Tax Reform: Camp Fires Up the Debate

Tax reform has reentered the headlines with the announcement of a plan from Representative Dave Camp (R-MI), chairman of the House Ways and Means Committee. This is a welcome development, for the present U.S. tax code is hopelessly complex, grossly inequitable, and generally tends to stymie growth. Even so, Mr. Camp's bill is not likely to pass, this year certainly or perhaps ever. The debate over it, however, can advance the general reform effort, pointing out what is necessary and what can work practically, from either an economic or a political angle.1

What Congressman Camp Has Proposed

To bridge between Republicans, who want to reduce Washington's take, and Democrats, who want to increase and redistribute it, Mr. Camp's proposals, he claims, would be revenue and distribution neutral. This, of course, is no place to go through all the many provisions of his 979-page bill. In general, it would do six things:

1) By standardizing breaks on education, child care, and the like, and by eliminating alternative minimum tax, it would relieve the bulk of the population of the need to itemize.

2) It would reduce today's seven individual income tax brackets to three, set at 10%, 25%, and 35%. He claims that 99% of the nation’s taxpayers would fit in the first two brackets.

3) The corporate tax would fall from 35% to 25%, and the proposed code would encourage companies to repatriate foreign earnings by eliminating or reducing the tax rates on such monies.

4) Camp's previsions would tax all "productive income" at the corporate, 25% rate by equalizing the tax treatment of all businesses, subchapter(s), and "pass through" alike.

5) Though the bill would slow some of the accelerated depreciation presently allowed, it would make permanent the research and development (R&D) tax credit.

6) To make up the revenue shortfall from the tax-rate reductions, this proposed code would eliminate many current tax breaks and preferences for individuals and companies.

Congress's Joint Tax Committee scores the bill favorably. Unlike past practice, these calculations account for the bill's likely growth effects. In the past, scoring has ignored such considerations, sticking to a so-called static approach. The bill's claim of revenue neutrality uses a static calculation. But the committee's consideration of growth concludes that Camp's proposals would create 1.8 million new jobs and add $3.4 trillion to economic growth, including an additional $700 billion to federal receipts over the next decade. It is encouraging that this dynamic scoring approach (if not Mr. Camp’s proposals) has received bipartisan support, most importantly and enthusiastically from Senator Ron Wyden (D-OR), chairman of the Senate Finance Committee, who referred to the adoption of dynamic scoring by the Congressional Budget Office as a "breakthrough" on tax reform.

Prospects

Still, for all the hard work done by Representative Camp and his committee, or the favorable scoring, passage is unlikely. Political pundits point out that neither Democrats nor Republicans have much appetite for dramatic legislation in an election year as fraught as this one. Democrats will have an especially hard time endorsing these reforms while campaigning on income inequality. President Obama will likely reject it as well and for the same reasons. For all the static revenue neutrality and dynamic revenue gains it promises, the president has made clear that he will gladly forego revenues and even economic growth rather than "unfairly" lower tax rates on the wealthy, and this bill would reduce the top individual income tax rate from 39.6% presently to 35%.

The proposed legislation also would face resistance because it eliminates tax benefits and breaks for powerful interest groups. Here, the list is long:

1) Though the bill would continue all existing mortgage interest deductions, it would disallow deductions going forward on mortgage amounts above $500,000. High-income earners might not mind, given that the bill also gives them a reduction on their income tax rate, but builders would lobby against this provision, as would representatives from states where property is more expensive.

2) High-tax states also would resist Camp's desire to end deductions for state income and property taxes.

3) The bill's proposals on municipal bonds would also face resistance. It seeks to limit to 25% the tax break provided by municipal bond income and impose a 10% surtax on municipal bond interest received by high-income taxpayers. Wealthy retirees especially would resist such provisions. Because changes would definitely raise the borrowing costs of states and municipalities, they would also stir resistance among the 50 state legislatures and 50 politically potent state governors.

4) The provision to cap itemized deductions for individuals making more than $400,000 a year and eliminate the charitable deduction until it exceeds the 2% of income might generate only passing resistance among wealthy taxpayers, but it would excite intense resistance among powerful charity and non-profit lobbies.

5) The bill would encounter taxpayer resistance by raising the top rate on capital gains, from the 23.8% just recently imposed to 24.8%. A similar resistance, plus objections from pensions or providers, would rise from the bill's proposal to cap the amounts wealthy individuals could place in tax-protected retirement accounts. Meanwhile, insurers and individuals would resist the provision to impose a 10% tax on work-provided healthcare plans.

6) Because the bill would eliminate cash accounting for large and mid-sized professional firms, it would generate particular resistance from doctors, lawyers, and accountants, all three of which are renowned for their lobbying power.

7) While corporations would surely welcome the decline in the tax rates on their overall and foreign earnings, some or all would resist provisions to: a) place a special excise tax on large, presumably systemically important banks; b) eliminate $4 billion in tax subsidies for oil, gas, and other fossil fuel providers; c) end carried interest; d) eliminate all the complicated tax benefits the present code gives alternative energy producers; e) reduce further the deductible portion of business meals and entertainment; f) impose a very complex formula to define which efforts are eligible for the R&D tax credit and entirely exclude violent videogames from the exemption; and g) impose a minimum tax on income above 10% of the value of plant and equipment.

8) The ultimate in broad-based resistance would surely arise from the bill's proposal to take away the tax-exempt status of the front office of the National Football League.

If all this, and it is only a partial list, renders Camp's legislation, as the political pundits seem to agree, dead on arrival, the effort nonetheless has value. It keeps the need for reform at the front of people's minds, both in government and outside it, and it informs all which measures can gain support and which cannot. The debate will also refine people's understanding of which provisions promote equity, efficiency, and simplicity at acceptable costs and which do not. The fate of the proposals and debates on them will also make clear how much genuine tax reform requires bipartisan support, such as existed during the last successful reform effort in 1986. This need is especially critical when it comes to simplification, for Camp's huge bill can only be considered simple when set next to the existing monstrosity.

1 All the facts are drawn from four articles, each used to enhance and verify what the other said: Douglas Holtz-Eakin, "Reforming Taxes, Goosing the Economy," The Wall Street Journal, March 6, 2014; "Tax Reform for Growth," editorial, The Wall Street Journal, February 27, 2014; Martin Sullivan, "25 Interesting Features of Chairman Camp's New Tax Reform Plan," Forbes, March 3, 2014; and "Factbox: On U.S. Tax Reform, Obama and Republican Rival on Same Page," Reuters, March 4, 2014.

The opinions in the preceding economic commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. This material is not intended to be relied upon as a forecast, research, or investment advice regarding a particular investment or the markets in general. Nor is it intended to predict or depict performance of any investment. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Consult a financial advisor on the strategy best for you.

© Lord Abbett

Read more commentaries by Lord Abbett