Tax Analysts' Martin A. Sullivan recently sat down with Alex Brill, a research fellow at the American Enterprise Institute, to discuss his tax reform plan, which he hopes can win bipartisan support.
Tax reform is a two-front war. On one side there is the battle of dollars and cents: special interests using every trick in the book to preserve their tax breaks. On the other side there is the ideological battle: liberals versus conservatives, each fighting tooth and nail for their core values. Congress will never prevail on the first front unless it can get a ceasefire on the second. And this is where the new tax reform plan from Alex Brill comes in. Brill, a research fellow at the American Enterprise Institute, has a plan that could get Congress past the partisanship.
The Brill plan seeks compromise. For conservatives, there are classic pro-growth policies, like a lower corporate tax rate and a permanent extension of bonus depreciation. It would move the tax system toward something like a consumption tax without the radical overhaul that a flat tax or a FairTax would entail. For liberals, there is a tilt toward progressivity by removing deductions that favor high-income taxpayers, which is a promising approach because Republicans are much less resistant to base-broadening than they are to rate increases.
There are six components of the plan:
• cut the corporate tax rate;
• limit corporate interest deductions;
• make 50 percent bonus depreciation permanent;
• curtail the mortgage interest deduction for high-income households;
• phase out the deduction for state and local taxes; and
• repeal the alternative minimum tax.
The most novel feature of Brill's plan is his proposal to limit corporate interest deductions. Specifically, the plan would disallow a deduction for 10 percent of C corporations' interest expense. After the financial crisis, it is hard to believe there is not more interest in paring back the tax advantages for debt over equity. Limiting deductions will be strongly opposed by public utilities, manufacturers, and financial institutions that rely heavily on debt financing. But some sort of limit on interest deductibility is likely to come up more often as Congress desperately seeks revenue to pay for a significant cut in the corporate rate.
In a brief interview, Brill explains his plan and provides insight based on his experience as policy director for the House Ways and Means Committee under former Chair William M. Thomas.
Tax Analysts: How can your tax reform plan -- or any plan that is focused on promoting growth -- increase the progressivity of the tax system?
Alex Brill: You are correct that the progressivity of the tax code matters for economic growth, and a system of ever-increasing marginal tax rates is certain to discourage entrepreneurship and risk taking. But my proposal increases the progressivity of the code only by broadening the tax base. There are no increases in statutory tax rates. While the changes are not explicitly tied to income, in practice, higher-income earners are generally the ones who reap the most benefit from claiming the deductions that my plan curtails.
"Instead of crafting another "ideal" proposal like ones we've already seen fail, I tried to embrace the political reality and develop a 'second best' plan that has something for both sides."
TA: Your plan is designed to "bridge the gap between Democrats and Republicans." Especially in these times, how does tax reform avoid the partisan gridlock?
Brill: The politics of tax reform are unavoidable. Quite simply, both parties recognize the real impact -- both direct and indirect -- of taxes on their constituents, and neither is going to give up the opportunity to make its mark. Instead of crafting another "ideal" proposal like ones we've already seen fail, I tried to embrace the political reality and develop a "second best" plan that has something for both sides. But only the actual legislators can decide if they are willing to compromise on this issue. As long as they aren't, this proposal will have no more effect than other recent tax reform plans.
TA: Is there anything that makes you believe Congress, after decades of intransigence, may now be willing to significantly reduce the mortgage interest deduction?
Brill: It is important to understand that my proposal for the tax treatment of mortgage interest expands the tax benefit for lower-income households, while limiting it primarily for higher-income homeowners. First, because my plan converts the mortgage interest deduction to a 12 percent credit, non-itemizers who have mortgages would for the first time receive a tax benefit. Second, all homeowners in the 10 percent tax bracket would receive a credit that is more generous than current law. Of course, the net effect of the policy is to reduce the subsidy and broaden the tax base, but the number of taxpayers facing a tax increase is similar to the number receiving a decrease.
TA: Your plan calls for an across-the-board 10 percent reduction in the deduction for interest payments by C corporations. Economists have always decried the corporate tax's bias in favor of debt over equity. But the financial crisis we experienced between 2007 and 2009 has given new impetus to reducing debt levels. How much is your proposal motivated by concerns about financial instability like that we saw during the crisis?
Brill: The tax treatment of interest expense did not cause the financial crisis. However, I believe that it may have exacerbated its magnitude. The current tax subsidy for debt financing induces firms toward higher levels of leverage and increases the risk of bankruptcy. I believe that the tax code should be neutral with regard to the choice between debt and equity finance, but the current system is highly skewed toward debt.
