Tax Analysts Blog

The Tax Reform Supermarket

Posted on Feb 23, 2015

One year ago this month, then-House Ways and Means Committee Chair Dave Camp provided American businesses with a glimpse of what politically realistic income tax reform might look like, and they haven't liked what they've seen. They are pleased with the 25 percent corporate rate and the move to territorial taxation, but that is not enough to overcome their dislike of the loss of all their tax breaks. Likewise, the individual side of the plan -- with a top rate of 35 percent and trimmed tax breaks for mortgage interest and charitable giving -- is a strong dose of reality for those who had been portraying tax reform as some sort of economic and political nirvana.

Slowly but surely, members of Congress are coming to the painful realization that conventional, Reagan-style tax reform is going nowhere. The Camp plan was the endpoint of a long three-year process involving dozens of expert staff and endless meetings with stakeholders and lobbyists. If seasoned Republican Ways and Means members and staff could not come close to drafting a politically feasible income tax reform in 2014, is it realistic to expect the 114th Congress to do any better? There is no modification of the Camp template that will magically transform its political viability. This means we will now be entering a period of increased interest in alternatives to conventional income tax reform.

To help navigate the often bewildering array of tax reform options, the possibilities can be divided into four general categories. Think of each of the categories as an aisle in the supermarket, like those shown in the figure below. In the following months, members of Congress and presidential candidates will be spending a lot of time browsing the aisles of the tax reform supermarket.




In Aisle 1 are all the conventional tax reform proposals that lower the income tax rates and pay for them by broadening the income tax base. Since Alan Simpson and Erskine Bowles got the tax reform ball rolling in 2010, this approach has gotten the most attention on Capitol Hill. Because of its detail and scope, the Camp proposal is the most noteworthy. But this is the same approach adopted by former Finance Committee Chair Ron Wyden, D-Ore., and Sen. Daniel Coats, R-Ind. Other prominent politicians who have suggested plans that incorporate this approach (although without supplying details) include Ways and Means Committee Chair Paul Ryan, R-Wis., in 2011 and Mitt Romney during his 2012 presidential campaign. President Obama has proposed lowering corporate rates and broadening the corporate tax base, but he does not support individual income tax reform.

In Aisle 2 are reforms that would lower income tax rates by tapping new sources of revenue. The proposed tax on large financial institutions included in the Camp plan would raise $86 billion over 10 years. Obama's latest budget also includes a tax on large financial institutions expected to raise $112 billion over 10 years. A financial transactions tax would raise $180 billion over 10 years. These taxes still would only pay for corporate rate reductions of 1 or 2 percentage points.

A carbon tax has much more revenue potential. A tax on greenhouse gas emissions could raise $1 trillion in a decade. This would be enough to replace revenue lost from a 10 percentage point reduction in the corporate tax rate.

The big kahuna of alternative revenue sources is the VAT. A broad-based VAT with a 5 percent rate would raise about $250 billion per year. Revenue of this magnitude is what is needed to make game-changing reductions in the individual and corporate income taxes.

Because of knee-jerk opposition to the tax in the United States, advocates avoid any reference to value added taxation. In December 2014 Senate Finance Committee member Benjamin L. Cardin, D-Md., introduced legislation that would impose a 10 percent VAT and use that revenue to lower the corporate tax rate to 17 percent and the top personal rate to 28 percent. He calls his VAT the progressive consumption tax. The Cardin proposal is a variation of the tax reform plan espoused by professor Michael Graetz of Columbia Law School.

In 2007 the Treasury Department studied the possibility of replacing the corporation tax with a VAT that it called the business activities tax. In 2010 a commission headed by former Sen. Pete Domenici and former Congressional Budget Office Director Alice Rivlin proposed a 6.5 percent VAT that they called the debt reduction sales tax. In 2010 Ryan proposed replacing the corporate income tax with an 8.5 percent VAT that he called the business consumption tax. (In the following year, Ryan dropped the VAT from his tax reform proposals.)

In Aisle 3 are proposals for corporate integration. Under these proposals, business profits are subject to only one layer of tax. To stop double taxation of corporate profits, relief must be provided either to taxed corporations or to investors in those corporations. Treasury's 1992 proposal for a comprehensive business income tax (CBIT) would impose tax on businesses and relieve investors of the income tax. This treatment would apply not only to shareholders (who would be exempt from tax on business income that had been taxed at the entity level), but also to bondholders (whose income would be taxed at the entity level because interest would no longer be deductible). Former JCT Chief of Staff Edward Kleinbard has proposed a variation on the CBIT that he calls the business enterprise income tax (BEIT). Under the BEIT, businesses would be taxed on an imputed return on capital called a cost of capital allowance, and investors would be taxed at the individual level on this same amount.

A bold approach to integration recently proposed by Eric Toder of the Urban Institute and Alan Viard of the American Enterprise Institute would move in the exact opposite direction of the CBIT and impose the entire burden of tax from business income on the individual. Under the Toder-Viard proposal, owners of passthrough businesses would largely continue to be taxed as they are now, but the corporate tax would be eliminated. To replace the lost revenue, corporate shares would be marked to market and taxed annually.

In Aisle 4 are even more radical changes. These proposals are often described as "fundamental" tax reforms because they would replace all or most of the current income tax system with new consumption taxes. Most familiar to the public are the proposals for a national sales tax called the FairTax and for a bifurcated VAT known as the Hall-Rabushka flat tax. (We say "bifurcated" because this particular flat tax subtracts wages from what otherwise would be the VAT base and instead taxes wages at the individual level.) Despite the attention lavished on them, these proposals are not politically viable because they would result in a large shift in the tax burden from wealthy Americans to the middle class.

