Category: Budget

How Much Would the Fiscal Cliff Raise Taxes?

Roberton William, Eric Toder, Hang Nguyen, and I are out with Toppling Off the Fiscal Cliff: Whose Taxes Rise and How Much?,  a detailed look at all the tax increases in the looming fiscal cliff. We have two basic messages.

First, the cliff is big, amounting to more than $500 billion in 2013, a 20+ percent increase.

Second, you can’t tell the players without a scorecard. Over the past dozen years, the snowball of temporary tax cuts (and, for 2013, the introduction of some new taxes) has grown to epic proportions. As a result, the cliff isn’t just about the 2001-03 tax cuts that grab most of the headlines. There are also the temporary cut in payroll taxes, the “extenders”, the expanded credits enacted in 2009, the current version of the estate tax, the AMT patch, and the start of new health reform taxes.

To make sense of it all, we had to divvy the pending tax increases up into nine categories. This chart shows how they would affect tax rates for households at different income levels:

Bottom line: People of all incomes will see their tax go up if we go completely over the fiscal cliff. But there are significant differences in which provisions matter most.

Of course, the full paper includes much more. Here’s the abstract:

The fiscal cliff threatens an unprecedented tax increase at year end. Taxes would rise by more than $500 billion in 2013—an average of almost $3,500 per household—as almost every tax cut enacted since 2001 would expire. Middle-income households would see an average increase of almost $2,000. Policymakers are rightly concerned about the potential impact on families and the economy of such a sudden tax increase and are considering proposals to delay, repeal, or offset parts of the cliff. To inform that discussion, this report provides a detailed look at the revenue, distributional, and incentive effects of these increases. Almost 90 percent of Americans would see their taxes rise if we topple off the cliff. For most households, the two biggest increases would be the expiration of the temporary cut in Social Security taxes and the expiration of the 2001/2003 tax cuts. Households with low incomes would be particularly affected by the expiration of tax credits expanded or created by the 2009 stimulus. And households with high incomes would be hit hard by the expiration of the 2001/2003 tax cuts that apply at upper income levels and the start of the new health reform taxes. Taken together, the scheduled changes would significantly increase the marginal tax rates that can influence behavior. Average marginal tax rates would increase by 5 percentage points on labor income, by 7 points on capital gains, and by more than 20 points on dividends.

About the Famous 47% Figure (and Its 46% Cousin)

My most popular blog post, by a long shot, was this one in July 2011 explaining why almost half of Americans paid no federal income tax. If you are interested in some context behind Governor Romney’s now famous remarks about the 47 percent (TPC calculated it as 46 percent for 2011), please check it out.

One item I didn’t mention in that post is that the number of taxpayers not paying federal income tax should decline over time. As the economy recovers, higher incomes will boost the fraction of households that pay federal income tax.

 

 

 

Understanding TPC’s Analysis of Governor Romney’s Tax Plan

The Tax Policy Center’s latest research report went viral last week, drawing attention in the presidential campaign and sparking a constructive discussion of the practical challenges of tax reform. Unfortunately, the response has also included some unwarranted inferences from one side and unwarranted vitriol from the other, distracting from the fundamental message of the study: tax reform is hard.

The paper, authored by Sam Brown, Bill Gale, and Adam Looney, examines the challenges policymakers face in designing a revenue-neutral income tax reform. The paper illustrates the importance of the tradeoffs among revenue, tax rates, and progressivity for the tax policies put forward by presidential candidate Mitt Romney. It found, subject to certain assumptions I discuss below, that any revenue-neutral plan along the lines Governor Romney has outlined would reduce taxes for high-income households, requiring higher taxes on middle- or low-income households. I doubt that’s his intent, but it is an implication of what we can tell about his plan so far. (We look forward to updating our analysis, of course, if and when Governor Romney provides more details.)

The paper is the latest in a series of TPC studies that have documented both the promise and the difficulty of base-broadening, rate-lowering tax reform. Last month, for example, Hang Nguyen, Jim Nunns, Eric Toder, and Roberton Williams documented just how hard it can be to cut tax preferences to pay for lower tax rates. An earlier paper by Dan Baneman and Eric Toder documented the distributional impacts of individual income tax preferences.

