William Gale, a senior fellow at Brookings, and G. William Hoagland, staff director of the Senate Budget Committee, will present opposing views on the current issues. Following their presentations, Gale and Hoagland will join a panel of experts in a discussion moderated by Alan Murray, Washington Bureau Chief of the Wall Street Journal.

      

 

 

No matter how they figure their liability, many Americans wonder why such a large share of their income goes to Uncle Sam. In 1998, federal, state, and local taxes reached the highest level ever, comprising just less than a third of all income generated. That’s because the rich are getting richer, and due to 1990 and 1993 tax reforms, they pay higher rates. But, for the vast majority of families, taxes remain as low or lower than in any time during the past twenty to thirty years. A family of four can earn as much as $28,200 and pay no federal income taxes. So why do the Republicans clamor for tax cuts?

As Americans complete their form 1040s, three experts convened at Brookings will provide straightforward answers to the tangle of tax questions that reappear each year:

• Can and will taxes be simplified?
• Are Americans overtaxed?
• What are the prospects for across-the-board tax cuts?
• Should Congress adjust the marriage penalty or enact other targeted tax cuts?

      

 

 

The plans put forward by leading Republicans in Congress – the Ryan-Brady plan – and the plan that Trump put forward during the campaign share many features.  Both plans, for instance, would slash individual tax rates.

But there are several issues where it might be hard to reach agreement, even among Republicans. Most of them are on the business side.  During the campaign, Trump said he would cut the top corporate rate from 35 percent to 15 percent, lower the top rate faced by pass-through entities (sole proprietorships, partnerships, and S corporations) to 15 percent, allow for expensing of investment instead of depreciation, repeal certain business tax expenditures, and impose a one-time tax on existing un-repatriated earnings.

The House plan would abolish the corporate tax altogether and replace it with what is called a “destination-based cash-flow” tax.   A classic value-added tax, a national tax on consumption, would tax only wages and business profits.  This one is slightly different:  It’s a value-added tax with a deduction for wages, so it would only burden business profits.  The rate would be 20 percent for corporations and 25 percent for pass-through entities.  The plan also includes provisions to make it harder for taxpayers to shift their income from wage earnings to pass-through income. Like all VATs worldwide, the House plan would allow for border-adjustability:  revenues from exports would not be taxed, and the cost of imports would not be deductible.

The proposals raise many interesting issues.  According to Tax Policy Center and Penn-Wharton Budget Model estimates, the Trump plan would have an initial positive short-term stimulus effect, but the added debt – $7 trillion over the next 10 years – would eventually cause economic growth to decline, and the economy would end up smaller after a decade than without the plan. This is in contrast to Trump’s claim that the plan would be “the most pro-growth…plan put forth perhaps in the history of our country.”  The Ryan-Brady plan would lose less revenue than Trump’s proposal, but still would cost several trillion dollars over the next decade.  It would raise GDP by 1 percent after a decade,  but after two decades, the economy would be smaller than under current law because of the added debt burden.  This estimate is consistent with the historical evidence that shows tax cuts do not necessarily spur economic growth.

Under both plans, the benefits are highly skewed towards the very rich, not the middle class (as originally claimed). Even though households in every income quintile would receive a tax cut under Trump’s plan, once the plan is fully phased-in, the lowest quintile would only receive a less than 1 percent increase in after-tax income compared to a 7 percent increase for the top quintile. The gains for the top 1 percent would be even greater at 14 percent (an average gain of more than $300,000).  Under the Ryan-Brady plan, the story is broadly similar.  However, those in the 60th-95th percentile would experience a drop in after-tax income.

The regressivity of the tax plans would be exacerbated once the tax cuts are actually paid for.  Because the government budget is currently on an unsustainable path, any reduction in the projected revenue stream must be made up for, over time, by some combination of new revenues or lower spending. For example, let’s assume that Trump’s tax plan is eventually financed by an equal dollar payment from each tax unit (through an across-the-board reduction in benefits from government spending or a lump-sum tax) or a payment from each tax unit in proportion to their income (though a reasonable combination of spending cuts and progressive tax increases). Under either financing scenario, households in the bottom 80 percent of the income distribution would be worse off relative to current law, while the top quintile would still experience a net increase in after-tax income.

Uncertainty about the tax cut is high, though.  The tax cuts could end up being much bigger than advertised.   In both the Trump and the House Republican plans, there are a number of “pay-fors” – such as cuts in itemized deductions, removal of the deduction for interest payments, and taxes on imports – that normally one party does not implement by itself.  Tax increases like this place a political target on those in power, especially given the Republicans’ unified control.  On the other hand, deficit hawks might balk at the overall size of the cuts, and push for a smaller revenue loss than the current plans call for.

Several questions also surround the status of international trade as a result of these plans.  Many legal experts think the House plan violates existing trade laws, although there may be ways to design the tax that skirt the rules.  In addition, despite economists’ assurances that border adjustability will lead to exchange rate adjustments and thus will not affect trade balances, many people believe that the Ryan-Brady plan will reduce the trade deficit (if they support the tax) or raise the price of imports (if they oppose the tax).

Tax changes may be an idea whose time has come politically – given the forthcoming Republican unified control and Trump’s emphasis on reducing the trade deficit.  Regardless which plan most closely resembles the eventual deal between Trump and Congress, the U.S. tax system may look very different by the end of next year.

