Tax reform: Ryan-Brady plan is a better way.
Earlier this year, Speaker of the House Paul Ryan and House Ways and Means Committee Chairman Kevin Brady released a tax reform framework titled, "A Better Way: A Pro-Growth Tax Plan for All Americans." The plan outlines House Republicans' priorities for reforming the nternal Revenue Code. Unlike the legislation introduced by Ways and Means Chairman Dave Camp in 2014, the Ryan/Brady proposal is framed as a concept rather than a bill. Nevertheless, most components of the plan are described in sufficient detail to be analyzed and discussed. The new plan is a clear departure from the budget-busting proposals advanced by Republican presidential candidates over the past year and reflects a coherent approach to lowering statutory tax rates; maintaining a progressive income tax; and dramatically reducing the marginal tax rate on new investment, a reform likely to spur a substantial increase in new investment.
The plan will simplify compliance with the tax code by increasing the number of filers choosing not to itemize their deductions. The individual income tax reforms approach revenue neutrality at the end of the budget window.
This report provides a summary of the plan, an analysis of its key components, an estimate of the budgetary impact of its individual income tax provisions, and an estimate of the effective marginal tax rate on new investment under the plan.
On June 24,2016, Speaker of the House Paul Ryan and House Ways and Means Committee Chairman Kevin Brady released a tax reform framework titled, "A Better Way: A Pro-Growth Tax Code for All Americans." This report was the final of six reports issued by task force committees that Ryan established on February 4, 2016. To develop the tax plan, the task force consulted with rank-and-file members of Congress and received input from experts, and the Ways and Means Committee held nine public hearings. The stated goals of this tax reform effort were to "create jobs, grow the economy, and raise wages by reducing rates, removing special interest carveouts, and making our broken tax code simpler and fairer" (Ryan and Brady 2016, 6).
In pursuit of this goal, the House Republican plan identifies five major faults with the current tax code:
* Complexity and high compliance costs,
* A narrow base as a result of excessive tax expenditures,
* A high penalty on savings and investment,
* A corporate tax code that disadvantages US multinational corporations operating in a globally competitive marketplace, and
* A "broken" IRS.
The plan addresses these problems by lowering statutory tax rates on household income while increasing the share of taxpayers claiming the standard deduction by 25 percentage points, reducing the corporate income tax rate and allowing full expensing of new investment while disallowing a deduction for net interest, and dramatically reducing the marginal tax rate on new business investment. The plan asserts that these reforms will not only simplify the overly complex tax code but also have a positive effect on economic growth in the United States by increasing labor force participation, capital investment, and productivity growth.
This report summarizes the plan, analyzes key components of the individual income tax reforms, estimates the budgetary impact of the plan's individual income tax provisions, estimates the effective marginal tax rate (EMTR) on new investment under the plan, and briefly discusses its corporate tax reforms. The report will rely, in part, on the American Enterprise Institute's Open Source Policy Center's (OSPC) modeling suite for scoring and distributional analysis of many of the plan's key provisions.
Summary of the Tax Plan
Ordinary Income Tax Rates. The plan proposes replacing the current seven rates on ordinary income (10,15, 25, 28, 33, 35, and 39.6 percent) with three (12, 25, and 33 percent). The current 10 and 15 percent brackets are combined to form the new 12 percent bracket; the current 25 and 28 percent brackets are combined to form the new 25 percent bracket; and the current 33, 35, and 39.6 percent brackets are combined to form the new 33 percent bracket. Table 1 compares the new rate schedule to the current schedule.
For single tax filers, the 12 percent rate would apply to taxable income up to $37,650, the 25 percent rate would apply to income up to $190,150, and the 33 percent rate would apply to income in excess of $190,150. For married joint filers, the thresholds would be 12 percent up to $75,300, 25 percent up to $231,450, and 33 percent for taxable income greater than $231,450. These thresholds would be indexed for inflation in future years as they are under current law.
