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Tax Base Broadening a Part of Everyone’s Deficit Reduction Plan–Even Paul Ryan’s

May 27th, 2011 . by economistmom

On Wednesday I attended the Peter G. Peterson Foundation’s “Fiscal Summit”–what felt like the fiscal policy world’s version of the Oscars, complete with stars like Bill Clinton, Paul Ryan, and two-thirds of the cast formerly known as the “Gang of Six” (now five), and even video presentations of the deficit-reduction proposals from six think tanks that felt amazingly similar to the clips from the Best Picture nominees.

President Clinton set the tone by encouraging an emphasis on the positive.  Instead of painting doomsday scenarios about what would happen if we don’t get our act together and reduce the deficit, he said we ought to emphasize what we have to gain from fiscal responsibility–you know, just little things (just kidding) like a strong economy and a more secure future for our kids and grandkids.

And in terms of the variety of proposals from the variety of participating think tanks, both the Wall Street Journal’s David Wessel, and the Tax Policy Center’s Howard Gleckman point out that while there are deep philosophical differences between the most liberal (Economic Policy Institute) and most conservative (Heritage Foundation) groups in terms of their views on the optimal size of government, they still all came up with mathematically consistent proposals that would actually reduce the deficit.  Heritage’s plan cuts spending the most in order to support a lower level of taxation (around the historical average of 18-19 percent of GDP), while EPI’s raises taxes the most in order to support a larger government.

Keeping on the positive, both David and Howard note the areas of agreement across the six proposals in terms of specific policy ideas, both awarding the “common ground” prize to… [drum roll please]… reducing tax expendituresDavid presents the award this way:

[H]ere’s the headline: All six would curb tax income-tax breaks, loopholes, deductions and credits, a.k.a. “tax expenditures” or “spending through the tax code” because Congress uses them as alternatives to explicit spending. “Until recently,” the Peterson Foundation observes, “tax expenditures drew little scrutiny outside budget circles, but the Bowles-Simpson commission put [them] at the center of the public policy debate.”

This unanimity points to the likelihood that any tax increases to which Republicans acquiesce in a deficit deal will curb tax expenditures rather than raise tax rates, perhaps even touching (while not eliminating) tax breaks for mortgages and employer-financed health insurance.

And Howard, this way:

How did they get there? They all would reduce or eliminate many tax expenditures, although most would preserve subsidies for charitable giving and mortgage interest in one form or another.

And while many commentators paint Paul Ryan’s (House Republican) plan as devoid of any tax-side solutions, that’s false.  Ryan’s deficit-reduction plan actually contains two tax plans which only when combined happen to add up to a zero-added-revenue plan: the first piece which broadens the tax base by reducing tax expenditures and hence raises revenue, and the second piece which reduces marginal tax rates and hence loses revenue.

So Paul Ryan proposes to reduce tax expenditures and raise revenue, too–just before he proposes to cut tax rates and lose the gained revenue.

Why does Ryan insist on keeping revenues in the 18-19 percent of GDP range?  Besides that nasty little (just kidding) “no new taxes” pledge the Republicans have taken, there’s Ryan’s genuine desire to promote economic growth and what I think is his sincere belief in the magic of “supply-side” (really, “Laffer Curvesque”) tax cuts.  But as he thought out loud about this at the summit, I made note that his logic goes this way (as quoted in a Politico story by Meredith Shiner, emphasis added):

Ryan reiterated his anti-tax hike stance, a point of contention with Democrats who say increases will be necessary.

“I think higher revenue is clearly helpful but we should get it through economic growth — job creation and economic growth,” Ryan said.

Ah… So I’d like to ask Paul Ryan to consider his stated economic goals and evaluate the tax pieces within his deficit-reduction plan, piece by piece.  If he recognizes that higher revenue “is clearly helpful” in reducing the deficit (by the basic mathematics that deficit = spending - revenues), then he should consider how each of his two tax policy components affect revenues, accounting for effects on economic efficiency and growth:

  • Paul Ryan Tax Piece #1: broadening the tax base by reducing tax expenditures.  This directly raises revenue, and indirectly, through improved allocation of resources from a more level “playing field” (more neutral tax treatment across different sources and uses of income) increases economic efficiency and economic growth–also raising revenue.  Score on Piece #1: unambiguously higher revenue = helpful!
  • Paul Ryan Tax Piece #2: lowering marginal tax rates, but holding the tax base constant. This directly reduces revenue, and indirectly, through increased incentives to work and to save, increases the tax base, which increases revenue.  Score on Piece #2: theoretically ambiguous; depends on which effect dominates, which depends on which side of the Laffer Curve we’re on.  But bad news: economists pretty much universally agree that in practice (i.e., reality) we are nowhere near the side of the Laffer Curve that folks like Grover Norquist would like people to believe we’re on.  So, likely lower revenue = NOT helpful!

So Chairman Ryan just needs to slow down when he self-analyzes his own tax proposals within his deficit-reduction plan.  If he would take a breather after recognizing the unambiguously positive economic effects from Paul Ryan Tax Piece #1 (reducing tax expenditures holding rates constant) and note that the costs are likely to exceed the benefits of Paul Ryan Tax Piece #2 (reducing marginal tax rates holding the tax base constant), he’s more likely to conclude that the other deficit reduction plans that also happen to involve raising revenue by reducing tax expenditures, but just don’t go so gung ho on the marginal tax rate cuts (as they shouldn’t given the cost-benefit test), aren’t really very different from his own optimal deficit-reduction plan.  That is, if he’s being honest with himself and true to his faith in economics–which he insisted at the fiscal summit motivates him more than his ideology.

