Graphic by Wesley Bedrosian as part of the Wall Street Journal’s weekend article on tax planning. After all, who doesn’t want to spend Thanksgiving weekend thinking about taxes?
Category: Politics
Happy Anniversary, Tax Reform
Twenty-five years ago today, President Ronald Reagan signed the Tax Reform Act of 1986 into law.
Happy silver anniversary, tax reform!
Over at the Tax Policy Center, Len Burman and Gene Steuerle, both Treasury staffers at the time, and Howard Gleckman, who covered the proceedings for BusinessWeek, offer personal reflections on how TRA86 happened and what that means for today’s efforts.
Gene offers a recipe for increasing the odds of productive tax reform:
If there is any lesson from TRA86, it is that real reform requires channeling forces and information in the right direction.
Put more broadly, it isn’t helpful to try to recreate historical circumstances to get the same outcome. It is far more useful to understand how to convert luck into serendipity to increase the odds that good things will happen.
In a recent testimony and a Tax Notes article, I outlined ten steps that increased the chances of reform in 1986 and for the most part are repeatable today. These include; seize today’s, not yesterday’s opportunities; rely on principles like equal justice under the law to determine what should be done; make reform comprehensive, in part, because the political cost is likely to be the same in any case; shift the burden of proof to those opposing the better system; form liberal-conservative coalitions in areas where both sides can gain something; plan strategies in advance for how to best present the proposals and their effects to the public; empower nonpartisan staffs like Treasury’s Office of Tax Policy and the Joint Committee on Taxation (who really assembled the ’86 reform); establish leadership on a variety of fronts; insure accountability so that very specific political leaders bear a significant cost if reform fails; and empower someone to run with the ball and strategize on how to make reform happen.
In 1984 through 1986, much of the political leadership came late to the game. And some of the lessons of 1986 were learned, not planned. For example, one key to passage was that at each step in the process, first Treasury Secretary Don Regan, then House Ways & Means Committee Chair Dan Rostenkowski, and finally Senate Finance Committee Chair Bob Packwood feared they would be blamed if the bill failed. As a result, each worked extremely hard to make sure that tax reform did not die on their watch.
Len agrees on the need, but is feeling a bit more gloomy:
Tax reform has never been more necessary, it’s hard to see a solution to our budget problems without it, and it’s just impossible.
And Howard points to the president–whoever that might be–as the key to the Tax Reform Act of 2013:
Tax reform will make nearly everyone mad. Big-bucks subsidies will be slashed or killed. Political demagoguery will run wild. The Reagan Administration saw that reform would only work if it began with a very specific plan that the White House owned. And President Reagan eventually became its best salesman. My Tax Policy Center colleague Gene Steuerle—who helped write TRA 86—always says the secret to success in Washington is writing the first draft. Put it this way: President Obama’s health reform strategy, which left the dirty work to Congress, is not the way to go.
Taxes and Energy Policy
Last week I had the opportunity to testify before two Ways and Means subcommittees–Select Revenue Measures and Oversight–about the way our tax system is used as a tool of energy policy. Here are my opening remarks. You can find my full testimony here.
As you know, our tax system is desperately in need of reform. It’s needlessly complex, economically harmful, and often unfair. Because of a plethora of temporary tax cuts, it’s also increasingly unpredictable.
We can and should do better.
The most promising path to reform is to reexamine the many tax preferences in our code. For decades, lawmakers have used the tax system not only to raise revenues to pay for government activities, but also to pursue a broad range of social and economic policies. These policies touch many aspects of life, including health insurance, home ownership, retirement saving, and the topic of today’s hearing, energy production and use.
These preferences often support important policy goals, but they have a downside. They narrow the tax base, reduce revenues, distort economic activity, complicate the tax system, force tax rates to be higher than they otherwise would be, and are often unfair. Those concerns have prompted policymakers and analysts across the political spectrum—including, most notably, the Bowles-Simpson commission—to recommend that tax preferences be cut back. The resulting revenue could then be used to lower tax rates, reduce future deficits, or some combination of the two.
In considering such proposals, lawmakers should consider how tax reform, fiscal concerns, and energy policy interact. Six factors are particularly important.
