Tag: Tax Reform

Fiscal Fights with Friends, Part I: Responding to Reihan Salam’s Argument against the Flat Tax

In my ultimate fantasy world, Washington wouldn’t need any sort of broad-based tax because we succeeded in shrinking the federal government back to the very limited size and scope envisioned by our Founding Fathers.

In my more realistic fantasy world, we might not be able to restore constitutional limits on Washington, but at least we could reform the tax code so that revenues were generated in a less destructive fashion.

That’s why I’m a big advocate of a simple and fair flat tax, which has several desirable features.

  • The rate is as low as possible, to minimize penalties on productive behavior.
  • There’s no double taxation, so no more bias against saving and investment.
  • And there are no distorting loopholes that bribe people into inefficient choices.

But not everyone is on board, The class-warfare crowd will never like a flat tax. And Washington insiders hate tax reform because it undermines their power.

But there are also sensible people who are hesitant to back fundamental reform.

Consider what Reihan Salam just wrote for National Review. He starts with a reasonably fair description of the proposal.

The original flat tax, championed by the economists Robert Hall and Alvin Rabushka, which formed the basis of Steve Forbes’s flat-tax proposal in 1996, is a single-rate tax on consumption, with a substantial exemption to make the tax progressive at the low end of the household-income distribution.

Though if I want to nit-pick, I could point out that the flat tax has effective progressivity across all incomes because the family-based exemption is available to everyone. As such, a poor household pays nothing. A middle-income household might have an effective tax rate of 12 percent. And the tax rate for Bill Gates would be asymptotically approaching 17 percent (or whatever the statutory rate is).

My far greater concerns arise when Reihan delves into economic analysis.

Grading the Rubio-Lee Tax Reform Plan

In my 2012 primer on fundamental tax reform, I explained that the three biggest warts in the current system:

  1. High tax rates that penalize productive behavior.
  2. Pervasive double taxation that discourages saving and investment.
  3. Corrupt loopholes and cronyism that bribe people to make less productive choices.

These problems all need to be addressed, but I also acknowledged additional concerns with the internal revenue code, such as worldwide taxation and erosion of constitutional freedoms an civil liberties.

In a perfect world, we would shrink government to such a small size that there was no need for any sort of broad-based tax (remember, the United States prospered greatly for most of our history when there was no income tax).

In a good world, we could at least replace the corrupt internal revenue code with a simple and fair flat tax.

In today’s Washington, the best we can hope for is incremental reform.

But some incremental reforms can be very positive, and that’s the best way of describing the “Economic Growth and Family Fairness Tax Reform Plan” unveiled today by Senator Marco Rubio of Florida and Senator Mike Lee of Utah.

Tax Reform Error #2: Phasing-in Lower Tax Rates

Since 1981, Republican legislators have shown a strong penchant for phasing-in tax rate reductions over several years.  That tradition is maintained in Ways and Means Committee Chair Dave Camp’s proposed 979-page “simplification” of the U.S. tax system.  The Camp draft retains a very high top tax rate of 38.8 percent on businesses that file under the individual income tax as partnerships, proprietorships, LLCs or Subchapter S corporations. For those choosing to file as C-corporations, by contrast, the Camp proposal would gradually reduce the corporate tax rate by two percentage points a year over five years, eventually reducing it from 35 to 25 percent. 

The trouble with phasing-in lower tax rates is that it creates an incentive to postpone efforts and investments until later, when tax rates will be lower.  Reducing the corporate tax rate by two percentage points a year would create an incentive to repeatedly delay reported profits, year after year, holding back the economy and tax receipts.  Sensible tax planners would write-off expenses soon as possible, including interest expenses, but defer investment until future years when the tax rate would be reduced on any resulting added earnings.  

Meanwhile, the widening gap between corporate and noncorporate tax rates (a difference of 13.8 percentage points after five years) would encourage many small businesses, farms and professionals to set up C-corporations to shelter retained earnings.  Owners of closely-held private corporations can defer double taxation indefinitely by not paying dividends and taking most compensation in the form of tax-free corporate perks. Many enterprises contemplating the new incentive to shift income from individual to corporate tax forms after five years would postpone expansion plans until after they made that switch, further depressing the economy and tax receipts.

