Brookings: Topics - Tax Reform

Supporting Broad-Based Economic Growth and Fiscal Responsibility through Tax Reform

Adam Looney — Wed, 22 May 2013 02:30:00 -0400

Chairman Murray, Ranking Member Sessions, and Members of the Committee: Thank you for inviting me to share my views on the role of tax reform in supporting broad-based economic growth and fiscal responsibility.

The United States faces a daunting outlook for budget deficits, an increasingly challenging global economy for many American workers and businesses, and rising income inequality.

Improvements in tax policy could help address these challenges by making our tax system more fiscally sustainable, more efficient, and more fair. Indeed, any tax reform will be evaluated based on how it affects each of those three criteria.

But improving on all three dimensions simultaneously is increasingly difficult because of tradeoffs between competing goals of efficiency, revenues, and equity.

Today’s long-term budget outlook means that we’re likely to need higher tax revenues in the future. And rising inequality means that changes in policy will be increasingly scrutinized for how they affect the progressivity of the tax schedule. But a tax reform that devotes revenues to deficit reduction and retains our progressive system would have much more difficulty achieving other goals—such as lowering tax rates.

In my testimony today, I want to describe some of these tradeoffs and some potential paths forward.

Tax Reform and the Budget

Much of the energy surrounding tax reform focuses on the model of the Tax Reform Act of 1986. In that reform, tax rates were lowered substantially and the lost revenue was restored by cutting tax breaks, deductions, exclusions, and other so-called tax expenditures. That reform enhanced economic efficiency without increasing the deficit. In the 27 years since then, however, the economic context has changed, making such a reform harder to achieve.¹

First, we face a dire long-run budget outlook; most believe that putting the budget on a sustainable path will require contributions from both spending cuts and revenue increases. Many hope that tax reform can help produce those revenues.

This makes tax reform more difficult because revenues allocated to deficit reduction are revenues that cannot be used to reduce rates, and vice versa.

Moreover, raising revenues and cutting rates at the same time is a tall order. At first glance, the list of tax expenditures is projected to add up to $1.4 trillion in 2015.² But that figure dramatically overstates the revenue gains that are available from cutting expenditures.

Some expenditures, including obscure items like imputed rent, would be difficult to eliminate for practical or administrative reasons; others, like credits and deductions for working families with children are integral to combating poverty and encouraging employment. These categories account for roughly one quarter of all tax expenditures.³ An additional one-third of the tax expenditures arise from the preferential treatment of savings and investment. And the largest non-savings-related expenditures include those for health insurance, mortgage interest, state and local taxes, and charitable contributions. These, and many others, tend to serve substantive goals, remain on the books because they were too difficult to eliminate in 1986, and, as you well know, are backed by popular constituencies.

In addition to political difficulties, there are basic practical issues to consider. Certain tax expenditures exist for the purposes of simplifying the tax system, to reduce record keeping, or to minimize the filing burden on taxpayers. Eliminating those provisions or scaling back others could make the system more complicated and onerous.

Because of such considerations, the Congressional Research Service warns that “it may prove difficult to gain more than $100 billion to $150 billion” each year from reducing tax expenditures.⁴ And those estimates are based on a 35 percent top rate; if marginal tax rates were reduced, eliminating a dollar’s worth of deductions would raise proportionately less revenue. In other words, if eliminating a dollar of mortgage interest today raised 39 cents, under a top rate of 25 percent, it would raise only 25 cents—37 percent less.

To put these numbers in perspective, in order to be revenue-neutral, the tax plan included in House Budget Committee Chairman Ryan’s budget would require eliminating roughly $450 billion worth of tax expenditures each year just to balance out the individual income tax rate cuts targeted in his plan.⁵ The plans initially developed by the Domenici–Rivlin Task Force and the Bowles–Simpson Commission, which reduce rates and contribute to deficit reduction, likely require reductions in tax expenditures of a similar or larger magnitude.

The gap between the reductions in tax expenditures required by such plans and those that could be agreed upon illustrates the challenge of formulating a plan that achieves both lower rates and higher revenues.

Tax Reform in a Progressive System

A second consideration is the issue of rising income inequality and its relationship to the tax code. Earnings have risen dramatically at the top—by more than 250 percent over the past 30 years for households in the top one percent of the income distribution. At the same time, many households at the middle and bottom have experienced stagnating or even declining earnings. Changes in the tax system over the past 30 years have exacerbated these problems; the very people who have received the biggest income gains in the past three decades have also seen the largest tax cuts. A progressive tax code is perhaps the most significant and powerful tool available to counteract income inequality. Indeed, there are increasing calls for policymakers to use the tax code for that purpose.

Such concerns were much less salient the last time we did tax reform. In 1986, the phenomenon of rising inequality had yet to be fully discovered or understood, and the technical expertise to measure how the tax system affected inequality had yet to be developed.

Today not only are concerns about the progressivity of the tax schedule heighted, but so is our ability to measure how tax changes affect different groups. That raises the level of scrutiny directed to reform and also reveals a substantive tradeoff: that any changes in rates and tax expenditures must balance out within income groups in order to retain a progressive tax structure.

In a series of papers, colleagues at the Tax Policy Center and I analyzed these tradeoffs by examining a hypothetical reform with the stated goals of maintaining tax revenues, lowering marginal tax rates, while at the same time ensuring a progressive tax system.⁶ We took as an example a plan that lowered the top rate from 35 to 28 percent and continued the low rates that apply to savings and investment. These rate reductions are roughly the same levels specified in earlier plans from Bowles–Simpson and Domenici–Rivlin, but are substantially smaller than those specified in Chairman Ryan’s plan. We asked what it would take to achieve other goals of revenue and progressivity.

In that analysis, we estimated the revenue losses due to lower rates, and then tried to pay for those revenue losses by eliminating tax expenditures. We assumed that certain tax expenditures were off the table because of the administrative difficulty of closing certain breaks; others were off the table because they provided preferential treatment for savings and investment.

