Tag: Taxes

How Should We Use the Revenue from Taxing Carbon?

Adele Morris co-authored this post.

A US carbon tax could raise $1 trillion or more in new revenue over the next decade. There is no shortage of ways to use it.

Tax reformers want to cut business and personal taxes. Budget hawks want to reduce future deficits. Environmental advocates want to invest in clean energy. Progressives want to expand the social safety net. And so on.

How should we make sense of these competing ideas? In a new policy brief, we suggest a framework for thinking through these options. We identify four basic uses of carbon tax revenues:

  1. Offset the new burdens that a carbon tax places on consumers, producers, communities, and the broader economy;
  2. Support further efforts to reduce greenhouse gas emissions;
  3. Ameliorate the harms of climate disruption; or
  4. Fund public priorities unrelated to climate.

Each has merit, especially as part of an effort to build a political coalition to enact and maintain a carbon tax. But some ideas have more merit than others.

On both policy and political grounds, it makes sense to use carbon tax revenue to soften the blow on lower-income households and coal workers and their communities. Doing so will require only a small fraction (15 percent or so) of carbon tax revenue, leaving substantial resources for other purposes.

Recycling revenue into broader cuts in personal and business taxes also has particular merit. It can help offset the economic burden of the carbon tax and facilitate pro-growth tax reforms. By assuaging concerns that a carbon tax is just another way to expand government, moreover, revenue recycling may be essential to enacting a tax. However, requiring strict revenue neutrality also has downsides. Some policy goals, such as assistance to displaced coal workers, could be better pursued by spending the money directly, rather than indirectly through the tax system.

Policymakers should approach other uses of carbon tax revenue with more caution.
For instance, they should be careful in using revenues to try to cut emissions further. A well-designed carbon tax would do a good job reducing greenhouse gas emissions, so additional policy initiatives should focus on filling in gaps—reducing emissions the tax may miss. Merely duplicating efforts—e.g., supporting clean electricity facilities—would not be cost effective. Indeed, policymakers could roll back tax credits for solar and wind power and other subsidies and mandates that a sizable carbon tax would make redundant. That would free up resources to pursue other, more beneficial goals.

Policymakers should be similarly cautious about tightly linking revenue to specific new spending, whether climate-related (e.g., coastal protection) or not (e.g., new highways). Earmarking risks overspending on any one line item, deploying resources inefficiently, and fueling concerns that the tax would become a slush fund for politicians’ pet projects.

Decarbonizing the economy requires long-term solutions. Many emissions-reducing investments involve large expenditures on long-lived capital, such as power plants and industrial facilities. A carbon tax package that businesses and people believe will endure will be more environmentally successful than one that people think may not survive the next election.

In Australia, for instance, a carbon tax that took effect in 2012 was repealed just two years later, an object lesson in how highly partisan climate policies can be rescinded by future governments. Policymakers should thus give special attention to identifying revenue uses that build ongoing support for a carbon tax.

What Should We Do with the Money from Taxing “Bads”?

What do indoor tanning, shopping bags, junk food, alcoholic beverages, tobacco, “gas guzzling” cars, ozone-depleting chemicals, sugary drinks, marijuana, gasoline, coal, carbon-containing fuels, and financial transactions have in common? Taxes that discourage them. The United States taxes indoor tanning to reduce skin cancer, for example, while Washington DC taxes shopping bags to cut litter, and Mexico taxes junk food to fight obesity.

Governments hope these “corrective taxes” will reduce harms from pollution, unhealthy consumption, and other risky behaviors. But taxing “bads” can also bring in big money. A US carbon tax could easily raise more than $100 billion annually, for example, and a tax on sugary drinks could raise $10 billion.

How should governments use that money? As you might expect, policymakers, advocates, and analysts have proposed myriad ways to use the revenue to pay for new spending, to cut taxes, or, in a few cases, to reduce borrowing. In a new paper, however, Adele Morris and I argue that all these options boil down to four basic approaches:

Revenue Use Table 2

Advocates often suggest that revenue be put toward the same goal as the tax. Carbon tax revenues might subsidize energy efficiency or clean energy, for example, and sugary drink revenues might subsidize healthier food or nutrition information programs. Using revenue that way may make sense if you believe the tax won’t sufficiently change business and consumer choices. But there are downsides. A successful tax will typically reduce the potential benefits from other policies aimed at the same goal. As a result, it may make sense to roll back other policies, rather than expand them, when a substantial corrective tax is implemented. Directing revenues to the same goal may also limit lawmakers’ ability to build a coalition for a corrective tax, while other uses may attract supporters with other priorities.