Authors

William G. Gale

The Arjay and France Fearing Miller Chair in Federal Economic Policy

Senior Fellow - Economic Studies

Director - Retirement Security Project

Co-Director - Urban-Brookings Tax Policy Center

A

Aaron Krupkin

Senior Research Analyst - Urban-Brookings Tax Policy Center

      

 

 

At 77 percent of GDP, federal debt is already the highest relative to the economy in U.S. history except for a few years around World War II.  Additionally, we are on the cusp of the full-on retirement of the Baby Boom generation, which will increase spending on Social Security and Medicare.  Our most recent current policy projections with Alan Auerbach imply that the debt will rise to 93 percent of GDP by 2026 and 150 percent by 2046, even if we assume the economy is near full-employment the entire time and we fight no new wars.  These projections also assume there are no new major changes to taxes or spending.  The rising debt will crowd out investment and stymie growth in the long-term.

At present, low interest rates – the one silver lining in the projections – suggest that the crowding effect is minimal.  But there are clouds on that horizon, too.  First, the Fed recently announced an increase in the federal funds rate of 25 basis points. This still leaves the U.S. with low interest rates. But historically, when the Fed has begun raising interest rates, it often follows up with a succession of rate increases.  Second, even if the Fed increase was undone and rates stayed constant over time, debt would still rise to about 119 percent of GDP by 2046.

Events in 2017 are likely to make the fiscal outlook more troubling.  With the election of Donald Trump as president and the Republicans’ retention of a majority in the Senate and the House, major tax changes seem likely.  Donald Trump and the House Republicans have proposed tax plans that would reduce revenues by $6.0 trillion and $2.5 trillion, respectively, according to Tax Policy Center and Penn-Wharton Budget Model estimates, even after accounting for effects on economic growth.  But leading Republicans have sent mixed signals about how big a tax cut, if any, will be, with some Congressional leaders suggesting their plan will be revenue neutral, and Trump claiming that economic growth would reduce the cost of his plan to $2.6 trillion and that the revenue losses would be made up for via spending reforms, trade, energy programs, and regulatory reform.

The Committee for a Responsible Federal Budget estimates that Trump’s tax and spending proposals – the latter including replacing the Affordable Care Act, modifying Medicaid, boosting military spending, and enacting savings in non-defense programs – imply that the debt will rise to 105 percent of GDP by 2026. The CRFB report leaves out any estimate of increased infrastructure spending, which Trump has said he would like to increase by roughly $1 trillion over a decade. Including that would add further to the debt figures.

The basic conclusion is that the fiscal outlook will deteriorate in 2017, but there are a couple of wildcards, too.  First, it is not clear by how much – that is, it is not clear how aggressive Trump and Congressional Republicans will be in pursuing tax cuts as opposed to structural reforms and increased spending – though one suspects that tax changes and repeal of Obamacare will be high on their list.  Second, the Republicans have railed against debt limit increases in recent years.  How they address that issue – which they will likely face as early as March – could change the fiscal course. Financial markets currently seem unconcerned about these fiscal prospects, but that could change abruptly.

      

 

 

In this paper, we focus on the implications of different interest rate scenarios for federal budget projections over a medium-term (10–30 year) horizon. We use the methodology and assumptions reported in Auerbach and Gale (2016), which has been updated to reflect the most recent projections by government agencies.[1]

Our baseline medium-term projections indicate that federal debt will rise from 77 percent of GDP at the end of 2016 to 93 percent of GDP in 2026 and all the way up to 150 percent of GDP by 2046 (see table 1 and figure 1). Those projections have increases in interest rates already built in. We use interest rate assumptions developed by the Congressional Budget Office (CBO), which projects that the average nominal interest rate on federal debt will rise from 1.9 percent in 2016 to 3.3 percent in 2026. The CBO expects inflation to remain fairly constant, so the projections simply increase in real interest rates through 2026. We then hold the interest rate constant at 3.3 percent through 2046. Because of rising interest rates and already high levels of debt, net interest payments rise from 1.4 percent of GDP in 2016 to 4.6 percent of GDP in 2046 (table 1). By comparison, the previous high for net interest payments as a share of GDP was 3.2 percent in 1991. 

The debt-GDP projections are sensitive to interest rate assumptions. Lower interest rates reduce the projected medium-term increase in debt. For example, if the interest rate on federal debt stays at its current low rate of 1.9 percent for the next 30 years, we project that the debt to GDP ratio would still rise over time but only to 119 percent of GDP in 2046 (table 1, figure 1). Net interest payments would also rise—because debt rises—but only to 2.1 percent of GDP in 2046.

But if interest rates rise faster than in the base case, the debt to GDP ratio will grow more quickly. Suppose interest rates rise as the CBO projects through 2026 and then gradually rise further to 5.2 percent by 2046. The latter figure represents the long-term nominal interest rate projected by the Social Security trustees, adjusted for differences in economic growth assumptions between the trustees’ report and the CBO Long-Term Budget Outlook.[2] Under those assumptions, the debt-GDP ratio would reach 175 percent by 2046 (figure 1), with net interest payments equaling 8.4 percent of GDP in that year (table 1).

The “fiscal gap” measures the size of the constant-share-of-GDP increase in taxes and the reductions in noninterest spending that would be required to meet a given future debt to GDP target in a given year. Under the base case for interest rates, with policy changes starting in 2017, the fiscal gap to reach the current debt to GDP ratio of 77 percent in 2046 is 2.7 percent of GDP (table 1).