Overall, the available tax breaks were enough to offset revenue losses from lower rates. But this resulting tax schedule, we found, was less progressive. Even when we implemented the most progressive way of reducing the remaining tax breaks, there was simply not enough revenue from these breaks in the top brackets to offset the revenue losses from lower marginal tax rates.

This result—that this sort of base-broadening reform led to a less progressive tax system—was true even when we incorporated revenue feedback, not just according to the standard dynamic effects used by Tax Policy Center, Treasury, and the Joint Committee on Taxation, but also additional feedback effects from optimistic estimates of potential economic growth, drawn from theoretical models.

The implication is that such a tax reform must give up on at least one of its stated goals: either higher-income taxpayers would receive a tax cut and middle- and lower-income taxpayers a tax increase; the deficit would go up; preferences for savings and investment would have to be reduced; or marginal tax rates would need to be higher.

Prospects for Reform

Of course, these considerations don’t rule out tax reform; indeed, many experts have put forward plans that provide more incremental reforms that simultaneously achieve efficiency gains, higher revenues, and a more progressive tax system. But such plans require substantial compromises.

For instance, certain plans proposed by the Domenici–Rivlin Task Force and the Bowles–Simpson Commission achieve their distributional goals by eliminating preferential rates for capital gains and dividends and curtailing other savings and investment-related tax breaks.

A host of other incremental reforms propose improving the efficiency of the tax system not by reducing rates but by reducing inefficient or wasteful tax expenditures. For example, deductions and exemptions—like for mortgage interest, that currently provide tax savings of up to 39.6 percent—could be replaced with flat credits of, say, 15 percent, providing continued support for homeowners but in a less-costly and more progressive way.⁷ An overall limit on the value of tax expenditures at 2 percent of income would provide an across-the-board reduction in costly tax expenditures.⁸ The President’s Budget includes a provision to limit the amount that certain tax deductions and preferences can reduce tax liability by to 28 percent. And at a meeting convened by the Hamilton Project last February, a bipartisan group of tax experts presented proposals to reduce benefits from the mortgage interest deduction, subsidies for fossil fuels, preferences for retirement savings, and the overall value of deductions.⁹ A common thread is that all of these proposals enhance economic efficiency, raise revenues, and increase progressivity.

Beyond economic appeal, proponents of this approach hope for political appeal. To paraphrase Harvard Professor Martin Feldstein: if Republicans want to reduce the deficit by cutting spending and Democrats want to increase revenues, by focusing on tax expenditures we should find a middle ground.¹⁰

1. For a further discussion see: Greenstone, Michael, Dmitri Koustas, Karen Li, Adam Looney, and Leslie B. Samuels. “A Dozen Economic Facts About Tax Reform,” The Hamilton Project (May 2012).

2 Marron, Donald B. “How Large are Tax Expenditures? A 2012 Update,” Tax Notes (April 9, 2012): 235.

3. For a description of these expenditures, see Nguyen, Hang, James Nunns, Eric Toder, and Roberton Williams. “How Hard Is It to Cut Tax Preferences to Pay for Lower Tax Rates?” Tax Policy Center (July 10, 2012): Table 1.

4. Gravelle, Jane G. and Thomas L. Hungerford. “The Challenge of Individual Income Tax Reform: An Economic Analysis of Tax Base Broadening,” Congressional Research Service (March 22, 2012): 3.

5. Tax Policy Center Table T13-0110

6. Brown, Samuel, William Gale, and Adam Looney. “On the Distributional Effects of Base-Broadening Income Tax Reform,” Tax Policy Center (August 1, 2012); Brown, Samuel, William Gale, and Adam Looney. “TPC’s Analysis of Governor Romney’s Tax Proposals: A Follow-Up Discussion,” Tax Policy Center (November 7, 2012); Marron, Donald. “Understanding TPC’s Analysis of Governor Romney’s Tax Plan,” Tax Vox (August 8, 2012); and Nguyen et al. (2012).

7. Batchelder, Lily L., Fred T. Goldberg, Jr., and Peter R. Orszag. “Reforming Tax Incentives into Uniform Refundable Tax Credits,” The Brookings Institution Policy Brief 156 (August 2006).

8. Feldstein, Martin, Daniel Feenberg, and Maya MacGuineas. “Capping Individual Tax Expenditure Benefits,” NBER Working Paper 16921 (April 2011)

9. See Alan Viard, “Replacing the Home Mortgage Interest Deduction,” Joseph E. Aldy, “Eliminating Fossil Fuel Subsidies,” Karen Dynan, “Better Ways to Promote Saving through the Tax System,” and Diane Lim “Limiting Individual Income Tax Expenditures” in 15 Ways to Rethink the Federal Budget, The Hamilton Project (February 2013).

10. Feldstein, Martin. “A Simple Route to Major Deficit Reduction,” The Wall Street Journal (February 20, 2013).

Authors

Adam Looney

Image Source: Chris Maddaloni

Federal Tax Reform? Don't Bet The Rent Money On It

Bill Frenzel — Tue, 14 May 2013 11:52:00 -0400

In some years there are no budgets. This year we have been presented with thre dueling budgets, one from each house and one from the president. Neither house has picked conferees, and neither has any current inclination to do so. Each prefers to glare at the other until the next election day.

The “Grand Bargain” on the Federal budget this year is still possible, but it seems less and less likely. The prospect is for another year of small deals, recurring crises, and several continuing resolutions.

As hopes for the big fiscal fix recede, tax reform moves to center stage. Ideally, tax reform ought to be a part of a larger budget agreement. But, with that agreement now slipping out of reach for 2013, tax reform seems to some observers to be a more promising suspect.

Tax reform appeals to both parties for different reasons. Democrats need it for new spending to stimulate growth. Republicans want to use it for lowering tax rates for the same reason. Those differences may be irreconcilable, but members of Congress seem to want to give tax reform a try.

Perhaps the best reason for tax reform optimism lies in the fact that the chairmen of both tax-writing committees really want to do it. Dave Camp, chair of the House Ways & Means Committee, is now serving his last term as chair under caucus rules. Max Baucus, Camp’s Senate Finance Committee counterpart, is in a similar position. He is retiring from Congress after this term.

