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In the Nation's Interest

Chairman Camp De-Camps

By Joseph Minarik

After months of behind-the-scenes work, House Ways & Means Committee Chairman Dave Camp (R-MI) has released detailed information on his proposal to reform the federal individual and corporate income taxes.  The end result is, of course, as yet unknown, but in March of the second session of a Congress, we won’t have to wait too long to get a preliminary idea of where this is going.  And that is part of the story.

A bit of personal history:  On the first Friday after Labor Day of 1981, I was part of a contingent of tax economists from the Congressional Budget Office who, along with our opposite numbers from the staff of the Joint Committee on Taxation – about 10 to a dozen economists in total, more than enough to cause a lot of trouble – were summoned by then Senator Bill Bradley (D-NJ) to discuss ideas for income tax reform.  I was fresh off my first overnight in a hospital since birth, having been stung by a wasp and gone into anaphylactic shock while alone driving my car.  I was on heavy pharmaceuticals to recover from that experience, with the side effects that my eyes were highly sensitive to light, and I could not sleep at night and was therefore exhausted all day.  I was under strict orders from my CBO supervisor, who was among our delegation, not to pass out copies of my own proposed approach to the issue, which nonetheless somehow found their way into my briefcase.  The upshot of the meeting was that Sen. Bradley instructed the staff director of the Joint Tax Committee, against the latter’s vociferous objections, to do a cost estimate of my plan.  As we walked out of the building, one of my CBO colleagues said to the rest of us, “Years from now, we all can say that we were at the meeting where income tax reform was born!”  And we all laughed.  (My laughter was a little more polite than heartfelt.)

Five years hence, late on Saturday evening, August 16, Senator Bradley gave me one of the pens that he had just used to sign the conference report of the Tax Reform Act of 1986.  It sits on the shelf above the desk in my study at home.

So the first steps of long journeys are sometimes the subject of some disbelief, or even ridicule (good-natured or not).  But without the first step, no long journey ever will be completed.  That said, not every first step reaches its distant intended conclusion.

So kudos to Chairman Camp for taking his first step.  A successful conclusion to the succeeding long journey would be good for everyone.  But the journey looks like it will be very long, with many risks along the way.  And even the definition of success surely will be contentious.

The need for tax reform is demonstrable, and unfortunately is no less now than it was in the early 1980s.  The “holy trinity” (somehow, these issues always boil down to threes) of a tax system long has been the simultaneous attainment of the conflicting goals of economic efficiency, simplicity, and fairness (in no particular order).  But these objectives always have boiled down to three because policymakers have taken a potential fourth, revenue sufficiency, for granted.  These days, revenue sufficiency is far from an automatic out in now-baseball-infected Washington, so we need to expand our holy trinity by one.

And today’s tax code strikes out – plus one more strike for good measure.  Just briefly:

(1) There is enormous leakage from our tax base – that is, preferential provisions of law, regulation and practice that reduce the tax paid on income earned in certain ways, or spent on certain goods and services.  Such tax preferences entail a double whammy: they steer investment and spending into particular activities whose merit lies not in the marketplace, but rather in the tax code.  That reduces economic efficiency.  And then, to make up for the resulting lost revenue, tax rates must be higher.  Higher tax rates blunt incentives and increase economic distortions, and thus reduce economic efficiency still further – and generally at a geometrically compounding rate as tax rates get progressively higher.  So again, that costs us economic value.

(2) The tax filing process for a family with only wage income and normal circumstances otherwise is generally quite simple.  However, as the taxpayer’s situation gets more complex – particularly if he or she is self-employed, or has considerable investment income – the tax return quickly becomes much more complicated.  For the self-employed with outside financing, some of the complexity would be there even without the tax system, by the requirements of providing the bank or the investor with complete and accurate accounting.  But the introduction of numerous and detailed tax preferences not only makes the tax filing process more complex, but also infects day-to-day business and investment planning with complicated and economically counterproductive choices to minimize taxes and so maximize after-tax income.  This complexity is a branch office of the economic inefficiency that results from special provisions in the tax code.

(3) Fairness is in the eye of the taxpayer, and it is likely that every person believes that the tax system would be fairer if others paid more and he or she paid less.  But on more thoughtful consideration, people do have principled standards.  In the broadest terms, people probably follow John Rawls (A Theory Of Justice) in believing that the fairest tax system is that which they would want if they did not know what their own life outcomes would be.  In this context, people would tend to choose a tax system that would satisfy them if fate handed them an income that was either high, low, or middle.  Experimentally, that tends to yield a tax code that is on average about as “progressive” as the one that we have – but it would be unlikely to allow for large scale legal tax avoidance (or illegal tax evasion) by those with considerable incomes.

(4) Tax reform in 1986 was a heavy lift.  But tax reform in 2014 would be even tougher, and the reasons all center to some degree around the used-to-be-taken-for-granted objective of revenue sufficiency.

The public debt in 1986 was about 35 percent of GDP and rising – troublingly higher than the 25 percent of 1980, but less than half of what it is now.  And today we have the looming one-two punch of steady population aging plus the episode of the retirement of the baby-boom generation, which will add to the demands on federal finances and likely require more revenue in the future than was sufficient in the past. 