Dividends, Capital Gains, and Interest Income. Under current law, tax rates on dividends and capital gains are 0 percent for taxpayers in the 10 and 15 percent marginal tax rate bracket; 15 percent for taxpayers in the 25,28, and 33 percent brackets; and 20 percent for taxpayers in the highest tax brackets, along with a 3.8 percent surtax on interest, dividends, capital gains, and passive business income for taxpayers earning more than $200,000 (single) and $250,000 (married).
The House Republican plan proposes a 50 percent exclusion for capital gains, dividends, and interest income and a repeal of the 3.8 percent surtax, yielding effective tax rates of 6,12.5, and 16.5 percent, depending on the taxpayer's ordinary income tax bracket. In the new framework, interest income would be eligible for the lower tax rate, whereas current law provides a lower rate only for long-term capital gains and qualified dividends. Table 2 illustrates the proposed new rates.
Business and Pass-Through Income. Under current law, income earned by a partnership, sole proprietorship, or S Corporation is taxed at the shareholder/partner's ordinary income tax rate. The House Republican plan proposes to cap that rate at 25 percent, a lower marginal rate for higher-income taxpayers who would otherwise be taxed at 33 percent. This income would be taxed on a cash-flow basis due to the adoption of full expensing instead of the current regime of depreciation.
In addition, the plan will treat businesses "as having paid reasonable compensation to their owner-operators," and such income will be "deductible by the business and will be subject to tax at the graduated rates for families and individuals" (Ryan and Brady 2016, 23). Additional details about how "reasonable compensation" will be determined are not specified. The exact share of high-income earners' income that would be subject to the lower rate is subject to the degree to which taxpayers are able to recharacterize their income to qualify as pass-through or small business income.
Standard Deduction, Personal Exemption, and Child Tax Credit. The plan proposes a broad reform to the standard deduction, additional standard deduction, personal exemption, and child tax credit. The standard deduction--currently $6,300 for individual taxpayers, $9,300 for head of household, and $12,600 for married joint filers--would be increased to $12,000, $18,000, and $24,000, respectively.
The plan would establish a new $500 nonrefundable dependent credit (which applies to both adults and children) and would repeal both the personal exemption ($4,050) and the additional standard deduction ($1,250) for elderly or blind taxpayers. Under current law, the tax savings from the personal exemption and the additional standard deduction increases as a taxpayer's income rises and he or she climbs into higher marginal tax brackets. For example, for a family of four in the 15 percent marginal tax bracket, the tax savings from the personal exemption are $2,430, or $607.50 per exemption. For a family of four in the 33 percent marginal tax bracket, the tax savings are $5,346, or $1,336.50 per exemption. Unlike current law, the plan's $500 credit is of equal value to all taxpayers who claim the credit.
The new $500 credit, as well as the existing child tax credit, would begin to phase out at $75,000 for single filers and $150,000 for married filers, an increase from $110,000 for married filers.
Itemized Deductions. All itemized deductions would be eliminated except for the mortgage interest and charitable giving deductions. According to the IRS Statistics of Income (SOI), 30 percent of taxpayers claimed itemized deductions in tax year 2014. Repealing most deductions and increasing the standard deduction will reduce that number considerably. Regarding the mortgage interest deduction, the plan makes clear that taxpayers who itemize deductions would be unaffected. Regarding charitable giving, the plan simply indicates that options to continue to encourage charitable giving will be pursued.
Most notable among the eliminated deductions is the deduction for state and local taxes paid, which is the single-largest itemized deduction, totaling $520.4 billion in 2014. Other notable deductions that would be repealed include casualty and theft losses ($2.2 billion in 2014) and medical and dental expenses in excess of 10 percent of adjusted gross income ($83.8 billion in 2014) (Internal Revenue Service 2016). While the increase in the standard deduction narrows the tax base, the dramatic curtailment of itemized deductions and the repeal of the personal exemption both broaden the tax base considerably.
Other Individual Income Tax Reforms. Four other reforms are worth noting. First, the alternative minimum tax (AMT) would be repealed. Second, while the plan would preserve current tax incentives for retirement savings, the report indicates that consideration will be given to approaches to consolidate the myriad of savings provisions. Third, the report indicates that tax provisions related to education would be simplified and consolidated but offers no specifics.
