Cruz Proposal Redirects Federal Tax System Toward Consumption

While most of the Republican presidential candidates’ tax proposals reorient federal taxes away from investment and toward consumption, Ted Cruz’s reforms go furthest with a flat income tax, the elimination of all payroll taxes and the introduction of a value-added consumption tax.

Like Trump’s proposal (see FEI Daily article on Trump’s tax plan), the Cruz plan would deliver pleasure and pain to private companies.  But the total transformation of the tax system under the Cruz proposal makes assessing the full measure of each difficult at best.  The three think tanks that have done analyses have produced widely different estimates of the proposal’s net effect on federal revenue.  Over the next 10  years, the Tax Foundation (a conservative think tank) estimated the Cruz plan will cost $3.7 trillion (T) in lost federal revenue. This compares with estimates by the Tax Policy Center (centrist) of $8.6T, and by Citizens for Tax Justice (a liberal institution) of $16.2T1.

Relying on the Tax Policy Center’s (TPC) study of the Cruz Plan², both because its estimate lies between the others and because it is the most detailed analysis, we can determine the effect on federal revenue of those provisions in the Cruz plan that impact private companies, under the assumption that a decrease in federal revenue represents a decrease in private companies’ tax obligations.

However, an evaluation of federal tax receipts will not capture the knock-on effects for state and local taxes (e.g. effective state rates should increase as federal income tax deductions are curtailed or eliminated for states that accept all or some federal deductions).  Nor does it account for the plan’s dynamic impact on economic growth, which can vary significantly across economic models.  We will discuss briefly some of the reasons for the differences between the Tax Foundation and TPC conclusions later on.

The TPC identifies a number of provisions in the Cruz plan that would affect private companies and their owners, including:

Individual Income Tax

• Replace the current seven tax brackets, which range from 10 to 39.6 percent, with a single rate of 10 percent, thereby creating a “flat” income tax. Repeal the preferential rates for capital income.
• Eliminate the 3.8 percent net investment income tax on high-income taxpayers enacted as part of the Affordable Care Act (ACA).
• Raise the standard deduction from $6,300 to $10,000 for single filers and from $12,600 to $20,000 for joint filers in 2015, indexed for inflation. However, leave personal exemptions unchanged at $4,000 per person in 2015, also indexed.
• Abolish the head of household and married filing separately filing statuses.
• Like Rubio’s proposal, eliminate all itemized deductions except those for charitable contributions and mortgage interest (subject to a lower cap of $500,000).
• Do away with all above-the-line deductions, except deductions for contributions to retirement savings accounts.
• Provide taxpayers with the option to make a deductible contribution of up to $25,000 annually to a new “Universal Savings Account” (USA).
• Throw out all tax credits except the child tax credit and EITC.
• Repeal the individual AMT.

Payroll Taxes

• Eliminate the 12.4 percent payroll tax for Social Security, the 2.9 percent payroll tax for Medicare, and the 0.9 percent additional Medicare tax paid by high-income workers.

Corporate Income Tax

• Eliminate the corporate income tax (including the corporate AMT).
• Impose a maximum 10 percent deemed repatriation tax on the profits of foreign subsidiaries of U.S. companies accumulated through 2016, payable over 10 years. Future profits of foreign subsidiaries of U.S. corporations would not be taxed.

Value-Added Tax (“Business Flat Tax”)

• Establish a new broad-based VAT (i.e. a “Business Flat Tax”) at a 16 percent (tax-inclusive) rate.
• Make wages paid by nonprofits and federal, state, and local governments subject to the VAT and deny any exemptions or deductions on business sales to nonprofits or governments.
• Permit deductions for employer contributions to employment-based retirement plans and for employer and employee payments for employment-based health insurance.
• Let businesses use unclaimed depreciation, net operating losses and inventories, and credits accumulated through 2016 against the new VAT.

Estate and Gift Taxes

• Eliminate federal estate, gift and GST taxes, and retain unlimited step-up in basis for inherited assets.

