Continuing on our Tax Week theme, this blog will focus on the various models there are for tax reform. Obviously, there are an almost unlimited number of ways to reform the tax code, but we will lay out the major "styles" of tax reform.
The tax reforms we will mention range from largely staying within the current structure to dramatically simplifying the current system to dramatically altering its structure.
- '86-Style Reform (Lower the Rates, Broaden the Base): In 1986, Democrats and Republicans came together to enact a comprehensive tax reform package. The package combined reductions in rates and simplifications of the code with cuts to various "tax expenditures" such as the deduction for credit card interest and the investment tax credit. It also taxed capital gains as ordinary income. The most recently incarnated of that style of reform is the Wyden-Coats legislation introduced last year, which consolidates six rates to three, reduces them somewhat, reduces a number of tax expenditures, and raises rates on capital gains.
- Zero Plan-Style Reform: The Fiscal Commission's Zero Plan is the 1986-style reform on steroids. Instead of identifying several tax expenditures to eliminates, this reform cuts out all tax expenditures and uses the money to substantially lower rates and deficits. Under this framework, the Commission then allowed tax expenditures to be "added back," but only if they were paid for with higher rates. For example, the Commission's illustrative tax plan brought rates down to 12%, 22%, and 28% (above the 8%, 14%, and 23% of the pure Zero Plan) and kept some form of many major tax expenditures (for example, the mortgage interest deduction was turned into a 12% credit). This style generally taxes capital gains and dividends as ordinary income, but it could maintain preferential rates in exchange for higher rates.
- National Sales Tax (FairTax): Many economists believe that moving to a consumption tax would help promote economic growth by favoring savings and investment. Some tax reforms would replace some or all of the current system with a sales tax. The most prominent of this type of reform recently, the FairTax, would replace nearly all federal taxes with a 30 percent retail sales tax. In addition, it would give rebates to all households based on the projected consumption of a poverty-level family, adjusted for family size. This system is designed to be revenue-neutral. A similar but alternative approach would be to instead replace the income tax with a Value Added Tax (VAT), which is like a sales tax except that it is collected at every point along the supply chain.
- Flat Tax (Hall-Rabushka): Consumption taxes need not be imposed at the point of sale. One alternative, associated with economists Robert Hall and Alvin Rabushka, is something called a flat tax. The flat tax would charge a single rate (perhaps 20 percent) on all corporate and individual income, but would exempt savings and investments. Since income by definition equals the sum of consumption and savings, exempting savings from taxation leads to a consumption tax.
- Progressive Consumption Tax (X Tax): One critique of consumption taxes is that they are regressive -- both because they tend to have a "flat" rate structure and because lower-income individuals spend a larger proportion of their income than higher-income individuals. One solution, generally associated with the late Princeton economist David Bradford, is to enact a progressive consumption tax -- what Bradford called an "X tax." As in the example above, this tax would exempt net savings and so focus on consumption. However, a progressive rate structure would ensure that higher income individuals pay at higher rates than they would in a flat tax.
- Partial Replacement VAT (Graetz Plan): Another approach for taxing consumption in a progressive way is to combined a new consumption tax with a more progressive version of the existing income tax. This is the approach taken by by Yale professor Michael Graetz in his plan to combine a new VAT with lowering corporate and individual tax rates, as well as an exemption from the income tax for families making less than $100,000 from the income tax, and a rebate for low-income individuals. Some versions of this proposal would go further by eliminating or reducing many tax expenditures as well. A variant on this type of reform would replace or reduce payroll taxes in exchange for a VAT.
- New Revenue Sources: The reform models discussed above pick one of two tax bases: income or consumption (or some combination of both, as the current system is). Other reforms could involve alternate sources of revenue either as a supplement to the existing system, as a partial replacement, or as a full replacement. New revenue could come from a carbon tax, a financial transactions tax, or other sources.
- Partial Reform: Of course, for as many comprehensive tax reforms as there are, there are many more plans which would partially reform the tax system by reforming tax expenditures or changing rates in isolation. These efforts can take on many forms, but most notably this label could describe the proposals in the President's budget (or other Democratic budgets), which reduce or eliminate some tax expenditures and allow some of the 2001/2003/2010 tax cuts to expire. Such reforms can help meet revenue or distributional goals without uprooting the current system.
