Rubio-Lee Hints at Tax Reform's Troubling Direction

Republican Senators Marco Rubio and Mike Lee have introduced what should probably be thought of as the first major set of tax proposals in the 2016 Presidential election. While their proposals are unlikely to be enacted, they hint at the troubling direction that tax reform debates seem to be headed.

The Senators would reduce the top income tax rate to 25 percent for corporations and pass-through entities like partnerships. They would eliminate the taxation of interest, dividends, and capital gain income at the personal level. They would allow full deductions of capital investments in the first year and disallow companies' interest deductions. They would increase the child credit for middle- income families, but not for poor families.

While many proposals in the 2012 election - including Mitt Romney's - aimed for revenue neutrality when estimated on a conventional (sometimes called a static) basis, the Rubio and Lee proposal would lose trillions of dollars in revenues over the next decade when estimated using the conventional approach.

Instead, Rubio and Lee aim to make up the lost revenue through economic growth. The dynamic scoring analysis by the Tax Foundation estimates that the plan would raise GDP by 15 percent and would raise revenue in the long term once those growth effects are taken into account.

The Tax Foundation's growth estimate is, to put it mildly, inconsistent with standard economic analysis. State-of-the-art analysis of a transition to a consumption tax is found in a 2001 American Economic Review paper co-authored by Alan Auerbach, Larry Kotlikoff and several other economists. Their paper estimates that conversion of the then-current system to a pure "flat tax" proposal would raise GDP by 4 percent over a decade.

The "flat tax" proposal they analyze is more pro-growth than Rubio-Lee is. It is a consumption tax. Like Rubio-Lee, it eliminates taxation of interest, dividends, and capital gains, introduces expensing, and eliminates corporate interest deduction. It goes further, though. Unlike Rubio-Lee it also eliminates the entire corporate income tax (whereas Rubio-Lee leave in place a 25 percent corporate tax). It also eliminates all itemized deductions, which allows a top rate of 21-22 percent, compared to 35 percent under Rubio-Lee. All of those differences should make the flat tax have bigger effects than Rubio-Lee, not smaller. This suggests that the claim that Rubio-Lee would boost GDP by 15 percent over a decade is way too high and that the notion that the tax cut will pay for itself is well beyond unrealistic.

Tax rate cuts in the past have not spurred much if any growth. Harvard's Martin Feldstein, a leading conservative economist who headed Ronald Reagan's Council of Economic Advisers, shows this in two papers regarding the 1981 tax cuts. Moreover, there is simply no credible evidence that the 2001 tax cuts generated any growth. Indeed, growth after 2001 was sub-normal and was concentrated in housing and finance, sectors that were not boosted by the 2001 tax cuts and were more likely helped by loose monetary policy. The literature on debt-financed tax cuts shows little if any growth effect from most such changes. Moreover, cross-country evidence shows great variation in top tax rates over time but no correlation between those rates and subsequent rates of economic growth.

In any case, if the proposal were to go forward legislatively, the Joint Tax Committee would have to score it and my guess it that their growth and revenue estimates would be quite different than the Tax Foundation's.

In the meantime, discussion of tax reform is a good idea. But it'd be even nicer to discuss serious ways to pay for reform as well.