David R. Henderson  

Rubio-Lee Isn't Great

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Co-blogger Scott Sumner, over at his TheMoneyIllusion blog, has a post titled "Rubio-Lee is great, so why not make it even greater?"

I don't agree that Rubio-Lee is great. It has many good features and Scott has listed pretty much all of them, so I won't repeat them here. It has a feature, that I'll mention shortly, that is a major negative. Also, however great or not great Rubio-Lee is, the one major addition that Scott proposes would lower the level of greatness. Scott proposes a stiff 50 percent marginal tax rate on all taxable income over $250,000 for single people and $500,000 for married people. That's a large increase from the current top rate of 43.4 percent. In fact, it's a 15 percent increase.

Scott argues that Rubio-Lee essentially changes the federal income tax into a progressive consumption tax, and he's basically right. But even for a consumption tax, 50% is pretty high.

If Scott Sumner's change to the Rubio-Lee proposal were adopted, the highest-income people in California, where I live, would pay a 50% marginal tax rate on their labor income to the feds and a 13.3% marginal rate to the state government. That's 63.3%. And remember that the 13.3% paid to the state government isn't a deductible expense under Rubio-Lee. (I'm not objecting on this last one: I agree with both Scott and Senators Rubio and Lee that state taxes should not be deductible.)

Unfortunately, Scott didn't mention the worst aspect of Rubio-Lee: the huge tax credits.

Here's what I thought Scott was going to say when I read the title of his post: a way to dramatically improve Rubio-Lee would be to have the two marginal tax rates both be lower (drop them from 15% and 35% to, say, 12% and 30%) but make up for the revenue loss from that reduction in rates by eliminating the high tax credits they propose and replacing them with tax deductions. For example, under Rubio-Lee, a married couple with 4 children would get a tax credit of $14,000--$4,000 for the couple and $2,500 for each of the 4 children. If that couple made $100,000 in wage income, the family would compute a $20,000 liability but then offset this with a $14,000 tax credit, for a net tax liability to the feds of only $6,000. I say "only" not because I think they should pay more but because, given what the various players, including Rubio and Lee, want the feds to raise in revenue, this is too small a number. So, for example, if Rubio and Lee proposed instead replacing tax credits with somewhat higher tax deductions for singles, couples, and children, there would not be as much of a revenue loss to the feds and they could have marginal tax rates be a few percentage points lower, as I mentioned above.

The big problem with tax credits is that they change literally no marginal tax rates. Tax deductions, on the other hand, would reduce marginal tax rates for at least a few people.


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CATEGORIES: Tax Reform , Taxation




COMMENTS (8 to date)
Scott Sumner writes:

David, Good post. A few comments:

I may well face a 63% tax rate on consumption, when you take into account the double taxation of capital. I consume a fairly small share of my wage income. But when I said "even greater" I was actually thinking more in terms of things from the perspective of liberal critics of the bill. I think that the only way we'll get sensible tax reform is to make the new code fairly progressive, so both parties buy into it.

I'd much prefer we get rid of deductions like mortgage interest and health insurance, and then lower the rates. And cut government spending, and lower them even more.

I didn't notice the tax credit problem---you are right that those are too large.

Duncan Earley writes:

I'm confused (no surprise). How is it a consumption tax? Income is still taxed in a given year even if I save it?

David R. Henderson writes:

@Duncan Earley,
How is it a consumption tax? Income is still taxed in a given year even if I save it?
Good question. I thought what you thought at first and, in fact, revised this post as I was writing. Answering this question is worth a post of its own, and it’s on my to-do list for later this week, unless a commenter wants to explain it on this post.

Vladimir writes:

@Duncan and David,
I might be misunderstanding the bill, but I had the same question occur to me while reading Scott's post. Maybe this answer will help somebody else, or prompt somebody to correct me.

The key insight I inferred from Scott is that the difference between income tax and consumption tax is the tax treatment of deferred spending, i.e., savings. Whether taxation occurs at the time money is earned versus at the time money is spent is a superficial difference, compared to the tax incentives on immediate consumption versus savings. To focus on the removal of capital gains in particular, while both the current and proposed tax codes impose taxes when income is earned, the proposed tax code disproportionately favors those who save their income. Correspondingly, if you keep all else equal, there is a relatively increased burden on those who consume all of their income. So this proposed tax must be more akin to a consumption tax.

David R. Henderson writes:

@Vladimir,
You put it well. With the exception of this clause--"the proposed tax code disproportionately favors those who save their income”--which I might even agree with if I understood what you mean, I agree with your analysis.
@Duncan Earley and others,
Does this do it for you or would you rather that I write a whole blog post?

Bob Murphy writes:

David,

Yes, please do write it up. Prima facie, wages are not the same thing as consumption, so it's hard to see how a tax on wage income is the same thing as a tax on consumption. I'm guessing it is a steady-state result if we assume there is no land in the economy?

I asked Scott about it and he just said (bottom of the comment) it's what he learned in grad school, so (to repeat) I would love for someone to spell out why some economists treat the two interchangeably.

Vladimir writes:

@David,
I meant that in reference to the tax on capital gains. This proposal would remove this tax, which would help people who save. It would have no impact on people who consume all of their income, and therefore never have capital gains.

ThomasH writes:

The way to have a consumption tax is to have a consumption tax. Rubio-Lee is not it. To get to a consumption tax one needs to:

1. Eliminate the corporate income tax and impute corporate income to shareholders. [Expect a lot of regulations of corporate income to insure that expenses were being used to provide untaxed consumption to employees or shareholders.]

2. Make (taxable) consumption will equal income minus documentable savings (= addition to wealth) minus “merit” consumption of such things as education, health maintenance costs, charitable giving, and state and local taxes. [Expect a lot of regulations to prevent hiding consumption from asset ownership and to limit levels of different kinds of merit consumption.]

3. Adopt a progressive rate schedule (which will presumably begin with a range of negative rates. Rates would be set to be more progressive on consumption than the actual system is on income.

4. Use the consumption tax to replace all other forms of federal taxation except fees for using Federal assets (e.g. highways, air traffic system, inland waterways) and Pigou taxes on negative externalities such as emissions of CO2 and other pollutants.

A consumption tax COULD BE fairer, more progressive and more efficient than the personal-corporate income tax, but since the current system resulted from a political system that favors the currently wealth, the change could be either better or worse that what we have.

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