Reform: Ryan-Brady Plan Is a Better Way By Alex Brill October 2016

Earlier this year, Speaker of the House Paul Ryan and House Ways and Means Committee Chairman Kevin Brady released a framework titled, “A Better Way: A Pro-Growth Tax Plan for All Americans.” The plan outlines House Republicans’ priorities for reforming the . 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 ; and dramatically reducing the marginal 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 In pursuit of this goal, the House Republican and House Ways and Means Committee plan identifies five major faults with the current Chairman Kevin Brady released a tax reform tax code: framework titled, “A Better Way: A Pro-Growth

Tax Code for All Americans.” This report was the • Complexity and high compliance costs, final of six reports issued by task force committees • A narrow base as a result of excessive tax that Ryan established on February 4, 2016. To expenditures, develop the tax plan, the task force consulted with rank-and-file members of Congress and • A high penalty on savings and investment, received input from experts, and the Ways and • A code that disadvantages US Means Committee held nine public hearings. The multinational corporations operating in a stated goals of this tax reform effort were to globally competitive marketplace, and “create jobs, grow the economy, and raise wages by reducing rates, removing special interest carve- • A “broken” IRS. outs, and making our broken tax code simpler and The plan addresses these problems by fairer” (Ryan and Brady 2016, 6). lowering statutory tax rates on household

AMERICAN ENTERPRISE INSTITUTE 1 income while increasing the share of Table 1. Statutory Individual Income Tax Rates taxpayers claiming the by Current Law House Republican Plan 25 percentage points, reducing the corporate 10% income tax rate and allowing full expensing of 12% new investment while disallowing a deduction 15% for net interest, and dramatically reducing the 25% 25% marginal tax rate on new business investment. 28% The plan asserts that these reforms will not only simplify the overly complex tax code but 33% also have a positive effect on economic growth 35% 33% in the United States by increasing labor force 39.6% participation, capital investment, and productivity growth. Source: Internal Revenue Code; Ryan and Brady 2016. Dividends, Capital Gains, and Interest Income. This report summarizes the plan, analyzes key Under current law, tax rates on dividends and components of the individual income tax reforms, capital gains are 0 percent for taxpayers in the 10 estimates the budgetary impact of the plan’s and 15 percent marginal tax rate bracket; 15 percent individual income tax provisions, estimates the for taxpayers in the 25, 28, and 33 percent brackets; effective marginal tax rate (EMTR) on new and 20 percent for taxpayers in the highest tax investment under the plan, and briefly discusses brackets, along with a 3.8 percent surtax on its corporate tax reforms. The report will rely, in interest, dividends, capital gains, and passive part, on the American Enterprise Institute’s Open business income for taxpayers earning more than Source Policy Center’s (OSPC) modeling suite for $200,000 (single) and $250,000 (married). scoring and distributional analysis of many of the The House Republican plan proposes a plan’s key provisions. 50 percent exclusion for capital gains, dividends, and interest income and a repeal of the 3.8 percent Summary of the Tax Plan surtax, yielding effective tax rates of 6, 12.5, and 16.5 percent, depending on the taxpayer’s ordinary Ordinary Income Tax Rates. The plan proposes income . In the new framework, interest replacing the current seven rates on ordinary income would be eligible for the lower tax rate, income (10, 15, 25, 28, 33, 35, and 39.6 percent) whereas current law provides a lower rate only for with three (12, 25, and 33 percent). The current 10 long-term capital gains and qualified dividends. and 15 percent brackets are combined to form the Table 2 illustrates the proposed new rates. new 12 percent bracket; the current 25 and

28 percent brackets are combined to form the Business and Pass-Through Income. Under new 25 percent bracket; and the current 33, 35, current law, income earned by a partnership, sole and 39.6 percent brackets are combined to form proprietorship, or S Corporation is taxed at the the new 33 percent bracket. Table 1 compares the shareholder/partner’s ordinary income tax rate. new rate schedule to the current schedule. The House Republican plan proposes to cap that For single tax filers, the 12 percent rate would rate at 25 percent, a lower marginal rate for higher- apply to up to $37,650, the income taxpayers who would otherwise be taxed 25 percent rate would apply to income up to at 33 percent. This income would be taxed on a $190,150, and the 33 percent rate would apply to cash-flow basis due to the adoption of full income in excess of $190,150. For married joint expensing instead of the current regime of filers, the thresholds would be 12 percent up to depreciation. $75,300, 25 percent up to $231,450, and 33 percent In addition, the plan will treat businesses “as for taxable income greater than $231,450. These having paid reasonable compensation to their thresholds would be indexed for inflation in owner-operators,” and such income will be future years as they are under current law. “deductible by the business and will be subject to

