Here's What An Almost Perfect Tax-Reform Plan Looks Like

The Lee-Rubio proposal is a good start, but this is how to make it better

As April 15 approaches, many Americans would welcome a simpler tax plan.

Sen. Mike Lee, a Republican from Utah, and Sen. Marco Rubio, a Republican from Florida, who is about to declare his candidacy for president, have published a draft tax plan with only two rates and an expanded child credit.

But under their plan, tax rates will rise on some singles and married couples without dependent children. As Lee and Rubio refine their plan, they should consider adjusting the rates and tax brackets so that no group gets a tax increase.

Everyone agrees that simpler is better. Lee and Rubio suggest replacing the current set of seven individual income tax rates ranging from 10% to 39.6% with two rates, 15% and 35%. They get rid of the alternative minimum tax, which now layers a second tax system on top of the basic one. They end the marriage penalty, because their tax bracket for two people is twice as high as the bracket for one person. They get rid of the complexities of interest: It would be no longer counted as income nor deductible as an expense, except for some mortgage payments. Children get an additional tax credit of $2,500, a credit that is refundable against income taxes and payroll taxes.

This expanded, partially refundable tax credit is justified because “parents simultaneously pay payroll taxes while also paying to raise the next generation that will pay payroll taxes,” according to the plan. That means parents are paying a greater share of Medicare and Social Security payments. “This creates a situation known as the ‘Parent Tax Penalty,’ where parents pay more, but are not compensated for these payments,” Lee and Rubio write.

The disadvantage of the proposed plan is that although the tax system would be simpler, singles and couples without children under 17 would pay taxes at higher rates. That is because the 35% tax rate would take effect at $75,000 in taxable income for singles and $150,000 for married couples, rather than the current level of $411,000. Some people in the 35% bracket would lose virtually all of their itemized deductions and get almost no rate reduction.

That would result in an increase in tax payments for singles and couples without dependent children in certain income ranges, around $100,000 to $500,000, according to my back-of-the-envelope calculations. The precise amounts depend on their other deductions, such as charitable contributions and mortgage payments. Those at lower and higher income levels would generally be net winners.

The higher payments would be offset by the boost to the economy from the business elements of the plan, which would likely be significant. Corporate and small-business tax rates would decline to 25% from current rates of 39%. Investment in plant and equipment could be immediately expensed. Companies would only be taxed on income earned in the United States, rather than worldwide, encouraging them to repatriate some of the $1.7 trillion now held overseas (at a tax rate of 6%).

That is why under the Tax Foundation’s dynamic scoring of Lee-Rubio, no income group would ever see a tax hike. The Tax Foundation estimates that the business-tax reforms would raise GDP by 15% after 10 years. That would increase incomes in all ranges, including the $100,000-to-500,000 range, and everyone would be a net winner.

As an added plus, in the Tax Foundation calculations, the effects on income groups are averaged without regard to family circumstances of individual families. That produces the result that at all income levels, the benefits to households with dependent children outweigh the increased costs to childless households.

However, individual income tax rates still matter for work incentives. Raising taxes on singles and childless couples in the name of tax reform is not an essential component of the Lee-Rubio tax plan. In subsequent versions of the plan, that element should be corrected.

One possibility would be to add a third bracket, perhaps 25%, between the 15% and 35% brackets. This could take effect between $50,000 and $125,000 for singles and $100,000 and $250,000 for couples. Another possibility would be to keep the two rates, but make them 15% and 25%. Both of those would avoid a tax hike on childless households — not only singles, but also families whose children are 17 and older.

Consider a couple with two children, the average number, and they are born three years apart. The couple would benefit from the Lee-Rubio child credit when the children were under 17, for a period of about 20 years. For people who work from age 25 to 65, that is half their working lives. During the other years, they would have to pay taxes at a higher rate, reducing their incentives to work. That does not help them, or society, because we want to encourage seniors to continue to work.

Adding a third bracket, or lowering the 35% rate to 25%, would cost money, and the plan on a static basis loses revenue as it is. Varying the child credit by income level would result in additional revenue that could be used for a third tax bracket.

In the Lee-Rubio plan, the proposed child credit would go to everyone, regardless of income. It is seen as “eliminating the inequity of tax treatment for those financing the entitlement system in the future via investment in children.” Why not just have it apply to lower- and middle-income Americans, as is the case with child credits now? It is unlikely that offering high-income families an additional $2,500 a year tax credit would affect their decisions to have more children, because it is a small share of their income.

Households earning above $196,000 are considered in the top 5%. Currently, there are 4.7 million children under the age of 18 in households earning over $200,000 a year. If the Lee-Rubio tax credit were ended for households earning over $200,000 a year, the annual savings would be about $12 billion. Those funds could be used to lower the tax rates.

Alternatively, if the credit applied only to the bottom 80% of households, ending at incomes of about $105,000, the annual savings would be $48 billion, enough to lower rates or add a third bracket.

The generous child credit would benefit residents of Utah, Lee’s state, which has the highest fertility rate in the nation. It would be less valuable to residents of Florida, Rubio’s home, and to the United States has a whole. As the senators begin drafting legislative language, they should consider lowering the top rate or adding a third rate so everyone wins, including singles and families without children at home.

This piece originally appeared in WSJ's Marketwatch

This piece originally appeared in WSJ's MarketWatch