Finally, the plan assumes that all tax provisions enacted in the Affordable Care Act will be repealed as part of the House Republican health care reform initiative, not as a component of the tax reform plan. In other words, the plan assumes a baseline that differs from current law due to other House Republican reform proposals.
In this analysis, I deviate from the implied House Republican's baseline in one respect; I include the 3.8 percent surtax on investment income in the baseline and therefore include the cost of its repeal in my analysis. I made this choice to compare the effects of the reform plan to current law with respect to the tax rate on investment income. Other tax changes, such as repeal of the medical device tax, which are not part of the House Republican tax plan, are excluded from this analysis.
Estate Tax Repeal. The House GOP plan repeals the estate tax and a related provision, the generation-skipping tax. Under current law, estates valued in excess of the exemption amount ($5.45 million in 2016) are taxed under a graduated rate structure with a top rate of 40 percent.
Beneficiaries of an estate currently enjoy a step up in basis on the value of the assets they receive. As a result, an asset that would normally be subject to capital gains tax if sold before a taxpayer's death will have its basis reset to its value at the time it is inherited by an heir, so that neither the deceased taxpayer nor the heirs pay tax on the capital gain. An alternative, carryover basis, refers to the original basis in an asset being passed forward to the inheriting heir. The House Republican plan does not indicate if the step up in basis is converted to carryover basis, but such a policy would be consistent with past Republican efforts to repeal the estate tax.
Corporate Tax Reforms. The House Republican plan would reduce the federal corporate tax rate from 35 percent to 20 percent and repeal the corporate AMT. Current rules for depreciation would be repealed and replaced with immediate expensing for new investment in equipment, structures, and intellectual property, but not land or inventories. No depreciation or expensing deduction would be allowed for land, and inventories would be subject to last-in-first-out (LIFO) accounting.(1) In addition, the deductibility of net interest expense would be eliminated. Taken together, these changes transform the corporate tax code from a 35 percent corporate income tax to something resembling a 20 percent cash-flow tax (with land and inventories still on income tax principles).
In addition, the corporate tax would be border adjusted, meaning that exports would be exempt from the tax and imports subject to it. While the reform plan claims this reform will eliminate a "self-imposed unilateral penalty on U.S. exports and a self-imposed unilateral subsidy for U.S. imports" (Ryan and Brady 2016,15), economists have questioned the real economic advantage of a border adjustment (see, for example, Viard (2009)), and such a reform may invite a legal challenge from the World Trade Organization.
Other corporate and business tax reforms in the plan include indefinite net operating losses carry-forward with an adjustment for inflation. (Current law permits only the nominal value of net losses incurred in one year to be carried forward to offset income in the subsequent 20 years.) The plan also includes a repeal of Section 199, the domestic production deduction that effectively lowers the corporate rate for certain manufacturing and other corporations to 32 percent; an unspecified reform of the research and development tax credit; and a broad statement that the reform plan "generally will eliminate special-interest [business] deductions and credits" (Ryan and Brady 2016, 27).
Analyzing the House Republican Tax Reform Plan
In this section, I analyze the budgetary impact of the House Republican plan's individual income tax provisions and the provisions' distributional effects, as well as the tax rate's impact on new investment.
To estimate the plan's revenue impact, I use a new individual income tax model made available by the OSPC. This suite of models can replicate all major provisions of the current individual income tax system and can estimate the budgetary impact of changes to the current system.(2)
The OSPC suite compares tax law changes to a current-law baseline and is calibrated to approximately match the Congressional Budget Office (CBO) revenue forecast. Some differences between the OSPC models and baseline and those used by the Joint Committee on Taxation (JCT) and the Treasury Department Office of Tax Analysis are to be expected, but those differences are modest for most policy changes. At present, the OSPC does not offer a model for estimating the budgetary impact of reforms to the corporate income tax.