Another approach is to use the revenue to offset the burdens that a corrective tax creates. New taxes on food, energy, and other products can squeeze household budgets, particularly for families with lower incomes. Shrinking the market for targeted products may disproportionately burden specific workers, industries, and communities. If a tax is large enough, moreover, it may slow overall economic activity. Tax cuts, expansions in transfer programs, or other spending increases may offset some of these harms while leaving the incentives intact. This is particularly important when taxes are intended to help people who suffer from internalities—health risks and other costs they unintentionally impose on themselves. In those cases, rebating revenue to affected consumers can help ensure that a tax actually helps the people who pay it.

A third approach is to use revenues to offset costs of the taxed activity. If an activity imposes costs on an identifiable group of people, it may make sense to compensate them for the harm. A US tax on coal does this, for example, by funding assistance to workers who develop black lung disease. Revenues can also cover some costs of providing public services that support the taxed activity. Fuel taxes paid by drivers, airplane passengers, and maritime shippers , for example, help fund the creation and maintenance of the associated infrastructure.

Finally, governments could treat corrective taxes like any revenue source, with receipts used to reduce borrowing, boost spending, or cut taxes in ways unrelated to the goal of the tax. Governments could allocate the money using ordinary budget processes, as Berkeley, California does with its soda tax revenue, or could earmark revenues to specific efforts, as France does by directing some financial transactions tax revenue to international aid.

Policymakers must consider a host of factors when deciding what mix of these options to pursue. Complete flexibility may allow them to put revenue to its best use over time. But surveys suggest that the public is often skeptical of corrective taxes if they don’t know how the revenue will be used. Many worry, for example, that the corrective intent of a tax may just be a cover story for policymakers’ real goal of expanding government.

Recycling corrective tax revenue into offsetting tax cuts can assuage that concern. But revenue neutrality has downsides as well. Matching incoming revenues and offsetting tax cuts may be difficult, given uncertainties in future revenues from a corrective tax and any offsetting tax cuts. In addition, it may be easier to achieve some distributional goals through spending than tax reductions. For example, a new spending program may be a more straightforward way to help coal miners hurt by a carbon tax than some kludgy tax credit. People who generally oppose wholesale revenue increases from corrective taxes should thus be open to modest deviations from revenue neutrality that provide a more effective way to accomplish policy goals.

Should Governments Tax Unhealthy Foods and Drinks?

With obesity and diabetes at record levels, many public health experts believe governments should tax soda, sweets, junk food, and other unhealthy foods and drinks. Denmark, Finland, France, Hungary, and Mexico have such taxes. So do Berkeley, California and the Navajo Nation. Celebrity chef Jamie Oliver is waging a high-profile campaign to get Britain to tax sugar, and the Washington Post has endorsed the same for the United States.

Do such taxes make sense? My Urban Institute colleagues Maeve Gearing and John Iselin and I explore that question in a new report, Should We Tax Unhealthy Foods and Drinks?

Many nutrients and ingredients have been suggested as possible targets for taxes, including fat, saturated fat, salt, artificial sweeteners, and caffeine. Our sense, though, is that only sugar might be a plausible candidate.

Sugar in foods and drinks contributes to obesity, diabetes, and other conditions. By increasing the price of products that contain sugar, taxes can get people to consume less of them and thus improve nutrition and health. Health care costs would be lower, and people would live healthier, longer lives. Governments could put the resulting revenue to good use, perhaps by helping low-income families or cutting other taxes.

That’s the pro case for a sugar tax, and it’s a good one. But policymakers need to consider the downsides too. Taxes impose real costs on consumers who pay the tax or switch to other options that may be more expensive, less enjoyable, or less convenient.

That burden would be particularly large for lower-income families. We find that a US tax on sugar-sweetened beverages would be highly regressive, imposing more than four times as much burden, relative to income, on people in the bottom fifth of the income distribution as on those in the top fifth.

