Fiscal FactCheck: Tax Reform and Economic Growth

This blog is part of the “Fiscal FactCheck” series designed to examine the accuracy of budget-related statements made during the 2016 presidential campaign.

Claim: Tax Reform Can Signifcantly Accelerate Economic Growth

Since the 2016 Presidential campaign began, a number of candidates have touted tax reform – either overhauling or replacing the current income tax – as a way to promote economic growth. In fact, well-designed tax reform can and probably would promote economic growth; though perhaps not by as much as some of the candidates claim.

Both the Joint Committee on Taxation (JCT) and Department of Treasury have attempted to measure the economic impact of tax reform. Depending on the type of tax reform, official estimates suggest the size of the economy can be boosted by between 0.1 and 2.4 percent on average over 10 years. This is equivalent to a 0.02 to 0.5 percent change in the annual growth rate, which would increase projected average real economic growth to somewhere between 2.35 and 2.8 percent over the next decade.

Tax reform could help to promote growth in several ways. Most significantly, it can improve incentives to work and invest (increasing labor and capital supply, respectively) by reducing effective marginal rates and can reduce the crowd-out of productive investment by increasing revenue collection for deficit reduction. Tax reform can also eliminate distortions in the tax code to help money flow to activities and investments which produce more welfare or yield greater economic returns, reduce the cost of tax compliance and avoidance, encourage certain pro-growth activities such as research and development, or improve America's global competitiveness.

Most of Deficit's Decline Because Tax Breaks Aren't Included

Much of the press coverage of the updated projections issued by the Congressional Budget Office last week focused on the fact that the deficit would be $59 billion lower in FY 2015 than it was in FY 2014. But those headlines overlooked a major reason the deficit is projected to decline: Congress is waiting until after the fiscal year ends to revive a host of expired tax breaks. These tax breaks expired last year but are expected to be taken up by the end of the year, adding potentially over $150 billion to the 2016 deficit.

CBO's current law baseline, which assumes these "tax extenders" expire, shows deficits declining for the next two years. Given likely action on the extenders however, those projections may be unrealistic. If lawmakers continue the extenders for two years, as legislation approved by the Senate Finance Committee would do, the 2016 deficit would be about $150 billion (37%) larger than CBO's projections. Increased deficits means it's important to offset the cost for any action on extenders, unlike what lawmakers did last year.

Allowing these tax breaks to expire and retroactively extending them one or two years at a time is one way Congress masks the extenders' impact on the deficit. More than half of the deficit's drop between FY 2014 and FY 2015 is explained by the delay of Congress in extending these tax breaks beyond 2014. If the provisions had already been extended, the deficit would have only declined to $468 billion in FY 2015, instead of $426 billion. However, because the tax breaks will not show up on the government's balance sheet until FY 2016, their costs will be shifted. Ultimately, this would push the deficit in FY 2016 to $566 billion. One stimulus provision, bonus depreciation, represents 60 percent of the package's cost in the next two years.

Carper's Highway Plan Responsibly Fixes Trust Fund But With a Catch

The three-month highway law that passed last month was intended to buy time for a more lasting solution for the Highway Trust Fund's finances, so it is encouraging to see Sen. Tom Carper (D-DE) propose a plan to do exactly that. His TRAFFIC Relief Act would gradually raise fuel taxes by 16 cents (bringing the gas tax to 34.4 cents and the diesel tax to 40.4 cents) and index them to inflation. However, the bill falls into the same trap as some other plans by double-counting the revenue going to the trust fund to pay for other tax cuts.

The bill would gradually increase fuel taxes by 16 cents over the next four years and index them to inflation once the 16 cent increase fully phases in. No official revenue estimate is available, but we estimate the fuel tax increases would raise around $200 billion over ten years, enough to fully close the Highway Trust Fund's projected $165 billion shortfall over that period and cover the spending authorized by the Senate highway bill that was considered in July. Importantly, because revenue would continue to grow each year, it would ensure a more lasting solution since revenue would be better able to keep up with spending if it grew with inflation. Because the tax increase is phased in, it would seem to require another revenue source in the short term, although presumably money could be loaned from the general fund and repaid in later years when trust fund revenue will exceed spending.

Finance Committee Approves Extenders, Adds to Debt

The Senate Finance Committee today approved a package of 50-plus tax breaks that expired last year known as "tax extenders." Unfortunately, they chose to extend almost all of them for two years by adding the costs of the tax cuts to the national debt.

The tax breaks are called the "tax extenders" because Congress typically only extends these expiring provisions a year or two at a time, but many of these provisions are quasi-permanent. (The research credit, for instance, has been extended at least 15 times since its creation in 1981.)  The provisions expired at the end of last year, but Congress can extend them retroactively because most people do not pay their 2015 taxes until 2016.

The bill costs $95 billion over ten years to extend all 50-plus provisions for two years (retroactively for 2015 and forward for 2016). The Committee did not offer a way to pay for the cost, so the amount will be added to the deficit. In markup, the Committee did slightly expand more than a dozen of the provisions and the expansion was paid for, as opposed to extenders legislation in the House of Representatives which dramatically expanded some provisions by adding to the deficit.

Inversions Come Up As An Offset Possibility

The House Budget Committee Democrats jumped into the transportation debate last week with a proposed surface transportation reauthorization that mirrors the President's proposal. The six-year bill includes $478 billion of spending, which would increase spending above current levels by about $56 billion over six years and $93 billion over ten years based on the score of the President's budget. The Highway Trust Fund is funded with $41 billion of revenue from limiting inversions, enough to keep the trust fund solvent through FY 2017.

