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Time to Rally for Sane Tax Policy!

September 29th, 2011 . by economistmom
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I wish I had even a fraction of the talent that Jon Stewart and Stephen Colbert–the “sanity ralliers”–have in explaining tax and budget policy in engaging ways. The Jon Stewart segment above is my latest favorite, but here’s a great one by Colbert on the “Buffett Rule.” In my Tax Notes column this week on “Evolved Tax Policy,” I argue that as our economy grows and changes shape over time, so should our tax policy. Why should we use our experience in the past to guide our policymaking more than our hopes and expectations for the future? How do I wish tax policy would better “evolve?” Here are a few ways I listed in my column (see the full column–if you are a Tax Notes subscriber–for more details):

Here are some forms of tax policy evolution we could use right now:

    1. recognizing that expanding the economy via tax policy isn’t as simple as cutting taxes and that tax cuts involve costs as well as benefits;

    2. allowing smart tax policymaking to at least occasionally trump clever tax policy politics;

    3. acknowledging that Wagner’s Law — which holds that the public sector is a luxury good — may apply, suggesting that the optimal size of government and hence the optimal level of revenue/GDP grow over time with the economy; and

    4. realizing or recognizing that because part of that growing role of the public sector may be the redistributive role, especially if wealth income inequality increase with aggregate income growth, the progressivity of the tax system may need to increase over time to partially compensate.

What is an example of how we’re NOT “evolving” on tax policy?  The fact that proposals for “flat taxes” seem to be back in vogue.  Take Republican presidential candidate Herman Cain’s “999 Plan.” A reporter called me about it, which was the only reason I went to the Cain website to check it out for a few seconds, which was all it took to “get” what his proposal is basically about:  (i) switching to a consumption-based tax system that exempts income from capital–which on its own is “regressive”; (ii) switching to a single (”flat”) marginal tax rate schedule–which on its own is (also) “regressive”; and then (iii) switching to a not-just-double-but-triple tax of consumed income (instead of saved income) through the 9 percent business tax (exempting capital income) and the 9 percent sales tax (which naturally exempts savings) that are layered on top of the 9 percent income tax (which exempts capital income as well)–which means all that regressivity I already listed is tripled!  Where did the 9 percent rates come from, I was asked by the reporter–and would it be revenue neutral?  My response:  “probably because 9 is one digit long” and theoretically, yes, it’s possible that a triple tax on consumed income with no or few exemptions which has an effective rate of 9+9+9 or 27 percent could indeed be revenue neutral.  (From Cain’s description of the 999 base, it’s not clear what is exempt other than charitable deductions–oh, and all of capital income, of course.)

I don’t know if I’ll feel compelled to say anymore about the Cain tax plan unless the candidate actually seems to have a decent chance of getting the Republican nomination, but on the way to seeing if that happens I hope people recognize how insane his tax plan is (without needing any detailed analysis).  This is one plan where my biggest reaction to the plan is not that it doesn’t raise enough revenue.  Like I said, theoretically it could, but why would we ever want to do it that way?

It’s sort of an example of what I called “Neanderthal tax policy” in my Tax Notes column.  So please don’t take it seriously.  Yeah, I know–it’s hard to believe I can say you should take the guys from Comedy Central–Jon Stewart and Stephen Colbert–more seriously than some of these presidential candidates when it comes to their wisdom on tax policy.  But you should.

Dynamic Deja Vu on Tax Policy

September 26th, 2011 . by economistmom

The “dynamic scoring” debate is back again. Last week the House Ways and Means Committee—chaired by Dave Camp (R-MI), who also happens to be a member of the debt-limit deal’s “super committee”—held a hearing on the subject, calling on the Joint Committee on Taxation’s chief of staff, economist Tom Barthold, to explain why that committee still estimates the revenue effects of tax legislation using “static” methods.

The Washington Post’s Lori Montgomery reported on this “old battle,” wondering out loud whether the super committee will resort to dynamic scoring as a “magic elixir that greases the skids to a more far-reaching compromise.”

Well, unfortunately for certain policymakers, dynamic scoring is not so magical.