These reforms are by no means an exhaustive list of possibilities, but these are some of the more common types of reform that you will see and hear about. Regardless of the form it takes, we know that reform has to happen. The current code is simply not cutting it.
Today is Tax Day and Financial Literacy Day, and just as we examine our own finances, our federal government should do the same. In The Hill, CRFB's own Senior Policy Director Marc Goldwein and Research Director Jason Peuquet write that this year will be critical for our nation's future finances. In laying out the problem, they say:
Having already grown from its historical average of below 40 percent of the economy to about 70 percent today, the nation’s debt is on course to rise to 85 percent of the economy by 2022, and 150 percent by 2040. By contrast, federal revenues have historically been at about 18 percent of the economy. It doesn’t take a financial literacy class to know that if you owe eight times as much as you earn, you are probably in trouble. The time to address our federal deficit is right now.
As regular readers of The Bottom Line already know, the sequester, the expiration of the 2001/2003/2010 tax cuts, and the expiration of the payroll tax cut, among other things, are all due at the beginning of 2013 -- a huge fiscal cliff. While the fiscal cliff would dramatically reduce the deficit, its magnitude could stall an already weak economy. Also, the policies involved are not the smartest way to reduce the deficit.
Do we need more revenue and more spending cuts? Absolutely. But the revenue should come from comprehensive tax reform that lowers rather than raises marginal tax rates and that reduces the deficit by cutting the various deductions, exclusions and credits, which are really just spending in the tax code. And the spending reductions should be focused on cutting wasteful and anti-growth spending and controlling the growth of entitlement costs — not mindless wholesale cuts that hit good spending as well as bad.
Changes set to occur at the end of the year offer an incredible opportunity for our leaders to act proactively and replace the automatic and abrupt savings with smart reforms. We must not let the moment pass us by.
The full op-ed can be read here.
"My Views" are works published by members of the Committee for a Responsible Federal Budget, but they do not necessarily reflect the views of all members of the committee.
Tax Reform Cometh…Eventually – Today is Tax Day, when federal tax returns are due. Procrastinators have DC Emancipation Day, a holiday in the District of Columbia celebrating the day President Lincoln freed the slaves there, to thank for the extra day to file. The law prohibits Tax Day from falling on a weekend or federal or state holiday. Congress returns from a two-week hiatus just in time for lawmakers to take advantage of the tax filing deadline to promote their favorite tax reforms. While the two parties agree on the need for a tax overhaul, they differ widely on how exactly to improve the tax code. In a statement, CRFB urged lawmakers to take heed of the tax deadline they face at the end of the year when several tax provisions expire to enact fundamental tax reform as part of a “Go Big” comprehensive fiscal plan. The so-called “taxmaggedon” is part of the “fiscal cliff” that threatens the economy unless lawmakers act thoughtfully. The tax reform plan put forward by the Simpson-Bowles Fiscal Commission serves as a model for a plan that can achieve bipartisan support and improve the tax code while also raising revenue. But for now, the two parties are taking vastly different tacks to tax reform.
Buffetting the Tax Code – The Democratic-controlled Senate held a vote Monday on the “Buffett Rule,” designed to ensure that millionaires pay at least 30 percent of their income in taxes. The White House promoted the bill all last week. Though the bill did not survive a filibuster, it will live on as a campaign issue. The Republican-controlled House will counter later in the week with a vote on legislation to let small businesses deduct 20 percent of their income. Fundamental tax reform that simplifies the tax code and broadens the tax base is desperately needed. It is clear that limiting or eliminating tax expenditures must be a key facet.
One Deadline Missed – Lost amid the tax discussion is another deadline that just passed. By law, Congress is supposed to produce a concurrent resolution on the budget for the next fiscal year by April 15. Yet again, Congress will not agree on a budget. The FY 2013 budget resolution that passed the House along party lines stands no chance in the Senate. While the Senate Budget Committee will mark up a budget resolution on Wednesday, Senate Majority Leader Harry Reid (D-NV) has already said that he will not schedule a vote on a budget. The stage is being set for yet another government shutdown showdown later this year as the two chambers move forward on divergent spending paths. The Senate will craft appropriations bills based on the topline number of $1.047 trillion in last year’s Budget Control Act. The House is moving forward based on the topline of $1.028 trillion in the House budget resolution and several committees will act on reconciliation instructions contained in the budget resolution. The latest budget battle not only highlights the need for a bipartisan fiscal plan that both sides can agree on, but also the need for reforming the budget process. See lots of budget reform ideas here. And try your own hand at the budget with our updated simulator.
