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Marco Rubio and Mike Lee's Tax-Reform Plan Isn't Terrible, But It Has One Fatal Flaw

John Gress/Getty Images

On Wednesday morning, senators Marco Rubio and Mike Lee released their long-awaited plan to overhaul both the individual and corporate tax codes. Like traditional Republican plans, it consolidates tax brackets, lowers the top rate, and eliminates a host of deductions. But instead of using every last dollar to lower marginal rates, Rubio and Lee finance a massive expansion of the Child Tax Credit (CTC).

That aspect of the plan, which Rubio and Lee have spoken about frequently over the past year, has already drawn significant criticism from those on the right because it uses money for the CTC expansion instead of solely focusing on lowering marginal rates. In the coming days, it will surely face even more scrutiny. It will be interesting, for instance, to see how House Ways and Means Chair Paul Ryan, an adamant supply-sider, reacts to the proposal. Regardless, Rubio and Lee have put forward a credible, conservative tax proposal that could lay the groundwork for comprehensive tax reform in the future—with one glaring flaw.

Business Tax Reform

Under the current tax code, businesses are either taxed under the corporate code or the individual code (where income is “passed through” the business entity to be taxed on the individual side). It’s a complicated system. The corporate tax rate is 35 percent, while “pass through” entities can be taxed at as high a rate as 39.6 percent. Rubio and Lee want to lower the maximum corporate and “pass through” tax rate to 25 percent.

That could inspire individuals to classify their labor income as business income, to pay the lower corporate rate—a potential problem Rubio and Lee are aware of. “In order to prevent abusive misallocation of labor income as business income, this plan also creates strong rules that preserve current tax arrangements for partnerships and independent contractors while discouraging abusive reclassifications,” they write. Whether those rules will work is another story, but at least the senators are clear-eyed about the dangers of taxing “pass through” entities at a lower rate.

On the international side, Lee and Rubio want to move to an international tax system, in which a company’s income is taxed only in the country where it’s earned. This is not that different from President Barack Obama's budget proposal. Under the president’s plan, foreign income would be taxed at a 19 percent rate, with a credit for any taxes paid overseas. It would eliminate any incentive for companies to keep their money abroad because the tax would apply to all foreign income, whether it’s repatriated or not. And since most countries have a tax rate above 19 percent, most multinationals would not owe any U.S. taxes on their foreign income. Only companies that earn much of their income in tax havens would owe additional U.S. taxes on that income.

The biggest problem with an international tax system is that it gives companies incentives to use complex tax strategies to move their income to low-tax jurisdictions. Many companies, especially Apple, have sold their intellectual property to separate entities based in Ireland, where the tax rate is 12.5 percent. (Apple uses other complex strategies to lower its rate even further.) Once again, Rubio and Lee are aware of this problem and say their “plan would also create strong rules regarding profit shifting and realization of intangible and financial income to decrease base erosion and disingenuous tax reduction maneuvers.” That’s fine, but companies are very good at finding a way around any rules, no matter how strict they are. Obama’s plan, on the other hand, offers a sure-fire way to make sure U.S. companies cannot avoid the U.S. corporate tax.

The Lee-Rubio plan for business tax reform would also eliminate the tax on capital gains, allow businesses to deduct 100 percent of investment expenses in the year the investment is made (instead of over a longer period) and would eliminate “extraneous business tax provisions.” Those first two provisions are designed to stimulate more investment by lowering the costs of investment for businesses. In theory, this makes sense. But the evidence that the capital gains rate has a major effect on investment is murky at best. Eliminating the capital gains tax also creates a huge incentive for Americans to classify their income as investment income. “Lowering tax rates on capital gains alone (1) distort work and investment decisions into activities that produce income taxed as capital gain instead of ordinary income,” Len Burman, the director of tax policy at the Urban Institute, wrote Tuesday, “and (2) create a giant loophole that can be exploited via tax shelters.”

Individual Tax Reform

Rubio and Lee would consolidate the current seven tax brackets into two brackets, and massively simplify the individual tax code. Single filers would pay at a 15 percent rate for their first $75,000 in income. All income above $75,000 would be taxed at a 35 percent rate. (The income threshold is $150,000 for dual-earner households.) Conservatives always want to consolidate the number of tax brackets but it’s an unnecessary change. After all, it’s not complicated to calculate your tax liabilities once you know your taxable income. In fact, moving to a system of infinite tax brackets would make the system more purely progressive and would not make the tax code more complicated.

Calculating your taxable income, on the other hand, can be very challenging. It requires navigating a host of tax deductions, credits, and exemptions. Most households use the standard deduction, which was $6,300 for a single earner in 2015. For instance, a fast food worker making $15,000 a year would have a taxable income of $8,700, which would be taxed at a 10 percent rate. The worker would also lower their taxes through credits like the Earned Income Tax Credit (EITC) and Child Tax Credit (CTC).

