For decades now, it's been traditional for Republican presidential candidates seeking an edge in the primary to unveil a tax plan. There was Steve Forbes' flat tax, Richard Lugar's national sales tax, the Mike Huckabee–backed FairTax, and Herman Cain's 9-9-9 plan, to name a few. And Sen. Marco Rubio's (R-FL) plan, crafted with Sen. Mike Lee (R-UT) and building on work Lee did last Congress, is by far the most interesting of the 2016 cycle.
The proposal would create a $2,500-per-child tax credit that is being criticized for leaving out some of the poorest families; eliminate taxes on capital gains and dividends entirely; and, according to static estimates by the Tax Foundation, a think tank sympathetic to the plan, increase the deficit by more than $4 trillion over 10 years. As a result, the plan is forcing two fights in the Republican Party simultaneously: how progressive should a Republican tax plan be, and can Republicans be both the party of tax cuts and the party of fiscal responsibility?
The ideological centerpiece of the plan is a proposal for a new $2,500-per-child tax credit for families with children. This credit would come in addition to existing tax breaks like the Child Tax Credit and the Dependent Care Credit. It would be somewhat refundable (that is, you can get it as a check in case you don't owe income taxes); people with no income tax burden could count it against their payroll taxes. However, it's not completely refundable, in that someone whose payroll tax burden is less than the value of the credit won't get the whole thing.
This may seem like a minor, technical change. But a loose movement of conservatives — known as reform conservatives, or "reformocons" — have seized upon the idea of a bigger child credit as their central economic policy proposal. The economist Robert Stein originated the idea in a 2010 article in National Affairs, arguing that while the Reagan administration's focus on cutting tax rates was appropriate in an era when the top rate was 70 percent, rates have gotten low enough that tax cuts can't spur economic growth the way they used to.
Better than focusing on rates, Stein argued, are tax reforms meant to reward parents. The point isn't just that child rearing is socially desirable; Stein and his fellow reformocons argue that the government is actively deterring families from having children. "A growing body of economic literature shows that in the United States, Social Security and Medicare have 'crowded out' the traditional incentive to raise children as a protection against poverty in old age," Stein explains. "Most workers foresee getting enough support from the public retirement system to stay out of poverty when they get older, making it less likely that they will have to call on direct aid — either in cash or in kind — from their own children."
Worse, this deters families from creating future workers necessary for financing the social safety net for the elderly. "Even as these systems depend upon a population of productive young workers at the national level, they diminish the economic need for children at the individual level — and so undermine their own sustainability," Stein writes. The solution is to counteract this disincentive by creating a child tax credit.
Rubio and Lee explicitly reference this argument in their proposal. "As parents simultaneously pay payroll taxes while also paying to raise the next generation that will pay payroll taxes, parents pay more into the old-age entitlement systems," they write. "This creates a situation known as the 'Parent Tax Penalty' where parents pay more, but are not compensated for these payments."
This isn't the only reason reform conservatives cite for favoring a bigger child tax credit. The idea also helps them rebut the perception that conservatives are primarily interested in reducing taxes on the wealthy and lack an agenda for helping middle-class families. Talking about an earlier Lee tax plan, National Review's Reihan Salam wrote that it "will give GOP candidates a meaningful way to talk about the anxieties plaguing middle-income families, and it offers a solid foundation for other proposals designed to attack worklessness. This is a big deal."
Friendly-to-some-families tax reform
Lefties have plenty to dislike in the child tax credit plan. The limited refundability means that very poor families with no income tax burden and a payroll tax bill of under $2,500 won't benefit. Worse, the plan allows an expansion of the child tax credit included in the 2009 stimulus package to expire. That expansion reduced the minimum income a family had to earn to qualify for the credit from $14,700 to $3,000, a huge change that let very poor families take advantage of it.
"Consider a mother with two children who works full time, year round at the minimum wage in a nursing home and receives a Child Tax Credit of $1,750," the Center on Budget and Policy Priorities' Chuck Marr writes. "The Lee-Rubio plan would let her credit disappear in 2018. It also would exclude her — and millions of other working-poor people — from its new child credit."
Stein told the Week's Ryan Cooper that poor families are left out on purpose: he already thinks they have sufficient incentive to have children, due to the Earned Income Tax Credit, which is far larger for families with children. The plan is meant, he said, to "hold harmless the bottom 20 percent," but "not designed to encourage fertility in the poor over and above what we already do."
