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How to Fix Dave Camp's Tax Plan

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Official Washington was hit with a mega-tsunami on Wednesday of this week when House Ways and Means Committee Chairman Dave Camp (R-Mich.) released his comprehensive tax reform plan.  Analyses have been circling the Beltway ever since.

Below, I'll walk through what's good with the plan, detail the biggest major problem the plan has, and propose a series of solutions to improve it.

A Good Starting Point

The plan has many, many commendable elements: it is not a net tax increase (it's actually a net tax cut paid for by a net spending cut); it lowers the top marginal income tax rate on households from 39.6 percent to 35 percent; it lowers the corporate income tax rate from 35 percent to 25 percent; it liberates 95 percent of Americans from having to keep itemized deduction records; it repeals the AMT.

Even more, the plan gave birth to the first-ever "dynamic analysis" by Congress's scorekeepers on taxes, the Joint Committee on Taxation (JCT).  The JCT dynamic score said that the plan would grow the economy relative to current tax law, especially in the areas of labor force growth, private sector employment, and consumption.  This additional growth would yield up to an additional $700 billion in tax revenue (over a decade) over and above the non-dynamic "static score" JCT also produced.

The plan authors weren't just operating with one hand tied behind their backs because they didn't use the dynamic score revenue windfall.  They were also limited because they had to assume that Congress would let the "tax extenders" expire.  "Tax extenders" are about four-dozen tax provisions that expire every year.  They last expired on December 31, 2013.  Congress always extends them, usually about a year late and retroactively.  If the Camp plan had assumed Congress would continue to pass the extenders package every year (a sound assumption), the plan could have cut taxes by another $1 trillion over the decade, according to committee staff.

Put the dynamic score revenue windfall and the "current policy" baseline together, and the Camp plan actually raises $1.7 trillion more in taxes than it needs to in order to be "real world" revenue neutral.  Even with this handicap, the features highlighted above were possible.

Capital is the Mother's Milk of Economic Growth

So what's not to like?  In a word, "capital."  The JCT score provides a clue.  Even though the dynamic analysis shows that real economic growth increases as a result of the Camp plan, it also shows that this extra growth occurs despite the ankle weight of higher taxes on capital.  Business capital investment actually shrinks in the JCT analysis.  This is confirmed in an analysis that the Heritage Foundation did which shows that gross private domestic investment plummets after the reform plan is phased in.

According to the JCT dynamic analysis, investment in capital is projected to decrease (relative to current law) starting five years into the Camp draft’s implementation. This is largely due to the unfavorable depreciation rules which are implemented that year and which I break out below. The resulting “investment gap” grows to be so large that it becomes a drag on the whole first decade of implementation, the first half of which is positive for capital growth. Outside the window, one can expect this negative drag to deepen, just as one can expect the positive elements of the dynamic analysis to accelerate in the longer term.

This growing effect can be seen in the Heritage Foundation macroeconomic analysis, which shows the annual change in gross domestic private investment plummeting in the same period as the JCT analysis shows a new capital investment rate of decline.  In years beyond this window, this investment should continue to fall relative to what would happen under current law.

(Committee staff have pointed out to me that the JCT analysis, while dynamic, may need to be improved to better reflect capital investment into the United States from abroad. That may improve the situation, but the data currently available paints a fairly clear picture of the tradeoffs that had to be achieved inside the Camp draft: capital investment begins to suffer several years into the plan, even as the labor and consumption factors in the growth equation improve.)

Over time, increasing taxes on capital is not likely to lead to enough long-run economic growth.  Capital is the seed corn of future economic growth.  To tax it is to get less of it, and less economic growth as a downstream result.

Sins of commission, sins of omission

The Camp plan has one major tax increase on capital, and fails to address a current capital tax problem.

The tax increase on capital comes in the form of lengthening depreciation lives.  Under tax law, when a business buys a piece of equipment or real property, they generally cannot deduct that property in the first year (small firms have an exception to this).  Rather, they are forced to deduct the expense in pieces over several to many years in a process called "depreciation."  Ideally, all business inputs would be expensed the first year, but the tax code is not an ideal document.