Both of these leaders are strongly motivated to produce a tax bill before they slide into history. Both are able veterans who know the tax code. They meet regularly. Both have held hearings on tax reform, and have given it much study over the past two years. In addition, Camp has the blessing of the House Republican leadership including Speaker Boehner, who has saved the precious number, HR 1, for a tax reform bill.

Some business interests, led by the U.S. Chamber of Commerce, want to see reform of the tax code, too. Many of them see advantages in potentially lower rates, and in reform of U.S. taxation of their foreign income. American business is by no means unified on this subject, but there clearly is plenty of interest.

There is, however, another side to the tax reform story. Historically, it is a rare event. The last successful effort was in 1986. Before that one has to backtrack to 1958 to identify a major tax reform enactment. In the 1986 version, both Congressional parties, (with Democrats in the majority) and the President, Ronald Reagan, strongly supported it. Even so, the process took two years. Nobody believes that the 1986 political consensus can be duplicated today.

In 1986, the American people polled strongly in favor of tax reform. Nowadays, they are not so sure. They saw the 1986 act substantially altered by amendment in the years immediately thereafter. Today, the public is not sure that tax reform will help them. And, even if it does help, they are pretty sure it will soon be amended beyond recognition. Trust in the government has all but faded away in the last three decades.

In the end, the biggest hurdle for tax reform will be to overcome the opposition of interests who are unwilling to part with their tax preferences peaceably. Unsurprisingly, many individuals and corporations just love their tax preferences. Some of them would be worse off with a system that abolished those preferences even if their basic tax rates were lowered.

This group is sophisticated. It knows how to make strategic political contributions, and it knows how to lobby successfully. It also knows how to maneuver in the current political environment where polarization is the rule, and in which members of Congress do not often trust one another. For these interests, the conditions on the playing field are just about perfect for defending their preferences.

Just as the country needs a Grand Bargain, it also needs tax reform. It would be wonderful if tax reform could be achieved this year. The two chairmen and many members will give the good old college try. But, if a budget compromise is not possible, it also seems unlikely that a good tax reform bill can be enacted. Cheer for tax reform; pray for it; just don’t bet the rent money on it.

Authors

Bill Frenzel

Publication: Forbes

Image Source: © Kevin Lamarque / 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

Charities Have Little to Fear from Effect of Deduction Rule on Contributions

Robert C. Pozen and Theresa Hamacher — Fri, 12 Apr 2013 00:00:00 -0400

As April 15 approaches, high-income taxpayers may be thinking about the impact of recent legislation limiting their itemized deductions. Under one part of the legislative package from January, itemized deductions are reduced once income exceeds a certain threshold: $250,000 for single taxpayers and $300,000 for married couples.

This is called a Pease reduction, after the original author of the provision. Charitable organizations are concerned that Pease will reduce the incentive for wealthy taxpayers to make charitable contributions. However, these concerns are based on a misunderstanding of how Pease affects itemized deductions.

To understand how Pease works, consider an affluent married couple — I will call them Joe and Judy. They have a combined taxable income (technically, “adjusted gross income”) of $500,000 and itemized deductions of $70,000. Under Pease, Joe and Judy’s itemized deductions are reduced by 3 cents for every dollar that their income exceeds $300,000. Their income is $200,000 more than the $300,000 threshold, so their itemized deductions are reduced by $6,000, from $70,000 to $64,000.

Now, suppose Joe and Judy gave an additional $1,000 to charity. If they did, their itemized deductions would rise from $70,000 to $71,000. Pease would still reduce these deductions by 3 cents for every dollar earned above $300,000, or $6,000, just as before. After the Pease haircut, Joe and Judy would have itemized deductions of $65,000 ($71,000 minus $6,000). So, as a result of their charitable contribution, their usable itemized deductions increase by $1,000, from $64,000 to $65,000. In other words, Joe and Judy effectively get the full deduction for the $1,000 charitable gift.

What’s going on here? The key point is that Pease reduces taxpayers’ itemized deductions based on their income, not on the amount of their deductions. Even if Joe and Judy had $200,000 in itemized deductions, the Pease haircut would only reduce their deductions by $6,000.

By contrast, suppose the joint income of Joe and Judy rose by $50,000 — from $500,000 to $550,000. Their income would now exceed the $300,000 threshold by $250,000, so Pease would reduce their itemized deductions by $7,500 (or 3 percent of $250,000), instead of the $6,000 before. In other words, the Pease haircut grows as the couple’s income increases.

Pease mainly functions as a stealth marginal tax rate increase on the wealthy, not as a mechanism for limiting deductions. Effectively, every dollar above the $300,000 threshold generates $1.03 in taxable income: one dollar from the income itself and 3 cents from the reduction in itemized deductions. For taxpayers in the top 39.6 percent bracket, Pease increases the effective marginal tax rate by roughly 1.2 percentage points — from 39.6 percent to 40.8 percent.

Of course, it’s possible for Pease to reduce itemized deductions by so much that the taxpayer decides to take the standard deduction instead of itemizing. If so, charitable organizations would have a very good reason to be concerned: Only itemizers can claim a charitable deduction.

However, this happens in rare situations, when itemized deductions are very low compared with the taxpayer’s income. For instance, a married couple, like Joe and Judy, with earnings of $500,000 would need to have itemized deductions less than $18,200 for this situation to arise. So long as they had more than $18,200 in itemized deductions, they would itemize even after the Pease haircut, meaning that Pease would not affect their incentive to claim a charitable deduction. In fact, Internal Revenue Service data show that itemizers with income between $250,000 and $500,000 claim, on average, more than $55,000 in itemized deductions.

So, in nearly all circumstances, charitable organizations need not fear the impact of Pease. Pease will raise the tax bill of affluent individuals based on the income that they earn, not the itemized deductions that they claim. Although high-income individuals may not like the cutback in their itemized deductions, Pease does not diminish the tax savings resulting from their charitable contributions.

