By Martin A. Sullivan -- email@example.com
Many Republicans in Congress have a simplistic way of thinking about tax reform. They reason that the corporate tax rate should be 25 percent because that is the average of other countries. Next they argue that it would be unfair for passthrough businesses to have a higher rate than corporations, so the top individual rate should be cut to 25 percent as well. Anybody who followed the debate surrounding GOP presidential candidate Mitt Romney's tax plan in 2012 or the draft released by departing House Ways and Means Committee Chair Dave Camp, R-Mich., in February should know that this is impossible if reform is going to be revenue and distributionally neutral. It is not Democrats who are blocking Republican aspirations for reform. It is arithmetic.
But Republicans are so fervently devoted to reform that they're not giving up. Yes, they are learning firsthand that jettisoning well-lobbied tax breaks is a monumental political challenge. But they are also discovering that massaging the meaning of revenue neutrality could significantly reduce the amount of painful base broadening needed to pay for lower rates. So far, at least three ways of doing this have surfaced.
First, there is the age-old gimmick of shifting revenue costs outside the official 10-year revenue window. This is a particularly promising approach for tax reform because so many revenue raisers are timing differences that raise a lot of revenue in the short term and then either raise little or no revenue in the long term. Examples of this in the Camp bill include the deceleration of depreciation allowances, the recapture of last-in, first-out reserves, the amortization of research expenditures, the amortization of advertising expenditure, and the one-time tax on outstanding unrepatriated foreign earnings. Published estimates from the Joint Committee on Taxation show that the Camp draft is revenue neutral in the 10-year window, but it almost certainly is a large revenue loser in the following years. This is a particularly troubling prospect given that deficits are expected to begin their spin out of control about a decade from now.
For folks who are hopeful that tax reform can pass the Senate with a simple majority if it is part of budget reconciliation, it should be noted that the Byrd rule requires that reconciliation bills not increase deficits outside the 10-year window. So it is probably impossible for tax reform -- particularly if it is business-only tax reform -- to pass Congress as part of reconciliation as long as the Byrd rule is in place.
The second way to ease the problem of achieving revenue neutrality is to implement dynamic scoring. If tax changes induce economic growth, a dynamically scored tax bill will include the extra revenues the federal government will get from a larger economy. Currently, official estimates of tax legislation do not include dynamic effects. Building on the work of his predecessors, incoming Ways and Means Chair Paul Ryan, R-Wis., will push the JCT to include macroeconomic feedback effects in its estimates of tax reform. Although any positive dynamic effects will make tax reform easier to pass because every dollar of extra revenue from growth is one less dollar of base broadening, it is unlikely that estimates calculated in this new way will be so different as to significantly change the challenging politics of tax reform. (Prior analysis: Tax Notes, Nov. 10, 2014, p. 603 .)
A third way Congress can ease the burden of passing revenue-neutral tax reform is by permanently extending as many expiring tax provisions as possible. Under current congressional practice, there is no requirement that the revenue cost incurred from the extension of expiring provisions be offset by tax increases or spending cuts. Thus the more tax cutting that can be crammed into an extenders bill, the smaller will be official projections of future revenue. And then tax reform will need to raise less money to be revenue neutral. (Prior analysis: Tax Notes, Nov. 17, 2014, p. 742 .)
A Fourth Option? Tax Triggers
In recent years, Republicans in many states have swept into power promising to cut individual and corporate income taxes. In states like Kansas, Oklahoma, North Carolina, and Missouri, they have succeeded, but after bruising legislative battles the tax cuts have usually been scaled down in size. Resistance came not just from Democrats but from special interests trying to protect their favorite tax breaks and from moderate Republicans worried about states' bond ratings and about adequate funding for education. (Prior analyses: State Tax Notes, Sept. 9, 2013, p. 639 ; and State Tax Notes, June 4, 2012, p. 680 .)
One approach to tax cutting that is becoming increasingly common in these battles is the inclusion of trigger mechanisms that allow tax cuts to take effect only after certain revenue targets have been attained. These triggers come in many shapes and sizes, but they usually involve a permanent cut in future tax rates if future revenues grow above a certain rate or exceed expectations. In Kansas, rate cuts will be triggered if in any year beginning in 2019 revenue grows by more than 2 percent. This and other state triggers are summarized in the table.
Examples of Conditional Tax Cuts in U.S. States
State Enacted If. . . . Then. . . .