- Our tax system needs a fundamental overhaul. Every tax provision, including those related to energy, deserves close scrutiny to determine whether its benefits exceed its costs. Such a review will reveal that many tax preferences should be reduced, redesigned, or eliminated.
- The code includes numerous energy tax preferences. The Treasury Department, for example, recently identified 25 types of energy preferences worth about $16 billion in 2011. These include incentives for renewable energy sources, traditional fossil fuel sources, and energy efficiency. In addition, energy companies are also eligible for several tax preferences that are available more broadly, such as the domestic production credit.
- Tax subsidies are an imperfect way of pursuing energy and environmental policy goals. Such subsidies do encourage greater use of targeted energy resources. But, as I discuss in greater detail in my written testimony, they do so in an economically wasteful manner. Subsidies require, for example, that the government play a substantial role in picking winners and losers among energy technologies. The associated revenue losses also require higher taxes or larger deficits.
- A key political challenge for reform is that energy tax subsidies are often viewed as tax cuts. It makes more sense, however, to view them as spending through the tax code. Reducing such subsidies would make the government smaller even though tax revenues, as conventionally measured, would increase.
- Tax subsidies are not created equal. Production incentives reward businesses for producing desired energy and are agnostic about what mix of capital, labor, and materials firms use to accomplish that. Investment incentives, in contrast, reward businesses merely for making qualifying investments and encourage firms to use relatively more capital than labor. For both reasons, production incentives tend to be more efficient than investment incentives.
- Well-designed taxes can typically address the negative effects of energy use more effectively and at lower cost than can tax subsidies. I understand that higher gasoline taxes or a new carbon tax are not popular ideas in many circles, but please bear with me. As I explain at length in my written testimony, well-designed energy taxes are a much more pro-market way of addressing energy concerns than are tax subsidies. Taxes take full advantage of market forces and, in so doing, can accomplish policy goals at least cost and with minimal government intervention. Subsidies, in contrast, make much less use of market forces and inevitably require the government to pick winners and losers. Energy taxes also generate revenue that lawmakers can use to cut other taxes or to reduce deficits.
P.S. Not surprisingly, that last point wasn’t picked up by anyone else, at least during my panel (one of three at the hearing). New energy taxes would, of course, be problematic for the macroeconomy if enacted immediately. And we’d have to make some adjustment, either in the tax code or in benefit programs, to offset the impact on low-income families. In the long-run, however, I think that would be a much better way to address many energy concerns, including carbon emissions and oil dependence. But that’s not the way our system works. Instead, as noted, it’s much more popular to use tax preferences, whose benefits are visible and whose costs are obscure, to pursue energy and environmental goals. Other participants discussed the particular incentives, existing and proposed, in greater detail; their testimony is available here.
Deadlines, Deadlines, Deadlines
My latest column for the Christian Science Monitor argues that a slew of budget deadlines will drive policy action this Fall. Case in point, the potential for a government shutdown when the government’s fiscal year ends next week. I don’t think that’s likely, at least not yet, but such deadlines will be the big thing this fall:
September brings the change of seasons. Football players return to the gridiron. New television programs replace summer reruns. In Washington, legislators gear up for another season of legislative brinkmanship.
What distinguishes such brinkmanship from ordinary legislating? Hard deadlines.
Such deadlines force Congress to address policy issues that might otherwise languish due to partisan differences or legislative inertia.
Last spring, for example, the repeated threat of a government shutdown forced Congress to decide how much to spend on government agencies in fiscal 2011. This summer, the debt limit forced Republicans and Democrats to reach a budget compromise before Aug. 3, the day we would have discovered what happens if America can’t pay all its bills.
Hard deadlines thus can force Congress to address major issues. But they also invite that brinkmanship.
Like students who put off writing term papers until the night before they’re due, legislators often drag out negotiations until the very end. As we saw with the debt-limit debate, the ensuing uncertainty – will the United States really default? – can damage consumer, business, and international confidence. Hard deadlines also give leverage to those legislators who are least concerned about going over the brink.
So get ready for the new season. The fall legislative season is full of deadlines that could invite such brinkmanship. Here are five.
