The Perils of Tax Reform

Recent legislative drafts show how tax reform could hurt economic growth.

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Recent legislative drafts published by Senate Finance Committee Chairman Max Baucus, D-Mont., are the most recent reminders that any future comprehensive tax reform effort will produce a complex set of winners and losers, perhaps more complicated than some supporters of tax changes realize. The leaders of the Senate Finance Committee – and House Ways and Means Committee Chairman Dave Camp, R-Mich. – deserve credit for pursuing a thoughtful process that solicits comments from stakeholders. However, the recent proposals from the Senate Finance Chair suggest caution must be exercised to prevent economically damaging impacts due to changes to long-standing tax rules.

A good example of potential harm comes from proposed changes to the tax treatment of depreciation. Under present law, the depreciation period for residential rental property is 27.5 years. Under the Finance Committee Chair’s draft, this period would be extended to 43 years, increasing the cost of apartment development during a period when the multifamily sector has been contributing to economic growth. The volume of construction of market-rate and affordable housing is determined by the rate of return of given projects as influenced by factors such as the tax treatment of depreciation. Among other real estate impacts, the draft proposal would also extend the depreciation period for leasehold improvements (alterations made to rental real estate to meet the needs of tenants) from 15 years to 43 years, harming the commercial real estate sector.

While some of these proposals represent timing changes, such as paying taxes earlier, they are nonetheless counted as revenue raisers for government budgeting purposes, as well as representing real financial costs for entrepreneurs. For example, some of the accounting changes in the proposal would require builders to pay taxes on construction projects prior to the sale of the property. These accelerated taxes must be financed alongside other development costs, raising the cost of the project and harming economic growth, while offering no benefit of tax simplicity or fairness. When proposed tax changes are being driven by revenue considerations rather than policy, economically costly changes are more likely to appear.

[See a collection of political cartoons on the budget and deficit.]

And further down the real estate acquisition/development chain, the legislative draft would eliminate the tax rules for like-kind exchanges, reducing the market value of certain kinds of real estate, thereby acting as a windfall loss for existing property owners.

As the 1986 changes to the rules for real estate proved, tax policy overhauls can produce significant price and macroeconomic impacts. After that last major tax reform effort, multifamily and commercial real estate experienced a recession due to large policy changes enacted with insufficient transition rules. While the proposal issued last week contains transition rules, the fact remains that these changes would apply to existing developments in addition to new construction, thereby modifying the cash flow of properties that were underwritten with present law.

These retroactive proposals can threaten the viability of existing properties, with impacts for real estate owners and tenants. Particularly vulnerable to tax changes are affordable housing developments, which typically operate under thin margins. This is shame considering that successful programs like the Low-Income Housing Tax Credit were due bipartisan efforts undertaken in the last round of tax reform.

These proposed changes also undermine the macroeconomic logic of tax reform, which is to promote growth. While most economists would agree that marginal rate reductions spur economic expansion (although there is considerable debate regarding how much), policies that deter investment, like increases in the depreciation period for business property, pull in the opposite direction, increasing the cost of investment and harming economic growth and job creation. For this reason, expensing is an often cited policy to promote growth. Lengthening depreciation periods represents a retreat in this regard.

[See a collection of political cartoons on the economy.]

The political future of tax reform is currently in doubt despite the hard work of those involved in crafting proposals, in part due to partisan differences on whether tax reform should be revenue neutral. However, one thing both political parties apparently agree on is that comprehensive tax reform does not mean an aggregate tax cut for the overall economy. While marginal rates can be expected to decline under a future reform effort, an individual’s final tax bill could go up due to losses of deductions and credits.

This is a requirement of the broaden-the-base, lower-the-rates tax reform approach, particularly when constrained with a revenue target that would either aim for higher revenues or revenue neutrality. Whether a family or small business, facing a lower rate on higher tax base, pays more, less or the same amount of taxes depends on all sorts of factors, including age, homeownership, health insurance status, number of children and location.

But tax reform that is not on net a tax cut must, by definition,  produce a significant number of people paying higher taxes to offset those who may experience a drop in tax liability. And many of these reform proposals, like changes to depreciation, would pump the brakes on sectors like housing and energy that have been the engines of recent economic growth. Slowing the expansion of those sectors that are actually increasing GDP would be a critical economic policy mistake.

Robert D. Dietz is an economist with the National Association of Home Builders. Previously an economist with the Congressional Joint Committee on Taxation, Robert writes on housing and policy issues at NAHB'sEye on Housing blog and @dietz_econ on Twitter.

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