Extend Trump’s 2017 tax cuts to promote growth, but cut spending too

America approaches a critical juncture. Many provisions of the Tax Cuts and Jobs Act of 2017 are set to expire this year. Congress could let them lapse, but that would mean a large, economically damaging tax hike for most Americans. Lawmakers could make all the cuts permanent, but without revenue offsets that would deepen the nation’s disastrous debt load.

There is a more targeted and responsible way to deal with this fiscal dilemma.

It’s a common, politically fueled mistake to talk about cutting taxes without also talking about our fiscal situation. We’re $37 trillion in debt — going on $59 trillion in a decade — and after years of alarming growth, the annual spending deficit is roughly $2 trillion. We also must grapple with the looming entitlement crisis, and interest payments on government debt are the fastest-growing budget item. Times are changing, making fiscal responsibility more crucial than ever.

While the upfront cost of the tax cuts back in 2017 was $1.5 trillion, on paper, to make them permanent could cost $4.6 trillion. The actual cost should be cheaper, as projections underestimate a likely increase in taxable income, investment and growth. But we shouldn’t deny that there is a significant cost.

There are also plenty of lessons to be learned from the 2017 reform. The first is that not all tax cuts are equally pro-growth. As such, we should make permanent only the most pro-growth provisions and allow others to expire or be extended on a short-term basis.

To the extent that the 2017 cuts spurred growth and higher revenue, that was mostly the product of the permanent reduction of the corporate tax rate from 35% to 21%. This provided businesses with long-term certainty, encouraging investment, capital formation and wage growth. Unlike temporary tax cuts, which lead to short-term boosts but create uncertainty, a permanent lower rate lets firms plan, expand operations and increase productivity.

Paired with the soon-to-expire provision that allows firms to fully expense their investments, the permanent corporate cuts attracted more domestic and foreign investment, leading to higher economic output and job creation over time.

A new Hoover Institution study reveals that businesses are more responsive to corporate tax changes than previously thought. Analyzing the 2017 cuts, Kevin Hassett (the National Economic Council’s new director), Jon Hartley and Josh Rauh found that a one-percentage-point reduction in the cost of capital can boost investment rates by up to 2.4%, surpassing earlier estimates.

Congress should hence prioritize making full expensing of capital investment permanent. It could also extend it to investments in structures.

Similarly, the cuts to individuals’ tax rates should be made permanent. This provision encourages work, savings and investments, especially for high earners, fostering a more dynamic and resilient economy. Recent research by Rauh and Ryan Shyu on California tax increases shows how much more sensitive high-income filers are to rate changes than most research generally assumes. The economists looked at taxpayers’ responses after Proposition 30 increased marginal tax rates by up to three percentage points for high-income households. An extra 0.8% of these taxpayers left the state as a result, and those who stayed reduced taxable income, eroding up to 61% of expected revenue within two years. This sensitivity to high tax rates and our progressive federal tax code mean that letting individual tax cuts expire will have a bigger impact than projected, and extending them will have a smaller deficit impact than most fear.

While the economics are straightforward, congressional rules are not. Budget reconciliation is a special process allowing Congress to pass tax, spending and debt-related bills with a simple Senate majority, bypassing the filibuster. But it’s limited to budgetary matters by the Byrd Rule and cannot increase the deficit beyond a 10-year window without offsets.

That leads us to the second lesson: Legislators should make permanent the 2017 measure’s revenue-raising provisions and cut some spending as well.

Extending the limits put on the state and local tax (SALT) deduction and mortgage interest deduction, and the removal of the personal exemption (a $4,050-per-household-member exclusion from taxable income) would generate significant revenue — more than covering the cost of the most growth-oriented tax cuts. Congress also needs to remove other tax breaks such as the corporate SALT deduction, energy subsidies and incentives for stadiums, just to name a few, and cut other spending to make it work.

Finally, all the other, costlier and less pro-growth (though popular) provisions should be extended on a temporary basis. These include the Child Tax Credit expansion, the larger standard deduction and alternative minimum tax reductions, which could be set to expire in a few years instead of being made permanent. That would help manage deficits while giving time for Congress to debate each one.

A similar approach could apply to Trump’s proposed new tax breaks on tips, overtime pay and Social Security benefits, which aren’t pro-growth and could cost $5 trillion over a decade.

A one-vote Republican House majority makes the process of extending the tax cuts even through reconciliation challenging. Setting strict priorities and guidelines should help get the job done. However, the key to success will be supporting growth of the economy without ballooning the deficit and the debt.

Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.