[The first two were funding for the Federal Aviation Administration, whose short-term funding was scheduled to expire on September 16 and the highway bill, whose funding was scheduled to expire on September 30. Both won temporary extensions between the time I wrote my column and when it appeared online. FAA funding now runs to January, and highway funding through March.] …
Sept. 30 also marks the end of the fiscal year – an especially important deadline. Congress has made woefully little progress in deciding next year’s funding. So we again face the prospect of temporary funding bills being negotiated in the shadow of threatened government shutdowns.
The fourth deadline comes on Nov. 23, the day the new “super committee” has to deliver a plan to address government debt and cut the deficit by at least $1.2 trillion over the next decade. If any seven committee members agree by that date, their plan will get special, expedited consideration in the House and Senate.
If the committee fails to reach agreement or Congress fails to enact it by Dec. 23, however, then automatic budget cuts go into effect for a range of programs, including defense, domestic programs, and Medicare, starting in 2013.
A final deadline comes at the end of the year, when several economic initiatives are set to expire, including the 2 percent payroll tax holiday and extended unemployment insurance benefits.
Each of these deadlines will command congressional attention. The downside of inaction will be tangible and visible. With renewed concern about jobs, policymakers will feel extra pressure to continue any funding or tax cuts that can be directly linked to employment.
These deadline-driven policy issues will thus dominate the fall legislative season. That will leave little space for any new initiatives that don’t come with a deadline.
More Budget Foxes, Fewer Hedgehogs
My latest column at the Christian Science Monitor:
America’s fiscal challenges are often portrayed as a conflict between hawks and doves. The real battle, however, is between foxes and hedgehogs.
“The fox knows many things, but the hedgehog knows one big thing,” wrote the ancient Greek poet Archilochus. Both foxes and hedgehogs play important roles in the policy ecosystem in normal times. In times of great change, however, society needs more foxes and fewer hedgehogs. More citizens and leaders who can adapt to new conditions, and fewer who want to preserve the status quo.
That’s where we find ourselves today. Despite all the anguish over a debt limit deal, America’s fiscal outlook remains daunting. Little progress has been made on our largest budget challenges. Despite bipartisan efforts, prospects for a grand fiscal bargain remain dim.
One reason is that fiscal hedgehogs still have the upper paw on key issues.
Consider entitlements. Everyone knows that entitlement spending is our No. 1 long-term budget challenge. Because of an aging population and rising health-care costs, spending on Social Security and federal health programs will explode. The Congressional Budget Office estimates that over the next 25 years spending on these programs will rise from roughly 10 percent of the economy to almost 17 percent. Accommodating that growth would require substantial cuts in other government programs, much higher tax revenues, or unsustainable deficits and debt.
The challenge is to find ways to keep the core benefits of these programs while reining in costs. This is where entitlement hedgehogs and foxes part company.
The hedgehogs know one big thing: These programs provide major benefits. Social Security, for example, has dramatically reduced poverty among seniors and provides essential income to millions of retirees.
Inspired by that one big thing, hedgehogs oppose any benefit reductions, such as increasing the eligibility age or trimming benefits to reflect increased longevity.
Entitlement foxes have a more nuanced view. They recognize, like the hedgehogs, the value of the guaranteed retirement income that Social Security provides. But they also know that the number of retirees receiving benefits is growing faster than the number of workers paying payroll taxes. They know that Americans are living longer but retiring earlier. They know, in short, that the future will be different from the past and that the program needs to evolve to remain sustainable. Foxes are thus open to ideas like raising the eligibility age or changing the benefit formula.
A similar dichotomy exists with taxes. Revenue hedgehogs know one big thing: Taxes place a burden on taxpayers and the economy. Thus, they oppose all tax increases, even efforts to reduce the many tax breaks that complicate our tax code.
Revenue foxes see things differently. They recognize the burden that taxes place on taxpayers and the economy. But they also know that tax increases are not all created equal. Higher tax rates, for example, are usually worse for the economy than cutting back on tax breaks. Indeed, cutting tax breaks sometimes frees taxpayers to make decisions based on real economic considerations rather than taxes, thus strengthening the economy. That’s why revenue foxes support eliminating many tax breaks.