The new study applies those insights to Governor Romney’s tax proposal. To do so, the authors had to confront a fundamental challenge: Governor Romney has not offered a fully-specified plan. He has been explicit about the tax cuts he has in mind, including a one-fifth reduction in marginal tax rates from today’s level, which would drop the top rate from 35 percent to 28 percent and a cut in capital gains and dividend taxes for families with incomes below $200,000. He and his team have also said that reform should be revenue-neutral and not increase taxes on capital gains and dividends. But they have not provided any detail about what tax preferences they would cut to make up lost revenue.

As a political matter, such reticence is understandable. To sell yourself and your policy, it’s natural to emphasize the things that people like, such as tax cuts, while downplaying the specifics of who will bear the accompanying costs. Last February, President Obama did the same thing when he rolled out his business tax proposal. The president was very clear about lowering the corporate rate from 35 percent to 28 percent, but he provided few examples of the tax breaks he would cut to pay for it. Such is politics.

For those of us in the business of policy analysis, however, this poses a challenge. TPC’s goal is to inform the tax policy debate as best we can. While we strongly prefer to analyze complete plans, that sometimes isn’t possible. So we provide what information we can with the resources available. Earlier this year, for example, we analyzed the specified parts of Governor Romney’s proposal and documented how much revenue he would have to make up by unspecified base broadening (or, possibly, macroeconomic growth) and how the rate cuts would affect households at different income levels.

The latest study asked a different question: Could Romney’s plan maintain current progressivity given revenue neutrality and reasonable assumptions about what types of base broadening he’d propose? There are roughly $1.3 trillion in tax expenditures out there, but not all will be on Governor Romney’s list. He has said, for example, that raising capital gains and dividend taxes isn’t an option and has generally spoken about lowering taxes on saving and investment. Based on those statements, the authors considered what would happen if Romney kept all the tax breaks associated with saving and investment, including not only the lower rates on capital gains and dividends, but also the special treatment for municipal bonds, IRA and 401ks, and certain life-insurance plans, as well as the ability to avoid capital gains taxes at death (known as step-up basis). The authors also recognized that touching some tax breaks is beyond the realm of political possibility, such as taxing the implicit rent people get from owning their own home.

Given those factors, the study then examined the most progressive way of reducing the other tax breaks that remain on the table—i.e. it rolls them back first for high-income people. But there aren’t enough of those preferences to offset the benefits that high-income households get from the rate reductions. As a result, a revenue-neutral reform within these constraints would cut taxes at the high-end while raising them in the middle and perhaps bottom.

What should we infer from this result? Like Howard Gleckman, I don’t interpret this as evidence that Governor Romney wants to increase taxes on the middle class in order to cut taxes for the rich, as an Obama campaign ad claimed. Instead, I view it as showing that his plan can’t accomplish all his stated objectives. One can charitably view his plan as a combination of political signaling and the opening offer in what would, if he gets elected, become a negotiation.

To get a sense of where such negotiation might lead, keep in mind that Romney’s plan is not the first to propose a 28 percent top rate. The Tax Reform Act of 1986 did, as did the Bowles-Simpson proposal and the similar Domenici-Rivlin effort (on which I served). Unlike Governor Romney’s proposal, all three of those tax reforms reflect political compromise. And in all three cases, part of that compromise was eliminating some tax preferences for saving and investment, which tend to be especially important for high-income taxpayers. In particular, all three reforms resulted in capital gains and dividends being taxed at ordinary income tax rates.

TPC’s latest study highlights the realities that lead to such compromises.

Has the Government Been Growing or Shrinking? Employment Edition

My recent post on government size prompted several readers to ask a natural follow-up question: how has the government’s role as employer changed over time?

To answer, the following chart shows federal, state, and local employment as a share of overall U.S. payrolls:

In July, governments accounted for 16.5 percent of U.S. employment. That’s down from the 17.7 percent peak in early 2010, when the weak economy, stimulus efforts, and the decennial census all boosted government’s share of employment. And it’s down from the levels of much of the past forty years.

On the other hand, it’s also up from the sub-16 percent level reached back in the go-go days of the late 1990s and early 2000s.

Employment thus tells a similar story to government spending on goods and services: if we set the late 1990s to one side, federal, state, and local governments aren’t large by historical standards; indeed, they are somewhat smaller than over most of the past few decades. And they’ve clearly shrunk, in relative terms, over the past couple of years. (But, as noted in my earlier post, overall government spending has grown because of the increase in transfer programs.)

