As Congress turns its attention to tax reform, there is a clear bipartisan consensus on the fundamental principles to employ, see here, here, here, and here.
Promote growth and increase wages for working families
Modernize our outdated business and international tax system.
Rely on reasonable economic assumptions
Make sure that any rewrite of the tax code is revenue neutral
The Tax Foundation has outlined several different approaches to tax reform which meet the above guidelines. Their Option A is especially attractive:
The corporate tax is reduced to 22.5% and full expensing for business investment is allowed.
GDP increases by 7.1% long term which translates to a .7% increase per year for ten years, which is substantial economic growth.
All income groups, except for the top 1%, will see an after-tax increase in income.
Individual Tax brackets are consolidated into the three rates of 12%, 20.5% and 37% and the standard deduction is nearly doubled (from $6350 to $12,000).
All itemized deductions are eliminated except for home mortgage interest (limited to $500,000) and charitable contributions.
Capital gains and dividends are taxed as ordinary income with individuals being allowed to deduct 40% of qualified dividends and long-term capital gains.
The estate tax is eliminated.
This tax plan is revenue neutral on a static basis.
Conclusion. There are many attractive features in this plan. Being revenue neutral, with strong economic growth, means that the increase in tax revenue will shrink our huge current annual deficits. Only the very wealthy top 1% of taxpayers will see their income (slightly) decreased. The substantial decrease in the corporate tax rate will incentivize multinational corporations to bring their overseas profits back home for reinvestment.
After seven straight years of anemic, sub-par growth of 2.1% annual growth, one of the most important questions in public policy today is whether or not the U.S. economy can do better. I have devoted my last three posts, here, here, and here, to this question, presenting both positive and negative points of view. There are very definitely strong headwinds slowing down growth but there are also specific strategies that are very likely to help speed up growth. One of these is tax reform. The nonpartisan Tax Foundation (TF) has just issued an excellent report, “Options for Reforming America’s Tax Code” with many good ideas. Here are just three of the many different examples presented. But they show the powerful effects that would be generated by significant tax reform.
Replace the Corporate Income Tax with a Value Added Tax (VAT) of 5%. This would be a huge change but it would also have a hugely positive impact. TF estimates that doing this would boost the economy by 5.5% in the long run as well as boosting tax revenue by a whopping $315 billion per year on average. Furthermore, all income groups from low to high would see equal gains in income.
Eliminate All Itemized Deductions Except for Charitable Contributions and Mortgage Interest and Lower the Top Individual Income Tax Rate to 27%. This change would grow the economy 1.1% in the long run and also create 496,000 new jobs. It would also increase tax revenues by $26 billion per year on average. It has the defect of raising incomes more for the affluent than for low- and middle-income groups. But this defect could easily be remedied by, for example, limiting the size of the mortgage interest deduction.
Cap the Total Value of Itemized Deductions at $25,000. This popular proposal would not help grow the economy but would bring in almost $200 billion a year in new tax revenue.
What is the better strategy? To be pessimistic and accept the point of view that faster growth is just too difficult or to adopt specific policies which are likely to help?
My last two posts, here and here, have pointed out the folly of the tax plans of the presidential candidates from both parties:
The Republican plans would stimulate the economy but at a cost of huge increases in the national debt, even using dynamic scoring to take into account the growth effects of these plans.
Raising the top tax rate to 50%, a Democratic idea, would bring in $100 billion per year, but this is not enough to either make a big dent on budget deficits or lower income inequality appreciably. The Tax Foundation has just published an excellent guide to income tax policy which makes several good suggestions for using tax reform to boost the economy:
Eliminating the deduction for state and local taxes would raise $81 billion per year. Using this revenue to reduce individual income tax rates would grow the economy by 1.77% of GDP over 10 years.
Eliminating the mortgage interest deduction would raise $75 billion per year. Reducing individual tax rates by the same amount would grow the economy by 1.61% of GDP over 10 years.
Capping itemized deductions at $25,000 would bring in $188 billion per year. Reducing individual tax rates by the same amount would grow the economy by 1.99% over ten years.
Sensible, i.e. revenue neural, tax reform will do wonders for the economy as this study from the Tax Foundation shows. It will bring in more tax revenue to help pay the bills. It will raise salaries for the already employed. It will create new jobs for the millions of unemployed and underemployed people who want them. It will thus reduce income inequality by increasing the wages of people on the bottom. Why is this so hard for so many people to understand?
Education tax credits have grown from a $4.5 billion program for 4.7 million taxpayers in 1998 to a $17.4 billion program claimed by over 7 million taxpayers in 2011.
Education tax credits are not well targeted toward low- and middle-income families; almost 50% of the benefits accrue to taxpayers earning more than $75,000, often much more. A much more sensible way to target low income students would be to increase Pell grants.
The overuse of tax credits by the federal government has turned the IRS into a spending agency, with refundable tax credits projected to double to nearly $200 billion in the next five years.
Trading the elimination of education tax credits for lower marginal tax rates would grow the economy by $19 billion per year and create 121,000 new jobs.
The authors go on to say: “It is likely that instead of helping, tax credits may be contributing to the rising cost of college education. Colleges are what economists call price discriminators because they can maximize the price that each student can pay. Because of the Free Application for Federal Student Aid (FAFSA), the college has intimate knowledge of each student’s (or family’s) income and if they are eligible for tax credits, loans, or other financial aid. This information allows the college to simply adjust its financial aid package in order to capture the maximum value of the tax credit. Instead of being a helping hand for students, tax credits have turned into a windfall for universities.”
There are many, many reasons to reform the tax code. The education tax credit is just one very good example!