOP plan. Meanwhile, two-thirds of those making $1 million or more would see notable declines in what they owe by 2027. This is why some pundits have argued that the GOP tax reforms are doomed to fail.

A man in a suit holding cash behind his back and crossing his fingers.

Image source: Getty Images.

The greatest flaw of the GOP tax plan

However, I believe there could be a considerably bigger fatal flaw in the GOP tax plan than the disproportionate number of breaks it appears to give to the wealthy relative to the middle class. The bigger issue is found on the corporate side of the equation.

As noted, Republicans believe that cutting peak marginal income-tax rates for corporations to 20% will level the playing field with the rest of the world. The current peak rate of 35% potentially keeps a number of foreign companies and investors out, and it presumably slows the expansion potential for businesses with regard to hiring new workers and boosting the wages of existing talent.

But herein lies the rub: the Republican tax plan assumes businesses will use their extra income to hire, expand, and boost wages. Corporations are under no obligation to do so and could choose other avenues to deploy their extra capital.

For example, publicly traded companies might choose to buy back shares of their stock in order to reduce their outstanding share counts and increase their earnings per share in order to make their stocks look more attractive to investors. Likewise, they could choose to up their dividend payout to shareholders. Other ideas include investing this extra cash in short-term equities with Treasury yields rising, or perhaps paying down debt that was built up when lending rates were at historic lows. Nothing guarantees that corporations are going to use this extra capital to hire more workers and boost the wages of existing employees.

A manufacturing worker standing with his arms crossed in front of heavy-duty machinery.

Image source: Getty Images.

If there's a possible consolation here, it's that the U.S. unemployment rate is at 4.1% as of Oct. 2017. That's the lowest rate of unemployment since the 3.9% unemployment rate in Dec. 2000. Given that the natural rate of unemployment tends to bottom out around 4%, the inference is that we're likely to begin seeing upward pressure on workers' wages at some point. In other words, the ball is in the court of workers, not corporations, which could indeed lead to some upward movement in wages. But keep in mind this is what economics and history suggests should happen. What actually happens is yet to be determined.

Long story short, if corporations don't stick to the Trump game plan, the GOP tax bill may wind up falling way short of its lofty growth expectations.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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