Changes in interest rates have larger effects on the projected debt to GDP ratio than on the fiscal gap, because debt increases affect the fiscal gap only to the extent of the added annual interest payments (as a share of GDP) that is needed to keep the debt to GDP ratio from growing. Under the low interest rate scenario, the fiscal gap is 1.9 percent of GDP, while under the high interest rate scenario, it is 3.1 percent of GDP (compared to 2.7 percent of GDP in the base case).

Thus, even if interest rate rates stay low, a sizeable change in noninterest spending, in taxes, or in both is still necessary to attain a debt to GDP ratio of 77 percent in 30 years. The fiscal gap is larger to the extent that policy adjustments begin at a date later than 2017 or the debt target is reduced below the current 77 percent level (table 1).

Although higher interest rates make the medium-term situation worse, they also increase the likelihood that policymakers will respond. When policymakers reached agreement on the 1990 and 1993 budget deals, the debt was much lower than it is today, but net interest payments as a share of GDP were higher. The amount of funds going to net interest payments helped galvanize attention to the deficit problem at that time.[3]

Notes:

a. Unless otherwise noted, values are percentages of GDP.

b. In the low interest rate scenario, the nominal interest rate is constant at 1.9 percent through 2046. In the high interest rate scenario, the nominal interest rate gradually rises from 1.9 percent in 2016 to 5.2 percent in 2046.

[1] Alan J. Auerbach and William G. Gale “Once More unto the Breach: The Deteriorating Fiscal Outlook,” Brookings Institution, Washington, DC, February 22, 2016, https://www.brookings.edu/research/once-more-unto-the-breach-the-deteriorating-fiscal-outlook/.

[2] Nominal economic growth from 2026 to 2046 averages 4.43 percent in the trustees’ report and 4.25 percent in the Long-Term Budget Outlook. See the Board of Trustees, Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds, “The 2016 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds,” 2016. See also Congressional Budget Office, “The 2016 Long-Term Budget Outlook,” Congressional Budget Office, Washington, DC, 2016.

[3] See Rudolph G. Penner, “The Political Economics of the 1990 Budget Agreement,” in Fiscal Politics and the Budget Enforcement Act, ed. Marvin H. Kosters (Washington, DC: AEI Press, 1992).

      

 

 

The standard, but failed, approach often advocated by conservatives is to cut taxes for high-income households.  Ever since the 1970s, when Jude Wanniski and Arthur Laffer came up with what’s become known as supply-side economics, conservative politicians have found it difficult to resist the notion that tax cuts for high-income households are good for all and will “trickle down” to the rest of the economy.  In the extreme versions that thrived through the beginning of the Reagan Administration, some supply-siders argued that tax cuts would pay for themselves by substantially increasing overall economic growth.  Decades of experience make that claim impossible to support, so advocates now make the more modest claim that tax cuts will spur enough growth to make up a large enough share of the revenue losses to still be good economic policy.

But the record is clear that deficit-financed tax cuts on high-income households and businesses have failed to boost growth at the federal or state level in the U.S., or in other countries.  For example, when growth is (appropriately) measured from peak to peak of the business cycle, the vaunted Reagan tax cuts produced a period of only average growth.  Indeed, research by Martin Feldstein, President Reagan’s former chief economist, and Douglas Elmendorf, the former Democrat-appointed Congressional Budget Office Director, concluded that the 1981 tax cuts had virtually no net impact on growth.  Instead, the post-recession recovery of the early 1980s benefited primarily from the Fed’s decision to reduce interest rates.

The record is clear that deficit-financed tax cuts on high-income households and businesses have failed to boost growth at the federal or state level in the U.S., or in other countries.

Nor did the 2001 and 2003 Bush tax cuts stimulate much, if any, growth. Despite cuts in tax rates on ordinary income, capital gains, dividends and estates, the economy grew sluggishly after 2001.  Moreover, even that lackluster growth is generally attributed to the Fed’s expansionary monetary policy (and to a housing boom that unfortunately went bust and triggered the Great Recession of 2008-9).

States have not fared better with high-income tax cuts.  On the advice of Donald Trump’s economic advisor Stephen Moore and others, Gov. Sam Brownback (R-KS) argued in 2012 that an income tax cut would be “like a shot of adrenaline into the heart of the Kansas economy.” Alas, the tax cuts coincided with an economic decline that continues to this day.  In the wake of faltering revenues, the state has cut education and raised more regressive taxes.  Other states that enacted tax cuts have similar stories to tell.

Top tax rate cuts fare no better in cross-country comparisons. There is no relationship  between changes in top marginal tax rates and growth between 1960-2010.  For example, the United States cut its top rate by over 40 percentage points and grew just over 2 percent annually per capita over that period. Germany and Denmark, which barely changed their top rates at all, experienced about the same growth rate.

Thus, high-income tax cuts have not magically improved economic growth.  Instead, the next president should focus on building economic capacity with new investments in infrastructure, research and development (R&D), education, and anti-poverty programs.

Research from a wide variety of sources broadly supports the notion that public infrastructure and R&D investments increase private sector productivity and GDP.  The impacts of public investment are greatest during periods of low growth.  Federal investments in R&D have aided the rise of modern medicine (such as the human genome) and technology (the microwave, the internet).  Public R&D policies can boost private R&D and increase productivity by generating knowledge that leads to new goods and services and improvements in existing ones. Investments in R&D can also drive down the price of new technologies, making them available to more people.

Research from a wide variety of sources broadly supports the notion that public infrastructure and R&D investments increase private sector productivity and GDP.

Federal investments in education lead toward a more skilled workforce, raising earnings and spurring innovation. Workers with only a high school education are twice as likely to be unemployed as those with at least a bachelor’s degree. Looking outside the U.S, an extra year of school is associated with a significant increase in per capita income.