Key Upcoming Dates (all times ET)
- Tax Day! Federal income tax returns are due.
- House Ways and Means Committee hearing on tax reform and tax-favored retirement accounts at 10 am.
- Joint Economic Committee hearing on "How taxation of capital affects growth and employment" at 10 am.
- House Budget Committee hearing on strengthening the safety net at 10 am.
- House Judiciary Committee marks up reconciliation proposal to comply with FY 2013 budget resolution at 2:15 pm.
- House Ways and Means Committee marks up reconciliation proposal to comply with FY 2013 budget resolution at 9:30 am.
- House Appropriations subcommittee mark-up of FY 2013 Energy and Water appropriations bill at 9:30 am.
- House Committee on Financial Services mark-up of reconciliation proposal to comply with FY 2013 budget resolution at 10 am.
- Senate Budget Committee mark-up of FY 2013 budget resolution at 2 pm.
- House Appropriations subcommittee mark-up of FY 2013 Commerce, Justice and Science appropriations bill at 9:30 am.
- House Ways and Means subcommittee hearing on using technology to better target public benefit spending at 10 am.
- Senate Appropriations Committee mark-up of FY 2013 spending bills for Commerce, Justice & Science and Transportation, Housing & Urban Development at 10:30 am.
- House Subcommittee on Economic Development, Public Buildings, and Emergency Management hearing: "GSA's Squandering of Taxpayer Dollars: A Pattern of Mismanagement, Excess, and Waste"
- Presidential contests in Connecticut, Delaware, New York, Pennsylvania, and Rhode Island
- Senate Finance Committee hearing on what tax reform means for state and local tax and fiscal policy at 10 am.
- Senate Finance Committee hearing on improving the taxpayer tax filing experience at 10 am.
- US Dept. of Commerce's Bureau of Economic Analysis releases its advance estimate of 2012 first quarter GDP growth.
- Dept. of Labor's Bureau of Labor Statistics releases April 2012 employment data.
- Presidential contests in Indiana, North Carolina, and West Virginia
- Presidential contests in Nebraska and Oregon
- Dept. of Labor's Bureau of Labor Statistics releases April 2012 Consumer Price Index (CPI) data.
- Presidential contests in Arkansas and Kentucky
- Presidential primary in Texas
- US Dept. of Commerce's Bureau of Economic Analysis releases its second estimate of 2012 first quarter GDP growth.
The House Republican budget resolution included reconciliation instructions to six committees to find $261 billion in savings over ten years intended to offset $78 billion from delaying the sequester for a year. This week, it appears the committees are ready to mark up the policies they have come up with, and some details have emerged.
The House Financial Services Committee will be striking at many Obama Administration priorities or policies. Their legislation will meet the $30 billion target by repealing the Dodd-Frank Act's FDIC resolution authority for financial institutions ($22 billion), eliminating HAMP ($3 billion), and cutting the Consumer Financial Protection Bureau ($5 billion). In addition, they will reauthorize and reform the National Flood Insurance Program ($5 billion).
|Required Savings by Committee (billions)|
|Energy and Commerce||$28||$97|
|Oversight and Government Reform||$30||$79|
|Ways and Means||$23||$53|
|Net Reconciliation Savings||$116||$261|
The House Judiciary Committee meets its $40 billion target by enacting tort reform as contained in the HEALTH Act (HR 5). CBO estimated that the latest version of the bill would get $50 billion of savings from tort reform.
While there appears to be no legislation available yet, David Rogers of POLITICO discusses savings from the House Agriculture Committee. The Committee is tasked with saving $33 billion, and it appears to come mostly from Food Stamps (SNAP). These savings include ending the temporary SNAP benefit increase two years early ($6 billion), limiting state "Heat and Eat" programs in which states provide small energy assistance benefits in order to bump up SNAP benefits ($14 billion), and tightening other eligibility rules ($6 billion).