P.S. Like my previous chart on government spending, this one focuses on the size of government relative to the rest of the economy (here measured by nonfarm payroll employment). Over at the Brookings Institution’s Hamilton Project, Michael Greenstone and Adam Looney find a more severe drop in government employment than does my chart. The reason is that they focus on government employment as a share of the population, while my chart compares it to overall employment. That’s an important distinction given the dramatic decline in employment, relative to the population, in recent years. 

P.P.S. As Ernie Tedeschi notes, this measure doesn’t capture government contractors. So any change in the mix of private contractors vs. direct employees will affect the ratio. This is another reason why focusing on spending metrics may be better than employment figures.

Has Government Gotten Bigger or Smaller? Yes.

Politicians and pundits constantly debate the size of government. Is it big or small? Growing or shrinking?

You might hope these simple questions have simple answers. But they don’t. Measuring government size is not as easy as it sounds. For example, official statistics track two different measures of government spending. And those measures tell different stories:

The blue line shows how much federal, state, and local governments directly contribute to economic activity, measured as a share of overall gross domestic product (GDP). If you’ve ever taken an intro economics class, you know that contribution as G, shorthand for government spending. G represents all the goods and services that governments provide, valued at the cost of producing them. G thus includes everything from buying aircraft carriers to paying teachers to housing our ambassador in Zambia.

At 19.5 percent of GDP, G is down from the 21.5 percent it hit in the worst days of the Great Recession. As Catherine Rampell of the New York Times pointed out last week, it’s also below the 20.3 percent average of the available data back to 1947. For most of the past 65 years, federal, state, and local governments had a larger direct economic role producing goods and services than they do today.

There’s one notable exception: today’s government consumption and investment spending is notably larger than it was during the economic boom and fiscal restraint of the late 1990s and early 2000s. From mid-1996 to mid-2001, government accounted for less than 18 percent of GDP. Relative to that benchmark, government is now noticeably larger.

The orange line shows a broader measure that captures all the spending in government budgets—all of G plus much more. Governments pay interest on their debts. More important, they make transfer payments through programs like Social Security, Medicare, Medicaid, food stamps, unemployment insurance, and housing vouchers. Transfer spending does not directly contribute to GDP and thus is not part of G. Instead, it provides economic resources to people (and some businesses) that then show up in other GDP components such as consumer spending and private investment.

This broader measure of government spending is much larger than G alone. In 2011, for example, government spending totaled $5.6 trillion, about 37 percent of GDP. But only $3.1 trillion (20 percent of GDP) went for goods and services. The other $2.5 trillion (17 percent) covered transfers and interest.

Like G, this broader measure of government has declined since the (official) end of the Great Recession. Since peaking at 39 percent in the second quarter of 2009, it has fallen to 36 percent in the second quarter of 2012.

Also like G, this measure has grown since the boom of the late 1990s and early 2000s. In the middle of 2000, government spending totaled just 30 percent of GDP, a full 6 percentage points less than today.

The two measures thus agree on recent history: government has shrunk over the past three years as the economy has slowly recovered from the Great Recession and government policy responses have faded. But government spending is still notably larger than at the turn of the century.

The story changes, however, if we look further back in time. Although governments spent more on goods and services in the past, total spending was almost always lower. Since 1960, when data on the broader measure begin, total government spending has averaged about 32 percent. It never reached today’s 36 percent until 2008, when the financial crisis began in earnest.

Much of the recent increase in overall spending is due to the severity of the downturn. But that’s not the only factor. Government’s economic role has changed. As recently as the early 1960s, federal, state, and local governments devoted most of their efforts to providing public goods and services. Now they devote large portions of their budgets to helping people through cash and in-kind transfers—programs like Medicare and Medicaid that were created in 1965 and account for much of the growth in the gap between the orange and blue lines.

Government thus has gotten bigger. But it’s also gotten smaller. It all depends on the time period you consider and the measure you use.

P.S. Keep in mind that this discussion focuses on a relative measure of government size—the ratio of government spending to the overall economy—not an absolute one. Government thus expands if government spending grows faster than the economy and contracts if the reverse is true.

P.P.S. Measuring government size poses other challenges. Eric Toder and I discuss several in our paper “How Big is the Federal Government?” Perhaps most important is that governments now do a great deal of spending through the tax code. Traditional spending numbers thus don’t fully reflect the size or trend in government spending. For more, see this earlier post.