Authors

Robert C. Pozen
Theresa Hamacher

Publication: Washington Post

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

The Tax Code Is a Hopeless, Complex, Economy-Suffocating Mess

Bill Frenzel — Thu, 04 Apr 2013 12:26:00 -0400

Throughout our population, experts and non-experts alike, the verdict is nearly unanimous. The U.S. tax code is a hopelessly complex mess, antithetical to growth, and is crammed with conflicting incentives, which screams for reform. But there is little agreement on how to repair it. My preferences are necessary, just, and ordained in heaven. Your preferences are unnecessary, unjust and counter-productive.

Tax reform is the most difficult and complicated piece in the U.S. budget battle. It is integral to both the Republican House and the Democratic Senate budgets. As in every budget item, there is a conservative vs. liberal confrontation, but tax reform is loaded with more confusing detail, and it adds extra layers of difficulty to the budget debate.

Some liberal and conservative inclinations tend to intersect when the conversation focuses on elimination of tax preferences. But, both sides have their favorite exceptions. Democrats love tax expenditures for the less affluent. Republicans love the preferences they suspect will stimulate growth.

Additionally, there are wide divergences about how the deficit savings from eliminated tax preferences should be used. Republicans like deficit-neutral solutions which invest all savings in lowering rates for growth. Democrats would like to spend those savings, either for compassionate spending or for Keynesian growth stimulus.

More real difficulties arise when tax preferences, individual and corporate, are considered one at a time. This is where powerful lobbying interests intervene. These are the interests that finance campaigns and parties. Regional factors arise, too. The normal political “rules” are often overridden. In some committee votes, it is hard to distinguish Democrats from Republicans.

Three of the four largest individual preferences are interesting examples. The first is the homeowners’ preference, which allows deductions for mortgage interest and real estate taxes. Homeowners’ enthusiasm for those benefits is exceeded, exponentially, by the real estate lobby, including real estate and mortgage firms, sun-belt governors, etc. The lobby, with bi-partisan support, easily defended its prize in the 1986 Tax Reform Act, and again, more easily, in President Bush’s Commission on Tax Reform in 2005.

The other two large preferences are charitable deductions and medical insurance (untaxed income for employees, and a deduction for corporations). Taking on the Little Sisters of the Poor, the big universities, or the United Fund is a fool’s errand. And standing up to powerful unions and corporations is not much easier.

Because these three big preferences, and others, are so well defended, many observers have suggested that placing a limitation on total individual preferences, a la Martin Feldstein, is a better approach. That strategy offers some hope, but it’s no piece of cake, either.

Reforming individual preferences is tough, but corporate preferences are, in some ways, even more perplexing. The last tax reform was achieved, at least partly, by shifting individual tax burdens on to corporations. That was okay in 1986. Today the common wisdom in both parties, and among knowledgeable observers, is that the U.S. corporate income tax rate must be reduced for reasons of international competition.

The task would be easier if individual and corporate income tax reform could be considered separately. Here again, there is a problem. Much of American business is transacted by small companies taxed as individuals. Separating these companies from their corporate competitors may not be practical.

Business operations are scattered over the U.S. supply chains extend everywhere. The tentacles of strong lobbying organizations also extend everywhere. Our system of territorial representation in Congress makes nearly every member a special defender of certain companies, industries, or unions. This factor tends to upset tax reform strategies. Sub-contracts loom large. Majorities appear, and disappear, unexpectedly.

Some budget observers believe that tax reform could be the key to long term fiscal compromise. Instead, some of these extra dimensions could make it the enemy. The devil is always in the details. Tax reform teems with details. Its politics are sometimes treacherous, even for seasoned politicians.

On the positive side, the tax committees of both houses are primed and ready to move forward. Chairman Camp and Baucus, while not exactly political soul-mates, have some similar ideas, a good business relationship, and regular communications. Both parties seem to want to try it.

Speaker Boehner has assigned tax reform the precious number of H.R. 1. If President Obama can extend his Congressional charm offensive, tax reform will never be the odds-makers’ favorite, but it is not out of the question for 2013.

Authors

Bill Frenzel

Publication: Forbes

Image Source: © Shannon Stapleton / Reuters

New Tax Provision on Deductions Won’t Hurt Charitable Giving

Robert C. Pozen — Mon, 01 Apr 2013 00:00:00 -0400

In the recent tax legislation to avoid the fiscal cliff, Congress reinstated a limitation on itemized deductions for affluent taxpayers, known as Pease (after its original author, the late Rep. Donald Pease). Under Pease, itemized deductions are modestly reduced depending on how much a taxpayer’s adjusted gross income exceeds a specified threshold — $250,000 for an individual and $300,000 for a married couple.

Many commentators have voiced concerns that Pease will discourage wealthy taxpayers from making charitable donations. However, these concerns are misguided. Even under Pease, virtually all affluent taxpayers will be able to get the full deduction for any additional gifts to charity.

Here’s how Pease works for a typical affluent married couple (let’s call them Andy and Amanda), who have a combined income of $400,000 and itemized deductions of $50,000. Under Pease, a taxpayer’s itemized deductions would be reduced by 3 cents for every dollar of income that exceeds the threshold ($300,000 for a married couple). Since Andy and Amanda’s income is $100,000 above that threshold, their itemized reductions would be reduced by $3,000, from $50,000 to $47,000.

Yet, Pease does not undermine the incentive for affluent taxpayers to increase their itemized deductions. To see why, suppose Andy and Amanda gave an additional $1,000 to charity. Here’s what would happen. Their itemized deductions would rise from $50,000 to $51,000. Pease would then reduce these deductions by 3% of their income above $300,000, or $3,000 — no change there. So, after the Pease haircut, their itemized deductions would be $48,000 ($51,000 minus $3,000) — which is $1,000 higher than it was before they made the additional $1,000 contribution. In other words, this additional contribution is completely deductible.

This benign result occurs because Pease cuts back on the couple’s deductions based on the level of their income, not on the amount of their itemized deductions. As long as Andy and Amanda have joint income of $400,000, they will lose $3,000 in itemized deductions — regardless of whether their itemized deductions are $50,000 or much more.