The other committees--Energy and Commerce, Ways and Means, and Oversight and Government Reform--must save $97 billion, $53 billion, and $79 billion, respectively. Policies may come from the December House version of the payroll tax cut extension, which include Medicare means-testing, federal workforce cuts, and others.
In honor of Tax Day on Tuesday, we will be doing blogs this week about the current shape of the tax code and what can be done to fix it. Our first blog will be about all the tax provisions that will expire at the end of the year, what has been labelled as "taxmageddon" (or the tax side of the fiscal cliff).
As our press release on Tax Day makes clear, the tax system has increasingly become temporary, and many temporary tax provisions are set to expire at the end of 2012, creating tremendous uncertainty for everyone. These expiring provisions affect taxpayers at all levels of income to varying degrees and affect a number of different targeted benefits that individuals and businesses receive; however, extending all of these would cost over $5 trillion over ten years. The provisions include:
- Tax rates: The 2001 tax cut lowered tax rates across the board, leading to tax brackets of 10, 15, 25, 28, 33, and 35 percent. If the 2010 tax cut expires, the 10 percent bracket will disappear and the other rates will be 15, 28, 31, 36, and 39.6 percent. Extending the brackets alone would cost about $1.3 trillion over ten years.
- Refundable tax credits: The 2001 tax cut increased the child tax credit from $500 to $1,000 per child and made it partially refundable, while increasing the Earned Income Tax Credit for married couples. The 2009 stimulus made the child tax credit more refundable, expanded the EITC for families with three or more children, and created the American Opportunity Tax Credit, a $2,500 refundable credit for college expenses that replaced the smaller non-refundable Hope credit. Continuing all of these credits at their current parameters would cost $665 billion over ten years.
- Capital gains and dividends: The 2003 tax cut lowered capital gains and dividends rates to 0 percent for people in the 10 and 15 percent brackets and to 15 percent for people above the 15 percent bracket. If these provisions expire, the rates would go back to 10 and 20 percent for capital gains and to ordinary income rates for dividends. Keeping these lower preferential rates would cost $315 billion.
- Estate tax: After the 2001 tax cut temporarily eliminated the estate tax in 2010, the 2010 tax cut reinstated the estate tax at a $5 million exemption (indexed for inflation beyond 2011; currently at $5.12 million) and a 35 percent top rate. If this provision expires, the estate tax will revert to the pre-2001 parameters of a $1 million exemption and a top rate of 55 percent. Extending the more generous estate tax parameters would cost $430 billion.
- Phaseouts: The 2001 tax cut also eliminated phaseouts of personal exemptions and itemized deductions for upper-income taxpayers (PEP and Pease, respectively), resulting in an effective rate cut for those who were previously hit by them. Permanently eliminating these phaseouts would cost $165 billion.
- Marriage penalties: The 2001 tax cut included a few provisions that were intended to reduce marriage penalties. These provisions extended the 15 percent bracket to higher incomes for married couples and increased their standard deduction. Extending these provisions would cost $55 billion.
- AMT patch: The Alternative Minimum Tax was originally created in 1969 to prevent high-income taxpayers from paying little or nothing in tax. However, the exemption was not indexed for inflation, so Congress has to act frequently to prevent the tax from hitting middle earners by increasing the exemption. The most recent patch expired at the end of 2011 but can be extended retroactively by the end of this year. The tax would only hit four million people if it is patched, but 30 million people if it isn't. Permanently patching the AMT would cost $800 billion on its own and $1.7 trillion if the other tax cuts are extended.
- Payroll tax holiday: The 2010 tax cut originally enacted the two percentage point payroll tax cut, which was scheduled to expire at the end of 2011. Congress acted late last year and again in February to extend it through this year. Although no official estimate currently exists, we estimate that extending the payroll tax cut for a year would cost about $120 billion.
- Other Tax extenders: Tax extenders are "temporary" and often narrowly-targeted tax provisions that are routinely extended (although that sounds like much of the tax code these days). The extenders are headlined by the popular R&E tax credit, which has been temporary for the past 30+ years. The extenders also include various energy incentives and other miscellaneous carveouts. All the extenders expired last year, but as with the AMT patch, they can be extended retroactively. Making them all permanent (excluding expensing provisions) would cost $455 billion.