“Dynamic scoring” refers to revenue estimates that would be adjusted to account for expected effects of tax policies on the aggregate size of the economy. As Barthold explained, conventional revenue-estimating methods account for how changes in tax policy might cause households and businesses to substitute lightly taxed activities for more heavily taxed ones. But the assumption is that the total level of economic activity stays constant. One thing to note is that this debate is about how tax cuts affect growth over the longer term and is different from the debate over short-term tax cuts designed to stimulate demand in a recessionary economy.

This is a déjà vu moment for tax policy experts. The issue comes up whenever politicians want to claim that tax cuts don’t cost that much and are fiscally responsible.

Those who push for dynamic scoring don’t necessarily adopt the extreme position that certain tax cuts “pay for themselves.” But their line of reasoning goes as follows: Tax cuts produce economic growth; growth enlarges the tax base; a larger tax base means more government revenue and less borrowing.

The first part of this chain is the weak link. If it is deficit-financed, a tax cut’s effect on economic growth will be relatively small; the harmful impact of the deficit financing is only partially offset by higher private savings.

On net, national saving is reduced — and that reduces rather than increases supply-side economic growth. (UC Berkeley professor Alan Auerbach did this analysis that precisely demonstrates that point.) So all the other potentially positive effects of the tax rate cut on economic incentives would have to do even better to make it an on-net “good” thing for the macro-economy.

We’ve been through this lesson before—most recently during the George W. Bush Administration when the Republicans in Congress last pushed for “dynamic scoring” to become part of the budget process. In 2003 they called for then-CBO director Doug Holtz-Eakin (freshly picked from the Bush White House) to make the case for it. He didn’t. (See the 2003 CBO macroeconomic analysis of President Bush’s budgetary proposals and the 2004 CBO analysis of a generic 10 percent tax cut.) Instead, as Alan Murray reported in the Wall Street Journal at the time, the CBO’s “dynamic analysis” of these tax cuts showed that:

Some provisions of the president’s plan would speed up the economy; others would slow it down. Using some models, the plan would reduce the budget deficit from what it otherwise would have been; using others, it would widen the deficit.

But in every case, the effects are relatively small. And in no case does Mr. Bush’s tax cut come close to paying for itself over the next 10 years.

Fast forward to today, and some Republicans are still hoping Holtz-Eakin will tell them that dynamic scoring is the magic elixir. He was one of their witnesses called to the same Ways and Means hearing at which Tom Barthold testified. Now unencumbered by the pressure to be nonpartisan (as a CBO director), Doug appeared diplomatically friendlier to the idea of dynamic scoring, but nevertheless he came to the same bottom line:

For many reasons, dynamic scoring will not provide a panacea for the policy decisions regarding the U.S. fiscal outlook, the most important of which is that the dynamic impact over 10 years can be relatively small.

In 2006, the Bush administration’s own Treasury Department conducted their own “dynamic analysis” of the proposed permanent extension of the Bush tax cuts. The lead official on Treasury’s analysis, then Deputy Assistant Secretary Bob Carroll, published a Wall Street Journal op-ed with President Bush’s former Council of Economic Advisers chair, Greg Mankiw, in which they tried to put as positive a spin as possible on the potential economic effects of the Bush tax cuts. But they were forthcoming enough to emphasize that “not all taxes [or tax cuts] are created equal” and “how tax relief is financed is crucial for its economic impact.” (Here is a Washington Post story that came out at that time.)

So we’ve been here before: Endorsing tax cuts by hoping that accounting for the feedback economic effects will make the cuts look less expensive and more “fiscally responsible.”

But the state of the art in terms of economic modeling, and the lessons we learn from the models, haven’t really changed. They have even been underscored by actual experience: the “dynamic” effects of tax cuts are pretty small. And with the kinds of tax cuts Congress has actually been passing and extending in recent years (the deficit-financed variety that doesn’t always improve economic incentives), accounting for the macroeconomic feedback effects might actually increase the cost of those tax cuts rather than decrease them.

So even if we decided we wanted to incorporate dynamic scoring into the federal budget process, it wouldn’t make tax cuts so significantly cheaper that they are a reasonable part of a “deficit reduction” strategy. Sorry, super committee, but this (still) isn’t any magic solution to your problem.

