The Promise and Pitfalls in a Tax Reform Plan

Jared Bernstein is a senior fellow at the Center on Budget and Policy Priorities in Washington and a former chief economist to Vice President Joseph R. Biden Jr.

Representative Dave Camp, the Michigan Republican who is chairman of the Ways and Means Committee, released an ambitious tax reform proposal on Wednesday.

The bill has some worthy aspirations, and he bravely throws some treasured loopholes, like “carried interest,” by the wayside. The plan significantly lowers the cap on the amount of mortgage interest that homeowners can deduct (a tax break that skews heavily toward the wealthy).  It includes an excise tax on large banks to offset the implicit subsidy these institutions enjoy by dint of being too big to fail.  It pegs tax brackets to a price index that grows more slowly, meaning more income will pass into higher brackets than is now the case.  Though the politics of tax reform is extremely cramped â€" even some of Mr. Camp’s fellow Republicans are saying his proposal isn’t going anywhere â€" it may prove to be a useful starting point for negotiations down the road.

But in its current incarnation, the plan is fundamentally flawed. First, it claims to be revenue neutral, but achieves that goal only with timing gimmicks that ensure that its revenue neutrality will not last. Second, revenue neutrality is itself a recipe for an unsustainable budget path.  Our demographics alone, not to mention growing challenges like climate change, imply future demands on government programs that clearly show neutrality to be a misguided guidepost for tax reform.

Mr. Camp’s plan seeks simplicity, a venerable goal, by reducing the current set of seven income-tax brackets (ranging from 10 percent to 39.6 percent) down to two (10 percent and 25 percent), although he includes a 10 percent surcharge on certain income sources for the top 1 percent of earners â€" again, not something you’d expect from his side of the aisle these days.

Two points here.  First, bracket complexity is largely an illusion.  Regardless of the number of brackets, it’s simple these days to figure out what you owe, once you define your taxable income, and that’s where the complexity comes in.  And from what I can see, there’s still lots of that sort of complexity in the Camp plan (for example, see the definition of income that gets hit with the surcharge: adjusted gross income minus many different income sources). You don’t simplify the code by reducing the number of brackets; you do so by not favoring one type of income over another.

Second, the word on the street was that Mr. Camp was working for years to achieve revenue neutrality while sticking with the two brackets of 10 and 25 percent.  He couldn’t do it, just as Mitt Romney couldn’t do it because the math doesn’t work.  Again, give the man credit for not pretending otherwise (though the scorekeepers would have busted him on this point).  So, if you tout up the new Camp surcharge and the 3.8 percent surcharge for the Affordable Care Act (a provision he appears to be keeping), you’re back to a top rate of 38.8 percent.

We don’t know yet about distributional results in terms of winners and losers relative to the current system, though Mr. Camp argued on the Op-Ed page of The Wall Street Journal on Wednesday that his plan would lower middle class tax liabilities by $1,300, and asserted at a news conference that it would be distributionally neutral. It will take analysis by outside scorekeepers to see how close he came to that goal. His proposed changes to the earned-income tax credit â€" a strongly pro-work, anti-poverty wage subsidy â€" look particularly worrisome.

There are other notable features, including a reduction in the top corporate rate from 35 percent to 25 percent and a shift to a territorial system for multinationals, something Mr. Camp has long championed but a measure that I’ve long pointed out is an incentive for more offshoring of production and jobs and is thus a significantly worse option than the administration’s idea for a minimum tax on foreign earnings.

But the real problem is on the revenue side.  There are far too many timing gimmicks that temporarily increase tax revenues in the scoring window (the first 10 years) to create the impression of lasting revenue neutrality and positive economic incentives.  But once these gimmicks expire, the plan will collect significantly less revenue, leading to all kinds of headaches for both deficits and growth:

- Mr. Camp proposes changes to the way retirement savings are taxed so that, compared with the current system, his plan will generate higher tax liabilities and more revenues in the near term and lower liabilities in the long term. That is, by providing retirement savers with an incentive to move into Roth-style IRAs, they’ll pay more in taxes in the first 10 years of the budget window. But those revenues will not be there in the next decade, while his lower rate structure will still be locked in.

-The corporate rate is phased in slowly, so revenue losses occur outside of the budget window.

-The plan eliminates accelerated depreciation on equipment purchases by businesses, a move that just shifts timing of tax receipts to now versus later.

-There’s a one-time transitional tax on deferred foreign earnings as part of the territorial package.

In his Wall Street Journal commentary, Mr. Camp promotes the positive growth and job impact of his plan as scored by the nonpartisan Joint Tax Committee.  But that’s based on a 10-year score wherein lower tax rates, by assumption, increase growth, jobs and labor supply.  O.K., but what about the following 10 years, when tax payments that were pulled forward are no longer there to help offset the revenue losses from the lower rates?  At that point, either we cut spending or raise taxes, or structural deficits will return.  And if it’s the latter, those growth assumptions will fizzle.

So there are some good ideas in this proposal, along with some rarely seen Washington courage for which Mr. Camp deserves credit, though we need to see the distribution results to get a better read on the impact on households at various income levels, with a particularly careful eye on low-income working parents.  But if history is a guide, once we engage in major tax reform, it will be a long time before we get back to that well.  We therefore cannot proceed with a plan that both fails to raise the revenue we’ll need and gets too much of its revenue from timing gimmicks.