As you can see from the descriptions above, there is something for everyone in these tax cuts. At the same time, there is a ton of money involved. How Congress handles all of these tax policies will be a major determinant in what our budget will look like going forward.
Note that the table and bullets above do not include taxes from the Affordable Care Act that will take effect in 2013, since those taxes are not temporary and are not generally discussed as a decision point to be made about the fiscal cliff. These taxes are highlighted by the 0.9 percent HI surtax on people making more than $250,000, and the 3.8 percent surtax that is applied to the investment income of those people.
With the fiscal cliff approaching and no solution yet emerging, former Sen. Judd Gregg (R-NH) has an interesting idea: bring back the Fiscal Commission. In an op-ed in The Hill, he notes the struggle that lawmakers will have in agreeing to a constructive plan that deals with future deficits while not coming down too hard on the economy in the short term. On the cliff, he says:
These two events, if allowed to go forward as proposed, would bludgeon the economic recovery and almost assure a relapse of the economy into some level of contraction, possibly even a renewed recession.
While the debt reduction that would result from these spending cuts and tax increases is needed to reduce our disastrous debt course, the manner in which they will occur will be counterproductive and would actually aggravate, to a large degree, the long-term debt problem by slowing economic growth.
Because of the toxic partisan environment, he sees a new Commission as one of the few options available that could get both parties on board for the kind of plan we need.
The Simpson-Bowles commission should reconvene before the crush of the lame- duck session. It should start where it left off with the fiscal menu it put on the table to cut $4 trillion from the debt over 10 years.
It should, however, be ready to expand beyond its original proposal, incorporating ideas from the president and Ryan, and adjust and update the original proposal. It should prepare a template that will give this lame-duck session, on which political pressure will be intense, an opportunity to act outside the partisan boxes that will frustrate serious action.
Whatever the method used, lawmakers will need to find an avenue for a bipartisan path forward. The Fiscal Commission plan is an obvious place to start.
Matt Miller and Ezra Klein wrote op-eds on Wednesday with a very similar message: neither party is doing themselves or the country any favor with their tax positions. Republican insistence on no new taxes and Democratic insistence on concentrating tax increases on a very small sliver of the population may force some outcomes that neither party will like.
First, Miller discusses taxes in the context of the demographic shift that is currently under way and will accelerate in the coming years. He quotes former CBO director and CRFB board member Dan Crippen in 2008 as saying that taxes would likely need to be at 22 percent of GDP to pay for the government we'd have by then (i.e. experiencing a huge enrollment increase in the retirement programs). In the case of Democrats, Miller notes:
But raising taxes on the top, while an important part of a fiscal fix, won’t suffice to fund the boomers, shrink the deficit and pay for fresh investments in R&D, infrastructure and education. Acknowledging this fact doesn’t help Democrats win elections, however. And President Obama wants to keep (for this term, at least) his vote-winning promise not to raise taxes on any but the top.
Klein's piece similarly talks about how the tax debate between the two sides is over a "sliver of territory" between not raising taxes on anyone and not raising taxes on almost anyone. Similar to Miller, he notes that taking either position will be difficult with the demographic shift that will force taxes to go somewhat above their historical average to keep debt under control. In reality, Klein argues, the parties should take positions that allow them to meet their priorities in a reasonable manner. He cites transportation spending as a past example:
We used to have a straightforward way to fund infrastructure in this country: the federal gas tax. In 1956, President Dwight Eisenhower raised the tax from 1.5 cents a gallon to 3 cents to help pay for the creation of the interstate highway system. In 1959, he increased it from 3 cents to 4 cents. In 1982, President Ronald Reagan raised the gas tax to 9 cents. In 1990, President George H.W. Bush raised it to 14 cents, with half of the increase going to reduce the deficit. In 1993, President Bill Clinton raised it to 18.4 cents.
In other words, from 1956 to 1993, there was a bipartisan consensus on the federal gasoline tax: Both parties agreed that it occasionally needed to be raised in order to help pay for the nation’s infrastructure. But since 2000, there has been a bipartisan consensus against raising the federal gasoline tax.