There are also gains to investments in early childhood education: the earlier the intervention, the more cost-effective, which is why policymakers have been focused on pre-school.  Children who attend early high-quality care and education programs are less likely to engage in criminal behavior later in life and more likely to graduate from high school and college.  Reducing the cost of preschool effectively increases a mother’s net wage, making it more likely she will return to the labor market.

Spending on effective social programs provides immediate benefits to low-income families and can improve long-term economic growth. For example, the Earned Income Tax Credit provides a critical tax break to low-income families and contributes toward a number of economic benefits: the increased income security contributes to better health; much of the credit’s benefit structure encourages work; and the credit can lead to increased college enrollment, which leads to higher wages.  Nutrition assistance programs improve beneficiaries’ health and also increase economic independence, while housing assistance programs such as portable vouchers can improve educational attainment and future earnings by allowing families to relocate from housing projects with concentrated poverty to areas with more diverse incomes  and higher levels of upward mobility.  Spending for low-income health programs such as Medicaid and the Children’s Health Insurance Program (CHIP) can improve economic outcomes; improved children’s health leads to a healthier future adult population, and better health leads to work stability and increased education completion.

A significant investment – say, 1 percent of GDP per year – could be made in the programs above and would spur broad-based, inclusive growth.

Added growth would boost revenues, but not by enough to pay for this new spending, thus raising the public debt.  The effects of debt cannot be ignored.  Fueled by rising Social Security, Medicare, and Medicaid obligations, our growing debt will eventually become a drag on economic growth.  We have plenty of tools that could deal with this problem – including a carbon tax, a value-added tax, a reduction in income tax expenditures, and judicious Social Security and Medicare reforms.  We just need the political will to implement them.

But it isn’t the time for debt reduction yet.  The current priority should be to establish more robust growth.  Research has shown that federal investments can lead to better future economic outcomes. The evidence on supply-side tax cuts is simply not supportive.  It is time for a pragmatic growth agenda, not magical thinking.

This piece originally appeared in Real Clear Policy. 

      

 

 

Executive Summary

The federal tax system is beset with problems: It does not raise sufficient revenue to finance government spending; it is complex; it creates outcomes that are unfair; and it retards economic efficiency.  In this essay, we discuss several ways to improve taxes including creating a value-added tax, increasing environmental taxes, reforming the corporate tax, treating low- and middle- income earners equitably and efficiently, and ensuring appropriate taxation of high-income households.  Although the politics are a major barrier to reform, the next president’s legacy may well be determined by how well he or she handles tax policy.

A good tax system raises the revenues needed to finance government spending in a manner that is as simple, equitable, and growth-friendly as possible. The United States does not have a good tax system. Long considered an outrageous affront by many observers, the U.S. tax system has generated perennial calls for everything from minor tune-ups to comprehensive reform. There is massive disagreement, however, about which issues are the most important and how they should be addressed.

In this essay, we highlight five areas where tax policy could be improved: raising long-term revenue; increasing environmental taxes; reforming the corporate tax; treating low- and middle- income earners equitably and efficiently; and ensuring appropriate taxation of high-income households.

Before addressing these issues, we start with two caveats. First, both Donald Trump and Hillary Clinton have already offered major tax plans as part of the 2016 presidential campaign. Our essay is less about what policies the candidates should have proposed and more about describing the important issues that they should address. We leave the political strategy questions to the political strategists.

Second, picking just five areas out of the entire tax system surely omits important issues. Comprehensive tax reform is easy to talk about, but hard to do. The pursuit of sweeping tax simplification is a noble goal, but quixotic. The effects of taxes on entrepreneurship are important, but elusive. These and other issues are worth addressing, but they are beyond the scope of this essay.

Long-Term Revenue

Under current law projections, federal debt as a share of the economy will rise from its current level of 77 percent—the highest level ever except for a few years around World War II—to about 129 percent by 2046, and to as much as 150 percent under reasonable alternative policy scenarios.[1]  Under current law, revenues will slightly increase to 19.5 percent of GDP in 2046 from about 18 percent now. The CBO projects total spending to be near 27 percent of GDP in 30 years, up from 21 percent currently, with the rise largely due to increases in net interest, Social Security, and health spending.

High and growing levels of debt will crowd out future investment and stymie growth. They will also reduce fiscal flexibility, or the ability to respond to future recessions.

High and growing levels of debt will crowd out future investment and stymie growth. They will also reduce fiscal flexibility, or the ability to respond to future recessions.

Alan Auerbach of the University of California at Berkeley and William Gale of Brookings estimate that, in order to return the debt level to its 1957-2007 average of 36 percent of GDP by 2046, immediate and permanent (through 2046) spending cuts and/or tax increases equal to 4.2 percent of GDP will need to be implemented. Just to maintain the 2046 debt at its current share of GDP would require adjustments, starting in 2017, of 2.7 percent of GDP.[2] It seems unlikely that changes of this magnitude could be managed on the spending side. Entitlements have proven difficult to reform, especially Social Security, as there is significant public and political backlash against cutting benefits. Moreover, any Social Security changes would likely be phased in slowly, and reasonable changes in the program would not affect the overall fiscal balance that much. In addition, discretionary spending has already been cut dramatically and is already slated to fall to historically low shares of GDP over the next 25 years. As a result, tax increases need to be part of a long-term fiscal solution.