By contrast, suppose the joint income of Andy and Amanda rose by $50,000 — from $400,000 to $450,000. Since their income rose, their Pease haircut would increase from $3,000 to $4,500 (which equals 3 percent of $150,000 — the amount by which $450,000 exceeds $300,000). Again, this $4,500 reduction occurs whether their itemized deductions are $50,000 or much higher.

Thus, Pease does not actually “limit” itemized deductions in any meaningful way. Instead, it functions as a stealth increase in the marginal tax rate for affluent people like Andy and Amanda. For every dollar of income earned above the $300,000 threshold, their taxable income increases by $1.03 — one dollar from that income itself, and three cents from the reduction in itemized deductions. For taxpayers in the top 39.6 percent bracket, this represents a roughly 1.2 percentage point increase in their effective marginal tax rate to a total of 40.8 percent.

In theory, Pease could eliminate enough itemized deductions to induce affluent taxpayers to take the standard deduction instead of itemizing their deductions. In this situation, a charitable organization should be concerned about disincentives for affluent taxpayers to make charitable donations, since only itemizers can claim a charitable deduction. However, for these disincentives to influence behavior in practice, taxpayers must have extremely low levels of itemized deductions relative to their income.

For instance, if a married couple making $1,300,000 per year had at least $42,200 in itemized deductions, they would still find it worthwhile to itemize even after the Pease haircut. By comparison, taxpayers with income between $1 and $1.5 million on average claim more than $160,000 in itemized deductions, according to IRS data. Thus, there would only be a handful of millionaires with so few deductions that Pease would have a meaningful impact on their charitable donations.

Moreover, Congress provided that Pease in no event may reduce itemized deductions by more than 80 percent. Of the 2 million taxpayers subject to Pease, only 44,000 would be affected by this 80 percent cap.

In short, despite the passage of Pease, the attraction of itemized deductions has not fallen for virtually anyone. Any increase in charitable deductions will almost always be fully deductible under Pease. Ironically, because the fiscal cliff legislation raised the top statutory income tax rate from 35 percent to 39.6 percent, the new legislation might actually enhance the attraction of charitable deductions to affluent taxpayers.

Authors

Robert C. Pozen

Publication: Boston Globe

Corporate Tax Reform Without Tears

Robert C. Pozen — Sun, 31 Mar 2013 00:00:00 -0400

Economists have long recognized the damaging effects of the high U.S. corporate tax—at 35%, the rate is the highest in the industrialized world. Over the past few years, politicians in both parties have come to understand that the corporate tax system itself is dysfunctional, causing resources to be misallocated and encouraging corporations to invest overseas.

In February 2012, President Obama proposed a substantial reduction in the corporate tax rate to 28% from 35%. This year, the president has spoken positively about corporate tax reform if it is revenue-neutral, meaning the rate cut should be paid for by broadening the corporate tax base.

This is progress toward a bipartisan solution. Lowering tax rates and broadening the tax base is a central tenet of conservative economic philosophy. High tax rates distort decisions on the margin, as do many specific deductions, exclusions and deferrals. Lower tax rates and a broader base allow the market to allocate resources with less interference from the government.

But what is the best way to meaningfully broaden the corporate tax base? Eliminating tax credits to specific industries, such as green energy, is a good place to start. Unfortunately, repealing these provisions wouldn't raise enough revenue to make a significant dent in the corporate tax rate. Larger corporate tax expenditures, such as the research and development credit, have strong political support on both sides of the aisle.

Congress could also raise revenue by requiring U.S. corporations to immediately pay tax on all of their foreign profits. Currently, corporations may defer taxation on their foreign profits until they bring them back into the U.S. However, almost all Republicans would prefer for the U.S. tax system to move in the other direction: taxing only those profits earned in the U.S. (with some exceptions to prevent such abuses as shifting profits abroad to take advantage of lower rates).

Given the importance of reducing the corporate rate—and the infeasability of the other options for paying for it—Rep. Kenny Marchant (R., Texas) and Rep. Jim McDermott (D., Wash.) are floating a proposal to modestly restrict the deductibility of gross interest expense for corporations. This change would meet two crucial criteria: It would raise a significant amount of revenue and significantly reduce economic distortions caused by the tax code.

Based on Internal Revenue Service data from 2000 to 2009 (the most recent available), I estimate that disallowing roughly 30% of interest deductions (that is, allowing for a 70% deduction for gross interest expense) would have fully paid for a reduction in the corporate tax rate to 25% from 35%.

Limiting interest deductions for corporations would also correct, to a degree, a serious imbalance. When a corporation finances an investment by issuing debt, the interest payments generate a stream of tax deductions. When a corporation finances an investment by using its cash on hand or by issuing new shares of stock, there are no analogous tax deductions.

Because of this difference, many corporations choose to maintain a debt-intensive capital structure—primarily for tax reasons instead of underlying economics. As a result, the economy will tend to be overly leveraged relative to a true free market. This makes corporations overly at risk of going bankrupt, increasing the fragility of the economy.

Some corporate officials have criticized such a limit on interest deductions based on the fear that it would increase their tax burden. This is false, on average, since the proposal would be structured to be revenue neutral.

Here's a simple example. Consider a corporation with taxable income of $100 million, calculated after deducting interest expense of $90 million. Currently, it would pay $35 million in corporate tax—35% of its $100 million taxable income. If interest deductions were capped at 70%, $27 million of interest expense would become nondeductible, increasing the corporation's taxable income to $127 million from $100 million. At a 25% tax rate, it would pay $31.75 million in corporate tax—slightly lower than under current law. In other words, because the proposal would be revenue-neutral, some corporations will pay a little more and others a little less.

A more legitimate concern is how existing debt would be treated under this proposal. Corporate executives have made financing decisions based on good-faith beliefs about the tax law going forward, so it might be unfair to deny a full deduction for interest payments on existing debt. Any restrictions to interest deductions should be phased in very slowly and should not apply to debt issued before some relevant date.