However, with the current tax positions, that sort of thinking has disappeared; in other words, the connection between what tax system the parties want and what system they need to fund their priorities has been severed. If both parties do not change their positions significantly, he argues, they could face some adverse outcomes: Republicans may end up forcing Democrats to push through tax increases on the rich on a partisan basis, while Democrats may be forced to accept unpleasant spending cuts if they concentrate on raising revenue from only the rich.
These two op-eds make a great point that is missing in the current debate: taxes pay for government. The political realm must re-gain sight of that, figure out what level of government services we should be providing, and raise enough revenue to do so.
Charles Blahous's paper on the Affordable Care Act has sparked a lot of buzz, leading to some discussion about "double-counting" the Medicare savings and how to view the federal budget with regards to trust funds. Thinking about how the trust funds fit into the budget can be a headache-inducing topic, but we'd like to simplify the views and see how it relates to Blahous's view on the HI trust fund. It is an important topic since it comes up frequently, especially with regards to Social Security, and it will continue to come up with regards to the various trust funds the federal government maintains.
The simplified version of the discussion breaks down to two views: the unified budget view and the trust fund view.
The unified budget view simply sees the budget as the whole of spending and revenue, ignoring trust funds and legal limits on the ability to pay benefits that come from them. Take, for example, Social Security. Under this approach, the program would not be considered separately from other federal spending or revenues -- it is simply a program of disability and retirement benefits that the federal government funds from all incoming revenues, including from the payroll tax. Trust funds are not important under this view. Comparing the two sides of the federal ledger (total spending and payroll tax revenue) shows that the program is either in surplus, deficit, or balance--currently, it is running deficits.
When a baseline is constructed with this view, it is implicitly assumed that any trust fund that will run out of money will have that hole filled by general revenues from the Treasury. This is the way most people/organizations construct a baseline, including CBO. Taking this view, the ACA reduces Medicare spending by the full amount of its cuts, leading to net deficit reduction as a result of the entire bill. With the regards to double counting, if one takes this view, then one would say that the savings count for reducing the deficit but don't really matter for the purposes of trust fund solvency.
The trust fund view states that balances in the trust funds matter for the purposes of program impact on the deficit and legal limitations on outlays. This is the view people take when they point to the Social Security trust fund balances as proof that the program does not add to the deficit, and it is also to some extent the view that Blahous used in his paper by focusing on the consequences of trust fund insolvency. Constructing a baseline with this view would require that all programs be financed by their trust funds without any general revenue, whether that means automatically cutting spending to bring it in line with revenue or assuming that the dedicated financing is increased. This view would hold that the Medicare savings could strengthen HI trust fund solvency, but if it did so, it would not have any impact on the deficit.
In a paper we wrote last year on Social Security and the budget, we compared these two views as it pertains to Social Security (note that we refer to the trust fund view as the off-budget view in this chart):
Neither view of the budget is necessarily wrong, but they do have different implications. Most baselines and projections tend to rely on the unified view since it provides a more realistic picture of debt going forward. Similar to how current policy baselines show more realistic policy outcomes than current law, that view assumes that Congress would more likely use general revenue transfers than allow transportation, disability benefits, Medicare, and Social Security spending to be cut significantly in one year. The unified view assumes that lawmakers will make good on the promises they have implicitly made, and thus highlights the extent to which they need to enact reforms to make good on those promises.
But taking the trust fund view, as Blahous does in his piece and as those claiming that Social Security does not add to the deficit, is not technically wrong either -- it is just a different way of looking at things.
What is wrong is to try to hold both views simultaniously in order to make two necesarily competing claims. Medicare savings cannot be said to both strengthen the HI trust fund and be available to offset new spending. Arguments to the contrary must rely on taking a mix of the two views: that dedicated financing flowing into a trust fund must go to future benefits and can't reduce deficits, and that reducing spending on a trust-fund financed program can reduce the deficit.
Neither view is necessarily wrong, but one must be consistent in their view when talking about the Affordable Care Act, Medicare, Social Security or any issue that involves trust funds in the federal budget.
Our recent paper on the fiscal cliff details the short-term or longer-term economic problems that the country will face if lawmakers either allow everything in the fiscal cliff to occur as scheduled or if they decide to extend it all. This blog will look farther into the potential short-term impacts, attempting to quantify what the cliff's 2013 effects would do to the economy.