AMERICAN ENTERPRISE INSTITUTE 2 tax at the graduated rates for Table 2. Tax Rates on Dividends, Capital Gains, and Interest Income families and individuals” (Ryan Current Law House Republican Plan and Brady 2016, 23). Additional Ordinary Income Dividends and Long- Interest, Dividends, and details about how “reasonable (Including Interest Term Capital Gains Long-Term Capital Gains compensation” will be determined Income) are not specified. The exact 10% 0% share of high-income earners’ 6% income that would be subject to 15% 0% the lower rate is subject to the 25% 15% 12.5% degree to which taxpayers are 28% 15% able to recharacterize their 33% 15% + 3.8% = 18.8% income to qualify as pass- 35% 15% + 3.8% = 18.8% 16.5% through or small business income. 39.6% 20% + 3.8% = 23.8% Source: Author’s calculations; Internal Revenue Code; and Ryan and Brady 2016. Standard Deduction, , and Child . The plan Itemized Deductions. All itemized deductions proposes a broad reform to the standard would be eliminated except for the mortgage deduction, additional standard deduction, interest and charitable giving deductions. personal exemption, and . The According to the IRS Statistics of Income (SOI), standard deduction—currently $6,300 for 30 percent of taxpayers claimed itemized individual taxpayers, $9,300 for head of household, deductions in tax year 2014. Repealing most and $12,600 for married joint filers—would be deductions and increasing the standard deduction increased to $12,000, $18,000, and $24,000, will reduce that number considerably. Regarding respectively. the mortgage interest deduction, the plan makes The plan would establish a new $500 clear that taxpayers who itemize deductions nonrefundable dependent credit (which applies to would be unaffected. Regarding charitable giving, both adults and children) and would repeal both the plan simply indicates that options to continue the personal exemption ($4,050) and the additional to encourage charitable giving will be pursued. standard deduction ($1,250) for elderly or blind Most notable among the eliminated deductions taxpayers. Under current law, the tax savings is the deduction for state and local paid, from the personal exemption and the additional which is the single-largest itemized deduction, standard deduction increases as a taxpayer’s totaling $520.4 billion in 2014. Other notable income rises and he or she climbs into higher deductions that would be repealed include casualty marginal tax brackets. For example, for a family of and theft losses ($2.2 billion in 2014) and medical four in the 15 percent marginal tax bracket, the tax and dental expenses in excess of 10 percent of savings from the personal exemption are $2,430, adjusted gross income ($83.8 billion in 2014) or $607.50 per exemption. For a family of four in (Internal 2016). While the the 33 percent marginal tax bracket, the tax increase in the standard deduction narrows the savings are $5,346, or $1,336.50 per exemption. tax base, the dramatic curtailment of itemized Unlike current law, the plan’s $500 credit is of deductions and the repeal of the personal equal value to all taxpayers who claim the credit. exemption both broaden the tax base The new $500 credit, as well as the existing considerably. child tax credit, would begin to phase out at $75,000 for single filers and $150,000 for married Other Individual Income Tax Reforms. Four other filers, an increase from $110,000 for married reforms are worth noting. First, the alternative filers. 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

