November 16, 2011

Grand Illusion

By: Roger Custer

by Charles Hughes

Herman Cain and Rick Perry cast themselves as bold reformers, but wield flashy proposals only to evade the crucial political challenges at stake.


Facing a flagging campaign after a brief stint as frontrunner, Rick Perry recently unveiled his tax reform proposal in an effort to regain some momentum. It is the second such plan to come from a Republican candidate, joining Herman Cain’s much discussed (and widely derided) 9-9-9 plan.

Perry’s flat-tax proposal would transform the current tax system: individuals could choose a flat tax rate of 20 percent on their income or stay in the current system. On the surface, this proposal is appealing because it would end the myriad loopholes and exemptions in the current tax code that distort economic decisions. It would also drastically reduce the costly and time-consuming burden Americans face each year in trying to figure out their taxes, allowing them to put this time and money to more productive or enjoyable use. To emphasize the simplicity of his plan in contrast to the current tax code, Perry has taken to carrying around a postcard, claiming that under his plan a family could file their taxes on a document that size. The flat tax proposal would also reduce the top tax rates and cut taxes on capital gains, dividends and estates, which would spur more economic growth. At first glance, the plan seems to be a simple, common sense, pro-growth proposal to reform the much reviled current system.

Upon further analysis, however, much of the plan’s appeal promptly evaporates. The simplicity that was such a big part of its allure proves illusory. The first layer of complexity arises from the fact that Perry’s plan would allow people to choose whether to opt in to the flat tax, so anyone who would have to pay higher taxes under it could instead choose to file under the current system. In order to determine which plan saves them more money, many people must calculate their tax liabilities twice. Problematically, the opt-in provision would suggest a scenario where only wealthier Americans would choose the new flat tax while lower-income people would stay in the current tax code. This would result in significantly lower tax revenue, and possibly a two-tiered tax system even more complicated than the current iteration. Perry’s plan would also preserve mortgage interest, charitable and state and local tax exemptions for families earning less than $500,000 annually, and it would increase the standard deduction from $5,800 to $12,500 for individuals and dependents. Some of the larger more popular deductions and exemptions would remain, but preserving some of them makes sense, both economically and politically. Significantly raising taxes on families living below the poverty line would achieve little in terms of revenue, lower their quality of life, and be wildly unpopular.

These factors point to the inherent flaw of Perry’s proposal: Set the new flat rate at a level that can raise as much money as the current tax code, and the middle class will pay more, which is hard to justify at any time, but especially untenable given Republicans’ staunch opposition to any tax increases. If the plan sets the flat rate low enough that middle-class taxpayers pay roughly the same as they do now, revenues drop precipitously. A recent analysis of the plan by the Tax Policy Center finds that tax revenues would be significantly diminished. According to their calculations, relative to a current policy baseline, the reduction in tax revenue would be almost $570 billion in 2015. This is a huge shortfall, all the more significant in light of the current annual budget deficit of more than $1.3 trillion. Less revenue is not necessarily a bad thing. More money in the private sector and less taxation can promote growth and prosperity, but the mounting debt and enormous budget deficits are an impediment to this growth. For his plan to be taken seriously Perry must pair it with a specific and substantive plan that cuts government spending and balances the budget.

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The other major tax reform plan to emerge in primary season is Herman Cain’s 9-9-9 plan. It has been the driving force behind Cain’s rise in the polls (before mounting sexual harassment allegations tarnished his campaign), and the 9-9-9 mantra can be heard in most of his debate answers, and almost all of his interviews and speeches focused on the economy. Like Gov. Perry’s proposal, Cain’s plan is appealing on the surface because it purports to lower tax rates and simplify the convoluted tax code. It has some good components, too, and in some ways would be an improvement over the current tax code, but deeper analysis reveals some fatal flaws.

On the surface, the plan is very simple. It would eliminate the current individual income tax, corporate income tax, payroll tax, and estate and gift tax, and substitute three taxes imposed at a 9 percent rate: a 9 percent national sales tax, a 9 percent business flat tax, and a 9 percent individual flat tax. To its credit, the plan would eliminate exemptions and loopholes, reducing the economic distortions the current tax code introduces. His plan would also aim to make the tax system more transparent. With only three taxes, he claims that it will be harder for the government to raise taxes without the public realizing it.

While the plan does have these positive components, it also raises a lot of questions that are as yet unanswered. It is unclear how Social Security and Medicare would be funded through the different phases of Cain’s plan, or how the plan would handle younger workers opting out of Social Security, something Cain has said he supports. The plan would also significantly increase the tax burden on the lowest income families who currently pay no income tax, and it is difficult to see how an unemployed individual with a negative total tax liability under the current system will not see a tax increase under the new plan.

Even if there are workable solutions to the many questions currently surrounding Cain’s proposal, each one introduces a new wrinkle of complexity, and the plan soon becomes much less simple than advertised. Moreover, a closer look at 9-9-9 can only reveal so much, as the 9-9-9 plan is actually only an intermediary step in Mr. Cain’s broader plan for tax reform. In the next and final phase, Cain would call for the quick exit of the 9-9-9 plan and introduce a fair tax (a single national consumption tax on retail sales) at a rate of 25–30 percent. So the full implementation of Cain’s tax reform plan would require two transformational tax reform laws, presumably in the space of the four years of his first term as President—a challenging task to say the least since getting to the intermediary 9-9-9 phase would require the most comprehensive tax reform seen in recent memory.