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(Post-script:  I’ll have more to say later, here on my blog, about the practical challenges of dynamic scoring in the revenue estimating/budget scoring process–i.e., why JCT and CBO do “dynamic analysis” now but not dynamic scoring–as well as more thoughts on what such dynamic analyses teach us about the macroeconomic effects of various “fundamental” tax reforms.  Stay tuned; we have a few months of such discussions ahead of us while the super committee mulls over how tax reform might or might not become a big part of their strategy.)

When Doing Something Falls Short of Doing Nothing

September 20th, 2011 . by economistmom

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About a month ago, the Brookings Institution’s Bill Gale made what I thought–and still think–is a brilliant analogy between budget baselines and weight loss goals at an event about the debt limit deal’s “super committee.” I liked it so much that I quoted from the transcript in my very next Tax Notes column (republished on the Concord Coalition site here), and I’d like to re-quote it here (emphasis added):

In terms of an example, think about this the following way: Suppose you’ve been eating badly the last, let’s say, 10 years, and you’ve been gaining a lot of weight and you want to lose weight and you want to lose 15 pounds. Well, we won’t go with 1.5 trillion pounds. You want to lose 15 pounds. The question is, compared to what?

Now, the way we’d usually think about it is, well, compared to where I am right now I want to lose 15 pounds. There’s another way to think about it, though, which is to say, well, I’ve been eating badly for 10 years. If I continue to eat badly the next 10 years I’m going to gain 45 more pounds, so I’m going to lose 15 pounds relative to that increase of 45 pounds that I’m going to do over the next decade.

Now, nobody that’s serious about losing weight builds in a 45-pound weight increase and then says, “I’m going to lose 15 pounds relative to that.” But using one of the baselines, the policy-extended one, as the standard for a deficit reduction goal would be the equivalent of increasing the deficit by $4.5 trillion and then saying, “I’m going to cut it by $1.5 trillion [in other words, increase it by $3 trillion relative to current law].”

In that same Tax Notes column of mine, called “Three Ways to the Current-Law Revenue Baseline,” I explained why I wanted the super committee to adopt a revenue goal of achieving a level of revenues consistent with the current-law baseline.  First, there are lots of ways to get there, and all aren’t too bad or so hard–the easiest option being the “do nothing” approach where Congress simply (goes home(?) and) avoids passing any new tax legislation–including any extension of any part of the Bush tax cuts, which have always been deficit financed.  Second, committing to those levels of revenues would insure getting our deficits down to clearly economically sustainable levels (not just borderline sustainable or “not quite” sustainable) over the next 10 to 20 years, while we’ll probably still be waiting for entitlement reform to either get done or materialize.  I pointed out that the super committee did not have to decide right now (or figure out how Congress and the Administration would actually agree to) the specific tax policy that would produce those current-law revenue levels.  All they would have to do is demand that the Bush tax cuts comply with strict pay-as-you-go rules going forward, such that any extension of any part of them would no longer be deficit financed.

In Bill’s lingo, they’d have to commit to not “eating” any more of those very fattening deficit-financed tax cuts.  In Bill’s lingo, that’s the way they’d really commit to changing their bad habits and thus not gain any more weight–not one pound of what would otherwise be a 45-pound weight increase.

Well, yesterday the President unveiled his deficit-reduction plan, one that has been characterized as qualifying as a “go big” approach–by the Administration, of course, but also by none other than Bill Gale, here, when he says (emphasis added):

The debt-limit deal signed in August had two parts. OMB estimates that the first part will reduce spending by $1.2 trillion (this may seem confusing, because the commonly-used figure for this part was $900 billion originally).

In combination with the debt-limit deal, then, the new proposals would (a) pay for the stimulus package the President proposed and (b) still reduce 10-year deficits by $4.4 trillion. Changes of this size constitute “going big” in current budget parlance and should be applauded.

In contrast, the Joint Select Committee needs to come up with “just” $1.5 trillion in deficit reduction to avoid the automatic second-round cuts. The president is asking Congress to go well beyond that and make a much more significant dent in the fiscal problem now.

Well, by the Administration’s own numbers, the plan’s revenue-gaining proposals raise nearly $1.6 trillion over ten years.  But that’s only after the Administration first cuts revenues by $3.9 trillion to adjust to their “policy-extended” baseline that assumes that under “business as usual” the entirety of the Bush(/Obama) tax cuts and Alternative Minimum Tax relief would be extended and deficit financed.  On net, this means that relative to current law (the purview of legislators, by the way), the President’s revenue proposals for “deficit reduction“–you know, his more “balanced” approach for deficit reduction because it supposedly includes higher revenue–would actually reduce revenues and increase deficits by $2.3 trillion ($3.9 trillion minus $1.6 trillion, from tables S-1 and S-2 in the Administration’s report) over ten years.