AMERICAN ENTERPRISE INSTITUTE 3 approaches to consolidate the myriad of savings Corporate Tax Reforms. The House Republican provisions. Third, the report indicates that tax plan would reduce the federal corporate tax rate provisions related to education would be simplified from 35 percent to 20 percent and repeal the and consolidated but offers no specifics. corporate AMT. Current rules for depreciation Finally, the plan assumes that all tax provisions would be repealed and replaced with immediate enacted in the Affordable Care Act will be repealed expensing for new investment in equipment, as part of the House Republican health care reform structures, and intellectual property, but not land initiative, not as a component of the tax reform or inventories. No depreciation or expensing plan. In other words, the plan assumes a baseline deduction would be allowed for land, and that differs from current law due to other House inventories would be subject to last-in-first-out Republican reform proposals. (LIFO) accounting.1 In addition, the deductibility In this analysis, I deviate from the implied of net interest expense would be eliminated. House Republican’s baseline in one respect; I Taken together, these changes transform the include the 3.8 percent surtax on investment corporate tax code from a 35 percent corporate income in the baseline and therefore include the income tax to something resembling a 20 percent cost of its repeal in my analysis. I made this choice cash-flow tax (with land and inventories still on to compare the effects of the reform plan to income tax principles). current law with respect to the tax rate on In addition, the corporate tax would be border investment income. Other tax changes, such as adjusted, meaning that would be exempt repeal of the medical device tax, which are not from the tax and imports subject to it. While the part of the House Republican tax plan, are reform plan claims this reform will eliminate a excluded from this analysis. “self-imposed unilateral penalty on U.S. exports and a self-imposed unilateral subsidy for U.S. Estate Tax Repeal. The House GOP plan repeals imports” (Ryan and Brady 2016, 15), economists the estate tax and a related provision, the generation- have questioned the real economic advantage of a skipping tax. Under current law, estates valued in border adjustment (see, for example, Viard (2009)), excess of the exemption amount ($5.45 million in and such a reform may invite a legal challenge 2016) are taxed under a graduated rate structure from the World Organization. with a top rate of 40 percent. Other corporate and business tax reforms in Beneficiaries of an estate currently enjoy a step the plan include indefinite net operating losses up in basis on the value of the assets they receive. carry-forward with an adjustment for inflation. As a result, an asset that would normally be subject (Current law permits only the nominal value of to if sold before a taxpayer’s net losses incurred in one year to be carried death will have its basis reset to its value at the forward to offset income in the subsequent time it is inherited by an heir, so that neither the 20 years.) The plan also includes a repeal of deceased taxpayer nor the heirs pay tax on the Section 199, the domestic production deduction capital gain. An alternative, carryover basis, refers that effectively lowers the corporate rate for to the original basis in an asset being passed certain manufacturing and other corporations to forward to the inheriting heir. The House Republican 32 percent; an unspecified reform of the research plan does not indicate if the step up in basis is and development tax credit; and a broad statement converted to carryover basis, but such a policy that the reform plan “generally will eliminate would be consistent with past Republican efforts special-interest [business] deductions and to repeal the estate tax. credits” (Ryan and Brady 2016, 27).

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.

AMERICAN ENTERPRISE INSTITUTE 4 Analyzing the House Republican Tax changes, economists have debated the Reform Plan magnitude of this elasticity for over two decades. The ETI captures both the In this section, I analyze the budgetary impact of substitution between labor and leisure that the House Republican plan’s individual income results from changes in tax rates and other tax provisions and the provisions’ distributional effects, such as the recharacterization of effects, as well as the tax rate’s impact on new income or timing shifts in the reporting of investment. taxable income. (Brill 2016) To estimate the plan’s revenue impact, I use a new individual income tax model made available Brill (2016) assumes an ETI of 0.3 based on the by the OSPC. This suite of models can replicate range of evidence reported by Saez, Slemrod, and all major provisions of the current individual Giertz (2012). Recent research by Sarah Burns and income tax system and can estimate the budgetary 2 James Ziliak finds strong evidence of a significantly impact of changes to the current system. higher ETI: The OSPC suite compares changes to a current-law baseline and is calibrated to Our preferred estimates suggest that the approximately match the Congressional Budget elasticity with respect to broad income is Office (CBO) revenue forecast. Some differences about 0.4 and with respect to taxable income between the OSPC models and baseline and those is about 0.55. These are based on our grouping used by the Joint Committee on Taxation (JCT) estimator that also controls for person-level and the Treasury Department Office of Tax demographics such as age, education, race, Analysis are to be expected, but those differences gender and family structure, along with lagged are modest for most policy changes. At present, cohort-state-year income to control for the OSPC does not offer a model for estimating heterogeneous trends. Even though our the budgetary impact of reforms to the corporate taxable-income elasticity is probably income tax. understated because of the lack of detailed data on deductions and exemptions in the Individual Income Tax Provisions. Because CPS, it is more than double the modal changes in affect taxpayers’ incentives estimate of 0.25 reported in the survey by Saez in a variety of ways, including their desire to work et al. (2012). Our results are consistent with and save and their decisions to report taxable larger estimates in the recent work from income, one crucial modeling assumption in this Blomquist and Selin (2010) and Weber (2014), exercise is the assumed taxable income elasticity suggesting an emerging consensus that the (ETI). As I have described previously: ETI may be larger than previously thought after adopting more robust identification A standard method incorporates behavioral strategies. (Burns and Ziliak 2016) change through a single measure of how a taxpayer changes his taxable income in In light of this new evidence, in the discussion response to a change in the share of marginal and tables that follow, I assume a taxable income income that he can take home after taxes. In elasticity of 0.4, the midpoint between Saez et al. the economics literature, this is called the (2012) and Burns and Ziliak (2016). elasticity of taxable income (ETI) with respect Regarding the changes in capital gains revenues to the after-tax rate. Research in this area has arising from the reform plan’s new rate schedule, been widespread following the publication of a semi-elasticity specific to capital gains Martin Feldstein’s seminal work in the 1990s realizations must be assumed. Recent research (Feldstein 1995; 1999). Using a variety of from the CBO and JCT (Dowd, McClelland, and datasets, econometric techniques, and policy Muthitacharoen 2012) estimates the permanent