But there's a decent argument to be made that, on Stein's own terms, you ought to extend the benefit to poor families, as well. "A poor person in a non-SS and non-Medicare world is especially motivated to have kids because they know they aren't going to be able to put much money away for retirement (unlike rich adults who could plausibly think they don't need a kid because they can save enough)," Matt Bruenig writes at Demos. "This would mean SS and Medicare especially tips the scales in a 'distortionary' manner for them."
It's not just lefties dissenting, however. More supply-side oriented conservatives and libertarians have criticized the child tax credit proposal, principally for distracting from the (to them) much more important project of cutting marginal tax rates. Veronique de Rugy has the most comprehensive version of this critique at National Review. "The opportunity cost of expanding the child tax credit in this way is huge, in terms of the possible tax reforms it crowds out," she writes. "If their proposed child-tax credit were smaller, Rubio and Lee could have also included a low-rate flat tax, for instance." She also disputes Stein's idea that parents are subject to a tax penalty: "People aren’t taxed at a higher rate nor do they pay more taxes the moment they have children. In fact, it is the reverse because of personal allowances."
Two tax brackets
The current tax code has seven income tax rates for individuals, ranging from 10 percent to 39.6 percent. Rubio and Lee reduce that to just two: 15 percent for income below $75,000 (or $150,000 for couples), and 35 percent for all income above that.
That amounts to a tax increase for certain income segments and a cut for others. Roughly speaking, low-income and rich but not super-rich individuals and families lose out while slightly less rich and even richer ones gain.
The 15 percent rate is more than the current 10 percent bottom rate, hurting low-income people (though the plan corrects for this a bit — more on that in a sec). Some middle-income people paying the 25 percent rate today will see it knocked down to 15. Then again, some people paying top rates of 28 or 33 percent today will be kicked up into the 35 percent bracket, while the richest taxpayers will see their top rate fall from 39.6 percent to 35 percent.
To put it another way, imagine four families: one with taxable income of $15,000, one with $100,000, one with $400,000, and one with $1 million. The first and third families would see their tax bills rise; the second and fourth would see them fall.
This aspect of the plan has provoked opposition from more supply-side-minded conservatives. "The sharp 20-point tax cliff that families on the cusp of $150,000 face," the Reason Foundation's Shikha Dalmia writes at the Week, "will create a huge disincentive for them to continue their climb up the income ladder."
A top rate of 35 percent is, while a cut from current levels, a deviation from most congressional Republicans' stated position. Paul Ryan's budget, which has been the centerpiece of the House GOP's economic agenda for years, creates a top tax rate of 25 percent. Other influential members of the caucus have moved away from that view — former Ways and Means Chair Dave Camp (R-MI) proposed a top rate of 35 percent, albeit one kicking in far above where Rubio-Lee's does — but it's still a notable difference.
The plan also simplifies the system of tax deductions and exclusions. All deductions except for the mortgage interest and charitable deductions are eliminated. There is no longer a standard deduction (so all filers can take advantage of the mortgage and charity deductions), and the personal exemption is turned into a credit, increasing its size substantially. That boost is meant to compensate low-income people for the loss of the 10 percent tax bracket.
All of this is meant to greatly simplify the code and, in the case of eliminating itemization and most deductions, reduce subsidies that overwhelmingly help high-income families. That said, most of the simplification work is done on the deduction side; a system with fewer rates isn't that much simpler than one with many. As the New America Foundation's Mark Schmitt once wrote, "We could have a four-rate tax system in which you could file your return on a postcard. The complexity and unfairnesses in the current system come not from rates, but from exemptions and deductions, from treating income from different sources differently, and from creating special provisions that phase out and in at different income levels and in different years."
The plan's big concession to supply-siders
While the 35 percent rate and child tax credit set Rubio and Lee apart from the most ardent supply-siders in the conservative movement, their plan does have one feature that should appeal to them: it makes all non-wage income tax-free. All capital gains, dividends, and interest would go totally untaxed.
The rationale behind this is that taxing that kind of income creates a disincentive against saving and investment, by "double-taxing" savings. Imagine you make $50,000 in wages and pay $10,000 in taxes on it. Then you take $5,000 of your post-tax income and invest it. Lucky for you, the stocks you picked grow in value to $55,000, at which point you sell. The $50,000 gain would, under current law, be taxable income, though the rate would be lower than for wages. But it's the result of a spending decision you made with money that had already been taxed. If you'd just bought a TV with that money, the federal government wouldn't have taxed the money again — but because you chose to save, it got hit again. That's an unfair saving deterrent that hurts the economy, opponents of capital taxation argue.