Congress need not finance the entire rate reduction by restricting interest deductions. For instance, Congress could cap interest deductions at a higher level—say, 80%—and finance the rest by limiting other deductions and credits now available to corporations.

But there's a particularly strong case in favor of restricting interest deductions: It could raise significant amounts of revenue while at the same time reducing economic distortions. This proposed change should be the core of any revenue-neutral legislation to reduce the corporate tax rate to 25% from 35%.

Authors

Robert C. Pozen

Publication: Wall Street Journal

China’s Carbon Tax Proposal Highlights the Need for a New Track of Climate Talks

Adele Morris, Warwick J. McKibbin and Peter J. Wilcoxen — Fri, 15 Mar 2013 00:00:00 -0400

China’s Ministry of Finance recently announced a carbon tax. Although the statement was vague about the timetable and the tax rate, the mere prospect of China pricing carbon should have prompted swift laudatory international responses, especially by countries that have long hectored China to take stronger action on climate. China’s announcement, and the underwhelming response of the international community, shows that it’s time to start an international conversation about pricing carbon and invite anyone who’s interested aboard. A Carbon Pricing Consultation (CPC) would allow China and other countries that want to price carbon (via a carbon tax, cap-and-trade system or a hybrid approach) to learn more about it, exchange views, find out what other countries are considering, and potentially coordinate their policies.

In a recent paper we proposed a CPC process that would lead to detailed, pragmatic, and ongoing international discussion of the implementation details of domestic carbon pricing approaches, policies that economists widely agree could address the climate problem cost effectively. A domestic carbon price creates broad, efficient incentives to reduce greenhouse gas emissions. Done well, it would gradually shift consumer demand, production methods, new investment, and technology development towards less emissions-intensive goods and services without unduly burdening poor households. Pricing carbon can also raise revenue to fund government programs or cut distortionary taxes. Finally, a carbon price can promote economic growth by replacing less efficient regulatory and spending policies.

Accordingly, we think parties should embrace carbon pricing as a key low-carbon growth strategy and establish a venue to discuss it. Disparate carbon prices across different countries can shift emissions, production, investment, and trade patterns, and mutual understanding of these cross-border effects is of interest to all. Several countries have adopted or are implementing carbon pricing policies, so there is increasing experience to discuss. And the vehement opposition to the EU’s efforts to price carbon in aviation fuels suggests that unilateral approaches to carbon pricing can undermine progress.

This moment to begin a CPC process is opportune. Climate talks in December 2012 in Doha, Qatar, resolved contentious questions about the future of the Kyoto Protocol and finally retired the constraints of the Bali agenda. Now negotiators will turn to developing a new agreement under the United Nations Framework Convention on Climate Change to cover the post-2020 period. At the same time, the Major Economies Forum (MEF) needs a new thrust of engagement, having developed the Clean Energy Ministerial into an enduring venue for technology discussions. A CPC would fit nicely within the MEF, or possibly the G20.

This new line of discussion would address a glaring gap in climate talks to date. Negotiations have tackled emissions targets, temperature targets, technology transfer, financial assistance to poor countries, forest preservation, and many other topics, but not the practical design of cost-effective domestic mitigation policy. Indeed, few countries include their finance and trade ministries in climate talks outside of discussions of finance. This vacuum of economic expertise and leadership leaves parties prone to commitments, such as a two degree maximum global mean temperature increase, that imply implausibly stringent global efforts and fail to identify concrete solutions.

The CPC, unlike existing clean energy and climate consultations, would be led by finance and trade ministries (not the environment and energy ministries). It would focus exclusively on the practical administrative and technical aspects of responsible mitigation policy. One advantage of this pragmatic approach is that parties could sidestep divisive issues such as who bears responsibility for collective mitigation goals, who should compensate whom for what, and whose approach is more ethical. However justifiable, these debates have done little to promote real emissions mitigation.

The CPC would focus on the technical and administrative aspects of the policies, such as options to identify taxable or regulated entities and sources and methods to track revenue, minimize administrative costs, and ensure compliance. Parties could also discuss the role of international offsets and the interplay between carbon pricing and other domestic climate and energy policies. Countries could discuss ways to predict the effects of alternative tax trajectories, and they could discuss how to distribute and manage markets of allowances and tax revenue. Other topics could include the design of border carbon adjustments and other trade-related issues. The CPC could also steer existing resources to assist developing countries in reducing fossil fuel subsidies and pricing carbon.

One impediment to climate policy in the United States is the concern that without meaningful action by developing countries, pricing carbon will harm the US economy with little overall environmental benefit. A move towards transparent price-based policies give all major emitters comfort they are moving forward in concert with others. The first step is to discuss how to do it.

Authors

Publication: East Asia Forum

Image Source: © Darley Shen / Reuters

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

The Many Benefits of a Carbon Tax

Adele Morris — Tue, 26 Feb 2013 08:00:00 -0500

In this policy proposal — part of The Hamilton Project's 15 Ways to Rethink the Federal Budget — Adele Morris proposes a carbon tax as a new source of revenue that could also help address climate change. She suggests that a carbon tax would reduce the buildup of greenhouse gasses, replace command-and-control regulations and expensive subsidies with transparent and powerful market-based incentives, and promote economic activity through reduced regulatory burden and lower marginal tax rates.

IMPACT

Deficit Reduction (10-year): $199 billion

Broader Benefits: Reduces the buildup of greenhouse gas emissions; replaces command-and-control regulations and expensive subsidies with transparent and powerful market-based incentives; promotes economic activity through reduced regulatory burden and lower marginal tax rates.