Another issue is how well sugar consumption tracks potential health costs and risks. If you are trying to discourage something harmful, taxes work best when there is a tight relationship between the “dose” that gets taxed and the “response” of concern. Taxes on cigarettes and carbon are well-targeted given tight links to lung cancer and climate change, respectively. The dose-response relationship for sugar, however, varies across individuals depending on their metabolisms, lifestyle, and health. Taxes cannot capture that variation; someone facing grave risks pays the same sugar tax rate as someone facing minute ones. That limits what taxes alone can accomplish.

In addition, people may switch to foods and drinks that are also unhealthy. If governments tax only sugary soda, for example, some people will switch to juice, which sounds healthier but packs a lot of sugar. It’s vital to understand how potential taxes affect entire diets, not just consumption of targeted products.

A final concern, beyond the scope of our report, is whether taxing sugar is an appropriate role for government. Some people strongly object to an expanding “nanny state” using taxes to influence personal choices. Others view taxes as acceptable only if individual choices impose costs on others. Eating and drinking sugar causes such “externalities” when insurance spreads resulting health care costs across other people. Others go further and view taxes as an acceptable way to reduce “internalities” as well, the overlooked harms consumers impose on themselves.

Policymakers must weigh all those concerns when considering whether to tax sugar. If they decide to do so, they should focus on content, not proxies like drink volume or sales value. Mexico, for example, taxes sweetened drinks based on their volume, a peso per liter. That encourages consumers to reduce how much they drink but does nothing to encourage less sugary alternatives. That’s a big deal because sugar content ranges enormously. Some drinks have less than 10 grams of sugar (2 ½ teaspoons) per serving, while others have 30 grams (7 ½ teaspoons) or more. Far better would be a content-based tax that encourages switching from the 30-gram drinks to the 10-gram ones.

Focusing on sugar content would bring another benefit. Most sugar tax discussions focus on changing consumer choices. But consumers aren’t in this alone. Food and beverage companies and retailers determine what products they make, market, and sell. Taxing drink volumes or the sales value of sugary food gives these companies no incentive to develop and market lower-sugar alternatives. Taxing sugar content, however, would encourage them to explore all avenues for reducing the sugar in what we eat and drink.

Note: I updated this post on December 15.

Should Governments Tax Products That Are Fun But Harmful?

Should you face an extra tax if you drink soda? Eat potato chips? Uncork some wine? Light up a cigarette or joint? Toast yourself in a tanning booth? Many governments think so. Mexico taxes junk food. Berkeley taxes sugary soft drinks. Countless governments tax alcohol and tobacco. Several states tax marijuana. And thanks to health reform, the U.S. government taxes indoor tanning.

One rationale for these taxes is that some personal choices impose costs on other people, what economists call externalities. Your drinking threatens bystanders if you get behind the wheel. Tanning-induced skin cancer drives up health insurance costs.

Another rationale is that people sometimes overlook costs they themselves face, known as internalities. Limited self-control, inattention, or poor information can cause people to eat too many sweets, drink too much alcohol, or take up smoking only to later regret the harm.

In a new paper, Should We Tax Internalities Like Externalities?, I examine whether the internality rationale is as strong as the externality one. Economists have long argued that taxes can be a good way to put a price on externalities like the pollutants causing climate change, but does the same logic apply to internalities?

People who look down on certain activities sometimes think so, with taxes being a way to discourage “sinful” conduct. People who prioritize public health often favor such taxes as a way to encourage healthier behavior. Those who emphasize personal responsibility, by contrast, often oppose such taxes as infringing on individual autonomy—the overreaching “nanny state.”

Economists don’t have much to say about sin. But we do have ideas about balancing health and consumer autonomy. One approach is to focus on efficiency: How do the benefits of a tax compare to its costs? Internalities and externalities both involve people consuming too much because they overlook some costs. Taxes can serve as a proxy for those overlooked costs and reduce consumption to a more beneficial level. In that way, the logic of taxing internalities is identical to that for taxing externalities.

But that equivalence comes with a caveat. Internality taxes should be targeted only at harms we overlook. If people recognize the health risks of eating bacon but still choose to do so, there is no efficiency rationale for a tax. Informed consumers have decided the pleasure is worth the risk. Efficiency thus differs sharply from sin and public health views that would tax harmful products regardless of whether consumers appreciate the risks.