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.

AMERICAN ENTERPRISE INSTITUTE 5 elasticity with respect to the marginal tax rate at expansion of the standard deduction, repeal of –0.79. For this purpose, a semi-elasticity is the personal exemption, expansion of the child required and is estimated to be –3.49.3 tax credit, and the new $500 personal credit; (5) repeal of all itemized deductions except for Individual Income Estimates. Table charitable giving and mortgage interest 3 divides the individual income tax provisions into deductions; and (6) AMT repeal. six groups: (1) ordinary income tax rate The total revenue impact of the individual reductions; (2) the 25 percent maximum rate on income tax provisions (including the lower rate pass-through business income; (3) new rates on on pass-through business income) over the capital gains, dividends, and interest income; (4) 10-year budget window (2017–26) is a $227.3 billion revenue loss. The revenue loss in 2026, the Table 3. Revenue Impact of Individual Income Tax Reform Provisions end of the budget window, is $18.5 billion, or 0.65 percent of total projected revenues in that year, Revenue Impact ($ billions) and declining, indicating that these provisions are close to revenue neutral in the long run. The reduction in ordinary income tax rates Provision 2017 2026 2017–26 from 10, 15, 25, 28, 33, 35, and 39.6 percent to 12, 25, and 33 percent is projected to cost $728.6 AMT Repeal –$40.1 –$67.8 –$533.0 billion over the 2017–26 budget window. The reduction of tax rates on pass-through income Ordinary costs $512.5 billion. The reduction in the average Income Tax Rate –$57.9 –$90.8 –$728.6 Reduction tax rate on dividends, capital gains, and interest income costs $590.7 billion. Expanding the Pass-Through –$45.6 –$62.8 –$512.5 Rate Reduction standard deduction, repealing the personal exemption and additional standard deduction, Investment Tax increasing the child tax credit, and creating a –$47.6 –$73.6 –$590.7 Rate Reform $500 dependent credit raises $615.2 billion, and Standard repealing all itemized deductions except for Deduction $47.9 $75.9 $615.2 mortgage interest and charitable giving Expansion, etc. deductions raises $1.52 trillion. Repealing the Itemized 4 Deduction $109.5 $200.5 $1,522.3 AMT costs $533 billion. Reform All Individual Income Tax –$33.8 –$18.5 –$227.3 Provisions Source: Author’s calculations using OSPC Tax-Calc.

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.