Individual Income Tax Provisions. Because changes in tax policy affect taxpayers' incentives in a variety of ways, including their desire to work and save and their decisions to report taxable income, one crucial modeling assumption in this exercise is the assumed taxable income elasticity (ETI). As I have described previously: A standard method incorporates behavioral change through a single measure of how a taxpayer changes his taxable income in response to a change in the share of marginal income that he can take home after taxes. In the economics literature, this is called the elasticity of taxable income (ETI) with respect to the after-tax rate. Research in this area has been widespread following the publication of Martin Feldstein's seminal work in the 1990s (Feldstein 1995; 1999). Using a variety of datasets, econometric techniques, and policy changes, economists have debated the magnitude of this elasticity for over two decades. The ETI captures both the substitution between labor and leisure that results from changes in tax rates and other effects, such as the recharacterization of income or timing shifts in the reporting of taxable income. (Brill 2016)
Brill (2016) assumes an ETI of 0.3 based on the range of evidence reported by Saez, Slemrod, and Giertz (2012). Recent research by Sarah Burns and James Ziliak finds strong evidence of a significantly higher ETI:
Our preferred estimates suggest that the elasticity with respect to broad income is about 0.4 and with respect to taxable income is about 0.55. These are based on our grouping estimator that also controls for person-level demographics such as age, education, race, gender and family structure, along with lagged cohort-state-year income to control for heterogeneous trends. Even though our taxable-income elasticity is probably understated because of the lack of detailed data on deductions and exemptions in the CPS, it is more than double the modal estimate of 0.25 reported in the survey by Saez et al. (2012). Our results are consistent with larger estimates in the recent work from Blomquist and Selin (2010) and Weber (2014), suggesting an emerging consensus that the ETI may be larger than previously thought after adopting more robust identification strategies. (Burns and Ziliak 2016)
In light of this new evidence, in the discussion and tables that follow, I assume a taxable income elasticity of 0.4, the midpoint between Saez et al. (2012) and Burns and Ziliak (2016).
Regarding the changes in capital gains revenues arising from the reform plan's new rate schedule, a semi-elasticity specific to capital gains realizations must be assumed. Recent research from the CBO and JCT (Dowd, McClelland, and Muthitacharoen 2012) estimates the permanent elasticity with respect to the marginal tax rate at-0.79. For this purpose, a semi-elasticity is required and is estimated to be -3.49?
Individual Income Tax Revenue Estimates. Table 3 divides the individual income tax provisions into six groups: (1) ordinary income tax rate reductions; (2) the 25 percent maximum rate on pass-through business income; (3) new rates on capital gains, dividends, and interest income; (4) expansion of the standard deduction, repeal of the personal exemption, expansion of the child tax credit, and the new $500 personal credit; (5) repeal of all itemized deductions except for charitable giving and mortgage interest deductions; and (6) AMT repeal.
The total revenue impact of the individual income tax provisions (including the lower rate on pass-through business income) over the 10-year budget window (2017-26) is a $227.3 billion revenue loss. The revenue loss in 2026, the end of the budget window, is $18.5 billion, or 0.65 percent of total projected revenues in that year, and declining, indicating that these provisions are close to revenue neutral in the long run.
The reduction in ordinary income tax rates from 10,15, 25, 28, 33, 35, and 39.6 percent to 12, 25, and 33 percent is projected to cost $728.6 billion over the 2017-26 budget window. The reduction of tax rates on pass-through income costs $512.5 billion. The reduction in the average tax rate on dividends, capital gains, and interest income costs $590.7 billion. Expanding the standard deduction, repealing the personal exemption and additional standard deduction, increasing the child tax credit, and creating a $500 dependent credit raises $615.2 billion, and repealing all itemized deductions except for mortgage interest and charitable giving deductions raises $1.52 trillion. Repealing the AMT costs $533 billion.(4)
Distributional Impact. The income threshold at which taxpayers who claim the standard deduction are first subject to income tax increases slightly under the reform plan. For example, a married couple with two children claiming the standard deduction and earning only wage income will owe income tax when their income exceeds $48,788. Under the reform plan, that threshold is increased to $49,000.
