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)

April 17

• 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.

April 18

• 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.

April 19

• 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" 

April 24

• Presidential contests in Connecticut, Delaware, New York, Pennsylvania, and Rhode Island

April 25

• Senate Finance Committee hearing on what tax reform means for state and local tax and fiscal policy at 10 am.

April 26

• Senate Finance Committee hearing on improving the taxpayer tax filing experience at 10 am.

April 27

• US Dept. of Commerce's Bureau of Economic Analysis releases its advance estimate of 2012 first quarter GDP growth.

May 4

• Dept. of Labor's Bureau of Labor Statistics releases April 2012 employment data.

May 8

• Presidential contests in Indiana, North Carolina, and West Virginia

May 15

• Presidential contests in Nebraska and Oregon
• Dept. of Labor's Bureau of Labor Statistics releases April 2012 Consumer Price Index (CPI) data.

May 22

• Presidential contests in Arkansas and Kentucky

May 29

• Presidential primary in Texas

May 31

• US Dept. of Commerce's Bureau of Economic Analysis releases its second estimate of 2012 first quarter GDP growth.

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.

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. 

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.

CBO Multipliers

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.

Zandi Multipliers

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.

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.