Cain’s plan also raises questions as to a potentially significant decrease in tax revenue; Bloomberg News calculated that if the plan had been in place in 2010, it would have collected $200 billion less. This is not necessarily tied to rates; over the past 50 years, marginal tax rates have fluctuated from a peak of 91 percent as late as 1963, to the current top rate of 35 percent. In all that time (current recession excluded), tax revenues have hovered around 18 percent of GDP, showing little responsiveness to changes in the tax rates. Again, as with Gov. Perry’s plan, the lower tax revenue is not a problem in and of itself. If Mr. Cain had paired his tax reform proposal with a serious spending plan that detailed deep and specific cuts that balanced the federal budget, the fact that 9-9-9 simplified the tax code and took less money out of the private sector would be praiseworthy, instead of a source of consternation. Mr. Cain has shown no such willingness to address spending cuts with the same diligence and persistence that he has shown toward tax reform, even less so than Gov. Perry. Both candidates, in introducing their dramatic proposals that would overhaul the much-maligned tax code, have shied away from making any serious or specific proposals to rein in government spending. While in some ways they should be praised for taking a serious look at tax reform, their proposals have served in large part as a way for them to avoid addressing the real issue, out-of-control government spending.

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That daunting problem seems nearly insurmountable today. Federal spending in 2011 will be around 24 percent of GDP, and the Congressional Budget Office generously projects that it will stay in this range for the next decade. Trends since the Clinton presidency suggest it is far more likely that without drastic intervention the percentage will continue its steady march upward.

It remains unclear what steps either of these aspiring candidates would take to address this monumental gap between the historic 18 percent revenue and current 24 percent spending, and it is not hard to see that a recurring annual deficit of 6 percent is in no way sustainable, especially with the high level of debt the United States is already facing. Perry at least acknowledges the issue of runaway government spending, but doesn’t propose anything definitive or specific, saying only that his plan will seek “a clear goal of balancing the budget by 2020. But growth is what will get us to balance, if we are willing to make the hard decisions of cutting. . . . We should start moving toward fiscal responsibility by capping federal spending at 18 percent of our gross domestic product, banning earmarks and future bailouts, and passing a Balanced Budget Amendment.” It’s hardly controversial or novel to recognize the need to control government spending. Those hard decisions to slash the budget will take determination and political will; unsurprisingly, in the tradition of retail politics, Perry sidesteps the challenge.

Perry’s not alone; all of the candidates enthusiastically embrace the need to drastically cut government spending to bring America back to sound fiscal footing, but refrain from naming specific areas where they would cut. Various candidates have expressed support for different aspects of Paul Ryan’s bold plan, but vague gestures of support without specifics are merely an attempt to reap the benefits of the plan’s credibility while avoiding the difficult and unpopular decisions that come with it. Only one candidate in the Republican primary has offered a serious plan to shrink the size of the federal government and to bring federal spending back down to manageable levels. Ron Paul’s “Plan to Restore America” would cut $1 trillion in the first year and balance the budget in three. It calls for the elimination of five Cabinet-level agencies: Commerce, Education, Energy, Housing and Urban Development, and Interior. It would pare back most other programs to 2006 spending levels, fundamentally change Social Security and convert most means-tested programs to block grants to the states. The plan is far from perfect; questions remain about the effect of these policies on the welfare of the lowest-income families, what functions of the five abolished departments would be folded into other agencies, and many other issues. What Ron Paul’s plan does is lay out a serious, specific path to shrink the size of government and significantly cut federal spending. Paul, even with the many imperfections and issues raised by his plan, at least seriously tries to answer the question of mounting debt and deficits.

The candidates’ reluctance to delve into policy specifics may reflect the fact that a winning personality is an important aspect of a successful campaign. The heavy debate schedule and pressure from primary voters has occasionally forced them to address policy more directly and leave behind the well-worn talking points. Both Cain and Perry have struggled mightily in recent weeks when wading into this more policy-focused territory. In the CNBC Republican debate, Perry provided the most cringe-worthy minute of the campaign season when he could not remember the third department he would pledge to cut (he later revealed it was energy). Even more recently, Cain fumbled his way through an interview with the Milwaukee Journal Sentinel, betraying a hazy understanding of the situation in Libya and expressing support for collective bargaining. As gaffes pile up, voters are increasingly concerned about candidates’ competency in policy matters, and will likely increase the demand for substantive, specific plans to combat the budget crisis.

Years ago, Milton Friedman succinctly articulated the correct response to tax reform proposals. He recognized the admirable intent and good content of these proposals, but insisted that the big problem is not taxes. The crucial question, he emphasized, is “How do you hold down government spending?” If the other candidates laid out substantive plans to cut government spending, voters could compare the plans and choose the candidate they feel has the best response to Friedman’s question. Unfortunately, for all the clamor of the endless series of Republican primary debates, we face a deafening silence.


Charles Hughes graduated from the University of Chicago with a degree in economics and public policy, and is currently a research assistant at the Cato Institute.