The Republican Party’s proclivity for phased-in tax cuts may have originated with former Federal Reserve Chairman Alan Greenspan.  In his January 25, 2001 testimony before the Senate Budget committee, Chairman Greenspan said, “In recognition of the uncertainties in the economic and budget outlook, it is important that any long-term tax plan … be phased in.”  That was the same advice he gave in January 1981 when Greenspan and I served on President Reagan’s transition team.  Unfortunately, his advice to phase-in lower tax rates was followed both times, with disastrous results.

During the deep recession from July 1981 to November 1982, Congress opted to postpone most tax relief until the 1983-84 tax years.  Individual tax rates were ostensibly reduced by 5 percent in October 1981, but with only three months left in the year that meant just 1.25 percent.   Rates were again reduced by 10 percent in July of 1982, but that applied to only half of that year’s income.  Meanwhile, bracket creep from high inflation kept pushing people into higher tax brackets (until indexing took effect in 1985), negating much of the intended effect.  The final 10 percent reduction in July 1983 was not fully effective until calendar year 1984. 

Oddly enough, the painful blunder of phasing-in the Reagan tax cuts after a recession was repeated by the Bush administration in March 2001, three months after the economy slipped into recession.  Aside from the fiscal frivolity of adding a 10 percent tax bracket on the first $12,000 of income (cutting taxes $300-600 at all incomes), reductions in the four highest tax rates were originally scheduled to be very gradually phased-in by 2006.  Congress later came to its senses in May 2003 and reduced marginal tax rates. Yet substantial damage was already done.   University of Michigan economists Christopher House and Matthew Shapiro found, “The phased-in nature [of lower tax rates] contributed to the slow recovery from the 2001 recession, while the elimination of the phase-in helped explain the increase in economic activity in 2003.” The harmful impact of the phase-in was confirmed by Cornell University economist Karel Mertens and Morton Ravin of University College London. 

Mertens and Ravin also found that lower corporate tax rates do not reduce U.S. tax revenues, partly because lower tax rates increase domestic investment while reducing tax incentives to take on excess debt.  The Camp plan to phase-in a 25 percent corporate tax rate over many years would be as unnecessary as it would be counterproductive.  Most other countries reduced their corporate tax rates to 25 percent or less long ago – creating marginal effective rates on new investment that are commonly less than half the U.S. level – with clearly beneficial effects on their economies and tax receipts.  

The important, unlearned lesson of 1981 and 2001 is that phased-in reductions in marginal tax rates can make things worse before they make things better.

An uncompetitive U.S. corporate tax rate fosters excessive tax-deductible debt and gives a big cost advantage to foreign enterprises.  There is nothing to be gained, and much to be lost, by improving the U.S. tax climate slowly rather than quickly.

Tax Reform Error #1: Confusing Tax Expenditures with Revenues

House Ways and Means Chairman Dave Camp has released a complex 182-page “discussion draft” called The Tax Reform Act of 2014. Rather get bogged down in details, I will take this opportunity to review several fundamental errors that repeatedly plagued most past and present efforts to reform the federal income tax, including the Camp proposal.

One of the most pernicious errors among would-be tax reformers is to assume that, as the Tax Policy Center asserts, “tax expenditures are revenue losses” attributable to various “loopholes.” On the contrary, the Joint Committee on Taxation (JCT) clearly states that the estimated dollar value of any “tax expenditure … is not the same as a revenue estimate for the repeal of the tax expenditure provision.” As the JCT explains, “unlike revenue estimates, tax expenditure calculations do not incorporate the effects of the behavioral changes that are anticipated to occur in response to the repeal of a tax expenditure provision…. Taxpayer behavior is assumed to remain unchanged for tax expenditure estimate purposes … to simplify the calculation.”

One glaring difference between revenue estimates and tax expenditure estimates involves taxation of capital gains if those gains are realized by selling assets from a taxable account (unlike IRAs or most home sales). Estimated tax expenditures from not taxing realized capital gains at the top income tax rate of 43.4 percent is listed as a big revenue-losing tax expenditure, even though Treasury, the JCT and the Congressional Budget Office (CBO) revenue estimates would rightly predict that the behavioral response to such a high tax would crush asset sales and thus lose revenue. 