Fiscal hedgehogs will never embrace such changes. To make progress, we need more fiscal foxes.
S&P’s $2 Trillion Error
In the final hours before Friday’s historic downgrade, Standard & Poors gave Treasury an advance copy of its report. Amazingly, that report contained a $2 trillion error in its calculations of U.S. deficits and debt over the next decade. Here are four things you should know about it.
1. Treasury hoped that S&P would change its decision in light of the error, but S&P shrugged it off as not material.
In a blog post, Acting Assistant Secretary for Economic Policy John Bellows described what happened when the error was discovered:
After Treasury pointed out this error – a basic math error of significant consequence – S&P still chose to proceed with their flawed judgment by simply changing their principal rationale for their credit rating decision from an economic one to a political one.
On Saturday morning, S&P issued a clarification / rebuttal acknowledging the error, but downplaying its importance:
The primary focus [of our analysis] remained on the current level of debt, the trajectory of debt as a share of the economy, and the lack of apparent willingness of elected officials as a group to deal with the U.S. medium term fiscal outlook. None of these key factors was meaningfully affected by the assumption revisions to the assumed growth of discretionary outlays and thus had no impact on the rating decision.
2. Despite S&P’s claim, $2 trillion would “meaningfully affect” “the trajectory of debt as a share of the economy.”
It’s own revised calculations show net general government debt hitting 85% of gross domestic product in 2021 instead of 93%. That’s a big difference.
The 85% figure is still uncomfortably high and may well not deserve a AAA rating. But S&P was too dismissive in its clarification.
3. The error is understandable but remarkably sloppy for such an important analysis.
The source of the error is painfully familiar to anyone who deals with U.S. budget projections. S&P’s analysts didn’t use the right measuring stick — i.e., the right budget baseline — when analyzing the effects of the recently-enacted Budget Control Act.
In one sense, it’s easy to see how this error happened. Budget discussions are now hopelessly confused by a profusion of different baseline projections of what spending and revenues will look like in the future. Indeed, I have devoted multiple posts to clarifying how different revenue baselines fit together (e.g., here and here). I’ve even used Johnny Depp to highlight the challenge.
A similar challenge exists with discretionary spending. Official budget baselines assume that annual appropriations (the defense and non-defense spending Congress fights over every year) grow with inflation unless subject to an explicit cap. That was the basis, for example, for the official baseline that the Congressional Budget Office used in evaluating the impacts of the Budget Control Act.
Before the BCA, there were no discretionary spending caps, so annual budget authority was assumed to grow with inflation from the most recent appropriated levels. The BCA then generated $917 billion in budget savings by setting annual spending caps below those levels.
S&P messed up because it based its analysis on another baseline. That “alternative fiscal scenario” assumes that discretionary spending grows at the same pace as the overall economy, not just with inflation. That baseline implies much more spending and debt over the next decade — $2 trillion more, in fact — than the official baseline.
So, again, it’s easy to see mechanically how this error happened. But it’s still remarkably sloppy. Budget experts are well-aware of the problem of multiple baselines. Indeed, we all pepper our conversations and analysis with the question “what baseline are you using?” It’s stunning that S&P didn’t have multiple analysts asking the same question to make sure their original numbers were right.
4. S&P’s response to the error further demonstrates that its primary concern about the United States is political not numerical.
As S&P said in Friday’s report:
Our opinion is that elected officials remain wary of tackling the structural issues required to effectively address the rising U.S. public debt burden in a manner consistent with a ‘AAA’ rating and with ‘AAA’ rated sovereign peers. In our view, the difficulty in framing a consensus on fiscal policy weakens the government’s ability to manage public finances and diverts attention from the debate over how to achieve more balanced and dynamic economic growth in an era of fiscal stringency and private-sector deleveraging.
In short, S&P worries that America won’t get its act together in time.
Five Things You Should Know About the S&P Downgrade
On Friday night, Standard and Poors announced that it was downgrading U.S. long-term sovereign debt from AAA to AA+, the first such downgrade in U.S. history.
Here are five things you should know about the downgrade — four important, one trivia.