Tax Revenue Effects

As was mentioned, TPC estimates the Cruz plan would reduce total federal receipts a total of $8.6T from 2017 to 2026 (excluding increased interest costs).  The largest reduction in federal tax revenue will come from the elimination of payroll taxes at $12.2T over 10 years, roughly half of which would go to employers (both corporations and pass-through entities). All individual taxpayers would realize $10.4T in tax savings from the flattening of the rate structure (at 10 percent) and the elimination of preferential tax rates on capital income during that period.  They would realize another $3.3T from increases in the standard deduction.  The elimination of the ACA surcharge and the personal AMT would save another $192 billion (B), and $366B, respectively.  The TPC estimates the new USA savings vehicle will cost the federal government $161B over 10 years. Elimination of the estate and gift taxes would yield another $224B in tax savings through 2026.  Of course, most of the savings on the individual side would be spread across all taxpayers, not just private company business owners.

Corporations (C-Corps) would realize roughly $3.6T in tax savings from the abolition of the corporate income tax, over ten years.

On the pain side, the new 16 percent VAT would cost all businesses (pass-throughs and C-Corps) $21.2T, offset by roughly $2T in unused business deductions and credits (as of January 1, 2017) for a net $19.2T in additional tax liabilities over 10  years. The new VAT would compensate the Treasury for about 70 percent of revenues lost from all other tax cuts.

The deemed repatriation tax would cost C-Corps another $134.8B over the same period.  The repeal of itemized deductions would increase tax liabilities by $818B, above-the-line deductions by $70B, and tax credits by $466B.  (Capping the mortgage deduction at $500k would cost taxpayers $43B and eliminating two filing statuses would add $54B to federal coffers.)

Economic and Distributional Effects

The elimination of the corporate income tax effectively means corporate earnings would be subject to tax only on distributed dividends or realized capital gains.  This would create incentives for pass-through businesses — especially closely held ones — to incorporate and defer their tax liability on retained earnings.

Under the Cruz proposal, the marginal effective tax rate (METR)³ on new investment for pass-through entities would decline from 19.1 percent to 9.2 percent, or a net drop of 9.9 percentage points.  However, C-Corps’ METR on new investment would decline 18.8 percentage points (from 25.7 to 6.9 percent).  Furthermore, while the METR on equity-financed corporate investments would decline from 32.5 to 6.0 percent, the METR on debt-financed corporate investment would actually increase from -6.2 to 9.0 percent.

The higher rate on debt-financed investments arises from the higher fraction of equities held by nontaxable investors and the lower effective tax rate on capital gains relative to interest income because of the ability to defer realizations, according to TPC.  The differentials in METR between C-Corps’ and pass-through entities’ new investments, and equity- and debt-financed investments, may provide additional incentives for incorporation.

The impact of the Cruz plan on economic growth varies, depending on whether the projected revenue decline ($935B in 2025) is offset by spending reductions or financed.  To offset, the TPC estimates discretionary federal spending would have to be reduced by 67 percent in 2025 or Medicare and Social Security by 37 percent.  If these shortfalls are financed, independent research and the TPC suggest that the impact on economic growth would be net negative.

The TPC determined that under the Cruz plan the average taxpayer would receive a tax cut of $6,100 in 2017, the top 1.0 percent would receive an average $400k tax cut, while the lowest quintile would get an average tax cut of $46. By 2025, the average taxpayer would receive $6,300, the top 1 percent, $490k, and the lowest 20 percent would experience an average tax increase of $116.

Of the three candidates’ tax plans that were analyzed by the TPC and the Tax Foundation (TF), the Cruz plan was the only one where the TPC’s revenue loss estimates significantly exceeded the TF’s ($8.6T v. $3.7T).  Overall, the TPC estimated revenue impacts were very close to those of the TF, except their estimate of revenue gained from the VAT.  There, TPC projected a net federal revenue gain of $19.3T, in contrast to the TF figure of $25.4T.  This difference may be partly explained by the inclusion of a $2.1T offset for unused business deductions and credits in the TPC analysis; the remaining differences might be explained by variations in baseline assumptions and modeling.

In the past, both Republicans and Democrats have been wary of introducing a federal VAT.  Democrats have never liked the regressive nature of a VAT, while the Republicans have been concerned that once introduced, a VAT would be difficult to repeal, even in the face of income tax increases passed by future Democrat-controlled Congresses.

¹ Jackie Calmes, “Analysts Question Viability of Deep Tax Cuts Proposed by Republican Candidates”, NYT, February 22, 2016.

² Tax Policy Center, “An Analysis of Ted Cruz’s Tax Plan”, Urban Institute and Brookings Institution, February 16, 2016.

³ METR is a forward-looking measure of the impact of the tax system on the rate of return of a hypothetical marginal (i.e., just break-even) investment project, TPC, p.15.