On the President's Proposed "Grand Bargain"

The talk of the town in recent days has been President Obama's new plan to combine corporate tax reform with public investments in what President Obama calls a "grand bargain for middle class jobs." From a growth perspective, there is a lot to like about this proposal. But there is also a lot we find discouraging about a plan which would decouple corporate tax reform from any broader deficit reduction effort. In our view, the best and most productive way to achieve corporate tax reform and boost public investment is through a comprehensive plan that also includes individual tax reform and entitlement reform in the context of medium- and long-term deficit reduction.

The Nuts and Bolts of the President's Proposal

For the most part, the President's new bargain is a rehashing of various investments in his budget, coupled with his business tax reform framework, which calls for the corporate tax rate to be reduced to 28 percent, many corporate tax preferences be eliminated, and incentives for manufacturers and small businesses to be increased.

At the time the framework was released last year, the President called for his tax reform to be revenue-neutral. However, corporate tax reform which is cost-neutral over the first decade is likely to lose revenue over the long-run because, as the Center on Budget and Policy Priorities explains, "many corporate tax subsidies are structured in such a way that scaling them back would generate much larger savings in the first ten years than over the long run."

To ensure corporate tax reform doesn't add to the deficit over the long-run, the President is now calling for reform where base broadening exactly pays for rate reduction over the long run but generates new net revenue in the ten-year period. That net new revenue would go to temporary investments such as those in the President's FY 2014 budget proposal for direct infrastructure investment, a national infrastructure bank, new infrastructure bonds, and various job training and community college initiatives.

The exact source of the ten-year revenue need not be specified since it can come from a combination of reforms, but one option which has been floated is to use revenue from a temporary transition tax on foreign income that could accompany broader international reform. Another possibility is to use the portion of the revenue from repealing or reducing accelerated depreciation schedules which represents a timing shift in tax payments, while leaving the portion which represent a permanant change in tax burden for rate reduction. 

Overall, the plan includes some encouraging aspects but also many negative aspects.

The Good News

In the past, we've called on policymakers to "go smart" and "go long" by focusing on economic growth and looking beyond the ten-year budget window. The President's proposal would, to some extent, do both.

As we've explained before, corporate tax reform can be an important part of an economic growth strategy to make United States businesses more competitive. For example, a 2005 Joint Committee on Taxation (JCT) study concluding that even a deficit-financed reduction in the rate to 28 percent would raise GDP by 0.2 to 0.4 percent. Using base broadening to reduce rather than increase the deficit and removing various distortions in the tax code could have additional economic benefit.

On top of the benefits from corporate tax reform, the President's proposed investments in infrastructure and job training initiatives could help to increase employment in the short run by boosting aggregate demand and could increase the productive capacity of the economy over the long run by boosting the supply of physical and human capital.

In addition to his plan likely being pro-growth, it is encouraging to see the President focus on the long-term deficit impact of corporate tax reform rather than just the first ten years. A number of perfectly sensible reforms will have the effect of raising more revenue in the first decade than over the long-run. By demanding that corporate tax reform look beyond the first decade, the President is ensuring the plan won't add to the debt over the long-term, when population aging and growing health care costs will present us with enough fiscal challanges as is. This focus will also discourage explicit timing gimmicks, such as the Roth IRA provision included in the fiscal cliff agreement.

The Bad News

Although there is some economic virtue to the President's plan, there is also much to be concerned about.

Reasonable people can disagree on whether corporate tax reform should be a revenue-generating or revenue-neutral part of a broader fiscal plan, but the President's proposal to make corporate tax reform revenue-positive and put none of that money toward deficit reduction seems to us a mistake.

The political challenges of generating an agreement which includes new net revenues are substantial. With $2.2 trillion of further deficit reduction needed to put the debt on a clear downward path, using none of that revenue for deficit reduction would be a significant missed opportunity in our view.

It would also be a mistake to divorce corporate tax reform from individual tax reform. The two codes are intertwined, with most businesses filing as "pass-through entities", paying on the individual side and with many corporate tax expenditures available to those businesses. Decoupling corporate and individual reform will mean either accepting a large divergence between the rates and/or tax base paid by C-Corps and pass-through entities or else devising a complicated and costly work-around.

Even if a solution for pass-through entities could be worked out, abandoning individual reform would be a fiscal and economic mistake. The individual tax code suffers from substantial complexity and costly distortions and should be addressed in ways that will lower rates, broaden the base, promote economic growth, and contribute to deficit reduction.

The Disappointing News

Failing to use new revenue for deficit reduction and seperating corporate from individual tax reform are problematic in our view. But our biggest concern is the President's decision to decouple corporate tax reform from the broader deficit reduction effort.

With few sweeteners left available for deficit reduction, the Administration had previously conditioned corporate tax reform on a broader set of changes to both raise revenue from high earners and slow the growth of entitlement programs. Although the President has not abandoned his call for deficit reduction, that he has decoupled it from tax reform and seemingly deprioritized it relative to tax reform is quite discouraging.

Indeed, any "grand bargain" for middle-class jobs is not complete without a plan to bring the debt under control. As it currently stands, sequestration is hurting short term growth, and our large debt burden will hurt long-term growth potential. New investments and corporate tax reform can make improvements on the margins. But absent a comprehensive plan to address the sequester, reform the individual tax code, reform entitlement programs, and put the debt on a clear downward path, it isn't clear that sustained growth will be achieved over the long term.

Now isn't the time to think small, it is time to think big. We are big fans of corporate tax reform which our corporate tax calculator shows can be designed a number of ways. But what the President has proposed is a mini-bargain. What we need is a grand bargain.