Economists often temper cost-benefit comparisons with concerns about the distribution of gains and losses. At first glance, taxes on internalities and externalities generate similar equity concerns. Both target consumption, so both may fall more heavily on poor families, which tend to spend larger shares of their incomes. But there’s another caveat. Internality taxes do not target consumption in general. Instead, they target products whose future costs consumers often overlook. Nearly everyone does that, but it may be more of a problem for people with low incomes. The stress of poverty, for example, can make it more difficult to evaluate the long-term costs of decisions today. As a result, taxes aimed at internalities are more likely to hit low-income families than are those aimed at externalities.

A third, paternalistic perspective focuses on people who overlook harms. Do internality taxes help them? To meet that standard, the benefit consumers get from reducing purchases must exceed their new tax burden. That can be a high hurdle. If consumers only buy a little less, they may end up with small health gains but a large tax bill. That might be a success from an efficiency perspective since the tax revenue ultimately helps someone. But it’s a loss from the perspective of affected consumers.

The economic case for taxing internalities is thus weaker than for taxing externalities. Internality taxes raise greater distributional concerns, and they place a new burden on the people they are intended to help. Internality taxes can still make sense if consumers find it easy to cut back on taxed products (so health gains are large relative to the new tax burden), if overlooked health risks are very large (as with smoking), or if governments rebate revenues to affected consumers. But when those conditions do not hold, we should be skeptical.

Everything You Should Know about Taxing Carbon

Climate change is hot. From the pope’s encyclical to the upcoming United Nations conference in Paris, leaders are debating how to slow and eventually stop the warming of our planet.

We economists think we have an answer: put a price on carbon dioxide and the other gases driving climate change. When emissions are free, businesses, consumers, and governments pollute without thinking. But put a price on that pollution and watch how clean they become.

That’s the theory. And it’s a good one. But translating it from the economist’s whiteboard to reality is challenging. A carbon price that works well in principle may stumble in practice. A real carbon price will inevitably fall short of the theoretical ideal. Practical design challenges thus deserve close attention.

To help policymakers, analysts, and the public address those challenges, Eric Toder, Lydia Austin, and I have published a new report, “Taxing Carbon: What, Why, and How,” on putting a price on carbon.

Some highlights:

  • Lawmakers could put a price on carbon either by levying a tax or by setting a limit on emissions and allowing trading of emission rights. These approaches have much in common. Politically, however, a carbon tax is on the upswing. Cap and trade failed in 2010, while interest in taxing carbon is growing, including three bills in Congress and endorsements from analysts of diverse ideological stripes.
  • Carbon prices already exist. At least 15 governments tax carbon outright, and more than 25 have emissions trading systems. Those efforts have demonstrated that the economists’ logic holds. If you put a price on carbon, people emit less.
  • Figuring out the appropriate tax rate is hard. The Obama administration estimates that the “social cost of carbon” is currently about $42 per metric ton. But the right figure could easily be double that, or half. That uncertainty is not a reason to not tax carbon. But it does mean we should maintain flexibility to revisit the price as new evidence arrives.
  • Taxing carbon could reduce the need for regulations, tax breaks, and other subsidies that currently encourage cleaner energy. Rolling back those policies, in particular EPA regulations for existing power plants, may make policy sense and will likely be essential to the politics of enacting a carbon tax. But the details matter. Rolling back existing policies makes more sense with a carbon tax that’s high and broad, than with one that’s low and narrow.
  • By itself, a carbon tax would be regressive: low-income families would bear a greater burden, relative to their incomes, than would high-income families. We can reduce that burden, or even reverse it, by recycling some carbon revenue into refundable tax credits or other tax cuts focused on low-income families.
  • By itself, a carbon tax would weaken the overall economy, at least for several decades. That too can be reduced, and perhaps even reversed, by recycling some carbon revenue into offsetting tax cuts, such as to corporate income taxes.
  • Unfortunately, there’s a tradeoff. The most progressive recycling options do the least to help economic growth. And the recycling options that do the most for growth would leave the tax system less progressive.
  • A global agreement on carbon reductions would be preferable to the United States acting alone.  Given the nation’s size and contribution to global emissions, a unilateral tax would make a difference, but would damage the competitiveness of some US industries. Special relief for these sectors could reduce the benefits of the tax, but may be necessary both practically and politically.

