The pernicious reality of the Rubio-Lee tax plan

Republican Senators Marco Rubio and Mike Lee recently released a tax reform proposal that is a curious mix of principled pro-growth measures and populist middle-class relief. Where it sticks to principle, it is great. But where it veers into populism, the plan collapses into incoherence.

The senators' plan is a first stab at translating the reform conservative vision (which I wrote about here) into a governing agenda for the GOP. Hence, it is hardly surprising that avowed reformocons jumped quickly to praise it. Ramesh Ponnuru declared it the most pro-growth plan since Calvin Coolidge's presidency, and something that Republicans should "learn to love." Yuval Levin seconded that sentiment. Reihan Salam noted that the plan's basic political bargain — coupling pro-growth policies with middle-class tax cuts — offered a sterling example of conservative political entrepreneurship.

It's true: There is much to like in this proposal, at least for anyone who believes that the road to prosperity lies not through Big Government stimulus programs, but a tax code that doesn't treat savings and investments as sins. To that end, the business tax overhaul that Lee and Rubio propose is definitely a step in the right direction.

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The plan would trim America's corporate tax rate from 35 percent, the highest among OECD countries, to 25 percent, something that liberals have been loath to do even though the higher rate has been crippling the global competitiveness of American companies. That's not the only item on the liberal no-no list that the conservative duo goes after. President Obama wants to double down on America's worldwide system of taxation, which taxes the overseas income of American companies and citizens. Rubio and Lee would join much of the civilized world by moving America to a territorial system that taxes only domestic income.

Likewise, President Obama has been pushing to raise capital gains and dividend taxes from 23 (ish) to 28 percent. Rubio and Lee would eliminate these taxes altogether, given that they are a form of double taxation, since corporate returns are already taxed before they are handed out to shareholders. The plan would also allow an immediate write-off — not the current slow depreciation — of expenditures on equipment, plants, and other capital expenses. It would also end most business tax credits and special deductions, vastly simplifying the tax code.

The non-partisan Tax Foundation estimates that these changes to individual and corporate taxes would boost investment by nearly 49 percent, wages by 12.5 percent, and employment by 2.7 million jobs.

Sounds great, right? Well, here's where the Rubio-Lee plan goes awry: the individual tax code. It collapses the current seven tax brackets into two, with individuals earning below $75,000 and couples below $150,000 paying 15 percent, and everyone else paying 35 percent. It would eliminate all itemized deductions and personal exemptions, except those for mortgage and charities, and replace the $6,300 standard tax deduction for singles and $12,600 for married joint filers with a tax credit of $2,000 for singles and $4,000 for married joint filers.

The real kicker is the introduction of a new refundable child tax credit of $2,500, in addition to the $1,000 credit that parents already receive. And unlike the current credit, this $2,500 wouldn't phase out with rising income. This is even more generous than the $2,000 additional child tax credit that President Obama proposed.

But who are the winners and losers here?

Poor families (and for simplicity's sake, let's consider only married joint filers) making under $18,450 wouldn't be harmed. They still wouldn't pay federal income taxes, even though their tax rate would technically go up from 10 percent to 15 percent. But because the new $4,000 tax credit would be worth quite a bit more than the current $12,600 tax deduction, and they would keep their Earned Income Tax Credits too, they'd still come out even.

Those making between $18,450 to $74,900 would come out a little ahead, since their tax rates won't go up but their tax credits will.

The big losers would be the many families making between $150,000 and $411,500 — or the vast middle and upper middle class who are supposed to be the purported beneficiaries of these reforms. Rubio and Lee's proposed 35 percent tax rate would constitute a big tax hike for these families. Some of the increase would be mitigated if they have children and can avail themselvesof the child tax credit. But still, it'll be a tax hike.

The biggest winners? Those making above $464,850. They'll get a hefty 4.6 percentage point tax cut, from their current 39.6 percent tax rate to 35 percent — plus the new credits.

But the plan has other problems beyond the uneven middle-class tax relief. It is also a monument to unintended consequences that'll hurt the very people it wants to help.

The advantage of the two-rate tax formula over the current graduated system is its simplicity. But that small advantage is eclipsed by its big down side: the sharp 20-point tax cliff that families on the cusp of $150,000 face. This will create a huge disincentive for them to continue their climb up the income ladder, a point that the Heritage Foundation's otherwise laudatory analysis of the tax plan highlights. One might even call it an anti-mobility tax.

Worse, given that usually women are second earners, it's their income that would likely put families over the $150,000 threshold. This means that it's their work that would face the 20 percent surcharge, making this an anti-working-woman tax.

But the really pernicious aspect of the Rubio-Lee plan is the child tax credit, which the Tax Foundation points out won't boost economic growth, but will lose the federal Treasury a whopping $173 billion annually — pretty much wiping out the $169 billion revenue gain from the corporate and other tax reform. (See Table 2).

Why are the duo insisting on this massive credit instead of, say, lowering the 35 percent upper tax bracket, upping the income level where it kicks in, or paying down the debt?

Their answer is that this credit is necessary to offset an alleged "parent penalty" that forces parents to pay for the Social Security and Medicare of current retirees while at the same time bearing the cost of raising children who will pay for future retirees. This penalty, the brains behind the Rubio-Lee plan claim, is producing the "suppressed fertility" of American parents, which will make these programs less sustainable.

But as Mercatus Center's Veronique de Rugy notes, references to a "parent penalty" are grossly misleading. "People aren't taxed at a higher rate nor do they pay more taxes the moment they have children," she points out. "In fact, it is the reverse because of personal allowances." Moreover, thanks to public schooling, parents already receive a huge subsidy from childless Americans.

Using the child tax credit to throw money at parents makes no sense. Instead, why not use the funds to directly shore up old age programs, or, better yet, fundamentally scale them back and make them more sustainable? After all, entitlement programs should serve the population that exists — not create a population to service them.

So what is the real reason that Rubio and Lee are pushing this? Partly, politics — it is a way to steal a liberal issue and create a middle-class conservative constituency. Partly, ideology — it is perhaps a way to advance the social conservative commitment to large, traditional families (with stay-at-home moms).

If that's the case, Rubio, Lee, and their backers should come out and say so and have an open airing of this vision — not inject their agenda into tax reform under the false guise of promoting economic growth and family fairness.