TA: In 2008 Germany adopted a new law that disallows deductions for net interest in excess of 30 percent of earnings before interest, taxes, depreciation, and amortization. Would you consider a proposal like this an acceptable alternative to your proposal for corporate interest?
Brill: I would be open to alternative approaches to limiting the interest deduction. It is important, however, that the change not be contrived as simply a revenue grab, but rather as part of a broader policy goal. A core objective in my proposal is to lower and flatten the marginal effective tax rate on investment. The negative tax rate on debt-financed investment should be raised, and the high positive marginal effective tax rate on equity-financed investment should be lowered. If the German approach achieves that goal, the next step would be to evaluate more technical matters such as simplicity and necessary transition rules.
"It is important to understand that my proposal for the tax treatment of mortgage interest expands the tax benefit for lower-income households, while limiting it primarily for higher-income homeowners."
TA: As you know, President Reagan proposed eliminating the deduction for state and local taxes as part of his May 1985 tax reform package. House Ways and Means Committee Chair Dan Rostenkowski dropped it from the House tax reform package in December 1985. Of course, this change would disproportionately burden high-tax states like California and New York. How can you expect Democrats to accept this while keeping your plan bipartisan? Or to put it differently, what major concession would Republicans be making in this plan?
Brill: Both the Bowles-Simpson and Rivlin-Domenici commissions included this provision in their recommendations and did so with support from prominent Democrats. While I fully expect there to be opposition to this plan from both sides, I am hopeful that there will be bipartisan interest and support as well. Another source of contention, particularly for Republicans, is that while my proposal does not raise tax rates, it does increase tax burdens on the wealthy. A concession that will be necessary from Republicans is accepting a tax code that is more progressive than the one we currently have.
TA: Do you believe fundamental tax reform -- like a flat tax or a FairTax -- is desirable? Is it possible? Or should Congress focus on restructuring the current system?
Brill: When I worked for Ways and Means Committee Chair Bill Thomas, he would often emphasize to staff and colleagues the importance of determining the difference between the doable and the desirable when crafting legislation. In my view, a consumption tax is the desirable policy goal because it would lead to an increase in savings and investment and greater long-term economic growth. However, consumption tax proposals face many political challenges. While at least one proposal, the Bradford X-tax, is a valiant attempt at a progressive consumption tax system, it is unlikely ever to become law. I see my tax plan as potentially in the doable category.
TA: The introduction to your plan states: "Many tax economists believe that the ideal way to spur long-run economic growth is a system that taxes all consumption instead of penalizing savings and investment as an income tax does." You are one of those economists, aren't you? What do you say to conservative economists who vehemently reject any broad-based consumption tax like a VAT on the grounds that it would be a money machine for big government?
Brill: I appreciate the concern of many conservatives that a more efficient tax system may permit higher levels of taxation without hindering economic growth relative to the current, inefficient income tax system. However, I fail to understand why it is better to preserve a bad tax system that we know hampers growth only because it may also help us limit taxation. In my opinion, the key objective of tax reform should be to remove the impediments to growth -- and that requires broadening the tax base and lowering the most distortionary tax rates first. Once we win that battle, we can then evaluate if a broad-based consumption tax is feasible.
TA: Do you think tax reform must be revenue neutral? What are your predictions on when reform might actually be enacted?
Brill: I am a tax reform optimist, always believing that it is just a few short years away. One day, I'll be right in that prediction. Obviously, there has been more attention to tax reform in the last couple of years than there was in the previous decade. From the Bowles-Simpson and Rivlin-Domenici commissions and the efforts by Ways and Means Chair Dave Camp to the popularity of tax reform proposals on the campaign trail, tax reform chatter is increasing.
As to the revenue consequences of tax reform, my view is that policymakers will negotiate this aspect more intensely than any other. Making things more interesting is the fact that it is not simple to define what revenue neutral really means anymore. A wide divide has now emerged between the current-policy baseline (which assumes extension of the 2001 and 2003 tax cuts) and the current-law baseline (which assumes the scheduled expiration of the 2001 and 2003 cuts).
My reform proposal avoids this baseline debate by only proposing reforms to tax provisions that are already permanent tax law. But I do believe that lawmakers will, at some point in the future, be forced to debate over what the tax burden (expressed as revenues as a share of the economy) should be over the long run. But that debate does not need to coincide with tax reform itself.
Alex Brill is a research fellow at AEI