A carbon tax won’t be perfect. Done well, however, it could efficiently reduce the emissions that cause climate change and encourage innovation in cleaner technologies. The resulting revenue could finance tax reductions, spending priorities, or deficit reduction—policies that could offset the tax’s distributional and economic burdens, improve the environment, or otherwise lift Americans’ well-being.

The challenge is designing a carbon tax that delivers on that potential. We hope our new report helps elevate what will surely be a heated debate.

Three Things You Should Know About Dynamic Scoring

The House recently changed the rules of budget scoring: The Congressional Budget Office and the Joint Committee on Taxation will now account for macroeconomic effects when estimating the budget impacts of major legislation. Here are three things you should know as we await the first official dynamic score.

1. Spending and regulations matter, not just taxes

You might think dynamic scoring is just about taxes. It’s not. Spending and regulatory policies can also move the economy. Take the Affordable Care Act. CBO estimates that the law’s insurance subsidies will reduce labor supply by 1.5 to 2.0 percent from 2017 to 2024, some 2 to 2.5 million full-time equivalent workers. If CBO and JCT do a dynamic score of the House’s latest ACA repeal, this effect will be front and center.

The same goes for immigration reform. In 2013 (and in 2006), CBO and JCT included some macroeconomic effects in their score of comprehensive immigration reform, though they did not do a fully dynamic score. Under today’s rules, reform would show an even bigger boost to the economy and more long-term deficit reduction than the agencies projected in the earlier bills.

2. Dynamic scoring isn’t new

For more than a decade, CBO and JCT have published dynamic analyses using multiple models and a range of assumptions. For example, JCT projected former House Ways & Means Committee chairman Dave Camp’s tax reform plan would boost the size of the economy (not its growth rate) by 0.1 to 1.6 percent over 2014 to 2023. The big step in dynamic scoring will be winnowing such multiple estimates into the single set of projections required for official scores.

Observers understandably worry about how the scorekeepers will do that. For example, what will JCT and CBO do with certain forward-looking models that require assumptions not just about the policy in question but also about policy decisions Congress will make in the future? If the agencies score a tax cut today, do they also have to include future tax increases or spending cuts to pay for it, even if Congress doesn’t specify them? If so, how should the agencies decide what those offsetting policies are? Does the existence of such models undermine dynamic scoring from the start?

Happily, we already have a good sense of what the agencies will do, and no, the existence of such models doesn’t hamstring them. At least twice a year, CBO and JCT construct baseline budget projections under existing law. That law often includes scheduled policy changes, most notably the (in)famous “fiscal cliff” at the end of 2012. CBO and JCT had to include the macro effects of the cliff in their budget baseline at that time, even though they had no idea whether and how Congress might offset those policies further in the future. That’s dynamic scoring in all its glory, just applied to the baseline rather than analyzing new legislation. CBO and JCT didn’t need to assume hypothetical future policies to score the fiscal cliff, and they won’t need to in scoring legislation either.

3. Dynamic scoring won’t live up to the hype, on either side

Some advocates hope that dynamic scoring will usher in a new era of tax cuts and entitlement reforms. Some opponents fear that they are right.

Reality will be more muted. Dynamic scores of tax cuts, for example, will include the pro-growth incentive effects that advocates emphasize, leading to more work and private investment. But they will also account for offsetting effects, such as higher deficits crowding out investment or people working less because their incomes rise. As previous CBO analyses have shown, the net of those effects often reveals less growth than advocates hope. Indeed, don’t be surprised if dynamic scoring sometimes shows tax cuts are more expensive than conventionally estimated; that can easily happen if pro-growth incentives aren’t large enough to offset anti-growth effects.

Detractors also worry that dynamic scoring is an invitation for JCT or CBO to cherry pick model assumptions to favor the majority’s policy goals. Doing so runs against the DNA of both organizations. Even if it didn’t, the discipline of twice-yearly budget baselines discourages cherry picking. Neither agency wants to publish rosy dynamic scenarios that are inconsistent with how they construct their budget baselines. You don’t want to forecast higher GDP when scoring a tax bill enacted in October, and have that GDP disappear in the January baseline.