So, relating this to Bill Gale’s original analogy of someone who wants to change his ways and avoid what would otherwise be a 45-pound weight gain from his “eating as usual” diet that’s very heavy on deficit-financed tax cuts, the President’s new “diet plan” would indeed avoid the 45-pound weight gain, but would still lead to a 26.5-pound weight gain–as $2.3 trillion in deficit-financed tax cuts is 59 percent (still the bulk of) of the $3.9 trillion worth of all of the possible deficit-financed tax cuts, and 59 percent of 45 pounds is 26.5 pounds.

Now, I want to give credit where credit is due, and certainly the President’s plan is:

  • far better than the Republican approach of suggesting even more deficit-financed tax cuts coupled with draconian (I would call “heartless”) cuts in spending; and
  • considerably better than the “business as usual” policy-extended baseline–that worst-case scenario where all of the expiring tax cuts are all extended and deficit financed.

But I think we should all take note that for all the work and hard choices the Obama Administration put into this plan, it still is “worse”–still falls short of–deficit reduction under the “Do Nothing” approach where all the expiring tax cuts just actually expire.

If I actually had a personal goal of avoiding a 45-pound weight gain and was told I could achieve that by doing nothing versus going on a “tough” and specific alternative diet that would lead to “only” a 26.5-pound gain, I don’t think I’d be that persuaded to sign up for that diet.

And if I instead was told that I could just commit to the equivalent of “doing nothing” in terms of my weight gain, that instead of starving myself completely off my favorite bad-habits food (letting my access to that particular food disappear as scheduled, analogous to letting the tax cuts expire) I could keep some of that favorite yummy-but-fattening food in my diet, but add enough additional exercise to offset the caloric impact?….Well, then sticking to the “do nothing” weight-gain goal (and avoiding the full 45 additional pounds) wouldn’t seem so awful and austere after all.

(I eat a LOT of sweets by the way, but I also do a lot of yoga.)

So, Bill Gale and I have been having a little bit of a personal disagreement over whether I’m being too much a “Debbie (or Diane) Downer” on this.  I mean, can’t I emphasize my usual “glass is half full” perspective?  Well, in this case, no.  I’ve always thought that the current-law revenue baseline is the right goal for tax policy going forward, and I especially think that’s true now.  If the President wanted to “go big” with an approach that’s a big contrast to the Republican approach, he should have “gone bigger” with revenues.  Falling short of “doing nothing” is far from good enough.  And I say this not because I’m a pessimist, but because I’m an optimist and truly believe we can do much better than this.

What Is “Pro-Growth” Tax Reform?

September 14th, 2011 . by economistmom

I testified before the House Budget Committee this morning, for a hearing entitled “The Case for Pro-Growth Tax Reform.”  My full written testimony is available at the committee’s website and also at the Concord Coalition site, here.  (Later you should be able to see the video on the committee website.)

As I explained at the opening of my testimony:

[T]he “case” for pro-growth tax reform is easy and non-controversial—as achieving a stronger economy makes pursuing any other social goals easier (deficit reduction, higher and fairer standards of living, greater investment in higher quality public goods and services, etc).

The disagreement is over what makes a given tax reform “pro-growth.”

Growing the economy through tax policy isn’t as simple as “cutting taxes” to reduce overall tax burdens.  Tax cuts all have benefits, but the first thing one learns in an economics class is in a world of scarce resources, we maximize well being by weighing costs against benefits, and at the margin starting from where we are right now.  Tax cuts that might benefit particular households and businesses don’t necessarily pass society’s cost-benefit test, even based on a narrower and naïve goal of maximizing GDP because:

(i)           If deficit financed, the direct reduction in public saving will typically outweigh any positive response from private saving, so national saving and economic growth falls.  This is the biggest factor preventing simple cuts in overall tax rates from being “pro growth” over the longer term.