1. S&P downgraded U.S. debt not only because of the deteriorating fiscal outlook, but also because of concerns about America’s ability to govern itself. It said:
The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year’s wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge, and, as we see it, the resulting agreement fell well short of the comprehensive fiscal consolidation program that some proponents had envisaged until quite recently. Republicans and Democrats have only been able to agree to relatively modest savings on discretionary spending while delegating to the Select Committee decisions on more comprehensive measures. It appears that for now, new revenues have dropped down on the menu of policy options. In addition, the plan envisions only minor policy changes on Medicare and little change in other entitlements, the containment of which we and most other independent observers regard as key to long-term fiscal sustainability.
2. Moody’s and Fitch recently reaffirmed their AAA ratings on U.S. sovereign debt. On Tuesday, Moody’s reaffirmed its Aaa rating, but assigned a negative outlook given the risk that the U.S. might flinch from further fiscal tightening, borrowing costs might rise, and the economy might weaken. Fitch similarly reiterated its AAA rating on Tuesday, but noted that it would have a fuller reassessment by the end of August. Fitch also emphasized the need for further fiscal adjustments.
One issue (on which I haven’t seen much discussion) is how the impact of a downgrade would increase if it spreads from just one rating agency to two or three.
3. In the past thirty years, five nations — Australia, Canada, Denmark, Finland, and Sweden– have regained a AAA rating after losing it. See, for example, this nice chart from BusinessWeek:
America still has much to learn from other nations that fixed their economies and budgets after financial crises. Sweden, for example, did a remarkable job addressing the fiscal challenges that followed its financial crisis in the early 1990s.
4. This downgrade may set off a cascade of further downgrades for other U.S. debt. The federal government provides an implicit or explicit backstop for many other debt securities. For example, the federal government stands behind trillions of dollars of debt and guarantees issued by Fannie Mae and Freddie Mac, GNMA securities, and securities backed by guaranteed student loans. It implicitly stands behind systemically important financial institutions. And it provides substantial support to state and local governments. S&P did not specifically address these other credits in Friday’s report, but did say that:
On Monday, we will issue separate releases concerning affected ratings in the funds, government-related entities, financial institutions, insurance, public finance, and structured finance sectors.
S&P did reaffirm its highest, A-1+ rating on U.S. short-term debt, which should limit impacts on money market funds and other short-term lending markets.
5. S&P was not the first rating agency to downgrade U.S. sovereign debt. In the category of trivia, China’s Dagong credit rating agency downgraded U.S. credit to A with a negative outlook earlier this week. Dagong had initiated U.S. coverage with a AA rating about a year ago, which was lowered to A+ last November. Dagong apparently views the United States as a greater risk than China. Despite all of America’s problems, that seems a stretch.
Update: In addition, Egan-Jones, a U.S. rating agency, cut the U.S. to AA+ in mid-July. Egan-Jones thus wins the prize as first U.S.-based agency to downgrade. Writing in the Financial Times, Michael Mackenzie noted:
Egan-Jones was officially recognised in 2008 by the Securities and Exchange Commission and, unlike its larger rivals, generates revenue from institutional investors and not from issuers of debt. During the past decade it downgraded US carmakers and structured credit products before similar decisions by the big rating agencies.
Thanks to reader Dan Diamond for pointing out the Egan-Jones downgrade.
Debt Limit: Routine or the End of the World?
Well, it certainly isn’t routine this time.
Life was much simpler on the West Wing:
This is a repost from May.
Why Do Half of Americans Pay No Federal Income Tax?
You may have heard the claim that about half of Americans pay no federal income tax. That’s a true fact. My Tax Policy Center colleagues estimate, for example, that 46% of households either will pay no federal income tax in 2011 or will receive more from the IRS than they pay in.
Today, TPC released a new study that examines why these people end up paying no federal income tax.
The number one reason should come as no surprise. It’s because they have low incomes. As my colleague Bob Williams notes:
A couple with two children earning less than $26,400 will pay no federal income tax this year because their $11,600 standard deduction and four exemptions of $3,700 each reduce their taxable income to zero. The basic structure of the income tax simply exempts subsistence levels of income from tax.