I am cautiously optimistic about dynamic scoring. Done well, it can help Congress and the public better understand the fiscal effects of major policies. There are still some process issues to resolve, most notably how investments might be handled, but we should welcome the potential for better information.

For more views, see the dynamic scoring forum at TaxVox, the blog of the Tax Policy Center.

Tax Policy and Investment by Startups and Innovative Firms

Our tax system includes many provisions to boost business investment, particularly by startups and innovative firms. In a new Tax Policy Center study, Joe Rosenberg and I find that those incentives are often blunted by other features of the tax code:

We examine how tax policies alter investment incentives, with a particular focus on startup and innovative businesses. Consistent with prior work, we find that existing policies impose widely varying effective tax rates on investments in different industries and activities, favor debt over equity, and favor pass-through entities over corporations. Targeted tax incentives lower the cost of capital for small businesses, startups, and those that invest in intellectual property. Those advantages are weakened, and in some cases reversed, however, by two factors. First, businesses that invest heavily in new ideas rely more on higher-taxed equity than do firms that focus on tangible investment. Second, startups that initially make losses face limits on their ability to realize the full value of tax deductions and credits. These limits can more than offset the advantage provided by tax incentives. We also examine the effects of potential tax reforms that would reduce the corporate income tax rate and achieve more equal tax treatment across the various forms of business investment.

A “Normal” Budget Isn’t Really Normal

Treasury closed the financial books on fiscal 2014 last week. As my colleague Howard Gleckman noted, the top line figures all came in close to their 40-year averages. The $483 billion deficit was about 2.8 percent of gross domestic product, for example, slightly below the 3.2 percent average of the past four decades. Tax revenues clocked in at 17.5 percent of GDP, a smidgen above their 17.3 percent 40-year average. And spending was 20.3 percent, a bit below its 20.5 percent average.

Taxes, spending, and deficits thus appear to be back to “normal.” If anything, fiscal policy in 2014 was slightly tighter than the average of the past four decades.

That’s all true, as a matter of arithmetic. But should we use the past 40 years as a benchmark for normal budget policy?

It’s common to do so. The Congressional Budget Office often reports 40-year averages to help put budget figures in context. I’ve invoked 40-year averages as much as anyone.

But what has been the result of that “normal” policy? From 1975 to today, the federal debt swelled from less than 25 percent of GDP to more than 70 percent. I don’t think many people would view that as normal. Or maybe it is normal, but not in a good way.

Just before the Great Recession, the federal debt was only 35 percent of GDP. Over the previous four decades (1968 through 2007), the deficit had averaged 2.3 percent of GDP, almost a percentage point lower than today’s 40-year average.

That comparison illustrates the problem with mechanically using 40-year averages as a benchmark for normal. A few extreme years can skew the figures. In 2007, we would have said deficits around 2 percent of GDP were normal. Today, the post-Great Recession average tempts us to think of 3 percent as normal. The Great Recession has similarly skewed up average spending (from 19.9 percent to 20.5 percent) and skewed down average taxes (from 17.6 percent to 17.3 percent).

As recent years demonstrate, we don’t want a normal budget every year. When the economy is weak, it makes sense for taxes to fall and spending and deficits to rise. When the economy is strong, deficits should come down, perhaps even disappear, through a mix of higher revenues and lower spending.

Looking over the business cycle, however, it is useful to have some budget benchmarks. A mechanical calculation of 40-year averages won’t serve. Instead, we need more objective benchmarks. On Twitter, Brad Delong suggested one benchmark for deficits: the level that would keep the debt-to-GDP ratio constant. I welcome other suggestions.

Seven Tax Issues Facing Small Business

Today I had the chance to testify before the House Small Business Committee on the many tax issues facing small business. Here are my opening remarks. You can find my full testimony here.

America’s tax system is needlessly complex, economically harmful, and often unfair. Despite recent revenue gains, it likely will not raise enough money to pay the government’s future bills. The time is thus ripe for wholesale tax reform. Such reform could have far-reaching effects, including on small business. To help you evaluate those effects, I’d like to make seven points about the tax issues facing small business.

