Brookings: Centers - Urban-Brookings Tax Policy Center

New Analysis of Who Pays What in Obama’s Budget

William G. Gale — Tue, 23 Apr 2013 12:57:00 -0400

The budget recently released by President Obama proposes a balanced path toward more fiscal responsibility, containing both spending cuts and tax increases. Although the president has proposed smaller changes than in previous budgets (even after adjusting for the recent tax act), his proposals do offer several helpful ways to move forward, most particularly the proposal to cap individual income tax expenditures at 28 percent.

However, I would have liked to have seen more ambition in his proposals. Given low interest rates and a listless economy, this is an opportune time for the government to borrow money and invest in the economy in the short-term. It should also do more to restructure its debt toward longer-term obligations to protect it from sharply increasing net interest payments when interest rates do start rising. Moreover, now is the time to implement reforms that can improve long-run growth and are consistent with the long-term revenue needs of the government, such as reforming the income tax code, implementing a VAT, and introducing a carbon tax. All of ideas, both short- and long-term, should be considered in order to put our economy on the optimal growth path going forward.

The Tax Policy Center has more on the president's budget.

Authors

William G. Gale

Image Source: © Joshua Roberts / Reuters

Why Tax Day Is the Best Day to Save Money

Michal Grinstein-Weiss — Mon, 15 Apr 2013 15:37:00 -0400

If you’re a smart money manager, you’ll take time on Tax Day to fill out one more form—a savings deposit form. With a healthier economy and less overall debt among U.S. households this year, tax time is an excellent opportunity to start or add to a savings account because the hard work of saving has already been done.

Saving money is hard. To save even small amounts, you have to deny yourself or your family the immediate pleasure of spending. That’s not easy to do when you’ve already been putting off purchases to stay on budget. But having savings is important to individual families’ security as well as our national security. Most Americans already participate in a national savings plan called “federal withholding tax.” Although frequently maligned, withholding tax is relatively painless because the money comes out of your paycheck before you see it, touch it, or have to hand it over to the tax collector. Once you file your taxes, the extra money you saved in your withholding account is returned to you (without interest).

Nearly 75% of Americans will get a tax refund, and the average refund in 2011 was $2,800—the biggest lump sum that many households see in a year. And most people say they plan to save part of their refund. But once the money is in their hands, fewer people actually put any portion of their refund into savings. There are too many barriers that get in the way such as procrastination, lack of spending self-control, and hassle of dealing with the financial institution. What’s missing from the tax filing process is a means for people to easily, painlessly, and automatically put part of their refund into a savings account.

To overcome the human tendency to delay saving or not save at all, researchers from Washington University in St. Louis and Duke University joined with tax software giant Intuit Inc., (makers of TurboTax) to test the Refund to Savings (R2S) program. The R2S program is woven seamlessly into the Tax Freedom Edition online tax prep software to take advantage of the “golden moment” when taxpayers know the amount of their refund but don’t have the money in their hands. At this point, the R2S program tests different messages to learn which message best motivates people to save. Each message also suggests a different savings-to-spending ratio. The test of R2S continues through midnight April 15, so the test results aren’t in yet. But other research has shown that people are willing and able to save money if they have access to simple, automatic means of saving, such as automatic payroll savings plans (Thaler, Richard H., and Shlomo Benartzi. “Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving.” Journal of Political Economy 112, no. 1 (February 1, 2004): S164-S187.).

Creating savings with a tax refund is a good idea any year, but an especially smart move in 2013. Although the economic recovery has been modest thus far, the country’s financial forecast shows continued, steady growth that will call for increases in interest rates. According to well-respected policy experts such as Fareed Zakaria, the editor-at-large of Time and a columnist for the Washington Post, American banks emerged from the economic crisis wiser and stronger. By putting at least part of their tax refunds into savings, American families can build a stronger financial foundation that will help them weather the next inevitable storm – whether it’s a natural disaster or a manmade emergency.

To encourage more Americans to save, the government needs to create a universal tax-time savings program that offers all taxpayers an easy way to designate a percentage of their tax refunds for automatic deposit in a savings account. Additionally, to create a new generation of savers, policy makers should give tax-free status to children’s savings accounts.

Until the government rolls out a universal tax-time savings program, Americans will need to exercise their self-determination. By putting 25%, 35%, or 50% of your tax refund into savings, you can buy yourself the best present possible – growing financial security and peace of mind.

Authors

Michal Grinstein-Weiss

Image Source: © Shannon Stapleton / Reuters

Small Business, Innovation and Tax Policy: A Review

William G. Gale and Samuel Brown — Fri, 05 Apr 2013 12:25:00 -0400

Introduction

Small businesses occupy an iconic place in American public policy debates. Numerous and diverse public policies subsidize small businesses, and political leaders of both parties routinely voice their support for the sector. At least part of this support is based on the notion that a healthy small business sector leads to innovation, jobs, and a healthy overall economy.

Not surprisingly, however, the economic issues surrounding small businesses and innovation are more complex and nuanced than any iconic designation would suggest. At the core of these issues are the questions of whether and how public policies should subsidize small businesses. On the one hand, economic theory prescribes that well-designed tax and spending programs, in the absence of externalities or public goods, should be neutral among types of investments and forms of business organization, leaving a free market to allocate resources efficiently between small versus large business. On the other hand, small business owners may face special barriers to entry or to firm expansion and many people assert that the small business sector is our principal engine of jobs, growth, and innovation. Either or both of these situations might justify preferential treatment for the small business sector. Recent proposals by Representative Dave Camp (R-MI), the chair of the House Ways and Means Committee, address a number of issues regarding the tax treatment of partnerships and S corporations.[1]

Against this backdrop, this paper aims to provide a clearer understanding of how the federal tax code affects small business. In section II, we provide background information on the small business sector, including alternative definitions of small businesses, the tax and income characteristics of small business owners, and the allocation of small businesses across different legal forms of business.

In section III, we examine evidence suggesting that being small, in and of itself, does not confer a special advantage to businesses in job creation or innovation. Rather it is in young firms, which by definition start as small businesses, where job growth and innovation tend to occur. Focusing on young and innovative firms likely implies a different focus for policy interventions than focusing on small businesses per se.

Section IV describes various tax policies and other public programs that are aimed at helping small businesses. We document the panoply of existing tax incentives and the significant credit and lending programs that encourage small businesses to hire, expand, and innovate. At the same time, we note that when pro-small business subsidies or policies are phased out as firm size expands, they may unintentionally discourage businesses from expanding because expansion will lead to loss of those subsidies.

Section V analyzes the existing literature on the impact of tax policies on small business behavior, including entry, exit, duration of entrepreneurial firms; the impact on employment, investment, and firm growth; the effect on research and experimentation spending, which presumably leads to innovations; the effect on organizational form; and the effects of taxes on the financing of new ventures. Section VI offers concluding remarks.

[1]See http://waysandmeans.house.gov/uploadedfiles/small_biz_summary_description_03_12_13_final.pdf.

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Small Business, Innovation and Tax Policy: A Review

Authors

William G. Gale
Samuel Brown

Image Source: © Carlo Allegri / Reuters

Tax Policy and U.S. Manufacturing in a Global Economy

Fri, 15 Mar 2013 08:50:00 -0400

Event Information

March 15, 2013
8:50 AM - 12:30 PM EDT

Falk Auditorium
Brookings Institution
1775 Massachusetts Avenue NW
Washington, DC 20036

Register for the Event
In his 2013 State of the Union address, President Obama stated "Our first priority is making America a magnet for new jobs and manufacturing." His “Framework for Business Tax Reform” would support this priority by focusing and deepening the existing tax deduction for domestic manufacturing activities. Others, including Senator Orrin Hatch, ranking minority member of the Finance Committee, are cool to the idea, saying, "We're starting to come back in manufacturing, and I don't think you need the government to show the way for them."

On March 15, the Urban-BrookingsTax Policy Center and the International Tax Policy Forum hosted a conference to assess the current state of U.S. manufacturing, its contribution to U.S. economic growth, and whether tax reform should maintain, deepen, or eliminate preferential income tax treatment of manufacturing income.

Brookings Co-Director of the Tax Policy Center William Gale gave introductory remarks and moderated the first panel with Brookings Director of the Initiative on Business and Public Policy Martin Baily, and Tax Policy Center Director Donald Marron served as a panelist. Former member of the Council of Economic Advisers Laura D’Andrea Tyson delivered the keynote address. After each panel, speakers took questions from the audience.

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Tax Policy and U.S. Manufacturing in a Global Economy

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The Tax Favored By Most Economists

William G. Gale — Tue, 12 Mar 2013 11:09:00 -0400

Looking for a public policy that would improve the operation of the economy, lower our dependence on foreign oil, reduce pollution, slow global warming, allow cuts in government spending, and decrease the long-term deficit? Then a carbon tax is what you want. As one of the few taxes favored by economists, carbon taxes could help the nation address several issues simultaneously.

The basic rationale for a carbon tax is that it makes good economic sense: unlike most taxes, carbon taxation can correct a market failure and make the economy more efficient. Although there are substantial benefits of energy consumption, there are also substantial societal costs – including air and water pollution, road congestion, and climate change. Since many of these costs are not directly borne by those who use fossil fuels, they are ignored when energy production and consumption choices are made, resulting in too much consumption and production of fossil fuels. Economists have long recommended a tax on fossil-fuel energy sources as an efficient way to address this problem.

Not surprisingly, most analyses find that a carbon tax could significantly reduce emissions. Tufts University economist Gilbert Metcalf estimated that a $15 per ton tax on CO₂ emissions that rises over time would reduce greenhouse gas emissions by 14 percent. Another study estimated that the European countries’ carbon taxes have had a significant effect on emissions reductions.

Although a carbon tax would be a new policy for the federal government, it has been implemented in several other countries (though not always in the manner advocated by economists), including the Scandinavian nations, the Netherlands, Germany, the United Kingdom, and Australia. The Canadian provinces of Alberta and Quebec adopted carbon taxes in 2007, followed by British Columbia in 2008. Meanwhile, California, the 9^th largest economy in the world, has recently initiated a cap-and-trade system, which auctions carbon permits to companies.

Estimates suggest that a well-designed tax in the United States could raise amounts ranging up to 1 percent of GDP, revenue that could and should be used to reform other taxes or address the country’s substantial and unsustainable medium- and long-term budget deficits.

A carbon tax could have other benefits too, including reducing the American economy’s dependence on foreign sources of energy and creating better market incentives for energy conservation, the use of renewable energy sources, and the production of energy-efficient goods. The permanent change in price signals from enacting a carbon tax would stimulate new private sector research and innovation in developing energy-saving technologies and in harnessing renewable energy. The implementation of a carbon tax also offers opportunities to reduce and reform federal spending on other energy-related programs.

Two problems are sometimes raised in response to a federal carbon tax proposal. The first is its impact on low-income households, who use most of their income for consumption. However, this regressivity could be offset in any of a number of ways, including refundable income tax credits or payroll tax credits. Thus, while this is clearly a concern, it should not be prohibitive to implementing a carbon tax.

The second concern is whether the U.S. should act unilaterally. Without cooperation from the rest of the world, critics fear that a U.S. carbon tax would reduce economic activity here and make little difference to overall carbon emissions or levels. This view, however, understates the value of a permanent price signal for research and development and the social and environmental value of the reduction in carbon emissions that would come from U.S. action. It also discounts the experience of other countries that unilaterally created carbon taxes; there is no evidence that they paid a significant price, or any price at all, in terms of economic activity levels. If there is ever going to be multilateral action to limit carbon emissions, the US – as the largest per-capita emitter of carbon dioxide – needs to take a leading role.

No one is claiming the carbon tax is a perfect outcome. But relative to the alternatives, it has an enormous amount to offer.

Authors

William G. Gale

Publication: Real Clear Markets

Image Source: © Bret Hartman / Reuters

Carbon Taxes as Part of the Fiscal Solution

William G. Gale, Samuel Brown and Fernando Saltiel — Tue, 12 Mar 2013 11:42:00 -0400

I. Introduction

The United States faces large federal fiscal deficits in the immediate future, the next 10 years, and the longer term. Although the current and recent deficits are thought to be helping the economic recovery, the deficits in the medium-term and long-term are more troubling because of their potential impact on national saving, economic growth, and financial markets. Addressing these medium- and long-term challenges will likely require a combination of spending cuts and revenue increases. None of the relevant options (some of which will need to be implemented sooner or later) are particularly attractive from a political perspective.

In this chapter, we consider the fiscal outlook, how new taxes on carbon could not only help address the fiscal problem but also bring about benefits on economic and environmental grounds, and how these taxes compare with some other revenue options. Section II discusses issues related to the fiscal outlook. In section III, we highlight the revenue, efficiency, and equity effects of taxes on carbon emissions and/or a higher tax on gasoline. Section VI provides a brief comparison of a carbon tax to other revenue options -- including a VAT and income tax expenditure reform. Section V offers a short conclusion.

II. Fiscal Outlook and Implications

This section summarizes the fiscal outlook, discusses why both revenue increases and spending cuts will need to be considered as part of the solution, and examines the long-term impact of tax-financed deficit reduction policies.

A. Fiscal Outlook

Figure 1 shows historical budget deficits and deficits projected under different future policy scenarios. Under the current-law baseline produced by the Congressional Budget Office (CBO) assumptions the deficit falls from 5.3 percent of GDP in 2013 to 2.9 percent in 2018, before rising to 3.8 percent by 2023.

Auerbach and Gale (2013), however, show that under a current policy baseline (reflective of more realistic policies), the federal deficit under current policies will hover around 3.5 percent of GDP between 2015 and 2019, before rising to 5.0 percent by 2023 (Figure 1). The policy differences between current law and current policy baseline are shown in Table 1.

Moreover, after 2022, projected deficits are poised to rise further under both scenarios (Figure 1), reaching 10 percent of GDP by 2036 under the current policy baseline and continuing to rise thereafter.

As for the debt-to-GDP ratio, after averaging 37 percent of GDP in the 50 years prior to the Great Recession that started in 2007 and attaining a value of 36.3 percent of GDP in 2007, the ratio is now projected to pass its 1946 high of 108.6 percent in 2035 under current policy baseline (Figure 2). Unlike the aftermath of World War II, however, the debt-to-GDP ratio will continue to rise after surpassing the previous peak. Expenditures are expected to rise significantly as the aging of the populace and excess cost growth of health care cause Medicare and Medicaid outlays to grow rapidly. Current estimates place the fiscal gap—the immediate and permanent increase in taxes or reduction in spending that would keep the long-term debt-to-GDP ratio at its 2012 level – or 72.5 percent of GDP – at 3-5 percent of GDP through 2089 and 5-7 percent on a permanent basis (Auerbach and Gale 2013).

In contrast to the U.S projected fiscal trajectory, many organizations place the desired debt/GDP ratio between 40 percent and 60 percent.[1] It is not entirely clear how an optimal debt/GDP ratio can be derived from theoretical first principles. What is clear, however, is the current trajectory for U.S. debt is not sustainable.

Although delayed implementation of deficit-reducing policies may be preferable given the current state of the economy, the longer it takes to put in place deficit-reducing policies, the larger will be the required spending cuts or tax increases in order to address the long-term fiscal gap. For example, if the adjustments are delayed until 2018, when the CBO projects the economy will reach potential GDP, the fiscal gap increases by up to 0.3 percentage points of GDP.

Budget projections (especially for the long-term) embody considerable uncertainty, and deficit projections are particularly uncertain as relatively small percentage changes in outlays and revenues can lead to relatively large percentage changes in deficits. In the current environment, economic projections also may be more uncertain than usual, given uncertainty about the effects of the recent recession on the long-term growth rate. The other major uncertainty is the rate of growth of health care spending, which can have enormous impacts on the projected budget outlook. Despite this uncertainty, it is hard to paint an optimistic picture of the fiscal outlook. Indeed, the projections above are based on a series of economic and political assumptions that could be viewed as optimistic.

B. The need for spending cuts and revenue increases

Since projected spending is slated to rise faster than GDP for the indefinite future, it is clear that spending cuts must be part of the solution, in particular for government health care programs, which have been rising as a share of GDP for several decades and are projected to continue to rise.

There are several reasons to consider tax increases (beyond those already included in the January 2013 budget deal), however, as well as spending cuts, as part of the fiscal solution. First, the sheer magnitude of the fiscal gap suggests that a spending-only solution would need to impose very substantial reductions on spending that might not be seen as equitable. At 5-7 percent of GDP, the fiscal gap is several times larger than the savings that were generated in budget deals in the past. The 1983 Social Security Reform reduced deficits by about 1 percent of GDP in the four years after passage while the 1990 and 1993 budget deals reduced deficits by about 1.4 percent of GDP and 1.2 percent of GDP, respectively, over the 5 years after passage.[2] The recently enacted tax bill only raised 0.3 percent of GDP in revenue over the next decade. In addition, Americans seem particularly reluctant to cut government spending on Social Security and Medicare, two of the key drivers of long-term spending, than on other forms of spending. For instance, a 2011 Gallup poll showed that over 60 percent of Americans were unwilling to cut social security and/or Medicare, and this was true across the political spectrum.