Table 4 presents these thresholds under current law and the reform plan for both single and married joint filers with no children, one child, and two children. In all cases, these income tax thresholds are higher under the reform plan than under current law. However, because the reform plan also broadens the tax base by eliminating many itemized deductions, some taxpayers who are currently able to eliminate their income tax liability by claiming large amounts of itemized deductions will be brought onto the tax rolls. I estimate that the net effect of the reform plan would be to increase the number of taxpayers by about 6.3 percent (6.5 million). Generally, these taxpayers will have incomes higher than the current law thresholds presented in Table 4.
More significant than the change in the number of tax filers owing income tax is the increase in the number of taxpayers claiming the standard deduction. Under current law, approximately 70 percent of taxpayers claim the standard deduction. The House Republican plan would increase that share to approximately 95 percent, reducing the number of itemizing taxpayers by 37 million. This change is a huge tax simplification, would likely reduce tax evasion by limiting taxpayers' incentives to fraudulently inflate deductions, and would reduce the current disparity in tax liabilities among similarly situated taxpayers (as defined by income and household size). Figure 1 illustrates the share of taxpayers at each income percentile that would itemize deductions instead of claiming the standard deduction.
Because of the reform plan, the average tax burden will change moderately across the income spectrum. Figure 2 illustrates the average federal income tax rate for taxpayers by quintile under current law, under the reform plan, and under an alternative baseline calibrated to mimic 2012 tax law, the last year when the Bush tax cuts were still in full effect. (The American Taxpayer Relief Act of 2012 made permanent most provisions of the tax relief enacted by President George W. Bush and congressional Republicans in 2001 and 2003 but raised the top marginal tax rate on ordinary income, capital gains, and dividends.)
The impact across the first four quintiles, taxpayers with adjusted gross incomes up to $268,000 under current law, is very small. The top income quintile (excluding the top 1 percent) would receive an average tax cut of approximately 2.5 percentage points relative to current law, returning their tax liability to par with the Bush tax cuts baseline. Taxpayers earning in the top 1 percent of income receive the largest average tax cut relative to current law but would still pay more on average than under the Bush tax cuts baseline.
The reform plan lowers taxes for taxpayers in the top quintile because of the reduction in top marginal tax rates relative to current law. It raises the average tax rate among taxpayers in the top quintile relative to the Bush tax cuts primarily because the tax rate on qualified dividends and long-term capital gains is slightly higher than in 2003-12 and the repeal of most itemized deductions raises the EMTR.
It should also be noted that the reform plan will likely alter the geographic distribution of federal taxes. For example, the current federal tax deduction for state and local taxes disproportionately benefits higher-income taxpayers in California, New Jersey, and New York. Repealing this policy will mitigate the tax savings arising from higher statutory rates in these states relative to states such as Florida, Nevada, and Texas.
Effective Marginal Tax Rates. In addition to analyzing the impact of the reform plan with respect to the change in the aggregate tax burden or the average tax burden for taxpayers at different incomes, it is also possible to estimate the change in the EMTR on wage and capital income for individuals and on new corporate investment.
Wage Income. Increasing the standard deduction, broadening the tax base, and generally reducing statutory tax rates will have a modest positive effect on the EMTR on labor, reducing it by 1.5 percentage points on average. The effective tax rate reduction will vary across income deciles and among individual taxpayers.
Figure 3 illustrates the average EMTR on wage income for all taxpayers under current law and the House GOP reform plan. This figure, which combines all taxpayers regardless of filing status, the number of dependents, or the amount of claimed deductions, indicates that the marginal tax rate on wages is virtually unchanged for lower-income households, modestly lower for middle-income households, and significantly lower for high-income households.
To more clearly illustrate the reform plan's effect on labor income for different types of taxpayers, Figures 4 and 5 plot the EMTR on wages for a married taxpayer with two children and a single taxpayer with no children, assuming all their income is wage income and they claim the standard deduction.
Capital Income. The changes in EMTRs on capital income are more significant. The average EMTR on long-term capital gains drops from 22.2 percent to 15.6 percent, the average EMTR on qualified dividends drops from 17.6 percent to 12.7 percent, and the average EMTR on interest income drops from 23.8 percent to 11.7 percent. Table 5 summarizes the average EMTRs for various forms of income under the baseline and reform plan.