INTRODUCTION

This paper proposes introducing a modest carbon tax to finance reforms to the U.S. tax system to promote economic growth, reduce budget deficits, reduce redundant and inefficient regulation, reduce unnecessary subsidies, and reduce the costs associated with climate change. The revenues from the new levy could fund permanent reductions in more distortionary taxes on capital income while also contributing to deficit reduction. And by providing simple, transparent, but powerful market-based incentives to reduce damaging greenhouse gas (GHG) emissions, this levy could supersede the array of costly regulatory command-and-control approaches and expensive subsidies aimed at reducing dependence on fossil fuels and promoting clean energy. In addition to these benefits, of course, is a contribution to stemming the global buildup of GHGs and improving the United States’ standing to foster the broader international action necessary to stabilize GHG concentrations and avoid catastrophic climate disruption. As this proposal shows, with a carbon tax these gains are possible with less-adverse, potentially even positive, consequences for economic activity, unlike other revenue raisers. Indeed, within twenty years a modest carbon tax can reduce annual emissions by 12 percent from baseline levels, generate enough revenue to lower the corporate income tax rate by 7 percentage points, and decrease the deficit by $815 billion, all while protecting the poorest households from undue burden.

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Download the policy proposal

Authors

Adele Morris

Publication: The Hamilton Project

Image Source: PonyWang

Creating an American Value-Added Tax

William G. Gale and Benjamin H. Harris — Tue, 26 Feb 2013 08:00:00 -0500

In this policy proposal — part of The Hamilton Project's 15 Ways to Rethink the Federal Budget — William Gale and Ben Harris consider how a value-added tax could be designed to help address the nation’s fiscal challenges.

IMPACT

Deficit Reduction (10-year): $1.6 trillion

Broader Benefits: Raises revenue in a manner that does not distort saving and investment choices.

INTRODUCTION

The Great Recession and its aftermath have left the United States with a difficult fiscal situation: a weak economy that would benefit from short-term stimulus, but also 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 greater scrutiny and pressure.

We propose a value-added tax (VAT) to contribute to the U.S. fiscal solution. A 5 percent broad-based VAT, paired with subsidies to offset the regressive impacts, could raise about
1 percent of GDP, or about $160 billion, per year. Although it would be new to the United States, the VAT is in place in about 150 countries worldwide and in every non–U.S. OECD country. In recent years, the VAT has raised about 20 percent of the world’s tax revenue (Keen and Lockwood 2007). This experience suggests that the VAT can raise substantial revenue, is administrable, and is minimally harmful to economic growth. Additionally, the VAT has at least one other potential advantage worth highlighting: a properly designed VAT might help the states deal with their own fiscal issues. Although a VAT would be regressive relative to current income, this regressivity can be easily offset by transfers that would make the net burden progressive. A VAT should only be imposed after the economy has returned to full employment, as the depressing effects of increased taxation in a demand-driven economy would suppress the economic recovery.

As the United States faces heightened long-term fiscal pressure, policymakers face the challenge of raising revenues in a way that puts as little burden on the economy as possible. While much of the discussion so far has focused on changes to income taxes, a consumption tax—here offered in the form of a VAT—offers advantages over higher income tax rates in terms of economic efficiency.

Like a retail sales tax, a VAT is a tax on consumption. Under a VAT, businesses pay taxes on the difference between their 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. The sum of value added at each stage of production is the retail sales price, so in aggregate the VAT simply replicates the tax patterns created by a retail sales tax and is like other flat tax rates 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. This distinction makes the VAT more administrable than a retail sales tax.

In the most common implementation of the VAT, producers are taxed based on their total output, and then receive credit for taxes they have paid on purchases to other firms.1 The tax credit thus acts as an incentive for compliance, and the VAT in practice is less likely to be evaded than is a retail sales tax.2 The VAT is therefore widely preferred to a retail sales tax when considering options for taxing consumption.

A VAT is also border-adjustable, since taxes on exports can be rebated at the border and imports can be taxed at the VAT rate. While this is sometimes touted as providing economic benefits, it is actually a neutral treatment of these items. Taxes assessed on imports ensure an even playing field across imported and domestic consumption goods, and the rebate for exports ensures that exporters are only taxed on the consumption of their product.

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Download the policy proposal

Authors

William G. Gale
Benjamin H. Harris

Publication: The Hamilton Project

Eliminating Fossil Fuel Subsidies

Joseph E. Aldy — Tue, 26 Feb 2013 08:00:00 -0500

In this policy proposal — part of The Hamilton Project's 15 Ways to Rethink the Federal Budget — Joseph Aldy proposes eliminating twelve subsidies to help level the playing field among fossil fuel producers relative to other businesses, and lead to potentially lower global fuel prices by providing the United States with increased leverage in negotiations over eliminating fossil fuel subsides in the developing world.

IMPACT

Deficit Reduction (10-year): $41 billion

Broader Benefits: Levels the playing field among fossil fuel producers and relative to other business investments; leads to potentially lower global fuel prices by providing the United States with increased leverage in negotiations over eliminating fossil fuel subsidies in the developing world.

INTRODUCTION

The federal government has subsidized the production of fossil fuels through the tax code for a century. While such subsidies may have once supported incremental investment in what was a very risky economic activity—drilling that may not yield a productive hydrocarbon field—the advances in technology and the high prices for oil in recent years have significantly changed the risk–reward calculus for domestic hydrocarbon investment. Indeed, the impact of these tax preferences on investment decisions is dominated by factors driving world oil prices (e.g., Asian demand and political events in the Middle East) and by the technological improvements in drilling for shale gas and oil and tight oil. Today, the U.S. government effectively transfers by way of tax expenditures more than $4 billion annually from taxpayers to fossil fuel producers (primarily oil and gas firms) with very little to show for it.

This proposal calls for eliminating twelve tax provisions that subsidize the production of fossil fuels in the United States. Implementing this proposal will contribute to a leveling of the playing field among oil and gas companies, since independent producers enjoy greater tax benefits than the oil majors, and will promote the efficiency in allocating capital across the U.S. economy. Since these subsidies have a very small impact on production, their removal will not materially increase retail fuel prices, reduce employment, or weaken U.S. energy security. This proposal complements other proposals to simplify the corporate tax code, and thus could facilitate the political support necessary to enact a simpler, more efficient corporate tax code. In addition, removing U.S. fossil fuel subsidies would enable the U.S. government to make the case more effectively that large developing countries (such as China, India, and energy exporters) should phase out their fossil fuel consumption subsidies that contribute to higher oil prices in the United States.