Second, as a political equilibrium, it seems likely that a sustainable budget deal would draw from both sides of the ledger. Indeed, in the past, major deals have included both tax increases and spending cuts. With the 1983 Social Security reforms, the 1990 bipartisan budget deal, and 1993 budget deals, Congress both slashed spending and raised taxes. For example, in the 1990 budget deal, 49 percent of the reductions came from higher tax receipts, 34 percent from reduced defense spending, and 17 percent from other cuts in spending (Steuerle 2004).

Third, as a matter of equity, the only way that high-income households will share significantly in the burden of fixing the deficit is through revenue increases since spending cuts typically do not have a large impact on high-income households.

Fourth, spending appears to be controlled more effectively by requiring that it be paid for with current taxes, rather than allowing deficits to grow. In contrast, the “starve the beast” hypothesis argues that keeping revenues down is an effective approach to curtailing spending. However, the hypothesis does not appear to be consistent with recent experience.[3] And evidence in Romer and Romer (2009), for example, suggests that tax cuts designed to spur long-run growth do not in fact lead to lower government spending; if anything, they find that tax cuts lead to higher spending. This finding is consistent with Gale and Orszag (2004a), who argue that the experience of the last 30 years is more consistent with a "coordinated fiscal discipline" view, in which tax cuts were coupled with increased spending (as in the 1980s and 2000s) and tax increases were coupled with contemporaneous spending reductions (as in the 1990s).

C. Long-Term Growth Effects of Tax-Financed Deficit Reductions

An increase in taxes will not necessarily slow long-term economic growth. Tax changes have two broad sets of long-term effects on the economy.[4] The first set operates through direct changes in relative prices, incentives, and after-tax income. These changes affect the degree to which households are willing to work, save, invest in education and training, etc. and to which firms invest and hire; these effects are known as income and substitution effects. Thus, for example, increases in marginal tax rates, holding other factors constant, can reduce the size of the economy and reduce economic growth.

However, other factors are not constant. The second broad effect is on national saving. A reduction in the deficit tends to raise public saving, which typically results in higher national saving (national saving is the sum of household, corporate, and government saving). This effect is often ignored in discussions of tax policy and economic growth, but it can be quite important.

Containing deficits matters for several reasons.

Sustained deficits may enhance the risk of a financial crisis. Even in the absence of precipitating a financial crisis, however, sustained deficits have deleterious long-term effects, as they translate into lower national savings, higher interest rates, and increased indebtedness to foreign investors, all of which reduce future national income. In addition to the growth impacts, sustained deficits may impose unfair burdens on future generations and may constrain U.S. foreign policy or defense positions, especially as they relate to creditor nations.

Gale and Orszag (2004b) estimate that a 1 percent of GDP increase in the deficit will raise interest rates by 25 to 35 basis points in the United States and reduce national saving by 0.5 to 0.8 percentage points. Engen and Hubbard (2004) obtain similar results with respect to interest rates. Thus, relative to a balanced budget, this study suggests a deficit equal to 6 percent of GDP would raise interest rates by at least 150 basis points and reduce the national saving rate by at least 3 percent of GDP. The IMF (2010) estimates that, in advanced economies, an increase of 10 percentage points in the initial debt/GDP ratio reduces future GDP growth rates by 0.15 percentage points. Hence (if this result is extrapolated linearly, and we do so with caution, since it would be easy to think of reasons that would make a larger debt change have more-than-proportional or less-than-proportional effects), the increase in the debt-to-GDP ratio from about 40 percent earlier in the decade to 85 percent by 2022 (Auerbach and Gale 2012) would be expected to reduce the growth rate by a whopping 0.675 percentage points. Thus a deficit reduction plan that included tax increases (at least on that did not primarily rely on raising taxes on savings and investment) could, on balance, help spur economic growth in contrast to continuing policy as normal.

The net long-term effect of a tax change is the result of the two effects outlined above, which are sometimes offsetting and sometimes mutually reinforcing. Stokey and Rebelo (1995), for example, show that even the very large tax increases associated with World War II—on the order of 10 percent of GDP—apparently had no discernible impact on the long-term economic growth rate. Likewise, the 1981 tax cuts, which cut the top rate from 70 percent to 50 percent, accounted for only a very small share of the growth of the economy between 1981 and 1986, according to Feldstein and Elmendorf (1989). Auerbach and Slemrod (1997) also document tepid economic growth responses to the 1986 tax act. Gale and Potter (2002) find that the impact of the 2001 tax cuts on the deficit and national saving outweighed its impact on incentives, so that the net effect on growth was negative. This suggests that raising taxes by undoing the 2001 tax cuts would raise long-term economic growth (due to the beneficial effect of lower deficits).

III. Carbon Taxes

The discovery and exploitation of natural resources by humans gave rise to the advanced civilization in which we live today. Coal, petroleum, and natural gas fueled industrialization, raising living standards and life expectancy for most. Energy use continues to fuel economic growth and development today. But along with the benefits of energy consumption come substantial societal costs – including those associated with air and water pollution, road congestion, and climate change. Many of these costs are not directly borne by the businesses and individuals that use fossil fuels and thus are ignored when energy production and consumption choices are made. As a result, there is too much consumption and production of fossil fuels.

Economists have long recommended specific taxes on fossil-fuel energy sources as a way to address these problems. That recommendation has gained additional urgency in recent years in light of the fiscal situation outlined above. New revenue from energy taxes could be used to reduce the debt or finance reform or reductions in other taxes.

Throughout this paper we use the phrase “carbon tax” to refer to a tax on carbon dioxide. Although a carbon tax would be a new policy for the federal government, the tax has been implemented in several other countries (though—as discussed in the introduction to this volume— not always in a way that conforms to the design principles advocated by economists). Finland, Norway, Sweden, and Denmark instituted carbon taxes in the early 1990s, followed by the Netherlands and Germany in the latter part of the 1990s. The United Kingdom followed suit in 2001. Australia introduced a carbon tax in 2011. North American jurisdictions have also implemented carbon taxes. The town of Boulder, Colorado, adopted a carbon tax in 2006, and Montgomery County, Maryland, did so in 2010. The Canadian provinces of Alberta and Quebec adopted carbon taxes in 2007, followed by British Columbia in 2008.

A. Revenue

Carbon taxes can raise significant amounts of revenue. For instance, in 2007 the tax raised revenue equivalent to about 0.3 percent of GDP in Finland and Denmark, and 0.8 percent in Sweden. A well-designed tax in the United States could raise similar amounts. As shown in Table 2, a number of studies have estimated the net revenue effects of carbon taxes—accounting for the reduction in revenues from broader taxes that would occur—with estimates (for the year 2015) ranging from 0.5 percent of GDP for a $15 per ton tax (McKibbin, Morris and Wilcoxen 2012) to 0.8 percent of GDP for a $31 per ton tax (Metcalf 2010) with intermediate estimates including CBO (2011) and Rausch and Reilly (2012).[5]

Based on analysis in Dinan (2012) discussed below, we assume 38 percent of net carbon tax revenues would need to be used to offset distributional effects—as noted later, this might be viewed as a generous estimate if a carbon tax is part of a broader package of measures to reduce the deficit, and other measures are progressive (i.e., they impose a disproportionately larger burden on higher income households). Our assumption leaves the net revenue yield after distributional compensations, at between 0.32 percent and 0.49 percent of GDP. In terms of gauging how large these taxes are in practical terms, a tax of $25 per ton of carbon dioxide would raise gasoline prices by 25cents a gallon (Bauman 2010)

B. Efficiency

In principle, carbon taxation receives high marks on efficiency criteria. Indeed, the basic rationale for a carbon tax is that it makes good economic sense: unlike most taxes, carbon taxation can improve the efficient allocation of resources by accounting for externalities in the market price. Externalities can be severe. Stavins (2007) notes that the efficiency benefits of a carbon tax are often understated since the largest efficiency gains come in the form of internationally-shared reduced greenhouse gas emissions. While the United States is the largest per capita emitter of carbon dioxide, China is the largest overall emitter, and the European Union makes a significant contribution as well. Therefore, enacting a program that would lead to better cooperation with other countries, and reduce emissions across the world, would be better suited to deal with the well-known problems brought about by global warming, such as rising sea levels, more frequency in extreme temperatures, among others.

Taxes on energy can address these externalities. Not surprisingly, most analyses find that a carbon tax could significantly reduce emissions. Metcalf (2008) estimates that a $15 per ton tax on CO₂ emissions that rises over time would reduce greenhouse gas emissions by 14.0 percent, while Sumner, Bird, and Smith (2009) estimate that the European countries’ carbon taxes have had a significant effect on emissions reductions, attributing reductions of up to 15 percent to the carbon tax. Furthermore, the University of Ottawa (2012) found that the carbon tax implemented in British Columbia led to a 9.9% reduction in greenhouse gas emissions in the province, compared to just 4.6% for the rest of Canada, where comprehensive carbon taxes were not applied.

In addition to reducing emissions, a carbon tax could improve other economic incentives by reducing other tax rates or paying down the deficit (Parry and Williams 2011). A carbon tax could have other benefits too. It would reduce the U.S. economy’s dependence on foreign sources of energy, and would create better market incentives for energy conservation, the use of renewable energy sources, and the production of energy-efficient goods. The permanent change in price signals from enacting a carbon tax would stimulate new private sector research and innovation in developing new ways of harnessing renewable energy and energy-saving technologies. The implementation of a carbon also offers opportunities to reform and simplify other climate-related policies affecting transportation sector.

C. Distribution

The net effects of a carbon tax will depend, of course, not only on the magnitude of the tax and the behavioral response by consumers and firms, as the studies above consider, but on how the funding is used. To be clear, all uses of carbon tax revenues (or of other revenues for that matter) involve some form of giving the money back to taxpayers. What varies is which taxpayers receive the funds, during what time period, and under what conditions. Providing a rebate to consumers obviously returns the revenue to citizens. But so do all other uses of the funds. For instance, paying down the deficit implicitly gives the money to future citizens by reducing the extent to which they have to pay higher taxes or bear the burden of spending cuts. Likewise, using the funds to provide corporate tax cuts reduces burdens for whichever individuals ultimately bear the burden of corporate taxation.

In many instances to date, carbon tax revenues have not been used for deficit reduction. Norway and Sweden do include carbon tax revenue as part of general government receipts, which suggests a possible effect on deficit reduction. But carbon tax revenue in Denmark is returned to industry and directed towards environmental subsidies. Several nations have used carbon tax revenue to reduce other taxes (Sumner, Bird, and Smith 2009). Australia coupled its carbon tax with a substantial increase in the tax-free level of income (and other tax changes).[6] The Netherlands and Sweden have exempted a large portion of the industrial sector from the tax, as well as helping low-income households offset the burden of the tax (the latter measure was also implemented by Germany) (Johansson 2001). Quebec deposits carbon tax revenues into a fund devoted to public transportation and environmental initiatives, while British Columbia makes its carbon tax revenue-neutral by reducing corporate and personal income tax rates and providing an annual credit of $100 per adult and $30 per child to lower-income citizens (British Columbia Finance Ministry 2008).

Distributional concerns over carbon taxes stem from the observation that low-income households devote a higher proportion of their income to consumption and will thus bear a higher burden of the tax relative to high-income households. The distributional effects of carbon taxation have been well-studied (Bull, Hassett, and Metcalf 1994, Hassett, Mathur, and Metcalf 2009, Metcalf 1999, Metcalf 2007). The regressivity finding is consistent across studies, but varies in magnitude. Metcalf (2008) analyzes the distributional effects of a carbon tax and finds that it would reduce the after-tax income of taxpayers in the first decile by 3.7 percent, compared to just an 0.8 percent reduction for the wealthiest decile. Findings are dependent on whether incidence is measured on a current income versus lifetime basis, with the tax being more regressive when measured on a current income basis relative to lifetime income basis. For example, Hassett, Mathur, and Metcalf (2009) find that the indirect component of a carbon tax (i.e., higher prices due to higher costs of production) is significantly more progressive, whereas the direct component, which focuses on the changes in the cost of gas and electricity, is regressive. Lastly, the incidence varies with timing: the carbon tax can either fall forward in the form of higher consumer prices or backwards in the form of lower returns to factor inputs. Bovenberg and Goulder (2001) and Paltsev et al. (2007) find that the short- and medium-term incidence falls primarily on consumer prices.

Importantly, the regressive impact of a carbon tax could be offset in any of a number of ways, similar to offsets for distributional effects of the VAT, as will be discussed in the next section. Most prominent among these options would be refundable income tax credits (Dinan 2012) or payroll tax refunds (Metcalf 2007). Dinan (2012) notes that CBO analysis suggests that fully offsetting the effects of carbon taxes for households in the lowest quintile would require about 12 percent of gross revenues, while fully offsetting the effects for households in the second quintile would require 27 percent of gross revenues. These figures do not account for added government costs (of indexing transfers or higher payments for inputs, for example). Nor do they account for the reduction revenues from other taxes noted above. As a rough approximation, for now we assume that 38 percent of net carbon tax revenues would have to be used for offset purposes. This is not inconsistent with Dinan’s estimates and is similar to the calculations derived by Toder and Rosenberg (2010) for a VAT. Thus, while the regressivity of a carbon tax is clearly a concern, it should not be considered an obstacle to the implementation of carbon taxes.

D. Motor Fuel Taxes

Raising taxes on gasoline and (motor) diesel is another option. While modest excise taxes on these fuels already exist in the United States, they are substantially lower than in other industrialized nations.

For example, in the U.S., federal excise taxes on gasoline amount to 18.4 cents per gallon, with local tax rates typically taxing gasoline at additional 20-30 cents per gallon in 2010. The OECD average for gasoline excise taxes is approximately $3.39 per gallon, about 7 times the rate of the U.S. tax.[7] OECD taxation of gasoline ranged from $0.34 per gallon (Mexico) to $5.14 per gallon (Turkey); the U.S. has the second-lowest rate of gasoline taxation among OECD countries (OECD 2011). In addition, per-mile fuel taxes in the U.S. are low by historical standards, falling by 40 percent in real terms since 1960 (Parry, Walls, and Harrington 2007). Moreover, fuel taxes at least three times as high as current levels (and perhaps higher still) appear to be justified by the adverse side effects of motor vehicles—pollution, congestion, and so on (Parry, Walls and Harrington 2007).

Higher excise taxes on motor fuels could raise significant amounts of revenue. For example, Parry (2011) estimates that raising gasoline and diesel fuel taxes to their corrective levels would increase revenue by around 0.8 percent of GDP, while CBO (2009) estimates that a 50 cent increase in the gasoline excise tax alone would raise about 0.3 percent of GDP. Raising the gas tax by 25 cents per year for 10 years would raise substantially more in revenues, but would still leave U.S. gas tax rates well below those of European countries.

Although higher fuel taxes would have some impact on reducing carbon emissions, they are much less effective than a carbon tax at reducing carbon emissions, since the former covers a much narrower range of externality-producing goods.[8] Davis and Killian find (2009) find that a 10 cent per gallon increase in the U.S. gasoline excise tax would reduce total carbon emissions by 0.5 percent overall and by 1.5 percent from vehicles. Like carbon taxes, gasoline taxes will fall disproportionately on low-income households, especially in the short-run when households have difficulty adjusting their behavior to avoid the tax (Poterba 1989 and 1991).

IV. Other revenue options

A carbon tax can be compared to other tax options – not necessarily because the ultimate choice will be one of those options versus another, as the country will probably need several ways to raise revenue, but rather to discuss the relative revenue-generating potential, efficiency and equity effects of the different taxes. A full-scale comparison is beyond the scope of this paper (see Gale and Brown 2012 for a more comprehensive discussion of the options). We do briefly describe options relating to the value-added tax (VAT) and to income tax expenditure reform however, to provide some sense of the trade-offs, and possible complementarities, between carbon taxes and broader fiscal options.

A. Value Added Tax

Under a VAT, businesses would pay taxes on the difference between their revenues from total sales to other businesses and households and their purchases of inputs from other businesses. That difference represents the value-added by the firm to the product or service in question.[9] The sum of value added at each stage of production (including extraction of the raw materials) is the retail sales price, so the VAT simply replicates the tax patterns created by a retail sales tax and is like other taxes on aggregate consumption. The key distinction is that VATs are collected at each stage of production, whereas retail sales taxes are collected only at point of final sale. Furthermore, the VAT is easier to enforce and is widely regarded as having a superior administrative structure to a retail sales tax. Although it would be new to the United States, the VAT is in place in about 150 countries worldwide and in every OECD country other than the United States. Experience suggests that the VAT can raise substantial revenue, is administrable, and minimally harmful to economic growth. Toder and Rosenberg (2010) show that a 5 percent VAT with a relatively broad base could raise revenue equal to 1 percent of GDP in the United States, even after accounting for distributional issues via rebates and adjusting for revenue losses from other taxes (Table 3).