Increasing federal revenues does not mean that marginal income tax rates have to go up. New revenue sources could be explored through energy taxes (discussed in the next section), a change in the treatment of tax expenditures, or a value-added tax (VAT).

One way to raise revenue is to broaden the tax base by reducing the number of specialized credits and deductions in the tax code. For example, under current law, a dollar’s worth of deduction reduces taxable income by a dollar and hence reduces the tax burden in proportion to the marginal tax rate. A high-income household saves 39.6 cents for a given dollar of deduction, whereas a low-income household only saves 10 cents or nothing at all for each dollar’s worth of a deduction. Setting the tax benefit of each dollar of itemized deductions to 15 cents would affect mostly high-income households and raise, on average, about 0.6 percent of GDP per year over a decade, or roughly a cumulative $1.4 trillion over the next 10 years. Current itemized deductions are expensive, regressive, and often ineffective in achieving their goals. The mortgage interest deduction, for example, does not seem to raise home ownership rates, yet it will cost the federal government around $70 billion in 2017. Limiting the benefits of the deductions for high-income households is a way of reducing the distortions created by the tax code, making taxes more progressive and raising revenue. Alternatively, the U.S. could cap the total amount of tax expenditures that an individual can claim. For example, Martin Feldstein, Daniel Feenberg, and Maya MacGuineas propose that tax expenditure benefits be capped at 2 percent of a taxpayer’s adjusted gross income. According to their model, this would have increased revenues in 2011 by 1.8 percent of GDP.[3]

An alternative way to raise revenue is through the creation of a federal VAT, as a supplement to the current income tax system, rather than as a replacement.^[4] A VAT is essentially a flat-rate consumption tax with administrative advantages over a national retail sales tax. Although it would be new to the U.S., the VAT is in place in about 160 countries worldwide and in every OECD country other than the U.S. Experience in these countries suggests that the VAT can raise substantial revenue, is administrable, and is minimally harmful to economic growth. Additionally, a properly-designed VAT might help the states deal with their own fiscal issues. Although the VAT is regressive relative to current income, the regressivity can be offset in several ways, and we should care about the distributional impact of the overall tax and transfer system, not just specific taxes. While the VAT is not readily transparent in many countries, it would be easy to make the VAT completely transparent to businesses and households by reporting VAT payments on receipts just like state sales taxes are reported today. While the VAT has led to an increase in revenues and government spending in some countries, higher revenues are precisely why the VAT is needed in the U.S., and efforts to limit spending should be part of an effort to enact a VAT. Making the VAT transparent should also reduce the extent to which a VAT would fuel an increase in government spending, a concern that is sometimes overstated by critics in the first place. While a VAT may lead to a one-time increase in prices, it is not the case empirically that VATs inevitably, or even usually, lead to continuing inflation.

Specifically, a new 10 percent VAT, applied to all consumption except for spending on education, Medicaid and Medicare, charitable organizations, and state and local government, could be paired with a cash payment of about $900 per adult and about $400 per child to offset the cost to low-income families (the equivalent of annually refunding each two-parent, two-child household the VAT owed on the first $26,000 of consumption).^[5] In all, this VAT could raise about a net 2 percent of GDP or about $390 billion in 2017, after allowing for the offsetting effect on other taxes. None of this implies that the VAT would unilaterally solve the country’s fiscal problems, nor would it be painless. Nevertheless, the VAT is a relatively attractive choice, given the need to close the fiscal gap and the other options for doing so.

Higher overall tax burdens do not necessarily hurt the economy. Over the 1970-2013 period, taxes as a share of GDP across all levels of government were more than 7 percentage points higher in the rest of the G7 countries (almost 33 percent) than in the U.S. (more than 25 percent). Yet, real per capita annual growth was similar in the rest of the G7 (1.9 percent) compared to the U. S. alone (1.8 percent). Even the massive tax increases during and after World War II—amounting to a permanent rise of 10 to 15 percent of GDP—did not hamper U.S. economic growth.

None of this means that the U.S. needs to move to European levels of high taxation. But between the very low tax revenues we raise now and the high levels of taxation in other developed countries, there is room to raise revenue in a way that achieves serious medium- and long-term debt reduction and supports a reasonable level of government.

Environmental 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, which raised 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 are thus 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. 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. It could also serve to raise revenue as an alternative to the taxes described above.

Although a carbon tax would be a new policy for the federal government, the tax has been implemented in several other countries. In 2007, the carbon 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 U.S. could raise similar amounts. In fact, according to Tax Policy Center and Congressional Budget Office (CBO) estimates, a reasonably designed U.S. carbon tax alone could, on average, raise revenue by about 0.7 percent of GDP each year from 2016-2025 (around $160 billion per year). Revenue from a carbon tax could be used to reduce other tax rates or pay down the debt.

Carbon taxes are a good idea even if we did not need to increase revenues because they can contribute to a cleaner, healthier environment by providing price signals to those who pollute. They have foreign policy benefits as well, as they plausibly reduce U.S. demand for oil and dependence on oil-producing nations.

Not surprisingly, most analyses find that a carbon tax could indeed significantly reduce emissions. Gilbert Metcalf of Tufts University estimates that a $15 per ton tax on CO₂ emissions that rises over time would reduce greenhouse gas emissions by 14 percent, while Jenny Sumner, Lori Bird, and Hillary Smith of the National Renewable Energy Laboratory 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 found that the carbon tax implemented in British Columbia led to a 9.9 percent reduction in greenhouse gas emissions in the province, compared to just 4.6 percent 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. It would also reduce the U.S. economy’s dependence on foreign sources of energy and 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 to develop new ways of harnessing renewable energy and energy-saving technologies. The implementation of a carbon tax also offers opportunities to reform and simplify other climate-related policies that affect the transportation sector.