CBO projects that with the fiscal cliff, unemployment would actually rise from an annual average of 8.8 percent in 2012 to 9.1 percent in 2013, while real growth would fall from 2.2 percent to 1.0 percent; in fact, growth would be negative in the first quarter of 2013 and negative combined in the first half of the year. Under CBO's Alternative Fiscal Scenario, which averts the cliff, the unemployment rate instead would fall in 2013 to an average of 8 percent (the middle of the range they give) and growth would be at an average of around 2.5 percent.
An even more detailed outline of the effect of the fiscal cliff on the economy would do so on a policy-by-policy basis, which we have attempted to do below.
In order to see how the budgetary costs of the fiscal cliff would impact the economy, including GDP and employment, one must use an economic multiplier for each policy -- detailing how much economic activity per dollar each policy produces. CBO has among the most detailed set of multipliers for these policies, coming from their November brief about policies to increase growth and employment and their most recent estimate of the economic impact of the 2009 stimulus. Some policies do not fit neatly into these multipliers (the Medicare cuts in particular), so we have made judgment calls where necessary. Obviously, note that these estimates are not official CBO estimates but simply our attempt to quantify economic impact using available information.
Our estimate of the fiscal cliff using CBO multipliers shows that it would hit the economy by about $550 billion or two percent of GDP from the beginning of 2013 through the end of FY 2014 (a total of seven quarters). The economic and budget impact is broken down below.
Note: 2001/2003/2010 Tax Cuts include interaction with AMT patch
It is important to note that while the impact of the entire fiscal cliff would be relatively large, extending/repealing these policies do not serve as a particularly cost effective form of stimulus: the overall multiplier of the fiscal cliff is slightly over 0.5. Of course, the cost effectiveness varies greatly among different policies. The most stark contrast is between the sequester and the 2001/2003/2010 tax cuts: while the tax cuts cost nearly three times as much as repealing the sequester, the sequester actually has a greater economic impact.
There are also a detailed set of multipliers from Mark Zandi at Moody's. His multipliers are somewhat more bullish on the economic impact of some policies than CBO (especially the payroll tax cut). Using multipliers from last year, we determined the cliff would hit the economy by $720 billion over two years, or about 2.5 percent of GDP (meaning a multiplier of about 0.7).
Note: 2001/2003/2010 Tax Cuts include interaction with AMT patch
This analysis is, of course, just one side of the coin. According to CBO's January baseline, extending/repealing all of these policies would negatively impact growth by around the end of the decade as excessive debt took its toll, and that negative impact would continue to grow in later years. Piling on a mountain of debt to avoid the short-term pain is not a viable option. Policymakers need to use the scheduled changes at the end of the year as an opportunity to enact smart reforms to gradually put debt on a downward path.
Congressional Quarterly's John Cranford has a nice profile of CRFB's "Stabilize the Debt" budget simulator. If you have not done so already, it is worth a run-through to get an idea of the kinds of choices that must be made to put debt on a downward path. Interestingly, Cranford also reminds readers of past efforts CRFB has done to quantify the impact of different budget options:
“Hard choices,” in fact, has long been the name of a particular exercise in meeting the increasingly difficult challenge of keeping federal spending and revenue in line. Pioneered a generation ago by the Committee for a Responsible Federal Budget — the original roost for deficit hawks in Washington — the hard choices exercise is so antediluvian that it once was passed around town on floppy disks. In that form, it was a parlor game that appealed mostly to the wonky denizens of Capitol Hill and K Street.
The predecessor to the Stabilize the Debt simulator was called “An Exercise in Hard Choices,” conducted with a pencil and paper scorecard. Besides the changes in technology since the 1998 version of the game, the debt path the country currently faces has changed tremendously. Back then, CBO had projections of future surpluses -- which actually came that year, earlier than expected -- and declining debt in the medium term (although a long-term problem still loomed). Now, the problems that used to be confined to the long-term horizon are now much closer, and the government's fiscal position has deteriorated significantly. As a result, the game feels much harder than it used to be, and it makes accomplishing the goal even more urgent and important.