The distributional burden of the VAT is regressive relative to current income (though not relative to current consumption). Concerns about the regressivity of the VAT are valid, but they should not obstruct the creation of a VAT for two reasons. First, while we accept the validity of distributional considerations, what matters is the progressivity of the overall tax and transfer system, not the distribution of any individual component of that system. Clearly, the VAT can be one component of a progressive system. Second, it is straightforward to introduce policies that can offset the impact of the VAT on low-income households. The most efficient way to do this is simply to provide households either refundable income tax credits, adjustments to cash-transfer benefits, or outright payments.[10] In contrast, many OECD governments and U.S. state governments offer preferential or zero rates on certain items like health care or food to increase progressivity. This approach is largely ineffective because the products in question are consumed in greater quantities by middle-income and wealthy taxpayers than they are by low-income households.[11]

B. Tax Expenditure Reform[12]

A third alternative is reform of income tax expenditures. In formal terms, tax expenditures are “revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which allow a special credit, preferential rate of tax or a deferral of liability” (The Congressional Budget Act of 1974 (P.L. 93-344)). The canonical focus for income tax reform is to create a system with a broad base that taxes all sources and uses of income at the same rate so as to generate lower statutory rates. Tax expenditure reform would be essential to achieving these goals. Broadening the base entails restricting the use of exclusions and deductions. Taxing all sources and uses of income, at the same effective rate, entails restricting the use of preferential rates, credits, and deferrals. This would reduce distortions between the taxation of different sources and uses of income and therefore could be efficiency improving.

Many major tax expenditures act essentially as government spending programs that happen to be embedded in the tax code rather than in outlays (Batchelder and Toder 2010; Marron 2012; Marron and Toder 2012). Tax expenditure reform in many cases can be thought of as reducing effective government spending.

The value of most tax expenditures, other than credits, rises with the marginal tax rate. A deduction or exclusion of $1000 would reduce tax liability by $150 for an individual in the 15 percent bracket but $330 to one in the 33 percent bracket.

Although different types of tax expenditures are distributed differently, the aggregate distribution of tax expenditures tends to be tilted toward high-income households because they itemize their deductions, receive a substantial share of the income in the form of returns to investment, which is often subject to preferential rates, they have more tax to offset, and they receive a higher benefit per dollar of deduction or exclusion due to higher marginal tax rates.

Tax expenditure reform can raise significant amounts of revenue. Although precise estimates are difficult to compute, illustrative calculations indicate the potential for revenue-raising. The FY2013 Budget lists 173 individual and business tax expenditures, the total value of which would approach 7.5 percent of GDP in the 2015 fiscal year (relative to current law) and about 80 percent coming from individual income receipts (Office of Management and Budget 2012, Marron 2012). Interaction effects increase the revenue loss: Toder and Baneman (2012) estimated that interaction effects increased lost revenue from non-business individual income tax expenditures by 9.6 percent in 2011.

Yet potential revenue raised from a realistic tax expenditure reform would be much less for administrative and political reasons. Some expenditures are difficult to eliminate for various administrative reasons. Many of the largest tax expenditures (e.g. mortgage interest deduction, employer sponsored health insurance) are broadly popular because they benefit middle-income, as well as high-income, taxpayers. Recent proposals have focused on capping overall tax expenditures for a tax filer rather than eliminating individual policies to ease the political constraints to tax expenditure reform. Such proposals still can raise revenue and increase the progressivity of the tax system.

One recent proposal would cap itemized deductions at $50,000. The Tax Policy Center estimates that, relative to current policy, a $50,000 cap would raise 0.33 percent of GDP in 2015 (Table 3). The policy will have a small effect on households in the bottom 90 percent of the income distribution. Households in the 90th to 99^th percentiles would see their after tax income decrease by between 0.3 and 0.5 percent. After-tax income would decrease by 3 percent in the the top one percent of the income distribution.

Feldstein, Feenberg, and MacGuineas (2011) propose a cap on the tax value of certain tax expenditures to 2 percent of the earner’s AGI.[13] Baneman et al. (2011) applied the cap to earners making more than $250,000 (married) or $200,000 (single) and estimated that it could raise 0.26 percent of GDP relative to current policy (Table 3). The cap would not affect taxpayers below the 95^th income percentile. It would decrease the after-tax income by 0.9 percent of income for filers between the 95^th to 99^th percentiles and by 3 percent for filers in the top 1 percent (Baneman et al. 2011).

V. Conclusion

The United States faces substantial and unsustainable medium- and long-term budget deficits, which will require a combination of tax increases and spending cuts to resolve. On the tax side, one relatively attraction option for raising revenue would be to impose a carbon tax. Besides its impact on revenues, the tax would improve environmental outcomes, increase economic efficiency, and allow the elimination of selected other tax subsidies and spending programs. The distributional effects would be regressive but could be offset by other policy changes. As policy makers search for solutions to the fiscal problem and for ways to improve the tax system, carbon taxation could play a positive role in addressing each situation.

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[1] The IMF (2012) suggested 60 percent as an appropriate ratio of gross general debt-to-GDP for advanced countries while emerging and low-income countries had a lower ratio of 40 percent. The Peterson-Pew Commission on Budget Reform (2011), the Bipartisan Policy Center’s Debt Reduction Task Force (2010), and the President’s National Commission on Fiscal Responsibility and Reform (2010) all had medium-term goals of a 60 percent of debt-to-GDP ratio by 2020 or 2021. Johnson and Kwak (2012) suggested a goal of 50 percent to err on the side of caution to account for the fact that the U.S. workforce is growing more slowly and for the fears that the U.S. may lose its global reserve currency status or face another financial crisis.

[2] Authors’ calculations based on Steuerle (2004) and CBO (1983, 1991, 1993).

[3] Bartlett (2007) outlines the development of the “starve the beast” theory and shows how it failed to apply during the George W. Bush administration.

[4] Short-term economic effects of tax-financed deficit reductions often differ from long-term effects. Consequently, the relative benefits of a tax-financed deficit reduction policy depend on the time frame of the analysis. Since this paper is concerned with a long-term fiscal solution, we focus on the long-term economic effects.

[5] The creation of carbon taxes will cause a partial, automatic reduction in other tax revenues. As one simple example of how this might work, a firm that pays $100 in carbon taxes would, in the absence of any other changes, have $100 less in corporate profits and so would owe less in corporate taxes. Studies estimate overall automatic tax offsets between 25 percent and 31 percent of the gross revenue levels, thus resulting in the net revenue levels reported in the text and shown in Table 2.

[6] Australia really has an emissions trading system. However, because most of the allowances are auctioned, and there is a price collar (at least until 2015) it looks more like a tax.

[7] Authors’ calculations based on OECD (2011).

[8] Sterner (2007), for example, estimates that fuel demand in Europe would be twice as high if European countries had faced U.S. gas tax rates.

[9] There are several options for administering the tax which we do not go into here. See Bickley (2006) and Cnossen (2009) for some discussion of these options.

[10] Toder, Nunns, and Rosenberg (2011) propose a two-pronged rebate. The rebate would be a credit equal to the VAT rate multiplied by a base of $12,000 for single households and $24,000 for married households (in 2012); the base could not exceed employment income. In addition, they propose an upward adjustment to Social Security payments to offset the reduction in real wages over time.

[11] Congressional Budget Office (CBO; 1992. xv) finds that “excluding necessities such as food, housing, utilities, and health care would lessen the VAT’s regressivity only slightly.” Toder and Rosenberg (2010) find that excluding housing, food consumed at home, and private health expenditures from the consumption tax base can somewhat increase progressivity, but not as much as a per-person payment would.

[12] All of the revenue estimates here refer to pre-ATRA baselines. Since ATRA raised tax rates, post-ATRA revenue estimates of tax expenditure reform would yield somewhat larger revenue estimates than indicated here.

[13] The Feldstein-Feenberg-MacGuineas proposal limited the tax value of itemized deductions, the health insurance exclusion, and the child tax credit, dependent care credit, and general business credit. For deductions and exemptions, the tax value is equal to the face value of the deduction or exclusion multiplied by the filer’s marginal tax rate. The tax value of a tax credit is equal to the credit.

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Carbon Taxes as Part of the Fiscal Solution

Authors

William G. Gale
Samuel Brown
Fernando Saltiel

Image Source: © Stringer . / Reuters

Fiscal Fatigue: Tracking the Budget Outlook as Political Leaders Lurch from One Artificial Crisis to Another

William G. Gale and Alan J. Auerbach — Thu, 28 Feb 2013 10:54:00 -0500

I. Introduction

With the passage of the American Taxpayer Relief Act of 2012 (in early January, 2013), many observers are claiming that fiscal issues have been, essentially, resolved and that the nation should move on to other issues. The February 2013 release of the Congressional Budget Office’s Budget and Economic Outlook provides an opportunity to re-examine these issues and to update our estimates (most recently, Auerbach and Gale 2012) of the fiscal status of the country.

Our overarching conclusion from this analysis is that, while the nation faces many other pressing economic and social issues – including boosting the strength and pace of the current recovery – we are still far from attaining a sustainable fiscal policy.

Several additional conclusions emerge as well. First, because ATRA instituted tax changes that had been widely expected, the official CBO (“current law”) baseline is now more reflective of plausible outcomes than it has been in the past, though alternative fiscal scenarios still seem more likely. Before ATRA, the differences between the current law and current policy baselines were so large that ATRA could be described as either a $600 billion tax increase (relative to a widely used current policy baseline) or a $4 trillion tax cut (relative to a current law baseline) (CBO 2013a). In practice, ATRA is widely regarded as a tax increase, because it raised taxes relative to a continuation of existing policies and because both political parties have an interest in making that case – the Democrats to show that they obtained a result that they had wanted, the Republicans to argue that no further tax increases are needed.

Second, unlike in long-term budget scenarios – where rising entitlement spending and, ultimately, health care spending is the single most important factor – there is no “smoking gun” in the 10-year projections. Mainly, there is “just” an overall continuing imbalance between spending and taxes. Revenue is not projected to collapse, as it did in 2009-12, but rather to grow to higher-than-historical-average levels. Spending isn’t spiraling out of control—it is projected at the same share of GDP in 2023 as it was in 2012, as large cuts in discretionary spending are offset by increases in mandatory spending and net interest rising to historically high levels.

Third, while we do not face an imminent budget crisis, the 10-year budget outlook remains tenuous. Even if seemingly everything goes right – in economic terms and in political terms – we still face the prospect of a dangerously high and rising debt-GDP ratio by the end of the next decade.

Fourth, the fiscal problems worsen after the next 10 years under all scenarios, with the debt/GDP ratio hitting 100 percent in 2029 and rising continually to 200 percent in 2049 under our current policy baseline (with projections of health care spending based on the Medicare Trustees latest report). Even under the most optimistic assumption about health care spending – that the recent slowdown in health care cost growth is assumed to be the start of a permanent slowdown – the long-term fiscal gap is on the order of 3-5 percent of GDP.

II. The 10-Year Budget Outlook

We provide three estimates of the 10-year outlook. The first estimate is simply CBO’s August 2012 baseline. The CBO baseline is typically referred to as a “current law” baseline. However, it differs from current law in at least three prominent ways. First, it assumes that the debt ceiling will be increased over time even if there are no enacted changes to tax and spending policies. Second, although it assumes that (almost all) temporary tax provisions are allowed to expire as scheduled under current law, it assumes that mandatory spending programs that are slated to expire are in fact continued.[1] Third, the baseline assumes that if dedicated trust funds – such as Medicare or OASDI – run out of money from which to pay scheduled benefits, that those scheduled benefits are paid anyway.[2]

The second approach, which CBO calls its alternative fiscal scenario, adjusts the baseline to reflect three factors. First, in their baseline, CBO assumes that all temporary tax provisions (other than excise taxes dedicated to trust funds) expire as scheduled. In their AFS, these provisions are assumed to be extended. Second, under current law, payments to physicians under Medicare are scheduled to decline by about 25 percent in January 2014. In every year since 2003, however, the Administration and Congress stepped in to postpone these reductions, adopting the so-called “doc fix.” The AFS assumes similar actions will prevail in the future and thus includes the cost of maintaining physician payment rates under Medicare at their current levels. Third, the current-law baseline assumes that the discretionary spending caps and sequestration procedures as imposed in the Budget Control Act of 2011 will be enforced. The AFS assumes that the original caps on discretionary appropriations set out in the Budget Control Act remain in effect, but that the automatic enforcement procedures of the legislation (sequestration in 2013 and lowered caps on discretionary budget authority) do not.

Our current policy scenario adjusts the AFS for two factors. First, based on CBO’s projections of scenarios not included in its official baseline (CBO 2013b, Table 1-6), we assume that war-related defense spending will fall steeply after 2012, resulting in a $582 billion reduction in defense spending relative to the CBO's alternative defense baseline.

Second, we assume that the increase in disaster relief spending that occurred last year will not be permanent, whereas CBO’s baseline and AFS assume it is permanent. Both of our adjustments reduce future deficits relative to the AFS.

The general trends for deficits and debt under the three scenarios are reported in Table 1 and Figures 1 and 2. Under the current-law baseline, deficits fall from 5.5 percent of GDP currently to 2.7 percent in 2017, before rising to 3.8 by the end of the decade. Note that this projection assumes that the economy returns to full employment in 2017 and remains there throughout the remainder of the projection period. Under the AFS, the deficit falls to 3.8 percent by 2017 before rising to 5.0 percent by the end of the decade. Our current policy projections generate a deficit estimate of 4.4 percent by 2023. The debt-to-GDP ratio is project to fall slightly under all of the scenarios and then rise – to 77 percent under current law, 87 percent under the AFS and 82 percent under current policy.

We organize more detailed analysis of the 10-year outlook around 13 specific thoughts.

(1) The current-law baseline and current-policy baselines are much closer together than before.

With the passage of the American Taxpayer Relief Act of 2012, much of the difference between the current-law baseline and various current policy scenarios has disappeared. Whereas the January 2012 Outlook showed a $7.9 trillion difference in the 10-year budget totals between current law and what CBO calls their alternative fiscal scenario, the February 2013 Outlook shows only a $2.5 trillion difference. Nearly all of this narrowing comes from the permanent adoption of several long-standing but temporary tax policies.

(2) Debt/GDP is projected to be high over the next decade.

Debt as a share of the economy will rise from 73 percent in 2012 to 77 percent in 2023 under current law. Debt rises to 87 percent of GDP under CBO’s alternative fiscal scenario and 83 percent under current policy. These levels are high compared to past experience: from 1957 to 2007, the ratio did not exceed 50 percent and averaged just 37 percent of GDP. Relative to the magnitude of historical shifts in the ratio and the doubling of the ratio since 2007, the debt/GDP ratio is essentially projected to stabilize at a new, higher level over the next 10 years under the current-law baseline.

(3) Total spending is projected to be about the same share of the economy in 2023 as it is in 2012.

Total spending was 22.8 percent of GDP in 2012, and is projected to fall to 22.2 percent in 2013 and to 21.5 percent in 2017, before rising to 22.9 percent by 2023 under current law. Under current policy, total spending will rise slightly over the decade, to 23.1 percent of GDP.

(4) Net interest payments are projected to rise to unprecedented levels.

Net interest payments rise from 1.4 percent of GDP in 2012 to 3.3 percent in 2023 under current law. The projected rise is due to the increase in the debt/GDP levels in recent years, coupled with an expected rise in interest rates as the economy returns to full employment. The projected rise in interest rates is particularly notable given both the low levels of current interest rates and the magnitude of the projected changes. The three-month Treasury bill rate rises to 4.0 percent in 2023 compared to 0.1 percent in 2012. The 10-year Treasury note rate rises to 5.2 percent in 2023 compared to 1.8 percent in 2012. Various measures of the inflation rate are expected to rise by 0.5 percentage points over the same period, so almost all of the projected increases represent higher real interest rates.

Net interest payments would rise to 3.5 percent of GDP under the current policy baseline and 3.7 percent of GDP under CBO’s alternative fiscal scenario. These are extremely high levels relative to the past. Net interest payments previously peaked at 3.3 percent of GDP in 1991.

(5) Non-interest spending is projected to fall significantly.

In 2012, non-interest spending was 21.4 percent of GDP. Under current law, this figure is projected to fall to 19.2 percent by 2018. By 2023 it rises slightly to 19.6 percent, but still remains 1.8 percentage points of GDP lower than the 2012 level. Under current policy, non-interest spending is also at 19.6 percent of GDP in 2023. This is a higher spending level than the historical average. From 1957 to 2008, non-interest spending averaged about 18.1 percent of GDP.

(6) The decline in non-interest spending is due to dramatic declines in discretionary spending, including both the defense and non-defense portions.

The projected decrease in discretionary spending is due to the Budget Control Act of 2011. The legislation instituted caps on discretionary spending that would, by itself, reduce discretionary spending to its lowest share of the economy since records separate records were kept in 1962 (see Alternative Fiscal Scenario data). The legislation also instituted, in the absence of further deficit reduction, a broad-based sequester of federal spending – mainly discretionary –that would drive down discretionary spending even further.

