The Economics of Senator Wyden’s Tax Reform Plan

Senator Ron Wyden (D-OR) will soon become the new chairman of the Senate Finance Committee. In his new role, it’s likely he will pick up where former chairman, Sen. Max Baucus (D-MT) left off: with tax reform.

As reported by Forbes, Sen. Wyden said last week that he hopes to reform the “dysfunctional, rotting mess of a carcass that we call the tax code.”

In a conference last week, the next chairman said his agenda will focus on a few key issues. From Forbes:

• Narrow the gap between taxation of investment income and ordinary income.
• Significantly increase the standard deduction.
• Simplify and enhance the refundable Child Tax Credit and Earned Income Tax Credit.
• Revise savings incentives by creating a new investment account for all Americans at birth, shift savings subsidies from high-income taxpayers to low- and moderate-income households, and consolidate and simplify the current tangle of existing tax-preferred savings incentives.
• Enhance job training.
• Restore Build America Bonds—a short-lived idea that partially replaced tax-exempt state and local bonds with direct federal subsidies. He’d also seek ways to encourage business to funnel overseas earnings into domestic infrastructure investment.

Much of his eventual plan will likely center on the tax reform package he put together with retired Sen. Judd Gregg (R-NH) and his more recent sponsor Sen. Dan Coats (R-IN).

In 2011, Tax Foundation economists Steve Entin and Michael Schuyler, both previously of IRET, analyzed Sen. Wyden’s plan, the “Bipartisan Tax Fairness and Simplification Act of 2010,” or commonly referred to as Wyden-Coats.

Entin and Schuyler found that while the Wyden-Coats tax plan has laudable goals such as simplification, on the whole, Wyden’s tax plan would further enhance the tax code’s present bias against savings and investment and, thus, damage economic growth. Taken in its entirety, the plan would reduce GDP by 4.32 percent.

Changes to the Individual Income Tax Code

On the individual side of the tax code, the Wyden-Coats plan has a couple positive components. It reduces the number of brackets from seven to three, with rates at 15 percent, 25 percent, and 35 percent. It also increases the standard deduction to $15,000 for individuals and $30,000 for couples. Up from the current level of $6,200 for individuals and $12,400 for married couples filing jointly. Additionally, it takes other steps to simplify the code, such as the elimination of AMT.

Previous analysis by my colleagues says that if this part of the plan were done alone, it would increase GDP by .66 percent – a minor increase, but an increase all the same.

Changes to Business and Investment Taxes

When you add in the components of the plan that deal with business and investment, the results turn negative. Though the plan would cut the corporate rate cut to 24 percent, the benefits of a corporate rate cut are offset predominately by the plan’s increase in capital gains and dividends taxes, its lengthening of depreciation schedules, and its treatment of the deductibility of interest.

Wyden-Coats would treat capital gains and dividend as ordinary income with a 35 percent exemption. This change would produce a top effective tax rate of 22.75 percent, up from the current rate of 20 percent. When you add the 3.8 percent surtax from the Affordable Care Act, the top rate jumps to 26.55 percent rate for cap gains and dividends.

The plan also lengthens the depreciation schedules of plant, equipment, and buildings. Depreciation schedules are important because they help determine the true cost of a company’s capital investment. Long depreciation schedules ignore the time value of money and inflation, which lessens the write-off value of an asset purchase. This overstates business income and understates costs, increasing a business’s tax bill.

Additionally, the plan goes the wrong direction on international corporate tax reform. According to previous Tax Foundation analysis, “[i]n order to finance the reduction of the corporate rate to 24 percent, Wyden and Coats eliminate the current "deferral" regime for foreign earnings and reinstate the "per-country" system of foreign tax crediting. These provisions will raise taxes on U.S. multinational by nearly $600 billion over ten years. [JCT score here].” This is what New Zealand did in 1988, but prolonged negative effects on the economy led them to shift to a territorial system in 2009.

Total Effect of the Plan on Economic Growth

Though the plan does simplify the individual side of the tax code, the most important measure of tax reform plans should be the growth it produces. On that measure, this plan falls short predominately due to its treatment of capital.

The economy is largely driven by the price of labor and the price of capital. The business and capital provisions in the Wyden-Coats plan would increase the cost of capital. Over the long run, this slows investment, decreases the capital stock and labor productivity, lowers wages, and damages economic growth.

On the whole, the Wyden-Coats plan would reduce GDP by 4.32 percent, reduce wages by 4.06 percent and reduce federal revenues by $105.4 billion. It’s important to note that these estimates are based on changes to 2011 law, before the Fiscal Cliff tax increases. This would change the estimates slightly, but the general effect would remain the same: the plan in its entirety would damage growth.

To read a complete analysis of the plan and its economic effects, click here for the IRET study written by Steve Entin and Michael Schuyler. For previous Tax Foundation analysis, click here.