1. Tax compliance places a large burden on small businesses, both in the aggregate and relative to large businesses.

The Internal Revenue Service estimates that businesses with less than $1 million in revenue bear almost two-thirds of business compliance costs. Those costs are much larger, relative to revenues or assets, for small firms than for big ones.

2. Small businesses are more likely to underpay their taxes.

Because they often deal in cash and engage in transactions that are not reported to the IRS, small businesses can understate their revenues and overstate their expenses and thus underpay their taxes. Some underpayment is inadvertent, reflecting the difficulty of complying with our complex tax code, and some is intentional. High compliance costs disadvantage responsible small businesses, while the greater opportunity to underpay taxes advantages less responsible ones.

3. The current tax code offers small businesses several advantages over larger ones.

Provisions such as Section 179 expensing, cash accounting, graduated corporate tax rates, and special capital gains taxes benefit businesses that are small in terms of investment, income, or assets.

4. Several of those advantages expired at the end of last year and thus are part of the current “tax extenders” debate.

These provisions include expanded eligibility for Section 179 expensing and larger capital gains exclusions for investments in qualifying small businesses. Allowing these provisions to expire and then retroactively resuscitating them is a terrible way to make tax policy. If Congress believes these provisions are beneficial, they should be in place well before the start of the year, so businesses can make investment and funding decisions without needless uncertainty.

5. Many small businesses also benefit from the opportunity to organize as pass-through entities such as S corporations, limited liability companies, partnerships, and sole proprietorships.

These structures all avoid the double taxation that applies to income earned by C corporations. Some large businesses adopt these forms as well, and account for a substantial fraction of pass-through economic activity. Policymakers should take care not to assume that all pass-throughs are small businesses.

6. Tax reform could recalibrate the tradeoff between structuring as a pass-through or as a C corporation.

Many policymakers and analysts have proposed revenue-neutral business reforms that would lower the corporate tax rate while reducing tax breaks. Such reforms would likely favor C corporations over pass-throughs, since all companies could lose tax benefits while only C corporations would benefit from lower corporate tax rates.

7. Tax reform could shift the relative tax burdens on small and large businesses.

Some tax reforms would reduce or eliminate tax benefits aimed at small businesses, such as graduated corporate rates. Other reforms—e.g., lengthening depreciation and amortization schedules for investments or advertising but allowing safe harbors for small amounts—would increase the relative advantage that small businesses enjoy. The net effect of tax reform will thus depend on the details and may vary among businesses of different sizes, industries, and organizational forms. It also depends on the degree to which lawmakers use reform as an opportunity to reduce compliance burdens on small businesses.

 

Time to Fix the Budget Process

Congressional negotiators are trying to craft a budget deal by mid-December. Fareed Zakaria’s Global Public Square asked twelve experts what they hoped that deal would include. My suggestion: it’s time to fix the budget process:

Odds are slim that the budget conference will deliver anything big on substance. No grand bargain, no sweeping tax reform, no big stimulus paired with long-term budget restraint. At best, conferees might replace the next round of sequester cuts with more selective spending reductions spread over the next decade.

Those dim substantive prospects create a perfect opportunity for conferees to pivot to process. In principle, Congress ought to make prudent, considered decisions about taxes and spending programs. In reality, we’ve lurched from the fiscal cliff to a government shutdown to threats of default. We make policy in the shadow of self-imposed crises without addressing our long-run budget imbalances or near-term economic challenges. Short-term spending bills keep the government open – usually –  but make it difficult for agencies to pursue multiyear goals and do little to distinguish among more and less worthy programs. And every few years, we openly discuss default as part of the political theater surrounding the debt limit.

The budget conferees should thus publicly affirm what everyone already knows: America’s budget process is broken. They should identify the myriad flaws and commit themselves to fixing them. Everything should be on the table, including repealing or replacing the debt limit, redesigning the structure of congressional committees, and rethinking the ban on earmarks.

Conferees won’t be able to resolve those issues by their December 13 deadline. But the first step to recovery is admitting you have a problem. The budget conferees should use their moment in the spotlight to do so.

P.S. Other suggestions include investing in basic research, reforming the tax system, and slashing farm programs. For all twelve, see here.