Under current law, discretionary spending will decrease from 8.3 percent of GDP in 2012 to 5.5 percent in 2023. Defense spending is projected to fall from 4.3 percent of GDP to 2.8 percent in 2023. Non-defense discretionary spending is projected to fall from 4.0 percent of GDP in 2012 to 2.7 percent of GDP in 2023. Under the current policy baseline, total discretionary spending decreases to 5.3 percent of GDP by 2023.

All of these shares are remarkably low relative to historical figures. Between 1962 and 2012, the lowest discretionary spending level as a share of GDP occurred in 1999, at 6.2 percent.

(7) Mandatory spending rises, but slower cost growth is projected for Medicare and Medicaid.

Mandatory spending is projected to rise from 13.1 percent of GDP in 2012 to 14.1 percent in 2022 and 2023. This is a slightly lower than CBO’s projection last year for 2022, which was 14.3 percent. The lower mandatory spending is due to slower projected cost growth in Medicare and Medicaid. Last year, CBO expected Medicare and Medicaid to account for about 6.7 percent of GDP in 2022; this year it projects these programs to be 6.3 percent of GDP in 2022. CBO’s projections for income security outlays and other mandatory outlays increased by 0.2 percentage points of GDP to partially offset the projected decrease in Medicare and Medicaid growth (CBO 2013c).

(8) Revenues are not only projected to recover from extremely low levels in recent years, but to rise significantly to above average historical levels.

Due to the recession and slow recovery, as well as tax policy choices, federal revenues have been at historic lows, less than 16 percent of GDP, since 2009, representing the lowest share of GDP in more than 60 years. As the economy recovers, and ATRA and surtaxes adopted under the Affordable Care Act (ACA) kick in, CBO projects revenue will rise to 19.1 percent of GDP by 2015 and remain close to that level for the rest of the decade.

Receipts averaged 18.0 percent of GDP from 1957 to 2007, and have exceeded 19 percent of GDP only eight times since 1957. Five of these years were during the 1990s at the end of the Clinton administration when real economic growth was particularly strong and income taxes surged with the growth in income at the high end of the income distribution. The assumed extension of temporary tax policies in CBO’s alternative fiscal scenario and in the current policy baseline reduce revenue levels to about 18.7 percent of GDP in 2023.

(9) Income tax revenues are projected to grow steadily and stay high

Revenues from the individual income tax are projected to rise steadily through the decade, reaching 9.8 percent of GDP by 2023 under current law. The only years the income tax has ever raised at least 9 percent of GDP in revenue were 1944 (at the height of the war), 1969 (the income tax surtax), 1980-82 (leading to the Reagan tax cuts) and 1997-2001 (leading to the Bush tax cuts in 2001 and 2003). The current law baseline, though, projects income tax revenues will reach 9.1 percent of GDP in 2017 and rise gradually to 9.8 percent by 2023.

It is not immediately clear how much extension of temporary tax policies would reduce income tax receipts (as opposed to other receipts), but the total revenue loss is 0.4 percent of GDP, so even if the entire loss occurred in the income tax, revenues from that source would still be high relative to levels that have been viable politically in the past.

(10) The projected growth rate of potential output has fallen.

CBO has lowered its projection of the growth rate for potential output to 2.3 percent, down from 2.5 percent last year. Declines in the growth rate will generally hurt the budget outlook.[3]

(11) Even if economic trends and political actions go well from the perspective of fiscal sustainability, the nation will face high levels of debt over the next 10 years. For example, under the current law baseline:

Revenues average almost 19 percent of GDP as projected from 2015 through 2023 (a level higher than revenues in all but 5 years since 1982),
Revenues from the personal income tax rise steadily to 9.8 percent of GDP in 2023 (a figured exceeded only once in U.S. history),
Defense spending falls to its lowest share of the economy since before WWII,
Non-defense discretionary spending falls to its lowest share of the economy since before separate records were kept starting in 1962,
Significant reductions in projected health care cost growth pan out as projected, and
The economy returns to full employment in 2017 as scheduled and remains there without recession through 2023.

Nevertheless, the implications of those favorable trends would be that:

Net interest payments will rise from 1.4 percent of GDP in 2012 to 3.3 percent in 2023 (tied for the highest level in history and a sign of approaching fiscal unsustainability),
The full-employment deficit would reach 3.8 percent of GDP in 2022 and 2023 (other than in the 2009-12 period, these would be the highest levels except for four of the past 50 years).
The debt/GDP ratio would be 77 percent by 2023. The ratio would be more than 20 percentage points higher in every year during the next decade than it was for any year between 1957 and 2007, and it would be more than double the 37 percent level it averaged during the 1957-2007 period.

Under CBO’s alternative fiscal policy baseline or our own measures of a current policy baseline, all of the budget projections are worse.

(12) How much would it take?

Under the current law baseline, it would take a cumulative $1.2 trillion of additional changes (revenue increases, non-interest spending cuts, and associated interest savings) to obtain in 2023 the 2012 debt/GDP ratio of 72.5 percent. It would take $4.4 trillion in budget cuts to get the 2023 debt/GDP ratio down to 60 percent, the target proposed by the Peterson-Pew (2010), Domenici-Rivlin (Debt Reduction Task Force 2010) and Bowles-Simpson (National Commission on Fiscal Responsibility and Reform 2010) commissions. These numbers are significantly larger under the alternative fiscal scenario and current policy baselines:

For purposes of comparison, it is worth noting that CBO projects that GDP will total $213 trillion over the 2014-2023 period.

(13) The debt-GDP ratio is projected to be rising at the end of the decade, under all three scenarios

Under the CBO baseline, the debt-GDP ratio rises by 4 percentage points from 2018 to 2023. Under the AFS, the increase exceeds 8 percentage points over the same period. Under the current policy baseline, the ratio rises by more than 6 percentage points over the last five years of the projection period. All of these increases occur despite the projection that the economy will be at full employment during this period. These trends hint at the unsustainability of the fiscal situation and the need for longer-term analysis.

III. The Long-Term Outlook

The fiscal gap is an accounting measure that is intended to reflect the long-term budgetary status of the government.[4] As developed by Auerbach (1994) and implemented in many subsequent analyses, the fiscal gap measures the size of the immediate and permanent increase in taxes and/or reductions in non-interest expenditures that would be required to set the present value of all future primary surpluses equal to the current value of the national debt, where the primary surplus is the difference between revenues and non-interest expenditures.[5] Equivalently, it would establish the same debt-to-GDP ratio in the long run as holds currently.

A. Initial Assumptions

We develop three sets of long-term estimates, corresponding to the three 10-year projections above. For years after 2023, for which no official baseline is available, we choose assumptions and, where available, projections for different components of taxes and spending. We assume that, after 2023, most categories of spending and revenues remain constant as a share of GDP. These long-run assumptions, however, would be seriously misleading for the major entitlement programs and their associated sources of funding, for which recent long-term projections are available. For the Medicare and OASDI programs, projections for all elements of spending and dedicated revenues (payroll taxes, income taxes on benefits, premiums and contributions from states) are available or can be calculated from figures presented for the intermediate projections in the 2012 Trustees reports.[6]

For our base case, Social Security spending, Medicare spending, and payroll taxes follow the growth rates assumed in the Trustees’ projections of the ratios of taxes and spending to GDP for the period 2020–2090 for OASDI and 2020–2080 for Medicare, assuming that these ratios are constant at their terminal values thereafter. (As discussed below, we also consider alternative projections for Medicare provided by the Medicare actuary and the CBO, both more pessimistic than the official Trustees’ projections and we consider different ways of incorporating the recent slowdown in health care spending into the long-term estimates.) For Medicaid, CHIP, and exchange subsidies, we use growth rates implied by CBO’s most recent long-term projections (CBO 2012a) through 2087 and assume that spending as a share of GDP is constant thereafter.[7]

It is important to understand how to interpret these assumptions. They do not represent a pure projection of current law but instead assume that policymakers will make a number of future policy changes, including a continual series of tax cuts, discretionary spending increases, and adjustments to keep health spending from growing too quickly. For example, if current tax parameters were extended forward, income taxes would rise as a share of GDP. Our forecast implicitly assumes policymakers will cut taxes in response. Conversely, our forecast assumes that a richer society will want to spend more on discretionary spending, going beyond the current services provided by government. Kamin (2012) provides additional perspective on these assumptions.

We provide six different projections of Medicare spending. The intermediate projections of the Medicare Trustees have for many years incorporated the assumption that Medicare growth will eventually slow in the future. Starting in the 2010 report, however, the Trustees’ official medical projections have assumed a much stronger slowdown, as a consequence of provisions in the ACA. These assumptions, though they may be consistent with the impact of the bill’s provisions should they remain in force over the long term, are controversial, for the sustainability of such spending reductions is not clear. Reflecting this controversy, the Medicare Actuary has, since 2010, released a separate set of projections (CMS Office of the Actuary 2012) showing less optimistic (although still positive) reductions in spending. CBO’s Alternative long-fiscal scenario (2012) provides a third, and more pessimistic projected path of Medicare spending.[8]

We provide long-term calculations for each of these three projected paths of the projected growth in health care spending, starting from CBO’s 2023 baseline projection. Also, for each of these three paths, we provide estimates that incorporate an additional permanent slowdown in the growth rate. CBO (2013c) noted that lower-than-expected health care spending growth rates had caused it to revise down its federal health spending assumptions. We provide simulations where the health care growth rates in each of the three scenarios mentioned above is permanently lower by 0.5 percentage points to reflect the continuation of the recent slow-down, not only through the 10-year window but for the long-term.

B. Estimates

Table 2 displays calculations of the long-term fiscal gap, in two panels corresponding whether the near-term projected reductions in health care spending growth are assumed to be temporary (upper panel) or permanent (lower panel). For each option, we show three variants according to the source of post-2023 Medicare projections — the Medicare Trustees, the Medicare Actuary, and CBO’s Alternative scenario. For each combination of 10-year baseline and long-term Medicare projections, we show the fiscal gap over two horizons: through 2089, and over the infinite horizon. We begin by discussing the various baselines that rely on the most optimistic Medicare projections, those in the official Trustees report, shown in the top row of the table.

Under the CBO baseline assumptions, we estimate that the fiscal gap through 2089 is now 3.51 percent of GDP (Table 2).[9] This implies that an immediate and permanent increase in taxes or cut in spending of 3.51percent of GDP — roughly $560 billion per year in current terms — would be needed to maintain fiscal balance through 2089. In present-value dollars, rather than as a share of GDP, the fiscal gap through 2089 under these assumptions amounts to $35.1 trillion. The fiscal gap is even larger if the time horizon is extended, since the budget is projected to be running substantial deficits in years approaching and after 2089. If the horizon is extended indefinitely, for example, the fiscal gap rises to 4.40 percent of GDP under the CBO baseline, or $82.9 trillion.

The fiscal gaps under the CBO’s alternative fiscal scenario are about 0.9 percentage points of GDP larger than the baseline scenario. Recall that this scenario has lower revenues because it assumes that the Congress will continue to renew the “tax extenders” and will renew certain tax provisions that expire in 2018. It also assumes higher spending as the sequestration is rescinded and the Medicare provider payment cuts are continually delayed. Through 2089, the fiscal gap is 4.42 percent of GDP, or $44.2 trillion. The fiscal imbalance over the infinite horizon is 5.32 percent of GDP. In present-value dollars, the gap exceeds $100.2 trillion.

Under extended policy, the fiscal gap lies between the CBO’s two scenarios. This scenario differs from the CBO’s alternative fiscal scenario because the higher spending assumptions are almost offset by the drawdown in war spending and eliminating the disaster relief spending that is extrapolated in discretionary spending. Under extended policy, the fiscal gap through 2089 amounts to 3.97 percent of GDP, or 0.5 percent of GDP more than under the CBO baseline. In present-value dollars, the fiscal gap under this scenario almost reached $39.7 trillion through 2089. Over the infinite horizon, the fiscal gap under the extended policy baseline is 4.86 percent of GDP, or $91.6 trillion.

In the second row, we see the impact of using the projections offered separately by the Medicare Actuary. Doing so raises the fiscal gap by about 1.0 percent of GDP through 2089 and around 1.7 percent of GDP under an infinite horizon. For example, under the scenario based on the CBO baseline, the fiscal gap rises to 4.47 percent of GDP through 2089 and 6.09 percent of GDP under an infinite horizon.

The third set of projections for Medicare spending, from the Alternative Fiscal Scenario in CBO’s long-term budget outlook (2012a), are the most pessimistic we consider and are shown in the third row of Table 2. These projections raise the gap by about an additional 0.3 percent of GDP through 2089 and 0.7 percent of GDP over the infinite horizon, compared to the Medicare Actuary projections. As a result, the permanent fiscal gap is 4.74 percent of GDP under the CBO baseline scenario, 5.67 percent of GDP under CBO’s alternative fiscal scenario, and 7.34 percent of GDP under the extended policy scenario.

The fourth through sixth rows of Table 2 show the fiscal gap projections if the CBO’s downward revision of health care spending growth is continued throughout the long-term horizon. Between the August Update (CBO 2012b) and the February Outlook (CBO 2013b), the CBO revised down the growth rates for Medicare and Medicaid, CHIP, and insurance subsidies by about 0.5 percentage points. If this slowdown is continued beyond 2023, the fiscal gaps through 2089 for the Medicare Trustees health assumptions are lower by about 1 percent of GDP. The fiscal gaps for health spending assumptions under both the CMS Actuary and the CBO’s Alternative Medicare decrease by about 1.2 percentage points each.

Although the fiscal gap is still positive and substantial, our estimates of the gap are considerably smaller than a few years ago, due to the passage of the Budget Control Act in 2011, the American Taxpayer Relief Act of 2012, the recent and projected slowdown in health care cost growth and other factors. For example, our estimates of the permanent fiscal gap – under current policy and under the Medicare Trustees’ projected spending – fell from 6.5 percent of GDP in 2011 before the Budget Control Act (Auerbach and Gale 2011a), to 5.9 percent of GDP in 2011 after the Budget Control Act (Auerbach and Gale 2011b), and then fell to 4.9 percent of GDP in the current estimate if the recent health care cost growth slowdown is assumed to last for 10 years, and to 3.1 percent of GDP in the current estimate if the recent cost growth slowdown is assumed to be permanent.

Figure 3 shows projected revenues and non-interest expenditures through 2089 under two “bracketing” scenarios: the most optimistic scenario (CBO 10-year baseline, Medicare Trustees health spending assumptions permanently modified by the CBO’s health revision) and the most pessimistic scenario (CBO’s alternative fiscal scenario and the CBO Alternative Medicare assumptions with the lower health spending growth only lasting through 2023). Under the former, non-interest outlays will keep rising and will reach 21.1 percent of GDP by 2089 – higher than the 19.0 percent of revenue projected for that year under the scenario. Under the pessimistic scenario, revenue will be lower — at 18.6 percent of GDP, much closer to its historical share — and non-interest outlays will exceed 28 percent of GDP by 2089. Thus, even using the most optimistic projections for both the short term and the long term, the current gap between spending and revenues persists far into the future.

Figure 4 shows the implied debt-to-GDP ratios under the most optimistic and most pessimistic projections. Under the first set, the economy would pass its highest-ever debt-to-GDP ratio (108.6 percent, in 1946) by 2035. This benchmark would be passed six years sooner (around 2029) under the more pessimistic scenario. In both cases, the following years would see additional growth in the debt-to-GDP ratio. Indeed, even the projected debt-to-GDP ratios under the most optimistic scenario would rise to 360 percent of GDP, an astronomical and unsustainable level.

Although not shown in the table, delaying the implementation of a fiscal solution will increase the fiscal gap and thus make it harder to assure the nation’s fiscal future. If Congress cannot reach compromise and implement a solution until 2018 — that is, when CBO projects the economy to return to full employment — the estimated permanent fiscal gaps for the most optimistic and pessimistic scenario rises to 2.82 percent and 8.15 percent of GDP, respectively, or 0.13 and 0.36 percentage points of GDP more than if fiscal adjustment were implemented immediately. Although gradual or slightly delayed implementation may be preferable in light of a still-struggling recovery, the decision to delay should be made actively with full awareness that the necessary fiscal adjustment will then be larger and will require more difficult sacrifices, rather than passively acquiescing to inertia and recent political impasses. And if a solution is not implemented for 10 years (i.e., not until 2023), the estimated permanent fiscal gaps for the most optimistic and pessimistic scenarios will be about 0.27 and 0.77 percent of GDP larger than shown in Table 2.

IV. Conclusions

Recent legislative changes – including the Budget Control Act of 2011 and the American Taxpayer Relief Act of 2012 – along with recent and projected slowdowns in the growth rate of health care spending have helped improve the nation’s medium-term and long-term budget picture. But the country was starting from a position of a substantial fiscal gap, and so while the recent improvements have helped shave part of the problem away, there is still a long way to go. Moreover, even as current-period deficits fall to less atypical historical levels from the enormous levels that persisted in 2009-11, the nation now must carry a debt load that is twice as large as its historical average and makes budget outcomes much more sensitive to interest rates.