Cutting Tax Breaks to Pay for Lower Rates Isn’t Easy

Broader base, lower rates.

That’s the bumper sticker for most tax reform proposals. To varying degrees, everyone from President Obama to Governor Romney to Bowles-Simpson has embraced it. Whatever your revenue goal, you can get there with lower tax rates if you are willing to slash tax breaks and thus broaden the tax base.

But cutting tax breaks to pay for lower tax rates is harder than it sounds. There may be more than $1 trillion in annual tax breaks out there, but that doesn’t mean there’s that much easy revenue available to policymakers.

In a new paper today, my Tax Policy Center colleagues Hang Nguyen, James Nunns, Eric Toder, and Roberton Williams document four particular challenges in cutting tax breaks to pay for lower rates:

1. Lower rates reduce the value of most tax preferences. Nearly all tax expenditures are in the form of deductions, exclusions, exemptions, deferrals, or preferential rates, all of which are valuable only to the extent they allow taxpayers to avoid regular statutory tax rates. If tax rates are cut, the value of these tax preferences goes down as well. Thus, cutting tax rates reduces the amount of offsetting revenue that cutting tax preferences can raise.

2. Some tax preferences may be hard to curtail for political or administrative reasons. For example, cutting back widely used and popular preferences such as the deductions for mortgage interest and charitable contributions may be politically difficult. And it would be administratively impractical to require homeowners to include in their income each year the rental value of their homes, although leaving that income untaxed is a tax expenditure (with a sizable cost associated with it). If such preferences can’t be curtailed as part of a realistic tax reform, it becomes harder to find the revenue needed to pay for lower tax rates.

3. Cutting back on tax preferences may alter the distribution of the tax burden in ways that are deemed unacceptable. Finding a combination of lower rates and cutbacks in tax preferences with acceptable distributional effects can prove quite difficult.

4. A tax reform that includes wholesale, immediate repeal of a significant portion of tax preferences would significantly disrupt existing economic arrangements in ways that might be deemed unfair. Instead, some preferences might be only partially curtailed, and some cutbacks might phase in, possibly over an extended period of time. In addition, taxpayers would likely change their behavior to lessen the impact of these cutbacks. All of these “real world” effects would likely reduce, perhaps substantially, the revenue gains from cutting tax preferences.

The chart above illustrates the first of these points. It shows how big tax breaks are in three scenarios: current law (in which all expiring tax cuts actually expire), current policy (most get extended), and current policy with reduced rates (rates get reduced by another 20 percent). The top income tax rate in 2015 under these scenarios is thus 39.6 percent, 35 percent, and 28 percent, respectively (before accounting for Medicare taxes and the health reform tax on investment income).

Most official estimates of tax preferences use the tax rates in current law. Under those rates, TPC estimates that the value of most deductions, fringe benefits, and small credits in 2015 is $590 billion. Under the lower rates of current policy, however, those preferences are worth only $525 billion. And under the still lower rates of current policy with reduced rates, they are worth only $446 billion.

Cutting tax rates thus materially reduces the amount of  money available from rolling back tax breaks.

For more, see Howard Gleckman’s take on the report.

Payroll Taxes Cover About a Third of Medicare Costs

I get the impression that many Americans believe Medicare is financed like Social Security. They know that a portion of payroll taxes goes to Social Security and a portion goes to Medicare. So they conclude workers are paying for Medicare benefits the same way they are paying for Social Security benefits.

That isn’t remotely true, as new data from the Congressional Budget Office demonstrate.

In 2010, payroll taxes covered a little more than a third of Medicare’s costs. Beneficiary premiums (and some other earmarked receipts) covered about a seventh. General revenues (which include borrowing) covered the remainder, slightly more than half of total Medicare costs.

If you prefer to focus on just the government’s share of Medicare (i.e., after premiums and similar payments by or on behalf of beneficiaries), then payroll taxes covered about 40% of the program, and other revenues and borrowing covered about 60%.

In contrast, payroll taxes and other earmarked taxes covered more than 93% of Social Security’s costs in 2010, and that was after many years of surpluses.

The difference between the two programs exists because payroll taxes finance almost all of Social Security, but only one part of Medicare, the Part A program for hospital insurance. Parts B and D (doctors and prescription drugs) don’t get payroll revenues; instead, they are covered by premiums and general revenues. But that distinction often gets lost in public discussion of Medicare financing.