AMERICAN ENTERPRISE INSTITUTE 6 Distributional Impact. The income Table 4. Income Level up to Which No Income Tax Is Owed threshold at which taxpayers who claim House Filing the standard deduction are first subject Children Current Law Republican Status to income tax increases slightly under the Plan reform plan. For example, a married Married 2 $48,788 $49,000 couple with two children claiming the Married 1 $39,188 $40,666 standard deduction and earning only Married 0 $29,188 $32,333 wage income will owe income tax when Head of 2 $43,653 $47,166 their income exceeds $48,788. Under the Household reform plan, that threshold is increased Head of 1 $35,844 $38,833 to $49,000. Household Table 4 presents these thresholds Single 0 $22,803 $24,500 under current law and the reform plan Note: This table assumes that all income is from wages or salary and that the for both single and married joint filers taxpayer claims the standard deduction. with no children, one child, and two Source: Author’s calculations using OSPC Tax-Calc. children. In all cases, these Figure 1. Share of Taxpayers Choosing to Itemize, by AGI Percentile 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 Source: Author’s calculations using OSPC Tax-Calc. will have incomes higher inflate deductions, and would reduce the current than the current law thresholds presented in disparity in tax liabilities among similarly situated Table 4. taxpayers (as defined by income and household More significant than the change in the size). Figure 1 illustrates the share of taxpayers at number of tax filers owing income tax is the each income percentile that would itemize increase in the number of taxpayers claiming the deductions instead of claiming the standard standard deduction. Under current law, deduction. approximately 70 percent of taxpayers claim the Because of the reform plan, the average tax standard deduction. The House Republican plan burden will change moderately across the income would increase that share to approximately spectrum. Figure 2 illustrates the average federal 95 percent, reducing the number of itemizing income tax rate for taxpayers by quintile under taxpayers by 37 million. This change is a huge tax current law, under the reform plan, and under an simplification, would likely reduce by alternative baseline calibrated to mimic 2012 tax limiting taxpayers’ incentives to fraudulently law, the last year when the Bush tax cuts were still

AMERICAN ENTERPRISE INSTITUTE 7 Figure 2. Average Tax Rates: Reform Plan vs. Current Law vs. Bush Tax It should also be noted Cuts 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 Source: Author’s calculations using OSPC Tax-Calc. analyzing the impact of the reform plan with respect to in full effect. (The American Taxpayer Relief Act the change in the aggregate tax burden or the of 2012 made permanent most provisions of the average tax burden for taxpayers at different tax relief enacted by President George W. Bush incomes, it is also possible to estimate the change and congressional Republicans in 2001 and 2003 in the EMTR on wage and capital income for but raised the top marginal tax rate on ordinary individuals and on new corporate investment. income, capital gains, and dividends.)

The impact across the first four quintiles, Wage Income. Increasing the standard deduction, taxpayers with adjusted gross incomes up to broadening the tax base, and generally reducing $268,000 under current law, is very small. The statutory tax rates will have a modest positive top income quintile (excluding the top 1 percent) effect on the EMTR on labor, reducing it by would receive an average of approximately 1.5 percentage points on average. The effective tax 2.5 percentage points relative to current law, rate reduction will vary across income deciles and returning their tax liability to par with the Bush among individual taxpayers. tax cuts baseline. Taxpayers earning in the top Figure 3 illustrates the average EMTR on wage 1 percent of income receive the largest average tax income for all taxpayers under current law and cut relative to current law but would still pay the House GOP reform plan. This figure, which more on average than under the Bush tax cuts combines all taxpayers regardless of , baseline. the number of dependents, or the amount of The reform plan lowers taxes for taxpayers in claimed deductions, indicates that the marginal the top quintile because of the reduction in top tax rate on wages is virtually unchanged for marginal tax rates relative to current law. It raises lower-income households, modestly lower for the average tax rate among taxpayers in the top middle-income households, and significantly quintile relative to the Bush tax cuts primarily lower for high-income households. 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.

AMERICAN ENTERPRISE INSTITUTE 8 Figure 3. Effective Marginal Tax Rate on Wages (2017)

Source: Author’s calculations using OSPC Tax-Calc.