Under even the most optimistic scenario, the necessary adjustments must be several times the size of those adopted under the recent legislation. The changes needed relate much more to medium- and long-term deficits, rather than the short-term deficits, which to a considerable extent still reflect the weakness of the economy. Moreover, cuts in discretionary spending alone will not suffice if substantial progress is to be made; changes to entitlement spending and to tax revenues will be needed to close the gap.

List of References

Auerbach, Alan J. 1994. “The U.S. Fiscal Problem: Where We Are, How We Got Here, and Where We’re Going.” In National Bureau of Economic Research Macroeconomics Annual 1994, Volume 9, edited by Stanley Fischer and Julio Rotemberg, 141–175. Cambridge, MA: MIT Press.

Auerbach, Alan J. 1997. “Quantifying the Current U.S. Fiscal Imbalance.” National Tax Journal 50 (3): 387–98.

Auerbach, Alan J., William G. Gale, Peter R. Orszag, and Samara Potter, 2003. “Budget Blues: The Fiscal Outlook and Options for Reform.” In Aaron, Henry J., James Lindsay, and Pietro Nivola (eds.), Agenda for the Nation, 109–143. Brookings Institution, Washington, DC.

Auerbach, Alan J., and William G. Gale. 2011a. “Tempting Fate: The Federal Budget Outlook.” Tax Notes 132 (4): 375-88.

Auerbach, Alan J., and William G. Gale. 2011b. “(Still) Tempting Fate.” Brookings Institution, Washington, DC.

Auerbach, Alan J., and William G. Gale. 2012. “The Federal Budget Outlook: No News is Bad News.” Tax Notes 136 (13): 1597-1607.

Board of Trustees, Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds. 2012. The 2012 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds. Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds, Washington, DC.

CMS Office of the Actuary. 2012. Projected Medicare Expenditures under an Illustrative Scenario with Alternative Payment Updates to Medicare Providers. Centers for Medicare and Medicaid Services, Baltimore, MD.

Congressional Budget Office. 2010. Social Security Policy Options. Congressional Budget Office. Washington, DC.

Congressional Budget Office. 2012a. The Long-Term Budget Outlook. Congressional Budget Office, Washington, DC.

Congressional Budget Office. 2012b. An Update to the Budget and Economic Outlook: Fiscal Years 2012 to 2022. Congressional Budget Office, Washington, DC.

Congressional Budget Office. 2013a. “The “Fiscal Cliff” Deal.” Blog Post. Available at: <http://cbo.gov/publication/43835>

Congressional Budget Office. 2013b. The Budget and Economic Outlook: Fiscal Years 2013 to 2023. Congressional Budget Office. Washington, DC.

Congressional Budget Office. 2013c. “How Have CBO’s Projections of Spending for Medicare and Medicaid Changed Since the August 2012 Baseline?” Blog Post. Available at: <http://cbo.gov/publication/43835>

Debt Reduction Task Force. 2010. “Restoring America’s Future: Reviving the Economy, Cutting Spending and Debt, and Creating a Simple, Pro-Growth Tax System.” Senator Pete Domenici and Dr. Alice Rivlin, Bipartisan Policy Center.

Kamin, David. 2012. “Are We There Yet?: On a Path to Closing America’s Long-Run Deficit.” Tax Notes 137 (3): 53-70.

National Commission on Fiscal Responsibility and Reform. 2010. “The Moment of Truth: Report of the National Commission on Fiscal Responsibility and Reform.”

Peterson-Pew Commission on Budget Reform. 2010. “Getting Back in the Black.”

[1] CBO is instructed to assume that most mandatory programs that are slated expire during the budget window will persist throughout the entire projection period. CBO (2013b) reports that the baseline includes $1,234 billion in outlays, not including debt service costs, for mandatory spending programs that are assumed to be extended beyond their expiration dates. CBO is also instructed to assume the continuation of excise taxes that are dedicated to trust funds, even if they are scheduled to expire within the projection period.

[2] See CBO (2010, footnote 11), which states “CBO prepares cost estimates for legislation under the assumption that scheduled payments will be made, which is consistent with a long-standing statutory requirement that CBO, in its baseline projections, assume that laws are implemented as specified and that funding for entitlement programs is adequate to make all payments. See section 257 of the Balanced Budget and Emergency Deficit Control Act of 1985, Public Law 99-177, as amended”; 2 U.S.C. 907.

[3] However, our current long-term growth projections use figures from the Social Security Administration’s 2012 Trustees Report, issued prior to CBO’s reduction in the projected long-term growth rate. This suggests that our long-term estimates may prove to be too optimistic.

[4] Auerbach et al. (2003) discuss the relationship between the fiscal gap, generational accounting, accrual accounting and other ways of accounting for government.

[5] Over an infinite planning horizon, this requirement is equivalent to assuming that the debt-to-GDP ratio does not explode (Auerbach 1994, 1997). For the current value of the national debt, we use publicly-held debt. As discussed above, an alternative might be to subtract government financial assets from this debt measure, but the impact on our long-term calculations would be small (reducing the fiscal gaps reported in Table 3 by less than 0.1 percent of GDP).

[6] Details of these computations are available from the authors upon request. The 2012 Medicare Trustees Report is at http://www.cms.gov/ReportsTrustFunds/downloads/tr2012.pdf. The 2012 OASDI Trustees Report is at http://www.ssa.gov/OACT/TR/2012/tr2012.pdf.

[7] CBO projects two scenarios for spending and revenues, which it refers to as its “Extended-Baseline” and “Alternative” scenarios. For federal spending on Medicaid, CHIP and exchange subsidies, these two scenarios are relatively similar, differing by about 0.4 percent of GDP in 2089. We use the higher of these two sets of projections, the Alternative scenario, to be consistent with our use of the Medicare projections from this scenario as one of the cases we will consider below.

[8] The Medicare projections under CBO’s more optimistic Extended-Baseline scenario yield estimates of the long-term gap that are similar over the infinite horizon to those based on the CMS Actuary’s projections.

[9] The discount rate in these calculations is based, for 2023 onward, upon the intermediate assumptions of the Social Security Trustees, which include a nominal interest rate of about 5.7 percent. For the first 10 years of the calculation, through 2023, we use a blend of the CBO forecasts of the ten-year and 3-month Treasury rates that roughly replicates the debt accumulation pattern under the CBO baseline.

Authors

William G. Gale
Alan J. Auerbach

Tax Expenditures and the Deficit: Time to Rethink Retirement Saving Policy?

Wed, 13 Feb 2013 10:00:00 -0500

Event Information

February 13, 2013
10:00 AM - 12:00 PM EST

Falk Auditorium
Brookings Institution
1775 Massachusetts Avenue, N.W.
Washington, DC 20036

As policymakers continue to search for ways to shore up the nation’s fiscal status, tax subsidies may be ripe for the picking. Tax subsidies for retirement saving account for more than $90 billion annually in lost Treasury revenue. New research suggests that the tax subsidy for contributions to retirement accounts only affects the behavior of certain financially sophisticated households and does not raise overall saving significantly, however, automatic enrollment can raise both retirement saving and overall saving. Over 60 million Americans participate in 401(k) plans. Are there less expensive, more progressive ways to generate the same or more retirement saving and overall saving than the current tax treatment of contributions to retirement accounts?

On February 13, the Retirement Security Project and the Urban-Brookings Tax Policy Center explored the results from a new study that examines whether a nudge or a subsidy is a better way to increase saving. The study also draws crucial distinctions between active and passive savers and the implications of the two groups for retirement saving policy. Speakers included study co-authors Raj Chetty and John Friedman of Harvard University, as well as Director of the Retirement Security Project William Gale.

Read the full paper and executive summary »

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Tax Expenditures and the Deficit: Time to Rethink Retirement Saving Policy?

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Observations on the CBO Budget Outlook

William G. Gale — Fri, 08 Feb 2013 11:43:00 -0500

The Congressional Budget Office released its latest Budget and Economic Outlook earlier this week. As always, the outlook provides insight into the fiscal status of the federal government. My three overarching reactions are:

First, because ATRA instituted tax changes that had been widely expected, the official (“current law”) baseline is now much more reflective of plausible outcomes than it has been in the past. Hence, the baseline is now a more reliable guide to the fiscal outlook.

Second, unlike in long-term budget scenarios—where rising health care spending is the single most important factor—there is no “smoking gun” in the 10-year projections. Mainly, there is “just” an overall continuing imbalance between spending and taxes. Revenue is not projected to collapse, as it did in 2009-12, but rather to grow to higher-than-historical-average levels. Spending isn’t spiraling out of control—it is at the same share of GDP in 2023 as it was in 2012. Large projected cuts in discretionary spending are offset by net interest rising to historically high levels and increases in mandatory spending.

Third, while we do not face an imminent budget crisis, the data in the outlook imply that we are not out of the woods. The 10-year budget outlook remains tenuous. Even if seemingly everything goes right—in economic terms and in political terms—we are still on the edge of dangerously high debt and deficit levels with little room to spare. For example, under the current law baseline, even if:

Revenues average almost 19 percent of GDP as projected from 2015 through 2023 (a level higher than revenues in all but 5 years since 1982),
Revenues from the personal income tax rise steadily to 9.8 percent of GDP in 2023 (a figured exceeded only once in U.S. history),
Defense spending falls to its lowest share of the economy since before WWII,
Non-defense discretionary spending falls to its lowest share of the economy since before separate records were kept starting in 1962,
Significant reductions in projected health care cost growth pan out as projected, and
The economy returns to full employment in 2017 as scheduled and remains there without recession through 2023,

the implications are, nevertheless, that:

Net interest payments will rise from 1.4 percent of GDP in 2012 to 3.3 percent in 2023 (tied for the highest level in history and a sign of approaching fiscal unsustainability),
The full-employment deficit would reach 3.8 percent of GDP in 2022 and 2023 (other than in the 2009-12 period, these would be the highest levels except for four of the past 50 years).
The debt/GDP ratio would be 77 percent by 2023. The ratio would be more than 20 percentage points higher in every year during the next decade than it was for any year between 1957 and 2007, and it would be more than double the 37 percent level it averaged during the 1957-2007 period.
It would take $1.2 trillion in additional budget savings (beyond the sequester) to get the debt/GDP ratio in 2023 down to its 2012 level of 72.5 percent, and it would take a total of $4.4 trillion in adjustments to reduce the debt/GDP ratio in 2023 to 60 percent.
Although not shown in the Outlook, which focuses on the 10-year horizon, debt/GDP would be projected to continue to rise sharply and indefinitely beyond 2023.

Under CBO’s alternative fiscal policy baseline or my own measure of a current policy baseline (both described in the full report(pdf)), all of the budget projections are worse.

Download the full report on the budget »

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What You Should Know About the Budget Outlook

Authors

William G. Gale

Image Source: © Yuri Gripas / Reuters

The Downside of States as Laboratories for Tax Reform

Tracy Gordon — Tue, 05 Feb 2013 10:35:00 -0500

With state finances gradually improving, some Republican governors are turning their attention to fundamental tax reform. Louisiana Governor Bobby Jindal has proposed replacing his state’s personal and corporate income taxes with higher sales taxes. Nebraska’s Dave Heineman and North Carolina’s Pat McCrory would do the same, broadening the sales tax base and perhaps including some previously tax-exempt services.

With Washington apparently stuck in gear on taxes among other issues, it may be tempting to see the states as leading a way to reform. Unfortunately, some of the proposals currently circulating—and the idea of states as laboratories for a fundamental federal tax reform—are fundamentally flawed.

First, as my Tax Policy Center colleague Ben Harris has noted, income-sales tax swaps would be regressive—or hit low income household the hardest. This is because low income households must dedicate a greater share of their income to consumption to achieve a basic standard of living and more of their consumption tends to go toward goods (which are taxed) versus services (which are typically not). These households also often benefit from income tax rebates which presumably would be wiped out along with the tax.

Another key issue is whether states would go after currently untaxed services. Most states have already picked off easy targets like tuxedo rentals and tattoo parlors. As pointed out by the Tax Foundation’s Joe Henchman, it’s a much heavier lift politically to tax professional services of lawyers, accountants, and real estate agents. Just ask lawmakers in Maryland, Michigan, and Florida who enacted new sales taxes on some services but were forced to repeal the levies in the face of industry backlash.

It is unclear whether states without an income tax would be able to raise adequate revenue to provide the services that individuals and businesses value. Proponents of tax swaps often point to modestly higher growth in states without a personal income tax. But these comparisons are misleading. States without income taxes usually have strong alternative tax bases like energy (Texas, Alaska, and Wyoming) or gambling (Nevada).

More broadly, states are not the federal government. The usual argument for a federal consumption tax—that it would spur investment by reducing future tax penalties on savings—does not apply in an open economy where people may respond to higher sales taxes by doing more shopping online or in neighboring states. The federal government can afford to worry less about tax flight. It is simply much easier to cross state rather than national borders to avoid taxes unless you're a professional athlete or, well, Gerard Depardieu. At both government levels, higher rates can also prompt flat out tax avoidance or cheating.

Proponents of sales-income tax swaps are correct in noting the income tax’s one major flaw: volatility. An overreliance on income taxes can put states on a revenue rollercoaster and make them very sensitive to economic downturns. This is a particular problem in states where income tax rates rise sharply with income or where individuals get more income from variable sources like stock options and capital gains.

However, states can address these problems by doing a better job managing their budgets. For example, they could improve their rainy day funds and park more money there when times are good. They might also reconsider rules that make it prohibitively costly to raid these funds in a bad economy.

In other words, state tax reform may be a good idea, but no tax cut in history has ever paid for itself. Switching from income to consumption taxes may sound like music to federal policymakers’ and some economists’ ears. But another equally resonant sentiment, especially among the latter group, is to upgrade fiscal infrastructure when the opportunity cost is low. Translation: fix the roof when it’s not raining.

Authors

Tracy Gordon

Publication: Real Clear Markets

Image Source: © Jessica Rinaldi / Reuters

Taxing the Wealthiest Could Go a Long Way

William G. Gale — Wed, 05 Dec 2012 13:26:00 -0500

Middle-class households will eventually have to see their taxes rise and some of their benefits fall as part of a long-term fiscal solution. The projected budget shortfalls in coming decades are too substantial for any large group to escape unscathed.

But increased tax revenue from high-income households alone could go a long way toward stabilizing the medium-term debt relative to the economy – a policy that could be achieved with about $2 trillion in deficit reduction over the next decade.

The administration has already proposed $1.6 trillion in tax increases on high-income households. The top two rates would return to Clinton-era levels, 36 and 39.6 percent. Tax benefits would be capped at 28 percent per dollar of itemized deductions, health insurance premiums, retirement contributions and tax exempt interest. These changes would have no effect on anyone currently in the 28 percent bracket or below, about 98 percent of households.

A plan that is not yet on the table would be to reform the alternative minimum tax. The A.M.T, originally intended to assure that the richest Americans pay taxes, applies to a broader income base than the regular tax. But it has an almost flat rate structure of 26 and 28 percent.

Two changes would be helpful. First, raise the top A.M.T. rate to 35 percent or the top rate in the personal income tax. (This would allow repeal of the phase-out of personal exemptions in the A.M.T.) Second, raise the tax rate on capital gains and dividends in the A.M.T. to 28 percent or to the rate that applies to regular income in the A.M.T. These changes would raise substantial revenue from high-income households and would turn the A.M.T. back into the shelter-reducing levy it was meant to be.

Authors

William G. Gale

Publication: The New York Times

Image Source: © Keith Bedford / Reuters

Tax Reform for Growth, Equity, and Revenue

Samuel Brown and William G. Gale — Fri, 30 Nov 2012 11:10:00 -0500

ABSTRACT

This paper examines the fiscal outlook and tax reform options in the United States. The major conclusions include: the United States faces a substantial fiscal shortfall in the medium- and long-term; both spending cuts and tax increases should contribute to the solution; tax increases need not do significant harm to economic growth; and there are sensible ways to both reform tax structure and raise revenues, including tax expenditure reform, the creation of a value-added tax, the creation of a carbon tax, or an increase in the gasoline tax.

INTRODUCTION

The Great Recession and its aftermath have left the United States with a difficult fiscal situation, with a weak economy that would benefit from short-term stimulus, but also with projected medium- and long-term budget shortfalls, even after the economy recovers, that indicate the need for fiscal consolidation. Addressing these medium- and long-term problems will likely require a combination of spending cuts and revenue increases. While tax reform would be a laudable goal even in the absence of a fiscal problem, building a better tax system becomes even more imperative when revenue requirements rise and the equity and efficiency of the tax code are put under even greater scrutiny and pressure.

In this paper, we consider how tax reform could be designed to simultaneously address three goals: promoting economic growth, improving equity, and raising revenue. We begin in section 2 by summarizing the medium-term and long-term fiscal outlook and reviewing the arguments for higher revenues as part of a fiscal solution.

In Section 3, we discuss how to broaden the income tax base by reducing and reforming tax expenditures. Public attention often focuses on raising revenues by raising income tax rates, but in the presence of the current narrow income tax base, this could create significant avoidance and prove economically damaging (Altshuler, Lim, and Williams 2010). Relative to rate increases, broadening the income tax base is more conducive to economic growth; it reduces the distortions created by the tax system and the inefficiencies involved in economic choices, it is fairer and simpler since different types of income and expenditure are treated the same way, and it could raise substantial revenue even when accompanied by lower rates.

