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Wyden-Gregg tax reform proposal

Senators Ron Wyden (D-Ore.) and Judd Gregg (R-N.H.) have introduced the "Bipartisan Tax Fairness and Simplification Act of 2010" (summarized here). They deserve a degree of praise for even trying this. But I suppose it's my job to examine the details critically without extending sympathy points for their need to keep in mind political feasibility issues.

Too many features to comment on all of them here. But some of the key ones include the following:

--3 individual income tax brackets (at 15, 25, and 35%) instead of 6. This is touted as simplification, but is entirely trivial in that regard. Presumably. most people simply look at the income tax tables to see how much they owe.

--Eliminate alternative minimum tax. Great, but the hard part is paying for it. According to the Congressional Research Service, despite base-broadeners they fall $230 billion short of revenue neutrality over 10 years (relative to an Obama Administration budgetary baseline that, needless to say, falls far short of long-term sustainability), and propose to pay for it by "cutting an average of $23 billion per year from corporate and business-related spending and transfers." These are of course unspecified, and good luck finding reductions that Congress would accept (although finding enough that ought to be cut would no doubt be easy). For a general list of their revenue offsets, see this.

--Near-tripling of standard deduction. In principle, a good way to lower tax burdens on the bottom of the distribution and to devalue itemized deductions that ought to be repealed but are politically embedded. I believe they don't phase it out, which might make little difference at higher income levels (if people mostly switch to itemizing anyway). But with a much larger standard deduction and, perhaps, lower qualified residence interest deductions in the future (from reduced home values and borrowing), conceivably standard deductions would be used much further up the scale than is now typical.

--Itemized deductions, including bad ones such as the qualified residence interest deduction, are generally retained, and no longer phased out. In general, the phaseouts make no sense as such - they are better thought of as temporarily high "bubble" rates, and evaluated based on what one thinks of such a rate structure - but this does modestly increase the deductions' value among those who ARE itemizing. Lost opportunity to use tax reform as a way of scaling these deductions back, e.g., by converting them to a 15% refundable credit. Interestingly, they do apparently convert the exclusion for municipal bond interest into a percentage credit.

--Itemized deductions currently subject to the 2% of adjusted gross income floor are repealed. Some of these items actually are costs of earning income, however.

--Consolidated and expanded retirement savings provisions. I'm in favor (makes it more of a consumption tax), but am concerned about the issue (under current law as well) of deductibly borrowing on one's home to finance supposed retirement saving.

--Lowers the U.S. corporate rate to 24% (while eliminating the farcical rate graduation in current U.S. corporate tax law). Good for attracting more investment $$, or simply reported taxable income by multinationals with planning flexibility, to the U.S. in competitive world capital markets. But with the corporate rate at 24% versus a top individual rate of 35%, they need to address the problem of high-earners transmuting their earnings into corporate income from their closely held companies.

--Elimination of a variety of special interest tax breaks. Great, if one can do it. This is indeed what 1986-style comprehensive tax reform is supposed to emphasize. Most of the items they list (which you can find on the links I provided above) are well worthy of repeal; for a few this could be challenged.

--Limit corporations' interest deductions to real interest (i.e., nominal interest is reduced by the inflation rate in determining what's deductible). This is a bit odd, given that nominal interest and other inflationary aspects of gain continue to be taxable elsewhere. They tout it as reducing the debt bias of current corporate tax law. But that really is a distinct issue from the inflation problem, which in theory (i.e., subject to administrative concerns) calls for comprehensive inflation adjustments for everything. A bit cute to try to address the more general debt issue this way - not sure it makes sense unless one posits that this is more politically feasible than more straightforward approaches.

--Move towards a more worldwide system for taxing U.S. companies foreign source income. In particular, they repeal deferral for business income that U.S. companies earn through foreign subsidiaries, and reinstitute the per country foreign tax credit. No doubt they (or perhaps more Wyden on the Democratic side) think of this as a key tradeoff for lowering the corporate rate, but perhaps not the best direction to go in given the increasing electivity of U.S. corporate residence. The domestic tax rate for all corporations operating in the U.S. and the treatment of foreign source income earned by resident U.S. corporations really are different margins.

Considered as a whole, this bill is potentially a good conversation-starter, but somehow I doubt that the conversation will get very far. I remain skeptical about the political prospects of using base broadening to pay for rate cuts, higher effective zero bracket, etcetera. Perhaps we could do this for corporations - lower corporate rate plus base-broadening and provisions to prevent individuals from exploiting the lower rate through closely held companies. Insofar as academics and policy types are deciding where to concentrate their fire, I'd place more emphasis on the long-term fiscal problem and likely need for a VAT to help stave off actual or implicit default by the federal government. Plus, if the rise of the AMT becomes politically salient to voters, financing its repeal through curtailment of itemized deductions and other personal income tax benefits might make sense, but the time for that does not yet seem to have come.

In sum, rather than try a general 1986-style reform, I'd propose emphasizing (1) raising revenues through a VAT, as part of a broader deal that addresses entitlements growth and perhaps purports to dedicate VAT revenues to particular purposes, (2) a narrower trade of rate reduction for offsets (other than increasing U.S. worldwide taxation) specifically for corporations, and (3) a similar trade with respect to individuals' targeted tax benefits and AMT repeal, if and when voters become concerned enough about the AMT for this to be feasible.

Full post as published by Start Making Sense on February 24, 2010 (boomark / email).