While it receives high marks on efficiency criteria when looking at the United States in isolation, a carbon tax could hurt the country if other countries do not adopt similar measures. Robert Stavins of Harvard notes that the largest efficiency gains would come in the form of internationally-shared reduced greenhouse gas emissions. While the U.S. is one of the largest per capita emitters 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 more effectively deal with the well-known problems brought about by climate change, such as rising sea levels, and higher frequency of extreme temperatures, among others.

However, no one claims that the carbon tax is a perfect solution. For example, it can have a large impact on low-income households who use most of their income for consumption. Nevertheless, this regressivity could be offset in a number of ways, including refundable income or payroll tax credits. Thus, while distributional effects are clearly a concern, they can be minimized and should not prohibit the implementation of a carbon tax.

Another way to raise revenue through energy taxation, and a method that may be more feasible than a carbon tax, is to increase the gasoline tax. The current federal rate on gas has been fixed in nominal terms at 18.4 cents per gallon since 1993. An increase in the gas tax would generate revenues to finance repairs to our crumbling infrastructure, stabilize the Highway Trust Fund, and help pay down the debt. Ian Parry of Resources for the Future estimates that raising gasoline and diesel fuel taxes to the levels justified by the externalities that gasoline consumption creates would increase revenue by around $100 billion per year, while CBO estimates that an inflation-indexed 35 cent increase in the gasoline excise tax alone would raise about 0.2 percent of GDP (about $46 billion in 2017) over 10 years. Raising the gas tax by 25 cents per year for 10 years would raise substantially more revenue, but would still leave U.S. gas tax rates below those of European countries.

Corporate Taxation

Recent controversies between the European Union, Ireland, and Apple have brought corporate tax reform issues back into the limelight.  In the standard textbook setup, the major problem with the current approach to corporate taxation is the double taxation of corporate equity. The earnings of equity holders are taxed under the corporate tax when they are earned, and then again, under the individual income tax, when they are paid to shareholders as dividends or capital gains. This standard summary both overstates and misstates the real problem. First, no corporate income is fully taxed under the individual income tax, since dividends and capital gains are taxed at preferential rates and capital gains are only taxed when the asset is sold. Second, a significant share of dividends and capital gains accrues to non-taxable entities—non-profits or pensions—thus reducing the tax burden further. Third, a large share of corporate profits is never taxed at the corporate level in the first place. Aggressive corporate tax avoidance, including shifting funds out of the country through transfer pricing or other mechanisms, is an important factor in corporations reducing their tax burden.

The U.S. has the highest top corporate rate in the world at 35 percent. For many businesses, the tax distorts choices in favor of the non-corporate sector over the corporate sector. For other businesses, the corporate tax burden is offset by tax preferences. In the corporate sector, the tax favors debt over equity and retained earnings over dividends. As a result of numerous loopholes, aggressive corporate tax avoidance, and the large share of U.S. businesses that takes the form of non-C-corporation activity (which is in itself a form of corporate tax avoidance), U.S. corporate tax revenues as a share of GDP are only average compared to other countries, despite the high tax rate. In recent years, for example, corporate profits have equaled 12 percent of GDP, but corporate tax revenues have hovered around 2 percent of GDP.

Hence, the problem is not just that some forms of corporate income face two levels of tax; it is also that some forms face no tax. As a result, the main goal of corporate tax reform should be to tax all corporate income once and only once, at the full income tax rate.

Given all of the flaws in the corporate tax, it should not be surprising there are several approaches to reform that could help. None is without problems; each would address different aspects of the system.

Given all of the flaws in the corporate tax, it should not be surprising there are several approaches to reform that could help.

One option, emphasized by Robert Pozen of MIT and others, is to reduce or limit the interest deduction and use the resulting revenues to reduce rates. This would reduce the bias toward debt in the tax system. Allowing firms to deduct some part of dividend payments could put dividends and interest on the same tax footing. Other ways to close loopholes and broaden the base would generate additional reductions in rates.

A totally different, and radical, approach would be to replace some or all of the corporate income tax with a tax on shareholder wealth accumulation, as proposed by Eric Toder and Alan Viard. Under this approach, there would be no corporate tax. Instead, “American shareholders of publically-traded companies would be taxed on both dividends and capital gains at ordinary income tax rates, and capital gains would be taxed upon accrual,” rather than realization.

Alternatively, Auerbach proposes that the U.S. convert the corporate income tax into a corporate cash-flow tax. This would encourage new investment by replacing deductions with immediate expensing for physical investment. Auerbach also calls for applying the tax on a destination basis, which essentially limits the focus of the tax to transactions occurring exclusively on domestic soil and thus avoids all international transfer pricing issues.

A major change in the treatment of foreign source income should be considered as part of any overall corporate tax reform. In a pure worldwide system, all income from around the world is taxable, and all costs are deductible. In a pure territorial system, income earned outside the country is not taxable, and costs incurred outside the country are not deductible. A key issue, of course, is how income and expenses are allocated to each country because firms go to great lengths to move income to low-tax countries and deductions to high-tax countries. Most advanced countries lean toward a territorial system. The U.S., on the other hand, leans toward a worldwide system, but there is an important exception—taxes on actively-earned foreign income are deferred until the income is repatriated to the U.S. Currently, U.S. firms have an estimated $2 trillion in actively-earned funds that have not been repatriated and therefore go untaxed.