4 Responses to “Tax Base Broadening a Part of Everyone’s Deficit Reduction Plan–Even Paul Ryan’s”

  1. comment number 1 by: B Davis

    “Until recently,” the Peterson Foundation observes, “tax expenditures drew little scrutiny outside budget circles, but the Bowles-Simpson commission put [them] at the center of the public policy debate.”

    That does seem like an important accomplishment of the Bowles-Simpson commission. I have to admit that I’ve been looking through the U.S. Budget for years and, until now, never noticed the section on Tax Expenditures. It can be found on pages 239 through 277 of the Analytical Perspectives from the latest budget. Table 17-3 on page 252 shows that the largest four income tax expenditures ranked by their projected effect on revenues in fiscal years 2012 to 2016 are 1) exclusion of employer contributions for medical insurance premiums and medical care, 2) deductibility of mortgage interest on owner-occupied homes, 3) step-up basis of capital gains at death, and 4) 401(k) plans. Their effects over the 5-year period are $1071 billion, $609 billion, $357 billion, and $356 billion, respectively. I was especially surprised by the size of #3, the step-up basis of capital gains on death.

    I also recently listened to an interview with Alan Simpson, the transcript of which can be found at this link. From the interview, it appears that the Bowles-Simpson plan cuts the mortgage interest deduction from a maximum of a million to a half million, keeps charitable giving, and keeps retirement savings accounts. In any event, I think that the new attention given to tax expenditures is a positive development. It will likely also help if more people become aware of the relative size of the existing tax expenditures and specific reductions that have been proposed by Bowles-Simpson and other plans. From my own experience, I suspect that many people still don’t have much knowledge of tax expenditures.

  2. comment number 2 by: SteveinCH

    Sorry Diane, but your contention here strikes me as very misguided.

    Piece 1 is unambiguously positive but only relative to an alternative tax code that raises the same amount of money through a more complex structure. Relative to the current tax code, from a growth perspective, it positivity ; ) is highly ambiguous. It takes money from private hands and puts it into public hands. That may or may not be positive depending on what is done with the money.

    Consider the outlier plans for a moment (Heritage and EPI and assume for the moment that EPI was willing to raise taxes high enough to hit the same deficit/debt level that Heritage hits, thus making the plans equal from a deficit management perspective. The question of which plan is better has a lot to do with how the tax code is structured and what the revenue is spent on.

    Again, let’s make a simplifying assumption (not true) that both plans have a tax code that eliminated most deductions and credits for all Americans so that the complexity of the code is not an issue.

    Under that set of assumptions, the question of which plan is better has to do with whether the incremental 8 percent of GDP taken out of the private economy and spent by the government creates more value than leaving that 8 percent of GDP in private hands for allocation. Everything I know about economics says that at the level of 8 percent of GDP (on top of 19), the money is probably better allocated by the private economy. Thus, the Heritage plan is “better” under the above assumptions than the EPI plan.

    On top of this, the EPI plan must (given the assumptions) have higher marginal tax rates. In actuality, it has much, much higher marginal tax rates (on the order of twice as high or maybe even a bit more). Again, all things being equal, higher marginal tax rates are a bad thing. We can debate how bad but we can’t debate that they are bad.

    Now coming back to your first point about Ryan’s plan. Relative to a tax code that raises the same amount of money and spends that money on the same stuff but is filled with exemptions, credits, and deductions, Ryan’s first move is positive. However, if the incremental money is spent, then whether step 1 is positive depends entirely on what the money is spent on.

    Said differently, the combination of Ryan’s two steps is unambiguously positive relative to today because it raises (roughly) the same amount of money with a less complex and less distortionary tax code. Your decomposition however creates a fallacy because the consequence of doing only step 1 creates a situation where spending may change as a consequence of step 1.

    I guess what I am pointing out to you is that one needs to look at the plans in aggregate and make two assessments.

    1. How simple is the tax code and how high are the marginal rates? All things being equal, more complex and higher marginal rates are bad.

    2. Is the marginal money raised by higher effective tax rates better spent by the government or the private economy? My own view is on the margin (1 to 2 percent of GDP), you can have a debate on this question. As substantially higher levels (and given that all the plans are spending at least 19 percent of GDP), it’s pretty hard for me to make this case.

    As a consequence of all of the above, in my view, the EPI plan is unambiguously bad. Most of the other left leaning plans are pretty demonstrably bad because of much higher spending and higher marginal tax rates. By the time you get down to BPC, there’s an argument to be make between that on one end and Heritage (which is reasonably close to the House Republican budget) on the other.

    By the point of posting was to note that the decomposition takes what is clearly a positive change (all other things equal) and makes it an ambiguous change.

  3. comment number 3 by: AMTbuff

    The tax expenditure folks want to equate all tax incentives to real spending. Then they can balance tax rate increases with “spending” cuts that also increase taxes.

    The irony is that that the advocates of this approach do not actually regard tax incentives as equal to real spending. They regard real spending controlled by the government as much, much better than tax breaks spread far and wide to the public.

  4. comment number 4 by: centerist cynic

    Whatever you call them tax breaks, exemptions, spending through the tax code or tax expenditures, we need to do a better job of monitoring their size, effectiveness and impact on competitiveness.
    Tax incentives once in place are not monitored and tend to become permanent. Developing policies that allow us to do that effectively is what is important not arguing over what to call them.