Low incomes (or, if you prefer, the standard deduction and personal exemptions) account for fully half of the people who pay no federal income tax.
The second reason is that for many senior citizens, Social Security benefits are exempt from federal income taxes. That accounts for about 22% of the people who pay no federal income tax.
The third reason is that America uses the tax code to provide benefits to low-income families, particularly those with children. Taken together, the earned income tax credit, the child credit, and the childcare credit account for about 15% of the people who pay no federal income tax.
Taken together, those three factors — incomes that fall below the standard deduction and personal exemptions; the exemption for most Social Security benefits; and tax benefits aimed at low-income families and children — account for almost 90% of the Americans who pay no federal income tax.
For further details and info about the other 10%, please see the study.
P.S.: The true fact — about half of Americans do not pay federal income taxes — often gets transmogrified in public discourse into the decidedly untrue claim that half of Americans pay no taxes. That simply isn’t so. There are many other taxes in our fair land, including payroll taxes, excise taxes, sales taxes, state income taxes, and property taxes. Most people who don’t pay federal income taxes still encounter some of these other taxes.
Does the Gang of Six Cut Taxes or Raise Them?
Here’s a quick multiple choice quiz about the Gang of Six’s new budget proposal.
Over the next ten years, would the proposal:
a. Cut taxes by $1.5 trillion
b. Increase taxes by $2.0 trillion
c. Increase taxes by $1.2 trillion
d. All of the above.
If you answered (d), you have a fine future as a budget watcher (or you peeked at the answer from the last time we played this game).
The answer depends on the yard stick you use to measure changes in tax revenues. Unfortunately, people now use at least three different yard sticks.
The first, known as the current law baseline, assumes that Congress doesn’t change the tax laws on the books today. That means every temporary tax cut expires in the next two years, including the individual tax cuts enacted in 2001/2003 and extended in 2010, the “patch” that limits the growth of the alternative minimum tax, and the current estate tax.
The second, known as the current policy baseline, assumes those three temporary tax cuts all get permanently extended.
The third, known variously as the Fiscal Commission’s plausible baseline or the alternative fiscal scenario of 2010, assumes that those three temporary tax cuts all get extended with one big exception: the tax cuts that benefit “high-income” taxpayers expire.
With three different yard sticks, we get three different measures of the impact of the Go6 proposal.
Relative to the current law baseline, the Go6 plan would be a $1.5 trillion tax cut. In other words, the Go6 plan would raise $1.5 trillion less in revenue over the next ten years than if Congress did nothing, and all the temporary tax cuts expired. That’s an important number because the Joint Committee on Taxation and the Congressional Budget Office are required to use current law in preparing official budget scores.
Relative to the Fiscal Commission’s baseline, the Go6 plan is a $1.2 trillion tax increase. That includes three pieces: $1.0 trillion from reducing tax preferences (some of which may be the moral equivalent of cutting spending), $133 billion in new revenues for the highway trust fund (but not from higher gas taxes), and about $60 billion from using a lower measure of inflation – the chain CPI – to index the tax code.
Relative to current policy, finally, the Go6 plan is roughly a $2 trillion tax increase. In addition to the $1.2 trillion in tax increases noted above, it assumes an additional $800 billion in revenue – equivalent to what would be raised by allowing the “high-income” tax cuts to expire.* The Go6 plan would thus raise about $2 trillion more in revenue over the next ten years than if Congress simply kept in place the tax policies that apply in 2011 (except the payroll tax holiday, which everyone assumes will eventually expire).
Bottom line: You should expect to hear the plan characterized as anything from a $1.5 trillion tax cut to a $2 trillion tax hike.
P.S. For a similar discussion comparing two of the three baselines, see this nice piece by David Wessel of the Wall Street Journal.
P.P.S. What really matters, of course, is the plan itself, not how it scores against some possibly arbitrary baselines. Bob Williams makes that point here.
* I revised this sentence to emphasize that the plan includes revenue equivalent to letting the “high-income” tax cuts expire; it doesn’t actually let the rates expire – instead, it includes a wholesale reform that includes lowering the top rate to no more than 29 percent.