Most business tax reform proposals promise two things that American companies really want -- a lower corporate rate and exemption of foreign profits from U.S. tax. Republican Rep. Devin Nunes has a draft proposal, the American Business Competitiveness Act of 2014, that would provide a third major benefit to business -- the immediate write-off of capital expenditures. Further, his rate reduction -- to 25 percent -- and accelerated capital recovery would apply to both corporate and noncorporate business. And Nunes intends that his proposal do all this "without adding a penny to the debt."
This is very different from conventional tax reform efforts — such as the Tax Reform Act of 1986 and former Ways and Means Committee Chair Dave Camp’s 2014 plan -- that would do the opposite regarding capital cost recovery. Those plans usually slow down depreciation schedules in order to pay for rate cuts. And so, unlike conventional business tax reform in which economic growth effects are tepid at best (because the economic benefit of rate cuts is more than offset by the negative effects of reduced investment incentives), the Nunes plan would likely deliver a powerful boost to the U.S. economy.
Now for the hard part. Like other tax reform plans, the Nunes proposal would banish all the tax breaks from the code that businesses have grown to love. This already poses nearly insurmountable political challenges to Congress. But the Nunes plan would make the politics even more complicated. To pay for the extra benefit of immediate write-off of capital costs, the Nunes plan would completely eliminate a deduction that is not normally considered a tax break: the deduction by business for interest on borrowing.
In the world of taxation this would be a revolutionary change. For tax lawyers, such an across-the-board disallowance of interest deductions seems like a sacrilege. After all, the corporate tax is a tax on income, and interest is a perfectly legitimate business expense that must be deducted to properly measure income. The Nunes plan would also be a momentous change for businesses that have built their capital structures around a mix of debt and equity that depends on their ability to deduct interest. Banks, private equity firms, and other businesses that depend on leverage are aghast at the mere thought. (Click here for an animated video explaining their point of view.)
For economists, however, the corporate tax already is already an arbitrary tax that makes little economic sense. Eliminating the deduction for interest transforms it from a bad, narrow tax on income from corporate equity capital to a less bad, broad-based tax on all corporate capital. Under the Nunes plan, the large bias in the current corporate tax that encourages businesses to load up on debt would be eliminated.
Although strange, bold, and different to most folks, the basic structure of the Nunes plan is not new to policy wonks. In many ways it resembles what is known as the X tax first proposed by David Bradford in the 1980s. The X tax is nearly identical to the much better known flat tax. The difference is that the individual component of the X tax has higher rates on individuals in order to retain progressivity. (Under the Nunes plan, progressivity is mainly achieved by taxing individuals’ capital income.) Despite its tremendous appeal to conservatives who say they loathe a VAT, the flat tax is nothing more than a VAT divided into two parts—a tax on business and a tax on individuals. So from an economic perspective, the simplest way to think about the Nunes plan is that it is a progressive consumption tax. Again, compared with current law, this would be favorable to the economy.
An added wild card to all this is uncertainty about whether the goal of lowering the rate to 25 percent and preserving revenue neutrality is attainable. Nunes phases in his rate reductions over a decade, so we have to be concerned that while his plan may be revenue neutral over the 10-year budget window used by Congress, it could be a large revenue loser in the following decades. Apparently the Joint Committee on Taxation has provided a revenue estimate to Nunes, but he is not sharing it with the public.
Another huge issue with the scoring of this bill is that the House of Representatives has just adopted a rule that requires the JCT to include macroeconomic effects in its scoring of major tax legislation. This move to dynamic scoring is extremely controversial, and as a practical matter it is unclear how the JCT will implement this new requirement. But what economists can tell you right now is that proposals like this one, that both cut rates and increase depreciation allowances, will register large positive effects in the JCT models—much larger than any positive effects in conventional tax reform plans. The increased revenue from economic growth means Nunes may well be able to get close to his hoped-for 25 percent rate. This could dramatically change the politics of tax reform, because compared with proposals without dynamic effects, there would be far few losers and far more winners.