The 1998 game reminds us that our fiscal balance can change as fast as the technological changes in our simulator. The tough decisions we put off now only make future reform that much more difficult. As Cranford says:
What’s best about the CRFB debt simulator is how clearly it shows the enormous difficulty — political and economic — that confronts anyone who wants to untie this Gordian knot. You’ll need tax increases — lots of them. You’ll need to reconfigure the big entitlements: Medicare, Medicaid and, yes, probably even Social Security. You’ll need to sacrifice some favored spending programs even while giving others a boost. Whoever solves this will need to be smart, creative, diplomatic and dispassionate.
There's no doubt, stabilizing and ultimately reducing the debt as a share of the economy will be hard. But the problem will only get harder to fix the longer we wait, and the actions we take now will be well worth it in the future. Hopefully, "Stabilize the Debt" can help get the message out and make fiscal reform a reality.
With the "Buffett Rule" set to get a vote in the Senate next week, we felt it was a good time to take a more in-depth look at the proposed policy -- at both its budget and tax impact.
The Joint Committee on Taxation has estimated that the Buffett Rule would raise $47 billion over ten years, although this is against a current law baseline, which assumes that dividends will already be taxed at ordinary income rates and capital gains rates will rise to about 25 percent. The bill's sponsor, Sen. Sheldon Whitehouse (D-RI), has claimed that relative to a current policy baseline, with capital gains and dividends taxes at a top rate of 15 percent, the revenue raised would be $162 billion. Tax Policy Center made alternate estimates that showed it would raise $115 billion relative to current law and $265 billion relative to current policy. The large difference between these estimates, though, is mostly due to the fact that TPC scores the Buffett Rule after a repeal of the AMT, meaning that more taxpayers would be hit by the Buffett Rule.
So how exactly would the Buffett Rule work? The short answer is that it would require those making over $1 million to pay an average tax rate of at least 30 percent, even though some pay substantially less today due to various deductions and the preferential treatment of capital gains.
To avoid imposing an astronomical jump in tax liability when income goes from $999,999 to $1,000,000, the bill instead phases in the 30 percent alternative tax rate for incomes between $1 million and $2 million. It does this by making taxpayers in that income range pay a hybrid of their taxes under the current tax system and the new system. Economically speaking, the taxes paid would be the amount paid under the normal system on the first $2 million of income, plus an additional rate (or "bubble rate") on income between $1 and $2 million.
The formula for determining the marginal rate between $1 million and $2 million is 60 percent minus the original effective tax rate; thus, the highest "phase-in rate" that is theoretically possible is 60 percent for a millionaire who pays no income tax (having to make up $600,000 in taxes to get to the 30 percent rate over a $1 million range).
Below are a series of graphs that illustrates the marginal and effective tax rates of different hypothetical taxpayers. The first is a taxpayer with a 20 percent effective tax rate.
Tax Rate for Taxpayer with 20 Percent Rate
Here is a similar example with a taxpayer whose effective tax rate is at 25 percent at $1 million. In this case, earned income is actually taxed at the same rate as it was before, but the tax rate for capital gains still jumps.
Tax Rate for Taxpayer with 25 Percent Rate
Finally, here is the theoretical Buffett Rule rate schedule for the top 400 taxpayers based on 2008 data. They had an average effective tax rate of 18.1 percent, so the average top 400 taxpayer's marginal "bubble rate" would be 41.9 percent.
Tax Rate for Top 400 Taxpayer
These graphs come with the caveat that the Buffett Rule allows the charitable deduction to be counted against the tax, which is not represented in these graphs. Thus, the effective tax rate of these taxpayers could still vary based on the amount of charitable contributions that each individual makes.
In any case, comprehensive tax reform could offer a much more elegant and pro-growth solution to the problem the Buffett rule is trying to address. The "modified zero plan" from the Fiscal Commission, for example, asks for the top one percent of income earners to contribute eight percent more of their after-tax income to taxes, while asking only one percent from the middle quintile and providing a small tax cut to the lowest quintile. The Domenici-Rivlin tax plan is also progressive. Both of these plans eliminate or reduce most tax expenditures and tax capital gains and dividends at earned income rates.
But both approaches could help control rising debt by raising additional revenue, depending on how they were designed.
Correction: This blog originally stated that the difference between Tax Policy Center and JCT estimates was due to differing assumptions about taxpayer behavior, but we have been informed it is because of differences in interacting policy assumptions.
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