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Authors

Joseph E. Aldy

Publication: The Hamilton Project

Limiting Individual Income Tax Expenditures

Diane Lim — Tue, 26 Feb 2013 08:00:00 -0500

In this policy proposal — part of The Hamilton Project's 15 Ways to Rethink the Federal Budget — Diane Lim’s discusses an approach to individual income tax expenditures that would raise revenue more efficiently and progressively by reducing tax expenditures, limiting potential negative impacts on subsidized sectors by preserving certain tax incentives, and equalizing implicit subsidies across middle- and higher-income taxpayers.

IMPACT

Deficit Reduction (10-year): $1 trillion

Broader Benefits: Raises revenue more efficiently by reducing tax expenditures; limits potential negative impacts on subsidized sectors by preserving certain tax incentives; equalizes implicit subsidies across middle- and higher-income taxpayers.

INTRODUCTION

It is often said that base-broadening tax reform—that is, expanding the definition of taxable income—should be an important part of solutions to address the fiscal trilemma of reducing the deficit, promoting fairness, and encouraging economic growth. Such reform would be expected to garner bipartisan support, but getting policymakers to move from that vague sound bite to specific policy proposals, without the usual ideological bickering, is another story. In this paper I argue why an across-the-board reduction in broad classes of individual income tax preferences, rather than targeting certain tax expenditures within a comprehensive overhaul of the tax system, could be an easy step to ensure we achieve our nation’s fiscal and economic goals, despite our seemingly dysfunctional political system. Indeed, if implemented correctly, base-broadening reform could raise tax revenues by more than $1 trillion over the next decade.

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Authors

Diane Lim

Publication: The Hamilton Project

Image Source: Stepan Popov

Better Ways to Promote Saving through the Tax System

Karen Dynan — Tue, 26 Feb 2013 08:00:00 -0500

In this policy proposal — part of The Hamilton Project's 15 Ways to Rethink the Federal Budget — Karen Dynan examines the design of government incentives for personal savings, outlining how reforms to these programs would improve saving and economic security for low-income households and reduce expensive and ineffective federal subsidies for high-income households.

IMPACT

Deficit Reduction (10-year): $40 billion

Broader Benefits: Improves saving and economic security for low-income households; reduces expensive and ineffective federal subsidies for high-income households.

INTRODUCTION

The U.S. personal saving rate has declined dramatically over the past several decades and is currently very low by historical standards. Americans saved about 4 percent of after-tax personal income in 2012, down from average saving rates of 5.5 percent in the 1990s, 8.6 percent in the 1980s, and 9.6 percent in the 1970s (figure 6-1).

Increasing personal saving in the United States is a desirable policy goal. To be sure, over the near future there would be a downside to households saving more because that means they would be spending less, and, in turn, the economic recovery would not be as strong as it otherwise would be. But, over the longer run, higher personal saving would lead to stronger economic growth. The correlation between a country’s saving rate and its investment rate remains large and significant despite the globalization of international capital markets (Obstfeld and Rogoff, 2000). Hence, higher personal saving in the United States should increase investment in this country, which, in turn, should raise our capital stock and our productive capacity.

In addition to promoting higher personal saving in the aggregate, policy also should encourage higher saving among individual households. Households need savings in order to cope with unforeseen disruptions to their income and unanticipated consumption needs. Having such reserves is even more important now than it was in the past because household income volatility has trended upward amid ever-more-competitive and dynamic labor markets: recent research has found that the share of households experiencing a 50 percent plunge in income over a two-year period climbed from about 7 percent in 1971 to 10 percent in 2008 (Dynan, Elmendorf, and Sichel 2012). Moreover, as policymakers look for ways to reduce growing budget deficits, they may cut social programs so that the need for households to have precautionary reserves may be even higher in the future.

Saving also provides households with opportunities. Funds accumulated through saving can be used to pay for college tuition and to purchase big-ticket items such as cars and homes. Saving is likely even more important to attaining homeownership than it was in the past, given the greatly reduced availability of low-down-payment mortgages in the wake of the recent mortgage crisis. In addition, saving puts some households in a better position to establish businesses.

Finally, higher saving is important to households because it means that they will enjoy a better standard of living in retirement. Although most people can expect to receive social security benefits when older and many will receive regular payouts from defined benefit pensions, these sources of income are generally not sufficient to make up for the step down in earnings that occurs at retirement. As a result, many older households will need to supplement pension income with accumulated wealth if they wish to maintain the consumption levels they had when younger. Encouraging adequate retirement savings among lower-income households is particularly important given the available evidence suggesting that these households are much more likely than other households to experience a material drop in their consumption at retirement (Hurst 2008). The possibility of austerity-driven cuts to programs that help older Americans makes the issue even more pressing.

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Authors

Karen Dynan

Publication: The Hamilton Project

Replacing the Home Mortgage Interest Deduction

Alan D. Viard — Tue, 26 Feb 2013 08:00:00 -0500

In this policy proposal — part of The Hamilton Project's 15 Ways to Rethink the Federal Budget — Alan Viard proposes to replace the mortgage interest deduction with a refundable credit as a way to reduce the artificial incentive for the construction of high-end homes by better targeting the tax breaks for housing.

IMPACT

Deficit Reduction (10-year): $300 billion

Broader Benefits: Reduces the artificial incentive for the construction of high-end homes by reducing and better targeting the tax breaks for housing.

INTRODUCTION

The federal tax treatment of owner-occupied housing cries out for reform. Current tax policy offers unwarranted subsidies for the purchase of expensive homes by high-income taxpayers, but does little to promote homeownership by those of more modest means. To address these problems, I propose to replace the mortgage interest deduction with a 15 percent refundable credit and to reduce the size of the mortgages eligible for the credit while providing transition relief. Although this proposal is not ideal in every respect, it offers an effective way to scale back and better target the tax system’s housing tax breaks while raising revenue in a progressive manner. Over ten years, such a proposal could increase revenues by approximately $300 billion.

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Authors

Alan D. Viard

Publication: The Hamilton Project

Image Source: Ryan McVay