In Section 4, we explore how a VAT could be designed as part of the solution to the U.S. fiscal problem. A VAT could raise significant revenue and, if the proceeds are focused on deficit reduction, would raise national saving. Distributional issues raised by the VAT can be addressed in a number of ways.

In section 5, we discuss how taxes on carbon emissions and/or a higher tax on gasoline would reduce externalities, make markets more efficient, and raise significant revenues. As with a VAT, the distributional issues could be addressed via other policies. Section 6 is a short conclusion.

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Tax Reform for Growth, Equity, and Revenue

Authors

Samuel Brown
William G. Gale

Publication: Urban-Brookings Tax Policy Center

Image Source: © Benjamin Myers / Reuters

The Tax Policy Center's Analysis of Governor Romney’s Tax Proposals: A Follow-up Discussion

Samuel Brown, William G. Gale and Adam Looney — Wed, 07 Nov 2012 13:29:00 -0500

ABSTRACT

Tax reform ideas played an important role in the recent Presidential election. Republican candidate Mitt Romney proposed large tax cuts and other changes that he said could be part of a revenue-neutral tax reform that also retained low rates on savings and investment and would not raise taxes on the middle class. In an earlier analysis, we showed that it was not possible to achieve all of Romney’s stated goals simultaneously. This paper reviews that analysis and critiques several responses to our analysis. Legislating realistic tax reform will require recognition of the difficult trade-offs among these competing goals.

I. Introduction

In February, 2012, Republican presidential candidate Mitt Romney laid out a four-part agenda for tax reform that featured cutting income tax rates by 20 percent from today’s levels, promoting “savings and investment for the American people,” repealing the estate tax, and repealing the alternative minimum tax.[1] He also proposed a variety of additional tax cuts, including a 29 percent reduction in the corporate tax rate. Taken together, the proposed tax cuts would reduce revenues by roughly $456 billion in 2015 or about $5 trillion over the next decade.[2] Governor Romney said that the changes would be part of a revenue-neutral reform that would offset the cost of the cuts by eliminating tax breaks and not raise taxes on the middle class, but he did not specify which tax breaks would be eliminated.

In August, the Tax Policy Center (TPC) published a paper we co-authored that analyzed these economic and policy goals.[3] As an illustration of the difficulty inherent in implementing such a substantial tax reform, our paper showed that achieving all of the goals listed above would, under reasonable assumptions about what tax breaks might be on the table, result in tax cuts for households with income above $200,000. Given the goal of revenue neutrality, this would seem to require tax increases on households with income below $200,000, something that Governor Romney has said he does not want to happen.

This conclusion was a mathematical demonstration of the difficulty of accomplishing simultaneously all of the goals Romney had laid out. It was neither a statement of Romney’s intentions nor a political prediction of what he would actually do if elected president. Indeed, Romney had also indicated that he did not want to cut taxes on high-income tax payers and that he wanted to reduce the burden for middle-income households.[4] Thus, our results demonstrated the more general conclusion that something would have to give: Romney’s proposals would fall short on at least one of the goals he had set out. Any practical reform based on his proposals would entail some combination of reduced revenues, tax increases on households with income below $200,000, higher taxes on saving and investment, smaller reductions in income tax rates, or other changes.

Our conclusions held even though we imposed the base-broadening measures in the most progressive manner possible, eliminating them for the highest-income households first before affecting anyone else. This was intended to place an upper bound on what the plan could achieve in terms of progressivity. Our analysis noted that, in reality, practical and administrative challenges of implementing the base-broadening reforms in this manner would mean that any realistic effort to close tax expenditures consistent with Romney’s goals would require higher effective tax rates and would yield even less progressivity, lower revenues, and more tax complexity than we had modeled. Furthermore, we excluded the effects of the corporate tax cuts, despite evidence that these provisions would also result in lower revenues.

Our results held even when we incorporated revenue feedback, not just according to the standard “microdynamic” effects used by TPC, Treasury, and the Joint Committee on Taxation, but also additional feedback effects from potential economic growth, based on estimates from a Romney adviser, even though we believe those estimates are overly optimistic.

In light of several responses to our work, some recent suggestions by Romney on how to finance part of his proposed tax cuts, and ongoing interest in tax reform, this paper reviews the discussion and to respond to various issues that have arisen in response to our paper.[5]

We offer several conclusions. First, we continue to stand by our original results. Although some media outlets and individuals have interpreted a second document that we published as somehow walking back or disavowing our earlier results, that is simply a misinterpretation on their part.[6]

Second, after reviewing several responses to our study, we note that even with the freedom to choose from a much larger set of “pay-fors,” not a single author has offered a plan that generates sufficient revenue to pay for all of Romney’s (non-corporate) tax cuts, exempts households with income below $200,000 from higher taxation, and is administratively feasible. None of the responses actually refutes our study – that is, none of them shows that our conclusions are wrong, given what Romney laid out as goals. Rather, the responses either shift the goal posts – by focusing on tax increases on different households or changing the baseline –

fail to raise sufficient revenue to offset all the tax cuts Romney has proposed; raise taxes on saving and investment, in violation of Romney’s goal of promoting these activities; or do a combination of these things.

Third, Romney subsequently described several ideas to help pay for some of his proposed tax cuts. This was a welcome update to the discussion, but the ideas (which Romney described but did not formally endorse) would not generate sufficient revenue to pay for the tax cuts.

Our paper proceeds as follows: Section II describes Romney’s proposals. Section III summarizes our earlier analysis. Section IV discusses and critiques the responses to our work. Section V discusses Romney’s recent ideas for paying for his proposals. Section VI concludes. An Appendix provides a detailed response to Rosen (2012).

II. Romney’s Proposals

In the Wall Street Journal on February 23, 2012, Romney published an op-ed laying out his economic plan, focused on four items:[7]

Cutting income tax rates by 20 percent below their 2012 level,
Promoting saving and investment (including eliminating taxes on capital gains, qualified dividends and interest incomes for households with income below $200,000; and retaining the current 15 percent top rates on capital gains and dividends for high-income households),
Repealing the estate tax, and
Repealing the alternative minimum tax.

He also proposed a series of other tax changes over the course of the campaign, including:

Repealing the surtaxes on investment and earnings of upper-income taxpayers that were enacted in the Affordable Care Act,
Extending all of the 2001/03 tax cuts,
Allowing the 2009/10 tax cuts to expire, and
Reducing the corporate tax rate to 25 percent from 35 percent.[8]

III. Our Analysis

The purpose of our analysis was to examine the trade-offs inherent in tax reform.[9] We drew on the Tax Policy Center microsimulation model, which was developed to provide revenue and distributional estimates of tax policies that had otherwise only been available from government sources, like the Joint Committee on Taxation (JCT) or the Department of the Treasury.

Much like the models used at these government agencies, the TPC model uses large samples of individual households from multiple data sources, projects the income and other tax-related variables of these households over the budget window, and estimates the taxes owed by each sample household under a specified proposal. The model includes estimates of the ‘microdynamic’ effects on revenues that occur when, for example taxpayers increase reported taxable income or capital gains in response to tax rate cuts, but not ‘macrodynamic’ effects of faster economic growth. (Our paper, however, discussed potential macrodynamic effects of the Romney proposal.)

While using a microsimulation model is more complex than using published tables from the IRS, estimates based on a large sample of individual income tax returns are capable of assessing the interaction of different tax provisions (for example, between changes to the AMT and to the regular income tax), and determining tax liability for households with different levels and sources of income, uses of funds, and family circumstances. This is the reason federal agencies and some private groups (including TPC and the National Bureau of Economic Research) use this type of model to estimate revenue and distributional effects of tax reform proposals. In short, by drawing on the TPC model, we can provide timely analysis of important policy-relevant issues using the basic methods of tax analysis used by the government agencies that provide the official scores of tax proposals.[10]

Regarding Romney’s proposals, TPC estimated in March that, in addition to extending the entirety of the Bush tax cuts, Romney’s explicit proposals would reduce revenues in 2015 by $481 billion on a static basis and by $456 billion after accounting for microdynamic behavioral responses.[11] (The commonly cited figure that Romney proposed $5 trillion in gross tax cuts, with unspecified revenue raisers, is based on the $456 billion estimate for 2015, adjusted for projected baseline growth in the size of the economy over the next decade.[12])

In our paper, we compared the Romney proposals to a current policy baseline and did not aim to finance the corporate tax cuts -- we only included the tax cuts listed in the first five bullets above. With these parameters, we estimated that Romney’s proposed cuts would reduce revenues by $360 billion in 2015, after including microbehavioral responses.

A key consideration of our analysis was how such cuts would be financed. In the absence of any specific proposals from the Romney campaign, we looked to existing tax expenditures that could be closed in order to raise revenues. Similar to a previous TPC study, we divided tax preferences into several groups: (1) exclusions of income from sources that are administratively difficult to tax; (2) tax preferences for saving and investment; and (3) all other tax expenditures.[13]

Of these possible revenue-raisers, we excluded tax expenditures in the first group. These preferences--including imputed rent from owner-occupied housing, and other items--are typically excluded from tax reform proposals due to their administrative complexities (and sometimes for other reasons as well). We also excluded consideration of closing preferences aimed at saving and investment, because of the prominence of promoting saving and investment in Romney’s economic proposals. (We discuss this further in the next section.) We considered all other tax expenditures (including those related to itemized deductions for mortgage interest, charitable contributions, and state and local taxes; the exemption of employee income in the form of health insurance; various other exclusions, above the line-deductions, and tax credits) fair game to pay for the proposed tax cuts.

A key aspect of our analysis is that we closed the available tax expenditures “from the top down.” That is, we offset revenue losses from tax rate reductions by first eliminating tax expenditures for the highest-income groups. If that did not generate enough revenue to pay for the tax cuts, we then closed all available tax expenditures of the next highest-income group and so on. Although it would be both administratively and politically impractical as well as economically damaging (because of the high marginal tax spike it would create) to eliminate all tax expenditures only above a given income threshold, it made the financing of the tax proposals as progressive as could be, for those tax expenditures.

The central results are summarized in Figure 2 from our paper, reproduced below. Among households with income above $1,000,000, Romney’s tax cut proposals (again, ignoring the corporate tax) would reduce tax payments by $106 billion. However, even the complete elimination of all the available tax expenditures (i.e., excluding those administratively difficult to tax or those affecting saving and investment) would only raise $54 billion in revenue from this group. As a result, they would receive a net tax cut of $52 billion. Likewise, each group of households with income of $200,000 or above would receive a net tax cut under Romney’s proposals, even if all available tax expenditures were eliminated from the top down. In total, households with income above $200,000 would receive a net tax cut of $86 billion (consisting of a gross tax cut of $251 billion, partially offset by base-broadeners of $165 billion) even if all of their available tax expenditures were closed.

As a matter of arithmetic, in order for the overall tax package to be revenue neutral and preserve incentives for saving and investment, the $86 billion in lower taxes paid by those with income above $200,000 would require a $86 billion tax increase that would be spread out in some fashion over the 95 percent of the population with income below $200,000. This would require a 58 percent reduction in the value of tax expenditures that go to these households. We did not specify how this burden would be distributed among households with income below $200,000. We did note that if the increased burden were shared equally (as a percentage of income) among all households in this group, after-tax income would fall by an average of 1.2 percent. (The average tax increase would need to be about $500 per household, and about $2,000 for households with children.[14])

This conclusion is mathematical in nature – it is what the analysis shows would have to happen to meet Romney’s stated goals. It was not a prediction of Romney’s actions, were he elected, and Romney has said, before and since, that he does not want to raise taxes on the middle class. That implies an inherent mathematical contradiction between the goals of his proposals: one or more of those goals would have to be compromised.

Finally, we included an analysis of the potential revenue feedback effects from economic growth. We used a model that was developed by Romney advisor Greg Mankiw, and included a significant feedback effect that allowed 15 percent of the tax cut to be paid for through higher economic growth.[15] This implies that the $360 billion cost would fall to about $307 billion. It is not clear how to allocate the increase in income, and hence the added tax payments, across income groups, but it is highly likely that income gains from faster economic growth would increase revenues from both high- and low-income taxpayers. What is clear is that, under any allocation of the changes across income classes, households with income above $200,000 would still receive a large tax cut that would require tax increases on households with income below $200,000 in order to maintain revenue neutrality.

IV. Responses

Since the publication of our paper, several responses have been issued. None of the analyses contradict the results in our study – that is, none shows that our results do not hold, given the goals laid out by the candidate. Moreover, none of the authors of the responses argues that the alternatives they considered would be desirable economic policy. The authors are focused instead on attempting to generate the existence of a plan that could meet all of Romney’s goals. Even so, none of the responses offers a plan that generates sufficient revenue to pay for all of Romney’s (non-corporate) tax cuts, exempts households with income below $200,000 from higher taxation, and is administratively feasible.

We divide our discussion of the responses into three subsections. First, we discuss two overarching issues in the responses: raising taxes on the return to saving and the impact of the Romney proposals on economic growth. Second, we discuss three responses that build directly off of the TPC results. Third, we discuss three responses that use 2009 IRS data to examine the issues.[16]

A. Overarching Issues in the Responses

1. Taxing saving and investment

As noted above, Romney made promoting saving and investment one of his four main planks for pro-growth tax reform, on a par with the income tax cuts and repeal of the estate tax and AMT. In Believe in America: Mitt Romney’s Plan for Jobs and Economic Growth, the major heading for the tax policy section is “Mitt Romney’s Plan: Promote Savings and Investment.”[17]

The claim of promoting savings and investment is an imprecise policy goal and is therefore open to interpretation. It could mean to preserve every incentive for savings and investment or it could mean on net to preserve broad incentives while leaving open the possibility of eliminating more targeted incentives. In the Wall Street Journal op-ed, Romney wrote that “I will promote savings and investment by maintaining the low 15% rate on capital gains, interest [sic] and qualified dividends, and eliminate the tax entirely for those with annual income below $200,000. These low tax rates will create powerful incentives for Americans to save and invest, while encouraging business investment and economic growth.”[18] This does not rule out imposing new taxes on some forms of saving.

Nevertheless, we did not impose new taxes on saving in our calculations because his language and goals do not seem consistent with the idea of raising taxes on any specific types of saving. Specifically, we do not see how raising taxes on various forms of saving is consistent with the goal of promoting saving.

In contrast, all of the authors who have criticized us have suggested including revenue raised from subjecting some forms of saving and investment to higher taxes – either ending the exclusion of interest on state and local bonds, eliminating the tax deferral on long-term saving in life insurance products (often referred to as taxing the inside build-up); or changing the treatment of capital gains on assets that are transferred at death. Including new taxes on forms of saving as a way to pay for the Romney proposals seems to imply either that (a) the authors are ignoring Romney’s goal of promoting saving and investment, or (b) the authors believe that taxing a particular form of saving will not reduce saving and investment.

2. Effects of tax reform on economic growth

We included a discussion of how economic growth would affect our results and we showed that our central results do not change even after accounting for revenue feedback using growth effects taken from Mankiw and Weinzierl.[19]

However, we are skeptical that the growth effects of tax rate cuts – whether taken in isolation or as part of a revenue-neutral package – are as large as is sometimes claimed. While a full debate about taxes and economic growth is beyond the scope of this paper, it is worth noting that estimates that do incorporate macro adjustments by the Congressional Budget Office (CBO) and JCT show smaller effects than Mankiw and Weinzierl.[20] Recent papers by analysts at the Congressional Research Service also highlights a weak relation between lower tax rates and economic growth.[21]

Moreover, history has not been as kind to the verdict that tax cuts generate economic growth as substantial as the campaign’s rhetoric would suggest. For example, the massive and permanent tax increases associated with World War II do not appear to have had an impact on U.S. economic growth rates.[22] Likewise, the 1981 tax cuts, which cut the top rate from 70 percent to 50 percent, accounted for only a very small share of the growth of the economy between 1981 and 1986, according to Martin Feldstein, who advises the Romney campaign today and who was Chair of the Council of Economic Advisers under Reagan.[23] Feldstein and now-CBO director Douglas Elmendorf analyzed the 1981 tax cut and concluded that:

“Our evidence contradicts the popular view that the [early 1980s] recovery was the result of a consumer boom financed by reductions in the personal income tax. We also find no support for the proposition that the recovery reflected an increase in the supply of labor induced by the reduction in personal marginal income tax rates. … The driving force behind the recovery of nominal demand was the shift to an expansionary monetary policy. The rapid response in nominal GDP can be explained by monetary policy without any reference to changes in fiscal and tax policy.”[24]

The 1986 tax act is the most recent example of base-broadening, tax-rate reducing, revenue-neutral reform. In that act, the top personal income tax rate fell by 44 percent and the corporate rate fell by 26 percent. Auerbach and Slemrod document tepid economic growth responses to the 1986 tax act.[25]

Most recently, the 1993 hike of 8.6 percentage points in the top income tax rate did not stop a remarkably strong decade of economic expansion and budget balancing from occurring. The 2001 tax cuts had no appreciable impact on growth during the rest of the decade – through most of the decade (before the Great Recession) growth occurred mainly in housing and finance, two sectors that were not favored by the cuts. Gale and Potter estimate that the deficit-increasing effects of the 2001 tax cut, which reduced long-term economic growth, outweighed the marginal-tax-rate-cut effects, which increased growth, so that the net impact of the tax cut on long-term growth was negative.[26] It is difficult to translate this result, however, into an analysis of the effects of revenue-neutral reform without knowing how the base-broadeners needed to generate revenue-neutrality would affect incentives.