New Corporate Investment. The proposed move from depreciation to expensing and the reductions in the corporate income tax rate and the tax rates on dividends, capital gains, and interest income cause the EMTR on new corporate investment to decline dramatically. Partially offsetting that change is the proposal to disallow the deductibility of net interest expense.
The CBO (2005; 2014) and the Treasury Department (2014) have estimated the EMTR for new investment across a range of business types and financing structures. The CBO (2014,42) finds that the overall effective tax rate under 2014 law is a 31 percent rate for C corporations and a 27 percent rate for pass-through entities. Equity-financed corporate investment faces an average EMTR of 38 percent, while the marginal tax rate on debt-financed corporate investment is -6 percent. Similarly, the Treasury (2014) estimates an average marginal rate on new corporate investment of 30.3 percent.
B-tax, a new model made available within the suite of tax models developed by the OSPC, allows users to calculate EMTRs on new investment under federal tax law and to specify alternatives to calculate changes in EMTRs.(5) B-tax methodology follows closely to CBO (2006), a paper outlining the methods employed by the CBO for calculating EMTRs on capital income.
I use B-tax to estimate the baseline and House GOP plan's average marginal effective total tax rate, inclusive of shareholder taxes, for corporate investment income, equity-financed and debt-financed. As described in Table 6,1 find that the average marginal rate on new corporate investment drops from 31.6 percent in the baseline to 17.9 percent. Corporate investments that are entirely equity-financed would face a marginal tax rate of 16.9 percent, as opposed to 38.5 percent in the baseline case. And finally, the marginal tax rate on corporate debt-financed investment would rise from -7.2 percent to 20.7 percent.
This decrease in the average marginal tax rate on new corporate investment is likely to spur considerable amounts of new investment. The JCT, summarizing the current empirical evidence, concludes, "On balance, the economic literature on tax policy and investment supports the conclusion that changes in taxes have a noticeable impact on investment. One survey of the literature, for example, concludes that investment is highly responsive to changes in the cost of capital" (Joint Committee on Taxation 2015).
Moreover, the near uniformity in marginal rates across corporate debt and equity financing will remove the current law bias against equity financing of new investment. Removing the bias toward debt will offer additional economic benefits to the US economy. (See Bianchi (2011).)
Corporate Tax Reforms. The OSPC modeling suite does not yet offer the ability to produce a revenue estimate from changes to the corporate income tax, but it is worth noting that JCT revenue estimates for similar changes are quite large. For example, the JCT estimates that a 25 percent corporate tax rate, a component of Ways and Means Committee Chairman Dave Camp's tax reform proposal, costs slightly more than $100 billion per year when in full effect. As reference, CBO (2016) projects average annual corporate tax receipts of approximately $400 billion for the same period.
However, the House Republican reform plan not only reduces the corporate tax rate but also significantly broadens the corporate tax base by disallowing the deductibility of net interest expense. Pozen and Goodman (2012) estimate that disallowing 35 percent of interest expense could fully finance the revenue loss of reducing the corporate tax rate from 35 percent to 25 percent. The President's Economic Recovery Advisory Board (2010) estimated that disallowing 10 percent of net interest expense could finance a 0.7 percent reduction in the corporate tax rate, which (roughly) implies that disallowing all net interest expense could finance a reduction in the corporate tax rate to 28 percent.
Other evidence suggests that the revenue loss associated with corporate tax reform is far less than would be estimated by the JCT models. Clausing (2007), Brill and Hassett (2007), and more recently Hartley (2016) have found evidence of Laffer Curve effects for corporate tax rates among developed nations. Hartley (2016) estimates a revenue-maximizing rate of 29.1 percent based on OECD corporate tax receipt data from 2000 to 2014, well below the current statutory rate of 35 percent. Brill and Hassett (2007) and Clausing (2007) find revenue-maximizing rates of 25 percent and 33 percent, respectively, using slightly older data. Based on the results from Hartley (2016), a reduction in the corporate tax rate to 23.2 percent would be revenue neutral if the United States is, for this purpose, representative of an average OECD country. If so, reducing the corporate rate further to 20 percent would cost roughly $40 billion annually based on the CBO's estimate that a 1 percentage point change in the corporate tax rate decreases tax receipts by $12 billion per year (CBO 2014).