And helping even the lighter lift in 1986 was President Ronald Reagan’s acceptance of a substantial corporate tax increase to finance an individual income tax cut.  That eased the unavoidable political “losers” problem:  In a revenue-neutral tax change, some people (the “winners”) see their taxes go down, while the others (the “losers”) see their taxes go up in equal aggregate measure.  Typically, the prospective winners either don’t believe it, or their tax cuts are so small that they don’t get excited about it.  Meanwhile, the prospective losers are very much aware that they will be hit much harder (because they would lose targeted tax breaks that are important to them) and so they scream bloody murder.  The political fight isn’t fair.  The 1986 corporate tax increase ameliorated that problem significantly.  And ironically, even some corporate executives whose firms’ taxes and whose individual taxes would go up were willing to be favorable or at least silent, because their own individual income tax rates at the margin would drop substantially.  They could see through the short-term tax increase and figure out that their next dollars of income would be taxed at lower rates – and that they would save all of the fees that they had been paying to tax-shelter promoters to avoid the higher tax rates that were in force under the old law.

So despite enormous obstacles, the 1986 law survived the political process.  This year’s version will not have the advantage of the corporate-tax-increase windfall (but read on for the details).

The revenue challenges to tax reform this year do not stop there, however.  The federal government has been piling up an enormous stock of debt.  That problem does not yet show up in the budget flow numbers because interest rates are extraordinarily low, in large part because today’s economy is so weak.  Let an economic recovery begin, however, and the federal government’s debt-service costs will grow by orders of magnitude, and very quickly.  A normal level of interest rates is built into the current budget baseline; but those baseline projections still explode before long, and the level of debt that we are carrying is far above “normal” – so we should not bet our future on a “normal” reaction by the markets once that rising debt-service cost begins to challenge the political will in Washington.

Furthermore, even though the U.S. economy was far from closed to the rest of the world in 1986, technology has opened it even more since then.  It is far easier to move productive economic activity from one country to another now than it was then.  But even more troubling, it is far easier to move the recognition of the income from productive economic activity from one country to another even without moving the productive activity itself.  A major objective of Chairman Camp’s proposal is to make the United States a more attractive location in which to undertake productive activity and to recognize its income, relative to other countries.  But we should not assume that Chairman Camp’s proposal would be the last and winning shot fired in that ongoing battle.  The United States is a real country with real obligations, including defending the free world (which right now is just about all of it – but not quite, which is the problem).  Other nations that sit safe and secure beneath our defense umbrella, and therefore have far smaller fiscal obligations, can bid against us for the siting of our corporations’ net income; and after we submit our bid, they can bid again.  The game is never over.  It is an unfair reality of the new world of mobile capital that the world leader is everybody’s target, and our responsibilities sharply limit our ability to defend ourselves against such tax poaching.  (And people rarely thank us for the use of our defense umbrella, either.)  Where this process will end, no one knows.

So Chairman Camp had all of these problems stacked up against him when he undertook this process.  How did he do at bucking the odds?

Well, his proposal was quite aggressive in taking on some of the politically touchiest tax preferences (and in cutting tax rates with the proceeds; more on that later).  It would introduce a floor of 2 percent of income under the charitable contribution deduction; only contributions in excess of 2 percent of income would be deductible.  (Spoiler alert:  Well-advised taxpayers will “bunch” the contributions they otherwise would have made over several years into one year, so that more will be deductible.)  The deduction for state and local taxes would be eliminated.  (Expect a call from Governors Cuomo and Brown.)  Higher-education tuition credits and deductions would be cut back.  The deduction for mortgage interest and the exclusions for employer health-insurance premiums and municipal bond interest would be limited in value to 25 percent, even for taxpayers in the higher 35-percent tax-rate bracket.  And the so-called “chained” consumer price index (CPI), which increases more slowly because it estimates consumer substitution of goods and services whose prices increase less rapidly, would be used for inflation indexing.

In other respects, Chairman Camp was much less aggressive.  The most common press description of the proposal for capital gains and dividends is that they would be “taxed as ordinary income with a 40 percent exclusion.”  Although I can understand in one technical respect the use of this language, it is basically a misdirection play.  There is nothing “ordinary” about a 40-percent discount on your income taxes.  (One reporter fell for a line that “Investment income would lose its special status and be taxed as regular earnings (although the first [emphasis added] 40 percent would be exempt.)”  This reminds of a Laurel and Hardy cartoon I saw as a child, in which Stanley offended by downing an entire glass of water that the two were supposed to share, but then apologized tearfully that he had to do so because “My ‘alf was on the bottom.”)

On the business side, Chairman Camp would hit a long list of tax preferences.  Among the big ones, the acceleration of depreciation deductions would be slowed.  Last-in, first-out (LIFO) inventory accounting would be abolished.  Firms would be required to amortize (that is, deduct over several years) rather than expense (that is, deduct immediately) the costs of advertising and research and experimentation (R&E).