They have a bit of a point. Most optimal tax models economists use suggest that capital income shouldn't be taxed. And it's not just conservatives and libertarians arguing this; a highly influential model by Anthony Atkinson and Joseph Stiglitz, both noted lefties, suggested that zero capital taxation was ideal. More recently, Emmanuel Saez and Thomas Piketty have argued that while there should be some taxation of capital income, the rate should be lower than for wages.
Another way of thinking about this is that Rubio-Lee would basically turn the income tax into a payroll tax, and in the long run payroll taxes are roughly equivalent to consumption taxes. And economists love consumption taxes — most research on the matter suggests that transitioning to taxing consumption rather than income would increase economic growth by removing disincentives to savings. Rubio-Lee also converts the corporate tax to a consumption tax by letting businesses immediately deduct all investments.
But there are also very strong reasons to keep taxing capital income. One is progressivity: the people who pay capital taxes are overwhelmingly very, very rich. "In 2013, an estimated 94 percent of the tax benefit of low rates on capital gains will go to taxpayers with cash incomes over $200,000, and three-fourths of the benefits will accrue to millionaires," the Tax Policy Center's Len Burman writes.
Moreover, while tax models suggest capital income should be exempt, empirical evidence on the matter is muddier. "There is no evidence that links aggregate economic performance to capital gains tax rates," the University of Michigan's Joel Slemrod, perhaps America's leading tax economist, has said. Burman notes that it's very difficult to find a statistical relationship between capital gains rates and economic growth over the past 60 years or so. That doesn't mean they had no effect — there are many confounding variables that complicate the analysis — but it suggests they're not a terribly important factor.
Some consumption tax advocates also believe exempting capital income is a bad approach, one that would benefit people who already hold a lot of wealth. "Whereas consumption taxes would place a burden on consumption financed by the sales of existing assets, eliminating capital income taxes would do the opposite, providing a windfall to owners of existing assets," UC Berkeley's Alan Auerbach writes. "Such a windfall would not only lower progressivity, but would also substantially reduce potential growth effects."
Burman also argues that by encouraging people to reclassify income as capital gains rather than wages, eliminating capital taxation or taxing capital income at a lower rate could actually cause economic distortions. In particular, it makes jobs like private equity — where the nature of the job is investing, and so incomes are taxed at capital gains rates rather than normal ones — extremely attractive because you can avoid tax on your salary. "The enormous tax savings available likely lure too many highly productive people into the private equity business, drawing them away from other potentially more socially valuable enterprises," Burman writes.
The big problem: not enough money
By far the biggest weakness of Rubio-Lee is that it would likely dramatically reduce tax revenue. The Tax Foundation estimates it would cost $414 billion a year, and a Tax Policy Center estimate of an earlier plan by Lee that didn't eliminate taxes on capital income found it would cost about $2.4 trillion over 10 years. For context, George W. Bush's 2001 tax cut cost $1.35 trillion over 10 years, and his 2003 one cost $350 billion. The Rubio-Lee plan is more than double the size of those two cuts combined, if the Tax Foundation estimate is to be believed.
Advocates of the plan argue that it will boost growth enough to recoup these staggering losses. The Tax Foundation goes so far as to say that the plan will grow the economy 15 percent and, accordingly, actually increase revenue by $94 billion a year. To call this extremely optimistic would be an understatement. As the Tax Policy Center's William Gale notes, standard economic models suggest a flat tax — which should theoretically boost growth much more than Rubio-Lee — would increase GDP by 4 percent. The idea that a less dramatic change would increase it by 15 percent is just fanciful.
This is by far the aspect of the plan that most concerns the reform conservatives whose work it's based upon. "I like the basic structure of Lee-Rubio," Salam writes. "What I don’t like is that in its current form, it is trying to promise everything to everyone. If Lee-Rubio ever gets to the point where it’s being debated in Congress, it will simply have to raise more revenue." New York Times columnist and Salam collaborator Ross Douthat agrees: "$4 trillion in deficit-financed tax cuts is simply not reasonable given America’s current fiscal situation, and the record of the modern Republican Party offers no reason to trust that pay-fors will emerge organically once a Republican president has been elected."