Other aspects of the corporate tax reform components of the House Republican plan will have significant budget implications. Expensing all equipment, buildings, and intangible assets will result in a net tax cut within the budget window, as deductions that would have occurred in later years are accelerated into the budget window. However, the long-run budgetary effects of moving to expensing are smaller in the long run than in the short run. Permitting firms to exempt revenues associated with exports and disallowing a deduction for the cost of imports would, given our trade balance, result in additional corporate revenues within the 10-year budget window. Repealing various special-interest deductions and credits will raise revenue, while adopting a territorial tax regime is generally considered to reduce revenues.
The House Republican tax reform plan represents a bold reform framework, one that simplifies the tax system, dramatically reduces marginal tax rates on new investment and capital income, and modestly lowers the average marginal tax rate on labor. The plethora of individual income tax reforms approach revenue neutral at the end of the budget window and beyond. With the inclusion of the business tax reforms (primarily lowering the corporate tax rate to 20 percent) and the repeal of the estate tax, this proposal is expected to reduce revenues relative to current law using standard revenue-estimating methodologies. A dynamic or macroeconomic analysis of the plan, a subject for future research, is likely to find positive economic effects, including offsetting revenue gains from growth.
In conclusion, the House Republican plan should be considered a significant reform of the income tax, one that broadens the tax base, lowers marginal tax rates on wages modestly, and reduces marginal tax rates on investment significantly. Relative to reforms proposed by recent Republican presidential candidates, including the Republican nominee, the House Republican plan has a far more modest budgetary impact while still encouraging work and investment.
About the Author
Alex Brill (email@example.com) is a resident fellow at the American Enterprise Institute. He previously served as the policy director and chief economist to the House Committee on Ways and Means and on the staff of the White House Council of Economic Advisers.
I would like to thank Alan Viard, Matt Jensen, Jason DeBacker, and Stan Veuger for valuable comments and Cody Kallen for excellent research assistance.
(1.) Under current law, some inventories are subject to the less favorable first-in-first-out (FIFO) accounting method. Businesses are not allowed to use LIFO on their tax returns unless they also use it in their financial statements, which some businesses are reluctant to do. It is not clear whether the plan would alter this rule and allow all businesses to use LIFO, regardless of their financial statements.
(2.) More information about tax calculator, the model employed to analyze the reform plan, and the OSPC generally can be found at www.ospc.org. The entire suite of models, including source code, is publicly available.
(3.) A simple tax rate elasticity cannot be used in a microsimulation model. Under current law, the marginal tax rate on capital gains is zero for taxpayers with low or moderate levels of income. An increase in the marginal tax rate on capital gains from 0 to 1 percent would produce an infinitely large response if implemented with a non-zero elasticity with respect to the marginal tax rate. In the modeling for this analysis, the semi-elasticity is estimated by determining the average effective marginal tax rate on long-term capital gains for taxpayers across various income groups and the share of capital gains realizations in each group. To avoid division by zero, the conversion method from tax rate elasticity to semi-elasticity is restricted to the top quintile of taxpayers, which has 95.4 percent of capital gains realizations. Using these groups, a weighted-average semi-elasticity of -3.49 yields a tax rate elasticity of-0.79.
(4.) The revenue cost of any provision or set of reforms is affected by the order in which the provisions are added to the model. Here the provisions are stacked in the order presented in Table 3. For sensitivity analysis, I also analyzed the reform plan assuming an ETI of 0.3. Among the six sets of reform changes presented in the table above, the only reforms that are estimated to have a significantly different cost with a change in the assumed ETI are the changes in statutory tax rates for ordinary income (-$841.0 billion instead of -$728.6 billion over the 10-year budget window). This change results in a net budgetary impact of-$34.0 billion in 2026 compared to an estimated net impact of -$18.5 billion in the preferred results presented in the table.