As recently at 2000, general revenues covered only a quarter of Medicare’s costs. That share has increased because of the creation of the prescription drug benefit in 2003 and because population aging and rising health care costs have pushed Medicare spending up faster than worker wages. Over the next decade, CBO projects that premiums will cover a somewhat larger share of overall costs, while the general revenue share will slightly decline.

Note: For simplicity, I have focused on the annual flow of taxes and benefits. The same insight applies if you want to think of Social Security and Medicare as programs in which workers pay payroll taxes to earn future benefits. That’s approximately true for workers as a whole in Social Security (but with notable differences across individuals and age cohorts and uncertainty about what the future will bring). But it’s not true at all for Medicare.

The “Tax Expirers”

Today I had the chance to testify before the Select Revenue Measures Subcommittee of the House Ways and Means Committee about a perennial challenge, the “tax extenders,” which really ought to be known as the “tax expirers.” Here are my opening remarks. You can find my full testimony here.

As you know, the United States faces a sharp “fiscal cliff” at yearend when numerous policy changes occur. If all these changes happen, they will reduce the fiscal 2013 deficit by about $500 billion, according to the Congressional Budget Office, before taking into account any negative feedback from a weaker economy. About one-eighth of that “cliff”—$65 billion—comes from the expiring and expired tax cuts that are the focus of today’s hearing.

In deciding their fate, you should consider the larger problems facing our tax system. That system is needlessly complex, economically harmful, and widely perceived as unfair. It’s increasingly unpredictable. And it fails at its most basic task, raising enough money to pay our bills.

The “expirers” often worsen these problems. They create uncertainty, complicate compliance, and cost needed revenue. Some make the tax code less fair, some more fair. Some weaken our economy, while others strengthen it.

Fundamental tax reform would, of course, be the best way to address these concerns. But such reform isn’t likely soon.

So you must again grapple with “the expirers.” As a starting point, let me note that they come in three flavors:

  1.  Tax cuts enacted to address a temporary challenge such as recession, the housing meltdown, or regional disasters.
  2. Tax cuts that have reached a sunset review. Prolonged economic weakness and recent omnibus extensions mean there aren’t that many of these, but they do exist.
  3. Tax cuts that expire to game budget rules. These appear to be the most common. Supporters intend these provisions to be long-lived or permanent, but they haven’t found the budget resources to do so.

To determine which of these policies should be extended and which not, you should consider several factors:

  • Does the provision address a compelling need for government intervention?
  • Does it accomplish its goal effectively and at reasonable cost?
  • Does it make the tax code more or less fair?
  • Do its potential benefits justify the revenue loss or the need for higher taxes elsewhere?

In short, you should subject these provisions to the same standards applied to other policy choices. And in this case, you should keep in mind that most of the so-called “tax extenders” are effectively spending through the tax code. You should thus hold them to the same standards as equivalent spending programs.

You should also reform the way you review expiring tax provisions.

  1. Flip the burden of proof. Today’s standing presumption is that most of these provisions will ultimately be extended. That’s why they are called “the extenders,” even after they have expired. Ultimately, though, we should move to a system in which the presumption, rebuttable to be sure, is that expiring provisions will expire unless supporters can justify their continuation. In short, they should be “the expirers.”
  2. Second, divide them up. Like musk oxen, the beneficiaries of these provisions have realized that there is safety in numbers. They thus do their best to coalesce as a single herd—“the extenders”—and to migrate across the annual legislative tundra with as little individual attention as possible.You should break up the herd. Reviewing each provision in detail may not be practical in a single year, but you can identify specific groups for careful review. For example, you can separate out the stimulus provisions, the charity provisions, the energy provisions, and so on.You should also spread scheduled expirations out over time. If fewer expire each year, you will be able to give each one more attention.
  3. Third, change budget rules for temporary tax cuts. Pay-as-you-go budgeting creates crucial discipline but has an unfortunate side effect: long-term tax policies often get chopped into one-year segments. In addition, 10 years of offsets can be used to pay for a single-year extension.To combat this, you could require that any temporary tax provision be assumed to last no less than five years in the official budget baseline. Proponents would then have to round up enough budget offsets to pay for those five years.In addition, Congress could require that offsets happen over the same years as an extension. That would eliminate situations in which 10 years of offsets pay for a single-year extension.