JCT Report Does Not Conflict With Rate-Reducing Tax Reform

Today, a report from the Joint Committee on Taxation was released that some claim to show the near-impossibility of deficit-reducing, rate-reducing tax reform. The JCT report shows an exercise in which the elimination of itemized deductions allows for a top rate of only 38 percent. Comparisons between this report and the various tax reform plans out there are highly misleading. As Erskine Bowles, Al Simpson, Alice Rivlin, and Pete Domenici said in a recent statement:

A new study by the Joint Committee on Taxation (JCT) assumes a less drastic reduction in tax expenditures and a different baseline that allocates more savings to deficit reduction, and therefore is able to achieve much less rate reduction. The fact that rates cannot be lowered as much if large tax expenditures are left unaddressed and if most of the savings from those that are eliminated are put towards deficit reduction illustrates a tradeoff, but does not surprise anyone who has worked with tax estimation.

The JCT study looks at only a subset of the tax expenditures we reformed or eliminated, thereby leaving out a substantial amount of savings that were included in our proposals. Most notably, the JCT study does not address the employer health exclusion, the largest tax expenditure in the code, as our plans would. In addition, the JCT study assumes tax reform is revenue neutral relative to a "current law" baseline - a baseline that includes the expiration of all parts of the 2001, 2003 and 2010 tax cuts, a position neither party is advocating. This assumption effectively required the JCT to find $4.5 trillion of deficit reduction through base broadening - far more than is included in our plans or any other plan - and use only roughly $700 billion for rate reduction.

There are at least three major distinctions between this study and the bipartisan tax reform plans out there:

• The study is revenue-neutral relative to a baseline in which all the tax cuts from the last decade expire -- a policy which neither party supports or measures against. Relative to the more commonly-used baseline, this plan raises taxes by $4.5 trillion over a decade.
• The study only repeals itemized deductions and the preference for newly-issues state and local bonds. It therefore does not account for dozens of additional tax expenditures worth trillions of dollars -- including the largest tax expenditure in the code which excludes employer health insurance from taxation.
• The study taxes capital gains at 38 percent, which according to JCT would actually lose revenue. JCT tends to estimate the revenue-maximizing level at about 28 percent.

Ultimately, the plan is only able to reduce the top rate from 39.6 percent to 38 percent because only about $700 billion is being used for rate reduction (compared to the $4.5 trillion for deficit reduction and the trillions more that remain as tax expenditures). This is not to say that tax reform is easy, but a number of partisan and bipartisan plans proposed by current lawmakers and experts show that it is possible to lower rates and deficits if policymakers are willing to make the hard choices.

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What Does the JCT Exercise Show?

The JCT thought experiment begins with the premise that we let all the 2001/2003/2010 tax cuts and AMT patches expire. That in itself would raise $4.5 trillion in new revenue; all rate reduction comes later. From that starting point, the plan would then eliminate all itemized deductions and the preference for newly-issued state & local bonds. However, as you can see below the experiment then would spend most of that money on repealing the Alternative Minimum Tax (AMT), repealing PEP and Pease, and extending the current child tax credit and EITC expansion. It would also tax capital gains as ordinary income, which JCT believes would actually lose revenue.

So what's left? About $700 billion. JCT uses that $700 billion to reduce all the rates by 4 percent, so that the top rate would fall from 39.6 percent to 38 percent and the others fall in kind.

^{Note: All estimates are relative to current law. Numbers may not add exactly to totals due to rounding.
*Capital Gains numbers not provided by JCT separately, though according to JCT methodology a 38 percent cap gains rate would lose money relative to current law. We assume 10-year cost of $150 billion.}

If instead of using $700 billion for rate reduction and $4.5 trillion for deficit reduction the report did the reverse, rates could be reduced substantially. In fact, that switch alone would likely be sufficient to push the top rate to 30 percent or below.

What the JCT Exercise Doesn't Show

The JCT study shows how much revenue could be raised by repealing itemized deductions and the interest exclusion for certain bonds. It does not show what would happen if other tax expenditures were eliminated -- including the largest tax expenditure in the code for employer provided health care. By contrast, the tax plans put forward by the Simpson-Bowles Fiscal Commission and the Domenici-Rivlin Task Force -- which would reduce the top rate to 28 percent or lower -- go after trillions of dollars of tax preferences not included in the JCT study.

So how much could rates be reduced in total? As we discussed in a blog post the other day, the Treasury Department found in 2005 that eliminating all tax expenditures would allow the top rate to fall to 23 percent, while still dedicating about $1 trillion in revenue to deficit reduction this decade. This is consistent with the findings of the Simpson-Bowles Commission.

The difference between the 38 percent from the JCT study and the 23 percent cited by Treasury and the Fiscal Commission is due both to the lower revenue target and the additional base broadening. Below we have drawn a rough bridge to illustrate the point:

Of course, this doesn't mean that tax reform will get the top rate down to 23 percent. There are some tax expenditures for which it is administratively difficult, economically unwise, or politically challenging to remove. That's why the Simpson-Bowles illustrative plan, the Domenici-Rivlin tax reform plan, the 2005 tax panel plan, and others have proposed top rates between 28 percent and 33 percent. Even these reforms will require making some very hard choices. But they can also offer real economic and fiscal benefits.