The Camp draft makes the depreciation bug even worse than current law.  They move to a slower system of depreciation where business assets must be depreciated over a longer time period and at a slower rate.  Additionally, there's an extender the Camp draft didn't re-up: 50 percent bonus depreciation (where half the value of a business asset can be deducted up front, and the rest subject to depreciation).

To their credit, they also index the basis of depreciable assets to inflation, but that isn't enough to overcome the new cost recovery regime.

A similar stretching-out process happens with intangible property, which is accounted for over twenty years in the Camp draft as opposed to the current code's five or fifteen years.

So that's the sin of commission.  There's also a sin of omission on capital.  The tax rate on capital gains and dividends is basically kept the same at about 24 percent (the committee staff and I have a rather arcane disagreement about whether they raised or lowered it a percentage point).  If anything, one would expect a GOP tax reform plan to cut this rate substantially, if not to zero.

Put together, the tax code's treatment of capital got no better from current law in one area, and got a lot worse in others.

As a result, JCT sees a big capital dropoff, falling by as much as 1 percent permanently.  That may not sound like a lot, but it's a drain of hundreds of billions of dollars in wealth, and who knows how much more than that over time.

Heritage agrees.  Despite seeing positive economic effects elsewhere and overall, it shows gross private domestic investment shrinking by tens of billions of dollars per year, and getting worse over time.

That's not encouraging if you want your tax reform plan to be a source of economic growth over the very long run.

A Camp Plan with Maximum Economic Growth

Fortunately, the Camp draft's tax treatment of capital is fairly easy to remedy.  All it requires is the will to use what was left on the table by the plan authors: the $700 billion in dynamic analysis extra revenue, and the $1 trillion from using a more realistic baseline.  Combined, there is $1.7 trillion which can be plowed back into fixing the capital tax problem.  Below is one plan to "patch" the Camp draft in order to remove the capital taxation ankle weight.

Cut the capital gains and dividends tax rate to 0%.  Believe it or not, this isn't that expensive to do.  Extrapolating from the JCT static score, doing this would only require the Camp plan to use up about $70 billion of the $1.7 trillion it has available.

Even if you have zeroed out the capital gains and dividends tax, you still have an Obamacare land mine to deal with.  One of the twenty new or higher taxes in that law imposed a 3.8 percent "surtax" on investment income, including on capital gains and dividends.  Looking at the Obamacare JCT score, junking this tax (and its payroll tax hike cousin) would use up about $350 billion of the $1.7 trillion.

Restore the old depreciation system.  Returning to the old depreciation system (including the 50 percent bonus depreciation) is potentially fairly expensive.  The faster lives and methods will run you about $270 billion according to the Camp draft's score.  The 50 percent bonus depreciation will cost another $300 to $400 billion (based on the JCT score from the post-fiscal cliff deal).  It's worth it, though, if it means reversing the capital stock shrinkage caused by the plan as is.

Tax corporations and non-corporations at the same rateUnder the Camp plan, corporations will be taxed at 25 percent.  However, businesses organized as partnerships, S-corporations, LLCs, and sole proprietorships will be taxed at 35 percent (except manufacturers).  This is not only a case of picking winners and losers in the tax code--it means the return on business capital is being taxed at a higher rate at the "flow through" firms.  These are about 600,000 successful small business owners facing a higher tax rate on their business activity.  Based on IRS data, I would calculate that cutting the tax rate only on this business income so it equals the corporate tax rate of 25 percent should cost about $400 billion over a decade relative to the Camp plan.

Put all of these "fixes" together, and you come out to $1.5 trillion.  So it fits pretty neatly into the extra money that the Camp draft had to play with but didn't use.  The remainder could be used to get rid of some annoying elements like taxing carried interest like ordinary income, making companies pay taxes on "accrued" dollars they haven't collected yet, and the like.

The bottom line is that the Camp draft is a good start, but it has a massive flaw in how it taxes capital.  The good news is that there's plenty of common sense scoring resources available to fix this problem and make the plan a model of pro-growth tax reform.