Mainly because the artificially estimated “tax expenditure” from a lower capital gains tax is wrongly equated with estimated revenues, the Simpson-Bowles plan hopes to raise an extra $585 billion over ten years. In reality, investors realize fewer gains when the tax rate goes up, so the higher tax on fewer transactions means revenues fall rather than rise.

Obama’s New Budget: Burden of Government Spending Rises More than Twice as Fast as Inflation

The President’s new budget has been unveiled.

There are lots of provisions that deserve detailed attention, but I always look first at the overall trends. Most specifically, I want to see what’s happening with the burden of government spending.

And you probably won’t be surprised to see that Obama isn’t imposing any fiscal restraint. He wants spending to increase more than twice as fast as needed to keep pace with inflation.

Obama 2015 Budget Growth

What makes these numbers so disappointing is that we learned last month that even a modest bit of spending discipline is all that’s needed to balance the budget.

By the way, you probably won’t be surprised to learn that the President also wants a $651 billion net tax hike.

That’s in addition to the big fiscal cliff tax hike from early last and the (thankfully small) tax increase in the Ryan-Murray budget that was approved late last year.

P.S. Since we’re talking about government spending, I may as well add some more bad news.

Grading the Camp Tax Reform Plan

To make fun of big efforts that produce small results, the Roman poet Horace wrote, “The mountains will be in labor, and a ridiculous mouse will be brought forth.”

That line sums up my view of the new tax reform plan introduced by Rep. Dave Camp (R-Mich.), chairman of the House Ways and Means Committee.

To his credit, Chairman Camp put in a lot of work. But I can’t help but wonder why he went through the time and trouble. To understand why I’m so underwhelmed, let’s first go back in time.

Back in 1995, tax reform was a hot issue. The House Majority Leader, Dick Armey, had proposed a flat tax. Congressman Billy Tauzin was pushing a version of a national sales tax. And there were several additional proposals jockeying for attention.

To make sense of the clutter, I wrote a paper for the Heritage Foundation that demonstrated how to grade the various proposals that had been proposed.

Bank Tax Is Wrong “Fix” for Too-Big-To-Fail

Chair of the House Ways and Means Committee Dave Camp is soon to roll out a plan for comprehensive tax reform. He is to be commended for doing so. Our tax code is an absolute mess with incentives for all sorts of bad behavior. Early reports suggest, however, that Congressman Camp will also include a “bank tax” to both raise revenue and address the “Too-Big-To-Fail” (TBTF) status of our nation’s largest banks. While the evidence overwhelmingly suggests to me that TBTF is real, with extremely harmful effects on our financial system, I fear Camp’s approach will actually make the problem worse, increasing the market perception that some entities will be rescued by the federal government.

Bloomberg reports the plan would raise “would raise $86.4 billion for the U.S. government over the next decade…would likely affect JPMorgan Chase & Co, Bank of America, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley.” The proposal would do so by assessing a 3.5 basis-point tax on assets exceeding $500 billion.

While standard Pigouvian welfare analysis would recommend a tax to internalize any negatives externalities, TBTF is not like pollution, it isn’t something large banks create. It is something the government creates by coming to their rescue. I don’t see TBTF as a switch, but rather a dial between 100 percent chance of a rescue and zero. By turning the banks into a revenue stream for the federal government, we would likely move that dial closer to 100 percent–and that is in the wrong direction. For the same reason, I have opposed efforts to tax Fannie Mae and Freddie Mac in the past. The solution is not to bind large financial institutions and the government closer together, as a bank tax would, but to further separate government and the financial sector. Just over a year ago, I laid out a path for doing so in National Review. Were we to truly end bailouts, limiting government is the only way to get that dial close to zero.   

If we want to use the tax code to reduce the harm of financial crises, then we should focus on reducing the preferences for debt over equity, which drive so much of the leverage in our financial system.  I’ve suggest such here in more detail. There are also early reports that Camp’s plan will reduce some of these debt preferences. Let’s hope those remain in the plan.

Pages