This income is often described as being trapped outside the U.S. This characterization is only partially correct, though. The money may actually be in a bank in the U.S. and funding investment in the U.S. However, the funds cannot be used to pay dividends to shareholders or to buy back firm shares until the funds are “repatriated” to the corporation, a legal procedure that then generates a tax liability. There are two general proposals to deal with the issue of funds sitting “abroad.” One is to move to a worldwide system without deferral. The other is to move toward a territorial system. As noted, a big issue with territorial systems is that they increase the incentives that already exist to shift income into low-tax countries and deductions/costs into high-tax countries. So, the implementation of a territorial system would need to be accompanied by very stringent rules about income and cost-shifting. There has been a desire on the part of some lawmakers to have a one-time repatriation tax holiday, perhaps to finance infrastructure. This would be a mistake and would simply encourage firms to shift more funds overseas in an effort to gain a future tax advantage.

A related issue was raised by a recent wave of corporate inversions, which occur when an American company is bought by a foreign firm and thus qualifies as a non-U.S. company for tax purposes. Although they are not quite “stroke of the pen” transactions, inversions can be accomplished without moving actual factories or human resources to another country. As a result, most observers believe that companies invert for tax reasons. Some argue the companies are showing a lack of patriotism.

Some recent, well-publicized inversions, coupled with the absence of Congressional action, led the Obama administration to issue new regulations that limited the practice. These new regulations and the potential threat of additional ones may have slowed the pace of new inversions. Still, Congress has not addressed the underlying tax causes of inversions, including high statutory U.S. corporate tax rates. Some believe that converting the U.S. corporate tax to a territorial system would curb inversions, but this is controversial, as Berkeley lawyer Eric Talley has noted.

“Patent boxes” raise another issue concerning cross-national income. Patent boxes, or intellectual property (IP) boxes, give preferential tax treatment for profits generated by IP investments. Ireland created the first patent box regime in the 1970s. Currently, around a dozen European countries, including the United Kingdom and France, offer patent boxes with preferential rates ranging from 5 to 15 percent, considerably lower than the standard corporate tax rates in those countries. Recently, Senators Portman and Schumer proposed similar treatment for the U.S.^[6]

The hope is that lower rates will attract research and development to the country with the patent box. But critics argue that patent boxes will just lead to a “race to the bottom” since IP income is easy to shift across countries without any effect on the location of real activity. It is therefore unclear whether these tax benefits actually increase research expenditures in the country in question. Studies have generally failed to identify a definitive relationship between similar U.S. strategies such as Section 174 and the research investment. To address these coordination issues, the OECD released an agreement in February 2015 tightening the conditions under which tax benefits from IP income would be awarded, but the issue is not settled.

Taxation of Low- and Middle-Income Earners

Under a progressive income tax, the highest statutory marginal tax rates are placed on the highest-income households. Under our current system, however, low- and middle-income earners often face very high effective marginal tax rates. These earners are in income ranges where increased earnings cause phase-outs of tax subsidies and benefit programs. The net effect of earning more—including higher wages, higher income tax payments, and lower program benefits—can turn out to impose quite significant effective tax rates on such households. This situation is unfair to those families, is inefficient, and discourages actions that would enhance social and economic mobility.

For example, Melissa Kearney and Lesley Turner note that a secondary earner in a married household typically pays a higher effective tax rate on the margin than the primary earner. This issue arises because the two incomes are combined to form one tax unit even though the secondary earner often has a lower individual income than the primary earner (and would have a lower marginal tax rate if filing as a single person). This is particularly problematic for low- and middle-income households because it discourages additional work to support their family which could result in extra income that may reduce their benefits or even render the family ineligible for programs such as food assistance or the Earned Income Tax Credit (EITC). On both fairness and economic grounds, Kearney and Turner propose a 20 percent secondary-earner tax deduction until a cap is reached. This deduction would improve the incentive to work, provide more economic security to working low- and middle-income families, and mitigate the secondary earner penalty. On net, the authors estimate their proposal would cost the federal government $8.2 billion per year.

Eugene Steuerle of the Urban Institute  points out that as a worker’s income increases, marginal tax rates may increase, and benefits from social programs may be phased out. This creates higher effective tax rates for beneficiaries of welfare programs such as the Supplemental Nutrition Assistance Program (SNAP, formerly known as food stamps) and government-subsidized healthcare, and reduces the incentives for work and marriage. According to Steuerle, as a family’s income rises, the phase-out of benefits from social programs effectively result in a combined marginal tax rate of about 60 percent for low- to middle-income earners, as compared with top income tax rate of 39.6 percent for high-income households. Those who receive more means-tested benefits initially may face combined rates closer to 75 percent. This is all compared to the earner’s statutory marginal tax rate of 25 percent if filing single or 15 percent if married. To combat this issue, Steuerle proposes that the government should “make combined tax rates more explicit and make work a stronger requirement for receiving some benefits.”

Of course, another option to mitigate the tax burden faced by low- and middle-income earners is to expand eligibility for the EITC or transform the Child and Dependent Care Credit (CDCC) to a refundable benefit. Both of these programs are already executed through the tax code in an effort to aid low- and middle-income families, and changes to the programs could expand economic opportunity or increase the degree of fairness in the system. Specifically, EITC benefits could be raised for families with fewer than two children (especially childless workers). This improves the incentives for work in these households, and it can lead to better economic outcomes for the associated families. By converting the CDCC to a refundable credit, low-income families would be able to reap greater benefits from the program and retain more disposable income. Additionally, it would incentivize the use of higher-quality child care. In order to make these options revenue-neutral and prevent them from exacerbating the long-term revenue issues described above, the income eligibility caps for these programs could be lowered or other provisions could be removed.