However, a small percentage of households will benefit from itemizing their deductions instead of using the standard deduction. The tax code is littered with special deductions. Some, like the home mortgage interest deduction and the deduction for state and local taxes, are huge. In 2013, the Congressional Budget Office (CBO) estimated that those two deductions will each reduce government revenues by more than $1 trillion from 2014-2023. The vast majority of these benefits accrue to high-income households.

If a policymaker is serious about simplifying the tax code, consolidating tax brackets is not enough. They also have to clean out all of these tax breaks—and that’s exactly what Lee and Rubio want to do. They would eliminate just about every tax deduction, with the exception of the deduction for charitable giving and a reformed mortgage interest deduction (although they don’t say how it’s reformed). In return for eliminating the standard deduction, they would create a new $2,000 personal tax credit ($4,000 for joint filers).

But the most important change would be a huge expansion of the Child Tax Credit. Currently, families can collect a credit worth up to $1,000 per child, although the exact amounts  can vary. The Rubio-Lee plan would raise that to $2,500 per child and make it refundable against payroll taxes, both on the employer and employee side. But it's not fully refundable, causing it to leave out many poor and non-traditional families. A better idea, as The New Republic's Elizabeth Stoker Bruenig has proposed, would be a child allowance available equally to all parents.

At the end of their 26-page proposal, Rubio and Lee give examples of how their plan would affect various American households. A joint filer with $50,000 in income, two children, $1,500 in charitable income, $1,000 in student loan interest, and $2,500 in retirement savings would save $4,500 a year, for instance. But as when any politician releases a tax plan, these are examples of American households who would benefit most—in this case, families with kids. Beyond that, the senators don’t give any details on how their plan affects the progressivity of the tax code.

When former Representative Dave Camp released a tax plan almost a year ago, he learned how hard it was to overhaul the tax code. His plan consolidated tax brackets, lowered rates and cleaned out the tax code, in ways similar to Rubio-Lee's. But it also imposed a new tax on too-big-to-fail banks and taxed capital gains as ordinary income—a non-starter for many Republicans. Mitch McConnell, then the Senate Minority Leader, said the plan had “no hope” of passing. For those hoping for a major overhaul of the tax code, the reaction on the right to such a credible, conservative pan was disappointing.

Lee and Rubio are hoping to avoid that fate—and may have found a way to do so. The reason Camp had to impose a tax on banks and tax capital gains as ordinary income is that it’s basically impossible to accomplish all conservative tax goals while keeping the plan revenue-neutral. Lee ran into this same problem with the first draft of his tax plan, which the Tax Policy Center scored as increasing the deficit by $2.4 trillion over the next decade. So when it came to this new proposal, Lee and Rubio decided they wouldn’t make it deficit neutral. It’s far easier to make a tax plan that appeals to all Americans when you raise less revenue than the current tax code.

In some sense, this isn’t a huge problem. As Rubio and Lee write, their plan is a first step on the long road to comprehensive tax reform. “A potential drawback to the Lee-Rubio plan — which will surely draw headlines as Rubio gears up to run for president — is that it swells the deficit,” Ramesh Ponnuru, who calls the proposal the “most pro-growth tax reform since Calvin Coolidge's presidency,” wrote at Bloomberg View. As Ponnuru writes, a major tax cut doesn’t necessarily have to blow a hole in the budget; it just has to be accompanied by huge spending cuts.

For those on the left, that’s a dealbreaker. Given the rising cost of Medicare, Medicaid, and Social Security, we’re going to need more revenue in the future, not less. Of course, few people on the left or right will say that. Even Democratic plans are generally revenue-neutral. But unless the health care cost curve bends considerably, we’ll hit a point in the near future where we will no longer be able to avoid this obvious problem.

Some on the right understand this as well. The American Enterprise Institute's James Pethokoukis, who largely supports the Rubio-Lee plan, posed a question to former Florida Governor Jeb Bush in Politico recently. “Given the aging of American society,” he wrote, “do you think the U.S. will need to tax and spend more (as a share of GDP) over the next 25 years than it did in the past 25 years?” Reihan Salam, the executive editor of National Review and also a Rubio-Lee fan, applauded Pethokoukis’s question and followed it up on Twitter:

Rubio and Lee apparently have a “super-magical plan.”

My biggest concern with Rubio and Lee’s plan is that it will cause Republicans to drop their commitment to revenue-neutral tax reform. They will see a comprehensive proposal that checks off nearly every conservative box and decide that a major tax cut is the way to go. If that happens—if the Overton window moves in a conservative direction—it will blow up the small chance that comprehensive tax reform could happen anytime soon.

This post has been updated to better reflect the effect of the CTC expansion.