(ii)          How taxes are cut matters:  marginal tax rates are what matters for supply-side growth effects (increases in incentives to work and save), and those responses depend on how large the change in marginal rates (we’re starting from relatively low rates), how large the responsiveness (“substitution effects”) of households and businesses to those rates (often pretty small), and how other factors (such as “income effects”) may swamp those responses to price changes.

(iii)          In an economy still recovering from recession, we have to worry about getting back to “full employment” (where we are putting all of our productive capacity to use) before turning to growing the productive capacity of the economy over the longer term.  Tax policies that help increase demand for goods and services (and hence businesses’ demand for workers) can be quite different from those that increase the supply of labor and capital.

Our experience with the Bush tax cuts has demonstrated each of these challenges, as their major contribution to record-high deficits clearly reduced national saving and economic growth, were not very effective at growing the supply side of the economy (even according to the Bush Administration’s own Treasury Department), and are not the kind of tax cuts that provide high “bang per buck” in a recessionary economy.

That is, growing the economy isn’t as easy as just “cutting taxes,” because the loss of revenues feeds dollar-for-dollar into a higher deficit and reduced public saving.  Unless private saving responds immediately or even eventually like gangbusters to the form of the tax cut (and that’s never been our experience by the way), national saving–the sum of public plus private saving–will likely fall.  So the first effect of a tax cut on economic growth is that direct and certain negative effect of the deficit on saving, that we gamble away for the hope of an uncertain positive private sector response to at least partially offset it.  But empirically, it never comes close to fully offsetting it, so empirically, there is always a cost to tax cuts that has to be weighed against any benefits.

It’s not enough that tax cuts are “good” (especially for those who receive them).  They have to be good enough.

If Only REINing in the Deficit Were As Easy As RAIN

September 8th, 2011 . by economistmom

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Just had to “tweet” that!  Mainly wanted to combine a complaint about the rain and a link to my Tax Notes column (reprinted on the Concord Coalition site, here) that argues that the first easy thing the debt limit deal’s “super committee” could do is commit to strict pay-as-you-go rules on the Bush tax cuts–and on other expiring tax cuts and on spending as well, by the way, but the biggest difference this would make in on tax policy.

Committing to pay-go rules on the Bush tax cuts wouldn’t be so hard in terms of making tax policy.  I explain in my column that there are three main ways we could get there–each with their economic and political pros and cons:

1. Do Nothing. Allow all expiring tax cuts to expire as specified under current law. That would mean reverting to Clinton-era marginal tax rates. (Hmmm, what was so bad about those tax rates for our economy?)

2. Do It Big. Extend some or all of the marginal tax rates under the Bush tax cuts, but fully offset the costs of extending the low rates by broadening the tax base and reducing some tax expenditures (for example, limiting itemized deductions or reducing the exclusion of employer-provided health benefits). This is the fundamental tax reform approach.

3. Do It to the Rich. Extend some or all of the Bush tax cuts — particularly those that affect middle-income taxpayers (lower tax rates, child tax credit, marriage penalty relief) — and fully offset the costs by imposing an extra tax on the very rich, such as a surtax on households with incomes in excess of $1 million.

I admit that’s still not as easy as rain, but it’s also far easier than the super committee having to do full-blown fundamental tax reform within the next few months.  And not being able to do all of fundamental tax reform right now isn’t a reason to avoid committing to a budget rule that would encourage smart and fiscally-responsible tax reform in the future.

Does No Jobs Mean No Deficit Reduction?

September 4th, 2011 . by economistmom

Nope. Simplest reason why not: the deficit reduction we’re talking about is over the next ten years. The extra or at least more effective stimulus we’re talking about better come sooner. Many of the same policies that contribute to the adverse longer-term fiscal outlook provide very little offsetting benefit to the near term. Getting our longer-term act together would give global investors, right now, more confidence in the security of Treasury bonds and help keep the cost of borrowing–for stimulus right now–low. So it seems the so-called “super committee” has no reason to shy away from its task of (another $1.5 trillion over ten years in) deficit reduction. There’s lots of opportunity for them to become “superheroes” in conquering both the near-term and the longer-term challenges facing our economy. And President Obama could encourage them by offering his own leadership on this issue–and let’s hope we hear some of that on Thursday. As “super” as they might be or might become, they can’t do it without his help.

(Link to this Concord Coalition video on YouTube here.)