Critics of Rubio-Lee Tax Reform Are Way Off the Mark

March 13, 2015

This article originally appeared at realclearmarkets.

Senators Marco Rubio (R-FL) and Mike Lee (R-UT) have generated quite a buzz in Washington by proposing an ambitious tax reform plan that would replace our arcane individual and corporate income tax systems with a two-rate wage tax, a very generous child tax credit for families, and a business cash-flow tax of 25 percent. The Senators contend that the plan is both pro-family and pro-growth.

While many critics have questioned both assertions, Tax Foundation economists ran the plan through our macroeconomic tax model and found that it would not only boost family incomes across-the-board, but that it would raise the level of the economy by 15 percent after about 10 years.

Some people will reflexively doubt that such growth is even possible. However, putting it into to context, 15 percent growth in GDP over 10 years only requires an additional annual growth of 1.4 percent on top of our currently moribund growth rate of about 2 percent. That is the sort of growth the U.S. experienced in the 1980s and 1990s. It's not remotely unprecedented.

William Gale of the Tax Policy Center is particularly skeptical, claiming that taxes just don't matter that much. He refers to a 2001 study by Alan Auerbach, Laurence Kotlikoff and other economists which simulates the economic effects of various revenue-neutral tax reforms. Gale notes the study's estimate that a revenue-neutral switch to a flat-tax – a type of consumption tax – would "raise GDP by 4 percent over a decade." However, under assumptions closer to ours, the same study finds a flat-tax would raise GDP by 5.9 percent over the long-run.

Most comparable to our analysis of the Rubio-Lee plan is the study's estimate of the effects of a proportional consumption tax, which would replace the federal individual and corporate income taxes with a wage tax and a business cash-flow tax (opposite of Gale's claim, the Rubio-Lee plan eliminates the corporate tax as we know it). The study finds this revenue-neutral proportional consumption tax would eventually raise GDP by 9.4 percent.

However, the Rubio-Lee plan is not revenue-neutral. It is a big tax cut, to the tune of $414 billion a year or 2.2 percent of GDP, according to our static estimate. Such a tax cut would raise GDP by about 6.6 percent, according to empirical estimates by leading economists such as Christina Romer, former chair of President Obama's Council of Economic Advisors. Add that to the Auerbach-Kotlikoff 9.4 percent estimate of a revenue-neutral tax reform and you get 16 percent growth in GDP – more than our 15 percent estimate of the Rubio-Lee plan.

Further, the 2001 Auerbach-Kotlikoff model assumes a closed economy, i.e. we have no saving abroad to bring home and foreigners can't send more of their saving here to help finance additional U.S.-based capital. That's a major, unrealistic constraint. Today's economy is globalized; trillions of dollars of investment flow between the U.S. and the rest of the world. We assume an open economy where shifts in our own and foreign saving to the U.S. finance the build-out of capital. Money flows instantaneously toward higher return investments, so the only real constraints in our model are physical, i.e. the time it takes to actually construct a building, for example, and regulatory, i.e. the time it takes to get the permits, etc. We estimate that more than 90 percent of the physical capital adjustment occurs within 10 years.

Kotlikoff recently updated his model to incorporate, among other things, some open-economy aspects. His latest estimate is that replacing the federal income tax system, on a revenue-neutral basis, with a "Fair Tax" type of consumption tax would raise GDP by around 16 percent. Kotlikoff also estimates a revenue-neutral elimination of the corporate tax, paid for by a consumption tax, would raise GDP by almost 10 percent within 10 years. This is substantially more growth than we estimate from just eliminating the corporate tax without replacing the revenue. However, Kotlikoff's economic adjustment path is now similar to ours, i.e. most of the change occurs within 10 years.

In sum, there are many reasons to think the Rubio-Lee tax plan, or something similar, would have tremendous growth effects. The Tax Foundation's macroeconomic tax model finds that the plan is indeed extremely pro-growth, while raising the after-tax incomes of families up and down the scale.

While critics may challenge the magnitude of these findings, given the current state of the economy and middle-class wages, this is a serious plan that should spur an honest debate over how best to overhaul our dysfunctional federal tax code.

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