Taxing the Rich

There are three major reasons to increase the tax burden on high-income households. First, their income has increased dramatically over the past several years, yet their tax payments have not kept pace. Second, if the fiscal reforms described above are implemented, the main benefit will be economic growth, but such growth in the past several decades has accrued largely to high-income households, who should thus be expected to pay for it. Third, despite much rhetoric to the contrary, reasonable variations in taxes on high-income households do not appear to have any negative discernible impact on growth.

Over the past several decades, the share of income accruing to high-income households has gone up dramatically. In 1979, the top 1 percent received about 9 percent of all market income. By 2013, that figure had risen to 17 percent. In real terms, market income among households in the top 1 percent was 188 percent higher in 2013 than in 1979. In contrast, for the middle quintile, real market income was only 11 percent higher.

In a progressive tax system, when someone’s income rises, their average tax rate is supposed to rise. Adjusting for overall growth of the economy, this means that as a group’s income rises relative to average, its tax burden ought to rise relative to average. This has not happened in the U.S. The average federal tax rate for households in the top 1 percent was 35 percent in 1979 compared to 34 percent in 2013. Thus, one reason to impose more taxes on high-income households is simply that they are not bearing their fair share of tax payments.

It is worth emphasizing that top income households currently pay the vast share of overall federal taxes (and income taxes in particular), but that the share of taxes paid is in fact not a good metric of how progressive the tax system is. For example, suppose we changed to a tax system where no one paid any taxes except the richest person, who paid $1. This change would obviously provide the biggest benefits to the richest people in the country, who would be relieved of the current progressive tax burdens they face. Yet, under this new system, it could be pointed out that the rich are now paying 100 percent of all taxes. The point is that the share of taxes paid is not a good measure of burden when either tax revenues or income levels are changing.

A second reason for increasing the tax burdens of wealthy households has to do with paying for the benefits of fiscal reform and consolidation. If fiscal reform could boost growth (as estimates suggest), but the benefit of that growth accrues disproportionately to high-income households (as the experiences of the last 35 years suggest it will), then the burdens of fiscal retrenchment should be disproportionately placed on high-income households. One such policy would be to means-test Social Security and Medicare, or otherwise adjust benefits downward for high lifetime income earners. But in practice, having the rich pay more means increasing their taxes, since neither the major entitlements nor any other government spending program affect the very wealthy that much.

The notion of increasing taxes for high income earners will cause horror in some circles, but a wide variety of evidence suggests that high tax rates are only weakly related to economic growth. For example, the vaunted Reagan tax cuts in the early 1980s produced a period of average growth, when growth is (appropriately) measured from peak to peak of the business cycle. Indeed, research by Martin Feldstein, President Reagan’s former chief economist, and Doug Elmendorf, the former Congressional Budget Office Director, concluded that the 1981 tax cuts had virtually no net impact on growth. They found that the recovery in the early 1980s could be ascribed wholly to monetary policy. It’s also worth noting that they found no evidence that the big 1981 tax cuts induced people to work more.

Virtually no one now claims that the 2001 and 2003 Bush tax cuts stimulated growth. The two enabling acts did have the word “growth” in their titles (the Economic Growth and Tax Relief Reconciliation Act of 2001, and the Jobs and Growth Tax Relief Reconciliation Act of 2003) and slashed tax rates on ordinary income, capital gains, dividends, and estates, but economic growth remained sluggish between 2001 and the beginning of the Great Recession in late-2007. Again, the gains that did occur are generally attributed to the Fed’s easy money policy.

Even the 1986 Tax Reform Act, the standard bearer in terms of broadening the base and reducing top rates, generated little impact on growth.^[7]  Moreover, in 1993, the top income tax rate in the United States rose to 39.6 percent, yet the economy flourished for the rest of the decade. Cross-country research provides similar evidence. Research by Thomas Piketty, Emmanuel Saez, and Stefanie Stantcheva found no relationship between how a country changed its top marginal tax rate and how rapidly it grew between 1960 and 2010. The United States, which cut its top rate by over 40 percentage points during that period, grew just over 2 percent annually per capita. Germany and Denmark, which barely changed their top rates at all, experienced about the same growth rate.

There are many ways to boost revenue collected from high-income households. The most prominent examples would include higher taxes on capital gains and dividends, restrictions on tax expenditures, higher income tax rates, or a tighter estate tax. Taxing carried interest as ordinary income also makes sense in principle, but is difficult to implement without creating new forms of avoidance and, as a result, would raise very little revenue.

Conclusion

Reforming the tax system so that it pays for government spending, treats taxpayers fairly, and improves incentives for productive activity can only be a plus from an economic standpoint. Even though the politics have been, and will continue to be, a major barrier to reform, the next president may well be judged a success or failure in significant part based on how he or she handles tax policy.

Read more in the Election 2016 and America’s Future series.

      

 

 

On September 23, the Retirement Security Project hosted an event to discuss these and related policy issues and released two new papers on the topic. The first paper proposes a number of ways to improve retirement saving options for contingent workers, such as exploiting innovations in technology and developing retirement accounts that follow the worker from job to job. The second paper explores differing types of rate-of-return guarantees, and who bears the costs of financing those assurances. After each paper presentation, discussants commented, and all panelists took questions from the audience.