B. Discussion of Studies that build off of the TPC results

Three authors presented responses that start with the estimates we obtained, described above, and modify the results in different ways.

1. Jensen

Jensen suggested that eliminating the exclusion of interest on state and local bonds and the exclusion of inside-buildup on life insurance vehicles could raise “upwards of $90 billion” in 2015.[27] In response, we showed that an upper bound on the revenue obtained from eliminating these two exclusions is on the order of $49 billion ($29 billion for tax-exempt interest, $20 billion for life insurance), at least $4 billion of which would come from families with income under $200,000.[28] Jensen obtained a much higher estimate by including corporate changes and by confusing the tax expenditure estimates for these items with revenue estimates of repealing the provisions. In fact, because taxpayers respond to such changes, the tax expenditure estimates are significantly larger than the revenue implications of repeal.[29]

2. Dubay

Dubay argues that the $86 billion shortfall could be made up by a combination of taxing municipal bond income, taxing the inside build-up in life insurance vehicles, ending the step-up of basis on assets with capital gains that are transferred at death, and incorporating the effects of economic growth.[30]

The novel factor in this study relative to the others is the notion of ending basis step-up on capital gains transferred at death and replacing it with basis carry-forward. He uses the tax expenditure estimate from the fiscal year 2013 Federal Budget that suggests eliminating step up in basis would yield $19 billion.[31] However, Dubay overestimates the revenue that could be collected from this policy, for two reasons. First, the tax expenditure figure he cites comes from a comparison of basis step-up and full taxation of capital gains at death. Replacing basis step-up with basis carryover (under which the tax basis does not get changed, but taxes are not due at the transfer at death – they are due only if and when the asset is sold) would generate significantly less revenue.[32]

Second, the figure he cites is based on current-law projections of tax rates, which for long-term capital gains are more than 50 percent higher than they would be under Romney’s proposals (23.8 percent under current law compared to 15 percent under Romney’s proposals), thus inflating the tax expenditure estimates relative to what they would be under Romney’s proposals.

3. Brill

Brill argues that the $86 billion shortfall could be made up by a combination of taxing interest income from municipal bonds, taxing the inside buildup in life insurance, dropping Romney’s proposal to repeal health care reform from the baseline, and accounting for economic growth.[33] Relative to the other responses, the novel aspect of Brill’s response is his choice to omit health care taxes from the baseline. This raises several issues.

First, Brill suggests that Romney’s tax proposals should be evaluated relative to a baseline that excludes revenues from the ACA taxes—revenues which are highly progressive.

We believe that modifying the baseline to reduce overall revenue and progressivity amounts to moving up the goal line to make the goals artificially easier to achieve. Describing a policy as “revenue neutral” or suggesting that high-income households will pay the same share of taxes implies a commonly accepted baseline. (It’s not “revenue neutral except for those revenues.”) Our analysis draws on the same assumptions for the current policy baseline used by the Congressional Budget Office (whose “current policy” baseline is called the “alternative fiscal scenario”) and by other groups (e.g., Bowles-Simpson and Domenici-Rivlin). The ACA taxes are scheduled to begin on January 1, 2013. Those taxes will thus be in effect when the next president is inaugurated and are rightly considered not only part of “current law” (which takes the law as written) but also “current policy” (which attempts to reflect the trajectory of existing policies—including the likely extension of many expiring tax cuts—and is the baseline we used to analyze Romney’s proposals). Like them or not, the ACA taxes are now part of existing tax policy, and repealing them would be a tax cut—one that particularly benefits high-income taxpayers. More generally, selectively omitting certain disadvantageous features of the baseline to make a policy look better undermines the stated goals of revenue neutrality and the credibility of an analysis.

Second, Brill also suggests that the budget effect of repealing ACA taxes “should be analyzed in the context of the repeal of the various other health care provisions.” Romney wants to repeal the health care reform act (ACA), which is approximately revenue-neutral and very progressive.[34] ACA raises coverage for low- and middle-income households and raises taxes for higher-income households. Both individual elements are progressive. Repealing each provision would thus be unambiguously regressive. We are unable to include repeal of the coverage/spending changes in the tax model, which therefore leads us to understate the regressivity of Romney’s proposals in our model. Removing the revenue portions of Romney’s ACA-repeal proposal, as Brill would like to do, simply leads to a further understatement of the regressivity of Romney’s stated proposals.

From the perspective of households’ wallets, it is a matter of semantics whether ACA repeal is considered “tax policy” or “health policy.” (Similarly, whether curtailing the tax preference for health insurance is “tax reform” or “health reform” is a semantic issue not a substantive one.) What matters is that Romney proposed ACA repeal and doing so would be roughly revenue-neutral but would hurt middle- and low-income households and help high-income households. Hence, we believe that if there is a shortcoming of our analysis of Romney’s proposal to repeal ACA, it is not the inclusion of the revenue changes, but the inability (because we are using a tax model) to incorporate the spending/coverage changes. Had we been able to do so, our analysis would have shown it to be even more difficult to meet Romney’s stated goals.

Finally, for Brill’s plan (or Jensen’s or Dubay’s) to work, of course, one would have to eliminate all tax expenditures for people with income above $200,000 and this would require an enormous spike in the marginal tax rate at that income level. (We know this because Brill worked off of our analysis, and as noted above, our analysis was meant to provide an upper bound on the progressivity of the base broadeners, not an implementable version of tax reform. The same issue applies to Jensen’s and Dubay’s analysis.) That is, a household with income of $200,000 would receive all of its deductions, exclusions, exemptions, etc. But if the household members earned one more dollar, they would immediately lose all of their itemized deductions, their health insurance would be fully taxed, and so on. This would create a massive marginal tax rate at the $200,000 level. We believe it is fair to say that every sensible economist (and we include Brill in this category) would say that such a spike is a bad idea, is probably not administratively feasible, and would generate significant responses in terms of tax avoidance and labor supply. Fixing this problem to reduce the spike would inevitably either reduce revenues or raise middle-class tax burdens. Martin Feldstein has suggested that a phase-in of a cap on itemized deductions would cost about $15 billion.[35]

C. Responses to Feldstein and Rosen, which use 2009 Aggregate IRS data

Two responses by Feldstein and one by Rosen are based on 2009 aggregate IRS data.[36] These responses have several features in common. First, by using data from 2009, they understate the cost of tax cuts (relative to the revenue available from closing deductions), since the economy was so weak that year, and taxable income fell more than itemized deductions.[37] Second, neither author provides financing for estate tax repeal; Rosen does not even cover the costs of AMT repeal. As a result, their efforts at best only show that the policies they do consider could be financed, they do not show that the collection of Romney’s non-corporate tax cuts could be financed. In addition, both authors include substantial revenues from eliminating the standard deduction for individuals who have enough itemized deductions to itemize under current law, but not eliminating the standard deduction for individuals that do not have enough deductions to itemize under current law. This is a bizarre and unenforceable policy; any realistic implementation of a reduction in the standard deduction would either result in higher taxes on lower-income households (violating one goal of the proposal), or would require higher statutory tax rates on ordinary income (violating the stated 20 percent tax cut).

1. Feldstein

Feldstein first attempted to contradict our findings in an op-ed in the Wall Street Journal.[38] Instead, his analysis actually confirmed our central result. As we discuss in a response, under Feldstein’s suggested approach to financing Romney’s proposals, there would be significant tax increases on households with income between $100,000 and $200,000.[39] This is perfectly consistent with our initial conclusion, since (at the risk of stating the obvious) households with income between $100,000 and $200,000 fall in the category of “households with income under $200,000,” the group that we had indicated would have to face higher taxes if the Romney proposals were implemented and the group that Romney has said he considers to be part of the middle class.[40]

We also showed that Feldstein’s method of financing Romney’s proposals made a number of specific omissions and inappropriate assumptions (regarding the estate tax, the standard deduction, and the effective marginal tax rate) that implied that his plan would lose at least $90 billion per year and so wasn’t even close to revenue neutral.

In a response to our comments and that of others, Feldstein corrects a technical error regarding the effective marginal tax rate (which has the effect of reducing revenues), and so he adds new taxes on saving and investment to try (i.e., on the interest income from municipal bonds and inside build-up in life insurance policies) to offset this.[41] Because of the new taxes on saving and investment, his revised proposal imposes even larger tax increases on households with income between $100,000 and $200,000 than his original proposal. In addition, his revised proposal fails to provide a standard deduction for most high-income households and fails to specify financing of the estate tax repeal. Correcting for these factors implies that even his revised proposal is not revenue neutral, contradicting one of the other goals Romney laid out.

2. Rosen

Rosen examined similar issues and concluded that -- under his version of what constituted Romney’s proposals -- incorporating the effects of lower tax rates on economic growth, in combination with aggressive base broadening, could raise taxes on high-income households and hence avoid a middle- or lower-income tax increase in a revenue-neutral plan.[42] But Rosen overstates the case and adjusting for several factors turns his tax increase for high-income households into a tax cut (which would then have to be financed by households with income below $200,000) even if we grant his growth assumptions.

First, the biggest problem is simply that Rosen doesn’t finance all of the Romney proposed tax cuts; he finances only the 20 percent income tax rate reduction. He ignores estate tax repeal and AMT repeal, both of which would provide large tax cuts for high-income households.[43] Thus, although he claims that his analysis shows that taxes on high-income households would rise, he is omitting two major tax cuts that would primarily affect high-income households.

Second, he uses data from 2009, a year when the recession was in full swing and revenues were particularly low relative to itemized deductions (See the Appendix for documentation), thus overstating the revenue gain from eliminating itemized deductions relative to the revenue loss from cutting tax rates.

Third, the analysis assumes that high-income households who currently itemize would not benefit from the standard deduction. Ordinarily in the current system individuals whose itemized deductions fall below the value of the standard deduction simply choose to take the standard deduction. One interpretation is simply that Rosen (and Feldstein) have ignored this behavioral response, and that they have therefore incorrectly assumed too much additional tax revenues. A second interpretation is that this is a deliberate policy choice to eliminate the standard deduction, but only from former itemizers. However, this leads to a bizarre situation where people who would not have enough itemized deductions to itemize in the current system could take the standard deduction in Rosen’s system, but people who did have enough itemized deductions to itemize in the current system would receive neither the standard deduction nor itemized deductions in Rosen’s system. There is no precedent for such a policy, and it would be difficult to enforce if enacted. It is certainly possible to eliminate the standard deduction for all taxpayers, or to recover forgone revenue equal to the value of the standard deduction from higher-income taxpayers, but doing so would either result in a tax increase on low- and middle-income taxpayers, or would require higher statutory tax bracket rates, contravening the pledge to reduce those rates by 20 percent..

Fourth, he imposes new taxes on saving and investment (municipal bonds and inside build-up), which we would argue is not consistent with Romney’s stated objectives.

Adjusting for these factors (see the Appendix) -- that is, estimating what we feel is an reasonable interpretation of Romney’s proposals and goals -- takes what Rosen estimates as a $29 billion tax increase for households with income above $200,000 and turns it into a $41 billion tax cut for those same households, even if we grant the growth effects that Rosen assumes. Thus, high-income households would be receiving a tax cut, which would then have to be financed with higher taxes on other households or running a deficit or compromising some other element of Romney’s proposals.

Even if one allows the tax increases on saving to occur and even if one grants Rosen’s assumptions about economic growth, there would still be a net tax cut of $19 billion on households with income above $200,000, which would require tax increases on the rest of the population.

Also, for a number of reasons, we (and many other economists) believe that Rosen overstates the growth effects of Romney’s proposals. Adjusting that effect downward would further increase the size of the tax cut for households above $200,000 and thus imply even higher required tax increases on others. (See the Appendix for further discussion.)

V. Financing the tax cuts

Recently, Governor Romney mentioned some ways to finance at least some of the proposed tax cuts. He floated the idea of putting a cap on itemized deductions.[44] He suggested that possible levels of the cap could be $17,000, $25,000 or $50,000 and that the cap could phase out to zero at higher income levels.[45] An analysis by the Tax Policy Center shows that a $17,000 cap would raise $1.7 trillion over the next decade, a $25,000 cap would raise $1.3 trillion, and a $50,000 cap would raise $760 billion, if income tax rates were cut by 20 percent from current levels and the AMT were repealed.[46] Romney campaign staff also floated the idea of imposing a tax on health insurance or pulling back on personal exemptions but specifics do not appear to be available.[47]

Thinking about how to finance the tax cuts is a step in the right direction. However, capping itemized deductions falls far short of financing his proposed tax cuts. It is also interesting to note that, consistent with TPC’s assumptions, Romney did not propose new taxes on any form of saving.

VI. Conclusion

By now, there is overwhelming evidence and widespread understanding that Governor Romney overpromised on the tax side. Alan Viard, an economist at the American Enterprise noted in the New York Times that Romney is “going to need to cut rates significantly less than 20 percent if he wants to honor his other goals.”[48] Dan Shaviro, a lawyer and tax expert at New York University has said of the Romney proposals: “There really is no serious dispute that the parameters of their plan can’t be met... There’s just no way to make the numbers add up.”[49] Josh Barro – a Bloomberg columnist and former senior fellow at the Manhattan Institute – has said “There you have the six “studies” on which the Romney campaign has based its defense of Romney’s tax plan. Individually and collectively they fail the task.” [50] The Economist magazine writes that “The same calculations the Tax Policy Center made in August still hold” and that “[Romney’s] response is an acknowledgement that he can’t make his numbers add up.”[51] Martin Sullivan, an economist and journalist for Tax Notes said that “I like tax reform. I want to broaden the base. It’s something I’ve devoted my life to. And I welcome Governor Romney and the Republicans’ strong push, but the plan doesn’t work out. It’s not mathematically possible.”[52]

Tax reform is a difficult task, but not impossible. The parameters that Governor Romney offered are significantly different from previous tax reform proposals and efforts. For example, the Tax Reform Act of 1986 was able to reduce rates and remain revenue- and distributionally-neutral by taxing capital gains as ordinary income, eliminating many then-existing tax shelters for non-corporate investors, and increasing corporate taxes substantially. Similarly, the plan of the co-chairs of the National Commission on Fiscal Responsibility and Reform (Erskine Bowles and Alan Simpson) and the proposals submitted by Bipartisan Policy Center’s Debt Reduction Task Force (under the leadership of Pete Domenici and Alice Rivlin) helped to finance their proposed rate reductions by including among their base-broadening measures the taxation of capital gains and dividends as ordinary income.[53] But these are precisely the proposals that Romney has sworn off.

Romney is not the first politician to overpromise on the tax side and won’t be the last. As discussions about tax reform move from the campaign trail to (we hope) the halls of Congress, realistic recognition of the trade-offs would be a huge step in the right direction.

Appendix: Discussion of Rosen (2012)

(1) Use of 2009 data will understate the revenue losses from tax cuts, relative to the revenue gained from closing itemized deductions. Due to the Great Recession and other factors, 2009 was an unusual year in tax terms, with particularly low taxable income and low tax revenue. (If there is little revenue to begin with, cutting taxes doesn’t cost very much). For example, a key measure in thinking about Rosen’s (and Feldstein’s) analysis is the ratio of taxes paid to the size of itemized deductions (since he reduces tax rates and then eliminates itemized deductions). For different measures of itemized deductions employed (all, or just the ones that Rosen eliminates) and the income group used (over $100,000 or over $200,000), that ratio was about 15 percent higher in 2006, a normal tax and economic year that predates the Great Recession than it was in 2009.[54] The result is that Rosen’s analysis significantly understates the revenue lost from tax cuts and/or overstates the revenue gained from eliminating itemized deductions in a year that is more normal than 2009.

(2) Rosen understates revenue losses by ignoring the cost of repeal of the estate tax. The estate tax is the single most progressive tax in the entire federal system and because it raised $21 billion in 2009. JCT, CBO, and Treasury consistently estimate that repeal would not only lose revenue but could actually lose more revenue than the estate tax collects because it would create opportunities for tax avoidance.

(3) Rosen understates revenue losses by ignoring the repeal of the AMT. This cost is partly mitigated by the fact that Rosen only reduces the deductions for state and local taxes by half.

(4) Rosen’s analysis removes itemized deductions for high-income households, but does not offer those households the option to use the standard deduction. Normally, taxpayers have the choice of itemized or standard deductions, and the standard deduction is not considered a tax expenditure. Under the proposal examined by Rosen, taxpayers with income above $100,000 who had previously taken the standard deduction would continue to take the standard deduction, but taxpayers with income above $100,000 who had taken itemized deductions would be granted neither the itemized deduction or a standard deduction.

