Tax Analysts Blog

Wanna-Be Tax Reformers Need a Dose of Reality

Posted on Nov 8, 2012

The table below summarizes some of the more prominent tax reform plans under discussion in recent years. To make life simpler, let's divide the plans getting the most attention into two categories.

In the first category, we have two plans proposed not as stand-alone tax reform but as adjuncts to major deficit reduction plans that raise revenue. The Bowles-Simpson plan would reduce the individual rate to 27 percent and the corporate rate to 27 percent, and it would exempt foreign profits entirely from U.S. tax (that is, move to a territorial system). Similarly, the Rivlin-Domenici plan would reduce the individual rate to 28 percent and the corporate rate to 28 percent, and exempt foreign profits entirely from U.S. tax. To pay for these rate reductions, both plans would pare tax expenditures to the bone. For example, both would -- after a long phaseout period -- eliminate the exclusion for employer-provided healthcare. Both would entirely eliminate the deduction for state and local taxes. And both would significantly cut the deductions for mortgage interest and charitable contributions. Let's call these two plans "pedal-to-the-metal tax reform."

In the second category, we have the campaign proposals of Mitt Romney, the tax reform outline draft proposal of House Ways and Means Committee Chair Dave Camp, R-Mich., and the corporate tax reform framework of President Obama. Romney wants to reduce the top individual rate to 28 percent, cut the corporate rate to 25 percent, and move to a territorial system. Camp wants a corporate rate of 25 percent and a territorial system. Obama wants a corporate rate of 28 percent with special provisions that will reduce the effective rate on manufacturing to 25 percent. These plans are all notable for their extraordinary vagueness on what form base broadening would take. The one notable exception to this lack of forthrightness is the dead-in-the-water international component of Camp's proposal (more on that below). Let's call these types of plans "fill-in-the-blanks tax reform."

Now, it doesn't take much arithmetic or a thousand-dollar-an-hour lobbyist to tell you these plans are totally unrealistic. They explicitly propose (in the case of pedal-to-the-metal tax reforms) or strongly imply (in the case of fill-in-the-blanks tax reform) severe cutbacks in provisions that will spark the ire of powerful interest groups that will fight tooth and nail to retain every dollar of tax subsidy.

Let's not dwell on that obvious point and instead move on to some other issues that should give you serious doubts about the prospects for sweeping tax reform.
On corporate tax reform, there are three prominent facts to keep in mind.

First, the notion of getting to a corporate rate of 25 percent is extremely far-fetched. If we put aside the near-sacrosanct research credit, the repeal of all domestic corporate tax expenditures with no transition relief will allow a corporate rate reduction to 29 percent.

Second, repeal of accelerated depreciation -- by far the largest potential corporate revenue raiser -- provides only a temporary increase in revenue. Because it is only a timing benefit, it provides significant revenue gains only during the 10-year window. The revenue dries up in the second decade when the need for extra revenue will be far greater than it is in the immediate future.

Third, revenue-neutral corporate tax reform as now contemplated will result in a politically untenable redistribution of the corporate tax burden onto the manufacturing sector. The big corporate tax expenditures targeted to pay for lower rates -- namely, accelerated depreciation and the section 199 deduction for domestic manufacturing -- mainly benefit the manufacturing sector. This is a particularly awkward development given the continuous drumbeat from Capitol Hill and the White House calling for the promotion of domestic manufacturing.

There are huge practical impediments to international reform.

First, there is the matter of approximately $1.7 trillion of foreign earnings, most of which can be repatriated only with a significant amount of U.S. tax. The Joint Committee on Taxation has estimated that a temporary repatriation tax holiday like the one enacted in 2004 will result in a revenue loss of $76 billion. That is a significant revenue hole to climb out of -- but everybody agrees that any international reform worth doing must find a way to unlock these trapped foreign profits.

Second, there is the painful component of territorial taxation that is too often ignored: the revenue raisers necessary to pay for the exemption of foreign profit. Often referred to as base preservation rules, these provisions usually are in the form of restrictions on domestic interest deductions and taxation of high-profit intangibles located in low-tax jurisdictions. Camp's draft proposal for territorial taxation includes both thin capitalization rules and current taxation of intangibles. That is why U.S. multinationals that have lobbied so long and hard for territorial taxation have greeted the Camp plan with a deafening silence.

In contrast to corporate tax reform, on the individual side there is a considerable amount of potential revenue from eliminating tax expenditures to pay for rate cuts. Economists at the Urban-Brookings Tax Policy Center have done calculations that give us a useful point of reference. If you take all the tax expenditures that do not promote saving and are not targeted to children and fighting poverty, you would need to cut the remaining tax expenditures by 72 percent to pay for a 20 percent across-the-board individual rate cut. Of course, cutting the home mortgage interest deduction, the charitable deduction, the deduction for state and local taxes, and the exclusion for employer-provided healthcare would be a herculean political achievement, but at least mathematically it is well within the realm of possibility.

The more difficult problem with individual tax reform is not the size of the potential pool of revenue from base broadening, but the distribution of that type of tax increase. As a proportion of income, itemized deductions are far more important to middle-income taxpayers than they are to the wealthy.

As in the past, politicians of all stripes will find it difficult to support tax reforms that are not distributionally neutral. If capital gains and other saving incentives are off the table, and if there are no significant cutbacks in tax benefits for charitable giving by the wealthy, it is difficult to see how the top rate on the wealthy could ever be reduced from 35 percent to less than 32 percent in a revenue-neutral reform. Of course, in a revenue-raising reform the potential rate reduction would be less.

Read Comments (1)

AMT buffNov 8, 2012

Great summary of the challenges on the tax side of closing the fiscal gap.

Gene Steuerle has pointed out that maxing out progressivity, which I define as
reaching the Laffer Curve peak for high-income marginal tax rates, will put
progressives in a bind. Any further revenue increases from that point will
necessitate making the tax system less progressive.

I doubt that many progressives have fully absorbed this truth. If they had,
they would not be in such a hurry to raise taxes only on the rich. They are
eating their dessert and leaving the spinach for later.

European countries have more regressive taxation coupled with larger spending.
The combination may be more progressive than in the US, but politicians here
always look at the progressivity of the tax system in isolation, as if the
progressivity in spending didn't matter.

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