(triggered tax refunds are temporary)
Oregon 1979 If total receipts are 2 Then entire excess
percent more than refunded to individual taxpayers
Colorado 1992 If total receipts grow at Then excess revenue
a rate faster than the sum refunded to taxpayers in
of the rate of growth of the form of sales tax
population and the rate of refunds, temporary
inflation individual income tax rate
reductions, and increases
in earned income tax credits
Tax Triggers (triggered tax benefits are permanent; and, except in North Carolina,
triggers remain in effect until maximum tax cut is attained)
Massachusetts 2002 If growth of inflation- Then individual rate
adjusted total receipts (currently 5.15 percent)
exceeds 2.5 percent cut by 0.05 percent but
not below to 5 percent
Kansas 2013 Beginning in 2019, if Then excess amount devoted
North 2013 (A) If during the 2014- (A) Then corporate tax
Carolina 2015 fiscal year general rate decreases to 4
(B) Then corporate tax
Oklahoma 2014 (A) If general revenue (A) Then top individual
Missouri 2014 If revenues exceed highest Then individual rate
If these mechanisms are easily triggered because there is a high probability the revenue threshold will be reached (as in Missouri and Kansas), the new law is basically saying, "Taxes can be cut as long as finances are not in really bad shape." These triggers only delay inevitable tax cuts if there is a significant revenue problem.
If these mechanisms are hard to trigger (as with the second part of the Oklahoma trigger), the new law is saying, "There must be better than expected revenue growth before a tax cut can take effect." At first glance these triggers give the appearance of allowing tax cuts only when unexpected economic growth in effect pays for tax cuts.
But really none of the five trigger mechanisms listed in the table -- even the more stringent ones -- actually entail mechanisms that pay for tax cuts with unexpected extra revenue. That's because the events that set off the triggers are temporary revenue increases, while the tax cuts the triggers allow are permanent. For example, North Carolina revenue could increase to $21 billion in fiscal 2014-2015 and 2015-2016, so the conditions for a reduction in the corporate tax rate to 3 percent would be met. But if revenues dropped in future years, there is no provision to restore rates to higher levels no matter how bad the fiscal situation might become.
State tax triggers should be distinguished from state tax limitations. As noted, state tax triggers can result in tax cuts that in the medium and long run result in significant reductions in state tax revenues. One-time attainment of revenue targets can result in permanent tax cuts. State tax limitations, on the other hand, provide only temporary tax relief for any occurrence of extra revenue that sets off the trigger. One-time attainment of revenue targets results in only temporary tax cuts. For example, in Oregon the "tax kicker" (as the refund mechanism is called by Oregonians) comes into effect when revenues exceed estimates by more than 2 percent. This excess amount results in a one-time refund to taxpayers. No future refunds occur unless excess revenues are generated in future years.
A Federal Tax Trigger?
No one should be surprised if antitax Republicans in Washington start imitating the practices of antitax Republicans in Topeka, Jefferson City, Raleigh, and Oklahoma City. It would be complicated, and there would be howls of protest from Democrats and maybe even from bond-rating agencies, but Republicans in Congress could make revenue-reducing components of their tax reform legislation conditional on revenue targets being met. This would be a fourth way Republicans could massage the definition of revenue neutrality to help pass tax reform.
There are several scenarios in which this could happen. For example, if in the next Congress Republicans decide to pass their own version of tax reform that everybody understands the president will not sign, they could draft a bill that for the most part is scored by the JCT as being revenue neutral but includes a provision that triggers additional tax cuts if future revenues are larger than expected. If the trigger requires unexpected excess revenue to be greater than the revenue cost of the triggered tax cuts, revenues would be larger than originally forecast even though the bill overall is a tax cut. This is mighty complicated, but it is the kind of budget maneuvering that can make or break legislation. What matters for politicians and the public is that trigger mechanisms suggest that lower taxes are possible without increasing the deficit.
As a technical matter, that could be critically important in the budget process. The JCT would probably assign a zero revenue cost to the trigger mechanisms. That's because the JCT assumes the economy will have a certain growth rate and the trigger mechanisms will likely kick in only if actual growth turns out to be larger than expected.
A second scenario in which the trigger mechanism would be included as part of tax reform would be if -- either in the next Congress or after the next presidential election -- a Republican-controlled Congress wants to reach a compromise with a Democratic president on tax reform. If Republicans insist on a revenue-neutral reform and the Democratic president insists that reform raise revenue, the bulk of the bill could raise some modest amount of revenue and a trigger mechanism could be added to make the bill overall revenue neutral if revenues are higher than expected. Once again, this is complicated, but one should never underestimate the lengths to which Congress will go to manipulate the budget process in order to pass a bill that otherwise has little prospect of enactment.