The inversion policy change would lower the threshold for determining when a U.S. company has inverted and is still treated as a U.S. company for tax purposes. Currently, when a U.S. and foreign company merge, the new company is still treated as a U.S. company if 80 percent or more of the shares remain American-owned. Last fall the Treasury Department introduced rules to prevent companies from gaming the current threshold, while this new bill would lower it to 50 percent. The $41 billion of revenue would fund part of the transportation reauthorization, although it is much less than the $210 billion one-time tax on U.S. companies' foreign-held earnings that the President proposed to keep the Highway Trust Fund solvent into 2023.


Finance Committee Provides Its Framework for International Tax Reform

The Senate Finance Committee has been working all year in five bipartisan working groups on tax reform, and today they have reports to show for it. Of particular interest is the international tax reform working group's report, since there has been some potential common ground emerging between the two parties, and this reform has been linked to a Highway Trust Fund solution. We will summarize the other four reports in a later post.

For background, the federal government taxes U.S. multinational corporations on their foreign income with a deferral system. This means that "active" foreign income is generally only taxed when it is repatriated to the U.S., while "passive" income – basically financial income that is highly fungible and mobile – is taxed immediately. The companies get foreign tax credits for the taxes they pay to foreign governments to prevent double-taxation.

The working group's framework discusses five issues in international tax reform:

New Discussions on a Carbon Tax

The Tax Policy Center (TPC) recently released a primer on carbon taxes. The report outlines how the construction of a carbon tax matters for its efficacy in reducing emissions, overall impact on economic well-being, and distributional impact. Particular focus is given to analyzing the potential winners and losers under a carbon pricing regime and how the revenue generated by the tax can be used to alter these effects. Conveniently, the report comes on the heels of a new carbon tax bill (described below) and new research released by CBO, which forecasts hurricane damage to rise five-fold by 2075 as a result of climate change.

Levin, Baldwin Introduce Bill to Close Carried Interest Loophole

Ways and Means Ranking Member Sander Levin (D-MI) and Senator Tammy Baldwin (D-WI) have introduced a bill to close a well-known tax loophole that allows investment and private equity fund managers to pay a lower rate on their taxes. The Carried Interest Fairness Act would close a loophole allowing fund managers to classify their income as long-term capital gains, which is taxed at a top rate of 20 percent, instead of wage income, which is taxed at a top rate of 39.6 percent. (Neither number includes Medicare taxes on investments and wages.)

Investment managers often have a partnership share in their investment fund, which is structured as a "passthrough" entity. When the fund does well and its assets increase, each partner's share of the gain is taxed as capital gains. Fund managers receive some of their compensation in the form of capital gains, even though they are being compensated for their work, not investing their own money.

A Comparison of the House and Senate Trade Bills

The House is considering trade legislation (H.R. 1314, H.R. 1295, and H.R. 644) this week that would fast-track authority for a few major trade deals that are currently being negotiated, change some trade enforcement rules, and extend various other trade-related provisions. Just as the House's previous bills and the Senate's bills (S. 995, S. 1267, S. 1268, and S. 1269) did, the costs contained in the legislation are paid for over ten years with savings from across the budget.

House Set to Target Deficit-Reducing Parts of ACA

Update (6/12/15): A new CBO score estimates that repealing IPAB will cost $7.1 billion over ten years, with all of the cost recorded after 2021. The text has been updated to reflect this score.

The House Ways and Means Committee today will markup several bills, including repeal of the Independent Payment Advisory Board (IPAB) and the medical device tax. You can find out more about the markup on the Ways and Means Committee website.

Unlike full ACA repeal, these policies stand a chance of overcoming a Presidential veto due to the bipartisan support already exhibited for each: as of this writing, the medical device tax repeal bill in the House (HR 160) has 281 cosponsors while the IPAB repeal bill (HR 1190) has 233 cosponsors. However, repealing these policies without offsetting savings from health care or revenue would be a mistake. IPAB, in particular, should not be abolished without a replacement that can similarly restrain long-term Medicare cost growth.

The Joint Committee on Taxation (JCT) has estimated that repealing the 2.3 percent medical device tax would cost $26.5 billion over ten years. However, JCT estimates that the amendment in the nature of a substitute that is expected to replace the bill in markup will reduce revenues by $24.4 billion over the same period.

Although the original co-sponsors of the bill, Reps. Erik Paulsen (R-MN) and Ron Kind (D-WI), said they expect the bill to be offset, no cost-savers have been produced yet. We suggested bundling payments for inpatient care as one option, which not only would produce enough savings to fully offset repeal but also achieve much of its savings from providers cutting their medical device costs. Thus, the medical device industry would still be asked to contribute to deficit reduction, but in a more efficient manner. There are many other options available as well, as we showed at the time and in our latest health care options.

Potential Offsets for Medical Device Tax Repeal
Policy Ten-Year Savings
Memo: Repeal Medical Device Tax -$24 billion
Health Options
Expand bundled payments for inpatient care $25 billion
Reduce state Medicaid provider taxes to 4.5 percent of patient revenues $35 billion
Reduce Medicare coverage of hospital "bad debts" $30 billion
Encourage use of generic drugs by low-income Part D beneficiaries $20 billion
Equalize payments for similar services performed in different settings $20 billion
Increase Medicare Advantage coding intensity adjustment $20 billion
Increase Medicaid drug rebates $10 billion
Revenue Options
Move up "Cadillac tax" by one year to 2017 $35 billion
Eliminate tax breaks for oil and gas companies $40 billion
Increase cigarette tax by 50 cents $35 billion
Close "John Edwards/Newt Gingrich" loophole $35 billion
Limit tax benefit of retirement accounts $30 billion
Eliminate tax exclusion for private activity bonds $30 billion
Require Social Security numbers for refundable portion of child tax credit $25 billion
Eliminate the mortgage interest deduction for second homes and yachts $15 billion

Source: CBO, JCT

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