Tonight’s debate will likely focus at some point on the candidates’ tax plans. The Wall Street Journal has a piece claiming that economists are more divided than usual on the Cruz tax plan. I don’t think that’s correct since there has been as much disagreement, if not more, among economists over the Rubio tax plan, and its giant child tax credit in particular.
I should note that I find it pretty exciting that this election cycle, all the major candidates on the Republican side have actually put out fundamental tax-reform plans. While all the proposals are different, they share common characteristics: They cut income-tax rates on households, lower the tax code’s bias against savings and investment, close some loopholes, and reform America’s anti-competitive corporate income-tax system. In other words, they all aspire to end in a better place and address some fundamental problems with the tax code; they are just taking different routes to get there.
In that context, I think it is important to understand that the debate around these plans, at least on the free-market side, has nothing to do with whether or not a particular plan would be an improvement over the status quo but rather it is a debate about which one of these plans is the best. In fact, I am often asked which one is my favorite plan and I have a hard answering that question precisely because there are a lot of things I like about each plan and a few things I dislike (more or less intensely) about each of them, too. Today, I will focus on the Cruz and Rubio plans since they seem to be the two people think of as opposites.
I am not going to spend as much time on the Rubio plan, though, since I have written in detail what I think of it. As I have said, it’s hard not to be happy with Rubio’s plan. It features a reduction of the corporate tax rate to 25 percent, sweeping reductions in double taxation by eliminating the capital-gains tax, the double tax on dividends, the second layer of tax on interest, and it eliminates the death tax and many other deductions.
But it is far from perfect. It includes some serious social engineering that carries a great opportunity cost; to make the $2,500 child tax credit work financially, the plan barely reduces the top marginal individual income-tax rate to 35 percent. As economists have shown, tax credits don’t stimulate the economy the way reducing the top tax rate does. It is in my opinion a terrible feature of the plan that I am sure is meant to cater to social conservatives, but as a result sacrifices a higher standard of living for all.
This pros-and-cons exercise applies to the Cruz plan as well. It would implement a flat tax rate of 10 percent on ordinary income and abolish the corporate income tax and the payroll tax; all good things in my opinion. However, it will also implement a business-activity tax. Here is how the Journal describes it:
What Mr. Cruz calls a business flat tax—and economists call a subtraction-method value-added tax—simply combines corporate and payroll taxes. Businesses would deduct capital purchases immediately and pay a 16% rate without deducting wages. Removing the current cap effectively enlarges the payroll tax for high-income workers.
Some economists are upset about this feature. As Dan Mitchell at the Cato Institute has explained, the choice of a VAT-like tax carries the enormous risk of turning America into Europe, well-known for having both a VAT and an income tax. This means bigger government and slower government.
My main objection to that part of the plan is its lack of transparency. If politicians aren’t going to cut spending, the tax system should reflect the real cost of government and people should feel that pain. Unfortunately, a business flat tax increases people’s illusion that government is free by hiding who is shouldering the tax. Research from Aparna Mathur at AEI and others have shown that business taxes are ultimately passed through individuals in the form of lower wages, reduced dividends, or higher prices. Business taxes are not transparent — and unfairly tax people without their knowledge. This is one of the reasons why business taxes should be abolished entirely and taxes should be paid in full at the individual level, preferably at a flat rate.
The Cruz plan abolishes the corporate income tax and the payroll tax, but the business flat tax ends up expanding the business tax base quite dramatically (businesses can’t deduct wages and benefits under this system). Under the plan both labor income and capital income are taxed at the business level and hence, the cost of government is further hidden from individuals who will shoulder it.
How bad is it? Well, according to the Tax Foundation, under the plan 71 percent of the tax revenue will come from this business flat tax. That means that people will only really see or feel the pain for a third of the cost of government. Currently, the hidden corporate-income tax plus the hidden half of the payroll tax equals 25 percent of total federal revenues — quite a difference. And as we know when the cost of something goes down, the demand goes up!
As Chris Edwards wrote recently in these pages: “If the government is going to take our money, it should mug us on the street in broad daylight, rather than sneak into our homes at night and burglarize us unnoticed.” Unfortunately, that’s what this tax does.
It doesn’t have to be this way. The Hall Rabushka flat tax collects taxes on businesses without making the tax burden less visible. And this plan could do the same. For instance, they could make both sides of the tax visible on pay stubs. Then it would be a perfect tax — flat rate, no deductions, pro-savings, 100 percent visible, and regressive.
Now, some serious people disagree that this feature of the tax is a problem. In a recent debate over at the Heritage Foundation, free-market economist Steve Moore defended it and so did former CBO director Dough Holtz-Eaken and Heritage’s David Burton.
To conclude, each of the plans have some good and not-so-good aspects to them. It is important to underline those features to help design the best possible tax-reform plan going forward. However, it is key to remember that each of these plans are a serious improvement over the status quo.