To more clearly illustrate the reform plan’s the tax rates on dividends, capital gains, and effect on labor income for different types of interest income cause the EMTR on new taxpayers, Figures 4 and 5 plot the EMTR on corporate investment to decline dramatically. wages for a married taxpayer with two children Partially offsetting that change is the proposal to and a single taxpayer with no children, assuming disallow the deductibility of net interest expense. all their income is wage income and they claim The CBO (2005; 2014) and the Treasury the standard deduction. Department (2014) have estimated the EMTR for new investment across a range of business types Capital Income. The changes in EMTRs on capital and financing structures. The CBO (2014, 42) income are more significant. The average EMTR finds that the overall effective tax rate under 2014 on long-term capital gains drops from law is a 31 percent rate for C corporations and a 22.2 percent to 15.6 percent, the average EMTR on 27 percent rate for pass-through entities. Equity- qualified dividends drops from 17.6 percent to financed corporate investment faces an average 12.7 percent, and the average EMTR on interest EMTR of 38 percent, while the marginal tax rate income drops from 23.8 percent to 11.7 percent. on debt-financed corporate investment is –6 percent. Table 5 summarizes the average EMTRs for Similarly, the Treasury (2014) estimates an average various forms of income under the baseline and marginal rate on new corporate investment of reform plan. 30.3 percent. B-tax, a new model made available within the New Corporate Investment. The proposed move suite of tax models developed by the OSPC, from depreciation to expensing and the allows users to calculate EMTRs on new reductions in the corporate income tax rate and

AMERICAN ENTERPRISE INSTITUTE 9

Figure 4. Effective Marginal Tax Rate on Wages, Married with Two Children (2017)

Source: Author’s calculations using OSPC Tax-Calc.

Figure 5. Effective Marginal Tax Rate on Wages, Single with One Child (2017)

Source: Author’s calculations using OSPC Tax-Calc.

AMERICAN ENTERPRISE INSTITUTE 10 investment under federal tax law and to Table 5. Average EMTR by Type of Income specify alternatives to calculate changes in 5 House Percentage EMTRs. B-tax methodology follows closely to Income Type Baseline Republican Point CBO (2006), a paper outlining the methods Plan Change employed by the CBO for calculating EMTRs Wages 23.7% 22.1% –1.6 on capital income. Long-Term Capital 22.2% 15.6% –6.6 I use B-tax to estimate the baseline and Gains House GOP plan’s average marginal effective Short-Term Capital 31.4% 31.1% –0.3 total tax rate, inclusive of shareholder taxes, Gains for corporate investment income, equity- Taxable Interest 23.8% 11.7% –12.1 financed and debt-financed. As described in Qualified Dividends 17.6% 12.7% –4.9 Table 6, I find that the average marginal rate on new corporate investment drops from Source: Author’s calculations using OSPC Tax-Calc. 31.6 percent in the baseline to 17.9 percent. Table 6. Effective Marginal Tax Rates on New Corporate Corporate investments that are entirely Investment equity-financed would face a marginal tax Current Law House Percentage rate of 16.9 percent, as opposed to (Without Republican Point 38.5 percent in the baseline case. And finally, Bonus Plan Change the marginal tax rate on corporate debt- Depreciation)* financed investment would rise from Corporate 31.6% 17.9% –13.7 –7.2 percent to 20.7 percent. Investment This decrease in the average marginal tax Equity-Financed 38.5% 16.9% –21.7 rate on new corporate investment is likely to Debt-Financed –7.2% 20.7% 27.8 spur considerable amounts of new investment. The JCT, summarizing the Note: Under current law, firms are allowed an additional (“bonus”) amount of current empirical evidence, concludes, “On depreciation equivalent to 50 percent of their investment amount. That provision, temporary in nature, is reduced to 40 percent in 2018 and 30 percent balance, the economic literature on tax policy in 2019 before expiring in 2020. In this analysis, I am comparing the reform plan and investment supports the conclusion that to current law without this temporary provision. changes in taxes have a noticeable impact on Source: Author’s calculations using OSPC Tax-Calc and B-tax model. investment. One survey of the literature, for example, concludes that investment is highly revenue estimates for similar changes are quite responsive to changes in the cost of capital” large. For example, the JCT estimates that a (Joint Committee on Taxation 2015). 25 percent corporate tax rate, a component of Moreover, the near uniformity in marginal Ways and Means Committee Chairman Dave rates across corporate debt and equity financing Camp’s tax reform proposal, costs slightly more will remove the current law bias against equity than $100 billion per year when in full effect. As financing of new investment. Removing the bias reference, CBO (2016) projects average annual toward debt will offer additional economic corporate tax receipts of approximately benefits to the US economy. (See Bianchi (2011).) $400 billion for the same period. However, the House Republican reform plan Corporate Tax Reforms. The OSPC modeling not only reduces the corporate tax rate but also suite does not yet offer the ability to produce a significantly broadens the corporate tax base by revenue estimate from changes to the corporate disallowing the deductibility of net interest income tax, but it is worth noting that JCT expense. Pozen and Goodman (2012) estimate

5. Details about the B-tax model can be found on OSPC GitHub repository at https://github.com/open-source-economics/B- Tax/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).