The revenues raised would be devoted to tax rate reduction – with a top individual tax rate of 35 percent, and a corporate tax rate of 25 percent.  And both the individual and corporate alternative minimum taxes would be repealed.  And this entire package, added up, would raise the same amount of revenue as the current law over 10 years.

But here is where it gets tricky – with respect to the budget in general, and the international tax issue in particular.

Chairman Camp would switch from a “worldwide” to a “territorial” tax system, such that overseas profits of U.S. corporations would be exempt from tax.  There would be a one-time transition tax on the profits of U.S. corporations that now are being held overseas without having borne U.S. tax.  That one-time tax is needed to make the entire proposal revenue neutral over the first 10 years.  And then, those same dollars are devoted to funding an increase in highway spending – doing double-duty in a fashion that may be deemed unnatural.  That plus several other temporary revenue raisers in the package suggest fairly strongly that the proposal will not be revenue neutral beyond the first 10 years.  In fact, it loses a non-trivial amount of revenue in the 10th year.

(And by the way, you might infer from press stories that Chairman Camp has created his own Reagan-style tax transfer, raising taxes substantially on corporations and cutting taxes by the same amount on individuals.  But on close examination that appears not to be the case.  The words “corporation” and “business” are not synonymous, and some business income is reported on individual income tax returns.  Chairman Camp’s documentation, for technical reasons, reports numbers sometimes for corporations, and at other times for all businesses.  By the best arithmetic, over the first ten years, total corporate income taxes and total individual income taxes come out close to unchanged.)

Where does all of this lead?  Let me raise two broad notes of caution.

It is in the nature of sales persons to want to make the best possible first impression.  But this proposal is not a finished product; it is a work in progress.  And if anything, the version of tax reform before us now is too good to be true, or at least better than it truly can be in its final form.  Many will insist that it needs to raise more revenue than it was planned to, to address the long-term budget and demographic problems.  Others will at least insist that its purported revenue neutrality not be invaded to fund the highway program.  Still others will want verifiable revenue neutrality beyond the first 10 years, which fairly clearly will require more revenue still.

Citizens who “buy” the proposal because of its attractive low tax rates will be upset if and when they discover that the low tax rates that won their hearts will have to be increased.  This will be true whether the rates rise during the legislative process, or after the proposal becomes law and the budget problem nonetheless comes home to roost.  (And it is likely to occur despite the claimed “dynamic scoring” benefits of the proposal; such a revenue bonus definitely falls in the believe-it-when-I-see-it category.)

In addition, this proposal faces a steep climb merely to get a vote on the House floor.  The House Republican leadership knows that a package that passes their chamber will not be acceptable in the Democratic Senate.  They also know that a vote for the Camp proposal will take on just about every powerful interest that now benefits from the current tax code, however deficient the current law might be.  Accordingly, the most attractive outcome from the perspective of many would be if the Camp proposal merely goes away, and as quietly as possible.

Chairman Camp is term-limited, and will not hold his position in the House next year.  He believes in tax reform, in the form in which he has proposed it, very deeply.  He has released his proposal because he urgently wants it to become law, and because this is his only opportunity to make it happen.  However, the chances of it happening this year are very slim, for all of the reasons mentioned above.  On a personal level, it is unfortunate that if tax reform should happen not this year but some years down the road, Chairman Camp will not be the one to gavel the vote.

President Obama submitted his fiscal year 2015 budget on Tuesday.  Preliminary press accounts had emphasized that the President would drop his previously proposed use of the chained CPI for income taxation and for Social Security and other benefit programs, to appeal to his own base that wants no change to Social Security.  The justification for withdrawing the proposal would be that the President had made it to extend an olive branch to the Republicans to start large-scale budget negotiations, and that the Republicans had reciprocated only with politically motivated attacks.  Yet another story was that the President would propose to extend the earned income tax credit (EITC) to childless workers, and that his pitch would be thereby to reduce economic inequality.

That much of the story appears so far to be accurate.

Otherwise, a first-day look at the President’s budget suggests that there is very little ground there for forward progress toward a bipartisan resolution.  A couple of points are striking.  One is that the President’s economic assumptions project significantly higher nominal gross domestic product (GDP) than do the assumptions of the CBO.  Because nominal GDP is what we tax, this difference helps the President to show progress in limiting the debt problem in the coming years.  Is this assumption reasonable?  Time will tell.  If not, the President’s proposed budget savings will be insufficient.

Second, the President proposes extraordinary reductions in annual appropriations for both defense and domestic programs over the next 10 years.  By the end of the budget window, spending on both would be well below previous years over the history of the data (which extend back to the early 1960s).  It is hard to say whether those numbers would be attainable; there is no precise precedent, but it is worth noting that the House of Representatives was unable to pass appropriations bills to apparently much more generous targets last year.  Assuming large cuts in future appropriations is by far the easiest way to avoid otherwise essential tough decisions.

The typical reception for every President’s budget over the last three decades at least has been to declare it dead on arrival.  This year’s budget clearly will follow that pattern.  Time to address our debt problem is not exhausted, but neither is it infinite.