The Frustrating Fixation on Statutory Rates

While reading Ramesh Ponnuru’s latest Bloomberg View column, on how small business owners are complicating efforts to reform the corporate tax code before taking on an overhaul of the personal income tax, I was struck by the following passage:

Many Republicans believe that it would be unfair to make some businesses pay 39.6 percent while others, filing under the corporate-income tax, paid 28 percent or less. The fairness argument is complicated, though, because filing under the individual-income tax generally reduces taxes on investment.

That’s a major reason why so many businesses do it, and why Congress has encouraged them to do it for decades. Take account of that, and the effective tax rate on corporate investment might end up being higher, even under Obama’s proposal, than the effective rate on other business investment.

But the effective rate may not matter as much politically as the statutory one. One well-connected lobbyist for a trade association that represents both small and big businesses says that a lower rate for the latter would look too bad for Republicans to support. She adds that her group’s small-business members would never stand for a reform that ignores all of their concerns with the tax code. If she tried to sell the idea to them, she says, they would probably fire her on the spot. [Emphasis added]

This instinct shapes tax policy in all kinds of ways. It undoubtedly shaped the design of Mitt Romney’s new tax proposal, for example. As we’ve discussed, it is the high-income rate reductions that deliver the most “bang for the buck” when we compare potential revenue less to growth-enhancing impact. Yet Romney, like George W. Bush a decade ago, seems to have concluded that one couldn’t advocate cutting marginal tax rates for high-earners without also cutting marginal tax rates across the board, despite the fact that high-earners will also benefit from a lower basic rate — it’s just that this cut will have no incentive effect for high-earners.

The Growth and Investment Tax Plan is an attractive alternative that generates as much revenue as current policy, unlike the Romney tax plan (and here we aren’t taking into account planned spending cuts, which are also compatible with GIT), yet GIT has a 15 percent basic rate. Even if, as seems likely, low- and middle-earners get a tax cut under GIT and the code remains as progressive as it is under current policy, the mere fact that the basic rate is higher than it is under current policy would be enough to sink it politically.

What this basically means, I fear, is that we can never raise the basic income tax rate, even if doing so would be an important part of making the tax code more growth-friendly without sacrificing too much revenue.

This relates to a number of broader obstacles to tax reform. Megan McArdle has a new post on why she favors abolishing the corporate income tax, and it includes the following aside:

I think the thing’s horribly inefficient–companies and rich people spend an exorbitant amount of time arranging their affairs to be lower-taxed, rather than more productive.  Taxing capital once, when it hits a person, as ordinary income, would in one fell swoop eliminate most of the tax-avoidance activity that goes on in this country.  It’s also not necessarily as progressive as its proponents think, and well, you can read all my other reasons for disliking it here.

This is not necessarily politically realistic, of course, which is a fair criticism of the plan.  But sometimes, I like to argue for first-best policy, even if it’s a no-hoper.

To make this more explicit, my guess is that abolishing the corporate income tax is politically unrealistic because it would presumably require raising more revenue through the personal income tax. Short of a thorough Zero Plan-style elimination of tax expenditures, this in turn would mean higher statutory tax rates.

I tend to think that the Barro strategy (also here), in which we preserve the tax preference for capital income while keeping a relatively high top marginal tax rate (or perhaps increasing the tax preference for capital income while raising the top marginal tax rate), would be more conducive to growth than reducing the tax preference for capital income while also lowering the top marginal tax rate, a la Bowles-Simpson.

But the latter approach is more “eye-catching,” and thus more likely to resonate with many right-of-center policy demanders. One is reminded of the role played by the money illusion in the stickiness of wages.

P.S. Bruce Bartlett has more on the corporate tax code, and why the efforts of reform advocates focused on C-corporations might not bear fruit.

Reihan Salam — Reihan Salam is executive editor of National Review and a National Review Institute policy fellow.

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