Less widely known but much favored in policy circles is the X tax originally proposed by economist David Bradford in the 1980s. It is similar to the Hall-Rabushka flat tax except that wages taxed at the individual level are subject to a progressive rate structure. In 2005 President George W. Bush's tax reform panel proposed a version of the X tax that it called the growth and investment tax, but because of distributional concerns it imposed some additional tax on capital income. An excellent 2012 book by Viard and Robert Carroll has helped rekindle interest in the X tax. Ways and Means Committee member Devin Nunes, R-Calif., has recently released a discussion draft of his version of tax reform that in many ways resembles the X tax.

During his campaign seeking the 2012 Republican nomination for president, Herman Cain made a big splash with his 9-9-9 tax plan. Under this proposal, the current federal tax system would be replaced with a 9 percent national sales tax, a 9 percent VAT, and a flat rate 9 percent income tax. Like the Hall-Rabushka flat tax and the FairTax, the plan would never go far in Congress because it would shift tax burdens from the rich to the middle class. But with a crowded field of Republicans competing for that party's nomination in 2016, we can expect a variety of similarly audacious reform proposals designed to catch maximum press attention.

Disillusionment with income tax reform means that tax reform proposals that relieve double taxation of corporate profits or that replace income taxes with consumption taxes can no longer be sloughed off as the musing of academics. Serious consideration of bold reforms different from the Camp plan may help break the logjam in the current tax reform debate. But don't count on this journey into largely uncharted territory to make enactment of tax reform any easier.

Read Comments (3)

edmund dantesFeb 23, 2015

These proposals, all four aisles, are far too esoteric to gain traction. The
model for the next tax reform is ERTA '81, not the TRA '86 (much as I loved the
'86 tax reform and wish we'd return to it). ERTA included bold changes thought
to be wildly unrealistic before Reagan was elected, ideas completely "outside
the box." Yet they could be explained so easily that any voter could quickly
understand them:

• 25% tax rate cuts for every taxpayer.
• IRAs allowed for every taxpayer with earned income.
• Inflation indexing to end bracket creep.
• Much faster depreciation for business investments.
• Maximum capital gains tax of 20%.
• Tax-free income for everyone, via All-Savers Certificates (one year only,
alas).
• Tripling the federal estate tax exemption and the annual gift tax exclusion,
so federal transfer taxes no longer affected the middle class.

Those bullet points are far from a complete description, of course. But any
one of those changes would have been unthinkable during the Carter
administration.

Before the election Reagan was widely mocked for his tax ideas. As ERTA was
shaping up, Democrats fell all over themselves trying to add to it to share the
credit.

BTW, on the record, ERTA did deliver the economic recovery that it promised.
Revenues from realized capital gains soared until 1986. ERTA contributed
substantially to Reagan's landslide re-election in 1984.

robert goulderFeb 24, 2015

Edmund: I enjoyed your comment, although I must confess that I've never
regarded ETRA'81 as falling under the category of "tax reform." It was more of
a tax cut, pure and simple. The point of ERTA was never really tax reform, per
se, but supply-side stimulus. The latter is not the same as the former. No?

Mind you, I have nothing against tax cuts. They serve my personal interests
fairly well. But we live in an era where stuff needs to be paid for. At least
that's the prevailing assumption one observes. (Admittedly, more so on the
taxing side than the spending side, where a great many things aren't paid for).

If current lawmaker - let's say Chairman Ryan or Chairman Hatch - were to
suggest we replicate ERTA today, the first question (from both Republicans and
Democrats) would be: Okay, but how do you plan to pay for all these wonderful
new tax cuts?

Invoking ERTA as a model for tax reform (as opposed to stimulus) would seem to
imply either: (1) that tax reform need not be revenue neutral, or (2) that tax
cuts pay for themselves. Perhaps that's your point.

Thanks, as always, for reading and commenting.

edmund dantesFeb 24, 2015

Robert: Good point. However, the general public doesn't care about the label
Congress puts on tax changes, whether reform or stimulus. For most taxpayers,
the bold changes of ERTA were a greater reformation of the tax code and their
tax planning opportunities than was TRA '86.

Although I wouldn't say tax cuts always pay for themselves, I believe that the
ERTA tax cuts did so. Total collected tax revenue went up continuously during
the Reagan administration (though they fell as a share of GDP), and in
particular capital gains taxes paid boomed as the economy grew. I believe that
a retrospective analysis of ERTA's projected "cost" would show that actual
costs were far less than expected, because the economy did recover.

That's why the Republicans want dynamic scoring of major tax changes. That
would be part of Ryan's or Hatch's response to how the changes will be "paid
for." Although I agree with the sentiment, I doubt dynamic scoring will be any
more accurate.

I don't think the next tax reform has to be only about cutting taxes. I would,
for example:

• tax all muni bond interest;
• tax the mega-endowments of universities and foundations;
• end nonprofit tax status, bringing everyone into the taxable tent;
• put a cap on the unlimited charitable deduction for estate and gift taxes.

These ideas are simple to understand, the general public would likely support
them, and they would raise meaningful revenue to offset rate reductions.
Unfortunately, no one is talking about them.

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