(5) Rosen raises revenue from taxing the return to saving – in particular, by taxing the interest income on municipal bonds and taxing inside build-up in life-insurance vehicles.

A Recalculation

What do these assumptions and features imply? It is beyond the scope of this short piece to fully estimate the various changes involved. But here are some rough calculations that suggest how the analysis would change, for some of the issues raised above.

Rosen argues that households with income above $200,000 would receive a $81 billion tax cut from Romney’s various tax cut proposals, that broadening the base would raise $95 billion in taxes from these households, and that supply responses would generate another $15 billion, for a total tax increase of $29 billion (-81+95+15).

Including estate tax repeal would provide an additional tax cut of about $21 billion. Since about 94 percent of the elimination of the estate tax would benefit households in the top 5%, eliminating it would provide a tax cut of around $20 billion to those making more than $200,000.[55]
Including AMT repeal would reduce revenues by $20 billion among those with income above $200,000. Eliminating the remaining state and local tax deductions that Rosen did not repeal would raise about $15 billion in the same income group, so the net reduction in revenue would be $5 billion.
Allowing for a more normal revenue year would raise pre-tax-cut revenues by 15 percent relative to itemized deductions and thus raise the cost of tax cuts relative to itemized deductions by 15 percent. This would increase the revenue loss among high-income taxpayers by about $12 billion.

Thus, the tax cut for households with income above $200,000 would be more like $118 billion ( = 81 + 20 + 5 + 12)

The tax cut for high-income households would be $10 billion larger if we allowed for standard deductions for households that lose itemized deductions (assuming a 24 percent effective rate under Romney’s proposals).
Not eliminating the tax preferences on saving (municipal bonds and inside-build up on life insurance) would reduce revenue from base broadening by about $22 billion (assuming a 24 percent tax rate under Romney’s proposals -- $14 billion for inside build up and $8 billion for municipal bonds).

As a result, the base broadening measures for households with income above $200,000 would raise about $63 billion ( = 95 – 22 – 10). This implies that the net tax cut for households with income above $200,000 would be $40 billion (118 – 63 – 15), even if we grant the growth effects that Rosen assumes.

Additional Issues

Several other issues are hard to quantify precisely but worth noting. First, Rosen overstates the revenue gain by ignoring the micro-behavioral responses to base-broadening. Rosen discusses and includes the effects of how taxpayers adjust their activities in response to lower tax rates (“micro behavioral” responses to tax rate cuts, which tend to reduce the revenue loss) but he neglects to include similar effects for how taxpayers respond to base-broadening measures. For example, he does not allow for the possibility that taxpayers with mortgages would likely choose to pay down their mortgages with taxable assets (and thus reduce taxable investment income) if the mortgage interest deduction were removed. Accurate scoring that includes such effects suggests that the revenue available from base-broadening is significantly smaller than Rosen’s static estimates (or base-broadening) would suggest. The tax cut for high-income households would rise further if one adjusted for individual taxpayer micro-behavioral responses to base- broadening (like reducing mortgage interest payments).[56]

Second, Rosen overstates the revenue gain by ignoring the macro-behavioral responses to base-broadening. If tax reform is truly going to be revenue-neutral and distributionally-neutral then effective marginal tax rates that take into account both the sources and uses of funds would not change very much if at all and certainly the reduction in marginal income tax rates alone -- ignoring the base-broadening -- would overstate the decline in effective marginal tax rates.[57] Brill and Viard (2011) provide further discussion of this point.

Third. Rosen does not incorporate the effects of the increase in the effective marginal tax rate that his proposal would create by eliminating itemized deductions and the exclusion of health insurance. If these tax expenditures were completely removed for all households, there would a large increase in low- and middle-class taxes even under Romney’s tax cut proposals. If the tax expenditure cuts are phased in as income rises (or introduced as a spike at $200,000), then they will increase effective marginal tax rates. Rosen’s analysis ignores these issues.

Finally, even ignoring the issues noted above, Rosen’s growth effects seem too large relative to the literature. He acknowledges that 3 percent growth (based on comparisons to current policy) is an educated guess, not the result of a rigorous proof. But 3 percent growth generates a 17.3 percent revenue feedback (24.9/143.9) for households with income above $100,000 and an 18.2 percent feedback for households with income above $200,000. Estimates by Mankiw and Weinzierl generate only a 15 percent feedback and that is in a model that cuts all capital and labor income taxes and where the response to capital income taxes is larger than labor income taxes.[58] In contrast, Governor Romney’s stated proposals do not cut capital gains and dividends tax rates for households above $200,000 (and these households receive a large share of aggregate capital gains and dividends). To be clear, we believe that JCT and CBO estimates support lower feedback mechanisms than Mankiw and Weinzierl. Our point is just that Rosen’s feedbacks are even higher than those presented by Mankiw and Weinzierl but the tax cuts proposed by Romney are less expansive, especially with respect to capital income, than the ones evaluated in Mankiw and Weinzierl.

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Footnotes

[1] Romney (2012a) and Romney (2012b).

[2] The $5 trillion figure is not a formal estimate. For a discussion of its derivation, see Marron (2012b).

[3] Brown, Gale, and Looney (2012a).

[4] Romney (2012b), Situation Room with Wolf Blitzer (2012), and CNN Political Unit (2012).

[5] For other reviews of the various critiques and issues see: Barro (2012), Greenberg (2012), Khimm (2012), and Matthews (2012).

[6] Our second paper is Brown, Gale, and Looney (2012b). For one example of the incorrect claim that we ”downgraded” our estimate, see Brill (2012). Brill and others appear to have confused our providing an estimate of two policies that they advocated (taxing municipal bond interest and taxing inside build-up in life insurance plans) with our endorsing those policies as consistent with Romney’s stated goals.

[7] Romney (2012b).

[8] Tax Policy Center (2012a).

[9] For related discussion, see Marron (2012a) and Nguyen et al. (2012).

[10] A detailed description of TPC’s microsimulation model is available at http://taxpolicycenter.org/taxtopics/TPC-Model-Overview-2012.cfm.

[11] Tax Policy Center (2012a).

[12] Marron (2012b).

[13] Nguyen et al. (2012).

[14] We are using the more familiar term “household,” instead of the technically accurate “tax unit.” A tax unit is an individual who files a tax return, or a married couple who file a tax return jointly, along with all dependents of that individual or married couple. A tax unit is technically different than a family or a household in certain situations: two persons cohabiting would be considered one household but if they were not legally married, they would file separate tax returns and thus be considered two tax units.

[15] Mankiw and Weinzierl (2006).

[16] Although there is no Romney tax plan, only a set of proposals for tax cuts coupled with unspecified base-broadening, some authors have nevertheless attempted to estimate the effects of what they see as a plan. Diamond (2012) estimates that “the Romney tax plan” would have favorable economic effects. He assumes that the tax cuts are paid for on a static basis, but he does not specify how the base-broadening occurs. Entin and McBride (2012) also estimate favorable economic effects of “Romney’s tax plan” but they do not specify offsets at all and they include revenue feedbacks that are about four times as large as those in Mankiw and Weinzierl (2006).

[17] Romney (2011), page 40.

[18] Romney (2012b).

[19] Mankiw and Weinzierl (2006).

[20] CBO (2003), CBO (2005), and JCT (2005).

[21] Hungerford (2012), Gravelle and Marples (2011).

[22] Stokey and Rebelo (1995).

[23] Feldstein (1986).

[24] Feldstein and Elmendorf (1989).

[25] Auerbach and Slemrod (1997).

[26] Gale and Potter (2002).

[27] Jensen (2012).

[28] Brown, Gale, and Looney (2012b).

[29] It is also worth noting that the estimates above refer to removing the tax exemption on all state and local bonds and taxing the inside build-up on all existing life insurance contracts. Changing the tax treatment only of new bond issues or new insurance contracts would raise far less revenue. Barthold (2012).

[30] Dubay (2012).

[31] OMB (2012).

[32] OMB (2012), page 273.

[33] Brill (2012).

[34] Romney (2011), page 59.

[35] Feldstein (2012b).

[36] IRS (2012).

[37] In 2009, itemized deductions for tax filers making more than $200,000 AGI were 6 percent lower than 2006, a normal economic and tax year. Taxable income for these filers, however, was almost 25 percent lower.

[38] Feldstein (2012a).

[39] Brown, Gale, and Looney (2012c). The income measures that we and Feldstein use differ somewhat. Feldstein uses adjusted gross income, whereas we use cash income, a more comprehensive measure (for a description of the cash income measure, see http://www.taxpolicycenter.org/numbers/displayatab.cfm?DocID=574). In 2009, 2.8 percent of households had AGI above $200,000 (in 2009 dollars), compared to 5.2 percent with cash income above $200,000 (in 2011 dollars) for our estimates for 2015.

[40] Stephanopolous (2012).

[41] Feldstein (2012b).

[42] Rosen (2012).

[43] Rosen also ignores the capital income tax cuts for households with income below $200,000. Since we focus on his results for households above $200,000, we do not address that issue here.

[44] Krieg (2012).

[45] Gabriel and Cooper (2012).

[46] Tax Policy Center (2012c).

[47] Rubin (2012).

[48] Lowrey and Kocieniewski (2012).

[49] Rubin and Przybyla (2012).

[50] Barro (2012).

[51] Democracy in America. (2012).

[52] Quoted in Lowrey (2012).

[53] National Commission on Fiscal Responsibility and Reform (2010) and Debt Reduction Task Force (2010).

[54] For taxable returns with AGI greater than $200,000, the ratio of income tax before credits to itemized deductions was 1.73 in 2006. By 2009, the ratio had decreased to 1.50. SOI (2012).

[55] Tax Policy Center (2012b).

[56] For example, see Poterba and Sinai (2008).

[57] For example, someone who faces a 35 percent statutory tax rate but exempts 20 percent of their income from tax using itemized deductions and other tax preferences actually faces an effective marginal tax rate of 28 percent (80 percent of 35 percent). If the statutory rate were reduced to 28 percent and the itemized deductions and other tax preferences were removed, the taxpayer would continue to face an effective marginal tax rate of 28 percent, so no change would be expected in their labor supply from the “20 percent marginal tax rate cut.”

[58] Mankiw and Weinzierl (2006).

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TPC’s Analysis of Governor Romney’s Tax Proposals: A Follow-up Discussion

Authors

Samuel Brown
William G. Gale
Adam Looney

An Updated Federal Budget Outlook: No News Is Bad News

Alan J. Auerbach and William G. Gale — Wed, 10 Oct 2012 11:31:00 -0400

Abstract

This article updates the authors’ most recent analysis of the budget outlook to incorporate the latest Congressional Budget Office projections and updated long-run data from the annual reports of the board of trustees for Social Security and Medicare and Medicaid, the Centers for Medicare & Medicaid Services actuary, and the CBO. The authors thank Samuel Brown and Fernando Saltiel for research assistance. All opinions and errors are the authors’ and should not be attributed to the staff, officers, or trustees of any of the institutions with which they are affiliated.

Although the official budget figures have improved from a year ago, realistic budget projections continue to show a troublesome medium-term outlook and an unsustainable long-term outlook. Even with the economy recovering fully by 2018, as projected by the CBO, a path following current policies on taxes and spending will result in deficits close to $9 trillion (4.5 percent of GDP) over the next decade, with the debt-to-GDP ratio exceeding 85 percent by 2022 and continuing to rise thereafter.

The long-term budget outlook is sensitive to assumptions about how healthcare spending will respond to recent legislation. Assuming that current policy holds for the next decade, the long-term fiscal gap ranges between 6.1 and 9 percent of GDP, depending on the assumed growth rate of healthcare outlays. Policymakers and the public will eventually be forced to address those issues. Although a still weak economy limits the scope for large adjustments immediately, addressing the long-term imbalance soon will allow for more reasonable and gradual adjustments.

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An Updated Federal Budget Outlook: No News Is Bad News

Authors

Alan J. Auerbach
William G. Gale

Publication: Tax Notes

Mitt Romney's Tax Proposals: Understanding the Debate

William G. Gale — Mon, 08 Oct 2012 11:27:00 -0400

For months, Mitt Romney had been advocating tax cut proposals that would reduce revenues by about $5 trillion over the next decade, and that were heavily tilted toward the rich. Yet he did not explain how he would pay for these cuts, just that he somehow would.

In a recent paper I wrote with two colleagues, we showed that a revenue-neutral plan that met five specific goals that Governor Romney had put forth (reducing income tax rates by 20 percent, repealing the estate tax, the alternative minimum tax, and capital income taxes for middle class households, and enhancing saving and investment) would cut taxes for households with income above $200,000, and—as a result of revenue-neutrality—would therefore necessarily have to raise taxes on taxpayers below $200,000.

This was true even when we bent over backwards to make the plan as favorable to Romney as possible. We considered an unrealistically progressive way of financing the specified tax reductions. We accounted for revenue feedback coming from potential economic growth estimates as estimated by Romney advisor Greg Mankiw. We even ignored the need to finance about a trillion dollars in Romney's proposed corporate cuts.

Our conclusion was not a prediction about Governor Romney would do as president, it was an arithmetic calculation: all of the promises couldn't be met simultaneously without resorting to tax increases on households with income below $200,000.

With both candidates referring to the study in the first debate, several responses to the study having been published, new proposals from Governor Romney on the table, and confusing and misleading partisan jabs on both sides of the aisle, it is time to take a new look at this discussion and help readers understand what is going on.

To do that, let's get out of the hyper-charged world of tax policy for a second.

Suppose Governor Romney said that he wants to drive a car from Boston to Los Angeles in 15 hours. And suppose some analysts employed tools of arithmetic to conclude that "If Governor Romney wants to drive from Boston to LA in 15 hours, it is mathematically impossible to avoid speeding." After all, the drive from LA to Boston is about 3,000 miles, so to take only 15 hours would require an average of 200 miles per hour. Certainly other road trips are possible—but the particular one proposed here is not.

(Note: this is just an example that uses the logic to be employed; I am not suggesting that Romney has in any way broken a law.)

Especially in this inflamed campaign environment, one can imagine the frenzied responses. The Obama campaign might put ads out that say Romney wants to speed or is going to speed. Romney's campaign might respond by saying the study is a "joke" and "partisan," that he supports speeding laws and would never, ever speed, and it is ridiculous to suggest that he would. The Romney campaign and its surrogates might say that the analysts must be wrong because they don't even know what his road plan is or which car he would drive. Besides, Romney never really said he wanted to go LA, he might want to go somewhere closer; he could get to LA without speeding if he took more than 15 hours; he could get somewhere else in 15 hours without speeding. And so on.

With a few substitutions, this is almost exactly how the tax debate has evolved. Substitute "the various tax cuts Romney has proposed" for "driving from Boston to LA;" substitute revenue-neutrality for "in 15 hours;" substitute "tax increases on households with income below 200k and tax cuts for higher income households" for "speeding" and you have the basic story: Romney can't do all of the tax cut proposals he has advocated, remain revenue neutral, and avoid taxing households with income below $200,000 or cutting taxes for higher income households.

Substitute "the full Romney tax plan" (which, by the way, does not exist) for the choice or road plan or car and you have the common complaint, "how can you evaluate the specific proposals when the overall tax plan is not even fully specified?" The answer to which is that even with incomplete information, there is enough to understand some of the implications.

Most obviously, despite all of the hoopla and name-calling, no one has proved or really even tried to prove that the analysts' original calculation was wrong—the proposed trip would require speeding, and Romney's original tax proposals would require tax increases on households below $200,000.

Romney has now also said that he does not want to raise taxes on the middle class and does not want to cut them for high-income households. Those seem like reasonable goals, but they don't break the knot. They simply add two more constraints to the list of goals he would like to achieve and makes the list even more impossible (if there is such a thing) to achieve jointly than the earlier list.

Romney campaign surrogates and right-wing media outlets have focused on the idea that new taxes on saving and investment should be imposed. After decades of these same outlets claiming that taxes on saving and investment are bad for the economy, scholars at AEI, Heritage, some academics and the Wall Street Journal editorial page appear lined up behind higher taxes on some forms of interest income, and removal of tax-deferral on some long-term saving products, as a way to finance part of the Romney tax plan. This is an interesting development and should be pursued.

To be clear, though, pursuing this policy wouldn't be refuting our earlier study, it would be accepting the constraints and conclusions there and finding a way around them.

Likewise, Romney's recent support of placing a cap on taxapayers' itemized deductions has the potential to finance some of the tax cuts, and so is a step in the right direction. It remains to be seen, though, whether Romney can develop enough "pay-fors" to cover his tax cuts and not burden the middle class.

Or as one example of what might happen, Alan Viard, a scholar at the American Enterprise Institute noted in the New York Times, suggested that Romney is "going to need to cut rates significantly less than 20 percent if he wants to honor his other goals." Exactly: something would have to give.

More generally, the basic power of arithmetic is overwhelming in showing that Governor Romney has so far overpromised on the tax side.

You still can't drive cross country in 15 hours without speeding.

Authors

William G. Gale

Publication: Real Clear Markets