AMERICAN ENTERPRISE INSTITUTE 11 that disallowing 35 percent of interest expense tax regime is generally considered to reduce could fully finance the revenue loss of reducing revenues. the corporate tax rate from 35 percent to 25 percent. The President’s Economic Recovery Conclusion Advisory Board (2010) estimated that disallowing 10 percent of net interest expense could finance a The House Republican tax reform plan represents 0.7 percent reduction in the corporate tax rate, a bold reform framework, one that simplifies the which (roughly) implies that disallowing all net tax system, dramatically reduces marginal tax interest expense could finance a reduction in the rates on new investment and capital income, and corporate tax rate to 28 percent. modestly lowers the average marginal tax rate on Other evidence suggests that the revenue loss labor. The plethora of individual income tax associated with corporate tax reform is far less reforms approach revenue neutral at the end of than would be estimated by the JCT models. the budget window and beyond. With the inclusion Clausing (2007), Brill and Hassett (2007), and of the business tax reforms (primarily lowering more recently Hartley (2016) have found evidence the corporate tax rate to 20 percent) and the of effects for corporate tax rates repeal of the estate tax, this proposal is expected among developed nations. Hartley (2016) estimates to reduce revenues relative to current law using a revenue-maximizing rate of 29.1 percent based standard revenue-estimating methodologies. A on OECD corporate tax receipt data from 2000 to dynamic or macroeconomic analysis of the plan, a 2014, well below the current statutory rate of subject for future research, is likely to find positive 35 percent. Brill and Hassett (2007) and Clausing economic effects, including offsetting revenue (2007) find revenue-maximizing rates of gains from growth. 25 percent and 33 percent, respectively, using In conclusion, the House Republican plan slightly older data. Based on the results from should be considered a significant reform of the Hartley (2016), a reduction in the corporate tax income tax, one that broadens the tax base, lowers rate to 23.2 percent would be revenue neutral if marginal tax rates on wages modestly, and reduces the United States is, for this purpose, representative marginal tax rates on investment significantly. of an average OECD country. If so, reducing the Relative to reforms proposed by recent Republican corporate rate further to 20 percent would cost presidential candidates, including the Republican roughly $40 billion annually based on the CBO’s nominee, the House Republican plan has a far estimate that a 1 percentage point change in the more modest budgetary impact while still corporate tax rate decreases tax receipts by encouraging work and investment. $12 billion per year (CBO 2014). Other aspects of the corporate tax reform About the Author components of the House Republican plan will have significant budget implications. Expensing Alex Brill ([email protected]) is a resident fellow all equipment, buildings, and intangible assets will at the American Enterprise Institute. He result in a net tax cut within the budget window, previously served as the policy director and chief as deductions that would have occurred in later economist to the House Committee on Ways and years are accelerated into the budget window. Means and on the staff of the White House However, the long-run budgetary effects of Council of Economic Advisers. moving to expensing are smaller in the long run than in the short run. Permitting firms to exempt Acknowledgments revenues associated with exports and disallowing a deduction for the cost of imports would, given I would like to thank Alan Viard, Matt Jensen, our trade balance, result in additional corporate Jason DeBacker, and Stan Veuger for valuable revenues within the 10-year budget window. comments and Cody Kallen for excellent research Repealing various special-interest deductions and assistance. credits will raise revenue, while adopting a territorial

AMERICAN ENTERPRISE INSTITUTE 12 References

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AMERICAN ENTERPRISE INSTITUTE 13 US Department of the Treasury. 2014. “Effective Marginal Tax Rates on New Investment.” August 20. https://www.treasury.gov/ resource-center/tax-policy/tax-analysis/Documents/New-Investment-Rates.pdf.

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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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