(5.) Details about the B-tax model can be found on OSPC GitHub repository at https://github.com/open-source-economics/BTax/blob/master/Notes_and_Guides/METR _Guide.pdf. Like the CBO, the B-tax model's results for all corporate investment is asset-weighted differently than the weights used to calculate equity- and debt-financed rates separately. As such, the average equity and debt-financed result, 30.5 percent under the baseline, is not a weighted average of the equity-financed (38.4 percent) and debt-financed rates (-13.2 percent).
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Arthur C. Brooks, President; Michael R. Strain, Director of Economic Policy Studies; Stan Veuger, Editor, AEI Economic Perspectives
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By Alex Brill
Table 1. Statutory Individual Income Tax Rates Current Law House Republican Plan 10% 12% 15% 25% 25% 28% 33% 35% 33% 39.6% Source: Internal Revenue Code; Ryan and Brady 2016. Table 2. Tax Rates on Dividends, Capital Gains, and Interest Income Current Law Dividends and Long-Term Capital Gains Ordinary Income (Including Interest Income) 10% 0% 15% 0% 25% 15% 28% 15% 33% 15%+ 3.8% = 18.8% 35% 15%+ 3.8% = 18.8% 39.6% 20%+ 3.8% = 23.8% House Republican Plan Current Law Interest, Dividends, and Long-Term Capital Gains Ordinary Income (Including Interest Income) 10% 6% 15% 25% 12.5% 28% 33% 16.5% 35% Source: Author's calculations; Internal Revenue Code; and Ryan and Brady 2016. Table 3. Revenue Impact of Individual Income Tax Reform Provisions Revenue Impact (billions) Provision 2017 2026 2017-26 AMT Repeal -$40.1 -$67.8 -$533.0 Ordinary -$57.9 -$90.8 -$728.6 Income Tax Rate Reduction Pass-Through -$45.6 -$62.8 -$512.5 Rate Reduction Investment Tax -$47.6 -$73.6 -$590.7 Rate Reform Standard Deduction $47.9 $75.9 $615.2 Expansion, etc. Itemized Deduction $109.5 $200.5 $1,522.3 Reform All Individual Income Tax Provisions -$33.8 -$18.5 -$227.3 Source: Author's calculations using OSPC Tax-Calc. Table 4. Income Level up to Which No Income Tax Is Owed Filing Status Children Current Law House Republican Plan Married 2 $48,788 $49,000 Married 1 $39,188 $40,666 Married 0 $29,188 $32,333 Head of Household 2 $43,653 $47,166 Head of Household 1 $35,844 $38,833 Single 0 $22,803 $24,500 Note: This table assumes that all income is from wages or salary and that the taxpayer claims the standard deduction. Source: Author's calculations using OSPC Tax-Calc. Table 5. Average EMTR by Type of Income House Percentage Income Type Baseline Republican Point Plan Change Wages 23.7% 22.1% -1.6 Long-Term Capital Gains 22.2% 15.6% -6.6 Short-Term Capital Gains 31.4% 31.1% -0.3 Taxable Interest 23.8% 11.7% -12.1 Qualified Dividends 17.6% 12.7% -4.9 Source: Author's calculations using OSPC Tax-Calc. Table 6. Effective Marginal Tax Rates on New Corporate Investment Current Law House Percentage (Without Republican Point Bonus Depreciation) (*) Plan Change Corporate 31.6% 17.9% -13.7 Investment Equity-Financed 38.5% 16.9% -21.7 Debt-Financed -7.2% 20.7% 27.8 Note: Under current law, firms are allowed an additional ("bonus") amount of depreciation equivalent to 50 percent of their investment amount. That provision, temporary in nature, is reduced to 40 percent in 2018 and 30 percent in 2019 before expiring in 2020. In this analysis, I am comparing the reform plan to current law without this temporary provision. Source: Author's calculations using OSPC Tax-Calc and B-tax model.
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|Title Annotation:||Congressional Representatives Paul Ryan and Kevin Brady|
|Publication:||AEI Paper & Studies|
|Date:||Oct 1, 2016|
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