February 2013

CBPP: Tax Expenditures Are Ripe for the Picking

Tax expenditures have been a hot topic lately as a way to raise additional revenue for a deficit reduction plan that could replace sequestration. Recently, Sen. John McCain (R-AZ) said he would be willing to consider several "revenue closers" (or tax expenditures) in a compromise, and reforming tax expenditures has been proposed by the White House as well.

This isn't surprising given the gains from tax reform. Yesterday, the Center on Budget and Policy Priorities released a new paper from Chuck Marr, Chye-Ching Huang, and Joel Friedman that makes the case for reforming tax expenditures as part of a deficit reduction package. They also go into some specific ways on how it should be done. First, they argue:

Tax expenditures are ripe for reform: they are costly, reducing revenues by over $1 trillion annually, and they are often poorly designed for achieving their desired policy goals. In many cases, there is little difference between benefits or subsidies provided through the tax code and benefits or subsidies provided through the spending side of the budget. So efforts to reduce spending should also address spending in the tax code. Further, tax expenditures tend to provide a disproportionate share of benefits to households higher up the income scale.

Of course, one would find very few economists and tax experts who would disagree with that statement. So what should be done about it?

The authors group their preferred solutions into two types. The first is a broad-based limitation on tax expenditures, similar to ones we talked in a recent paper on raising revenue from high earners. Specifically, they mention limiting the value of deductions and exclusions to 28 percent, limiting the amount of deductions a taxpayer can take, and limiting the value of certain tax expenditures. All three methods would likely represent progressive changes to the tax code -- although that would depend on the design -- but CBPP prefers the first option, since it would maintain incentives at the margin for preferences involved with these limits. We have also talked about ways in which marginal incentives could be preserved in the other two limits albeit at the cost of reduced revenue.

The second solution the CBPP discusses is closing loopholes or reducing tax expenditures that allow high-earning taxpayers to substantially reduce their tax burdens. They discuss in more detail five of these tax provisions:

  • Carried interest: Private equity fund managers typically receive a management fee plus 20 percent of the fund's profits (the latter being "carried interest"). The fee is taxed as ordinary income, but the carried interest is taxed at lower capital gains rates. Many analysts would argue that the carried interest is more like ordinary income, since it is compensation for managing a fund rather than the return on capital that the manager has invested.
  • Like-kind exchanges: Like-kind exchanges are a way to defer capital gains taxes. If a property is held for business or investment proposes, it can be exchanged for similar property, hence the name "like-kind exchange." For example, almost all land exchanges can qualify as like-kind even if they have very different values. Thus, these exchanges can function as a way of avoiding paying capital gains taxes.
  • Valuation discounts: Valuation discounts are used to reduce estate tax liability. They reduce the value of assets that are hit by the estate tax by placing temporary restrictions on their usage. This depresses the value of those assets for estate tax purposes while eventually allowing heirs to make full use of the assets at a later date.
  • S corporation loophole: S corporations are a form of corporation that does not pay the corporate income tax; rather, it passes through the income to its owners, who are then taxed at the individual income tax. However, these profits are not hit by payroll taxes. S corp owners are supposed to report "reasonable compensation" to themselves, income that is subject to payroll taxes, but this rule has not seemed to adequately serve its purpose. Proposals to close this loophole would instead subject both compensation and S corporation profits to payroll taxes.
  • Inside buildup: Cash value life insurance is a type of life insurance that not only pays out death benefits, but also invests premium payments to build up investment earnings. This "inside buildup" is not taxed until the policy is cashed out and may actually be never taxed if the proceeds are paid out upon death or if they are used to pay the policy's premiums. These provisions offer a distinct tax advantage to these type of life insurance policies.

The authors also mention other provisions, such as international tax loopholes and the tax treatment of derivatives that could be targeted. Many of these options are also ones we highlighted in our large table of revenue-raising options.

We agree with CBPP that tax expenditures should absolutely be part of the discussion. Many of these tax breaks make the tax code complex, economically distortionary, and unfair. There is certainly a lot of room for reform in both the ways they described and in other ways, such as reforming the largest tax expenditures in the code.

Brookings Rethinks...Natural Disasters, Transportation, Visas & Housing

Our fourth blog on "15 Ways to Rethink the Federal Budget," a new report from the Brookings Institution's Hamilton project examines national disaster funding, transportation, visas and housing. We've already examined proposals to reform defense spending, tax expenditures, and the Social Security Disability Insurance program, and those proposals should be considered along with the ones below to make our budget more efficient while reducing our deficit. Let's examine each of the proposals.

Reforming Disaster Assistance

David R. Conrad, a Water Resources Policy Consultant, and Edward A. Thomas of the Natural Hazard Mitigation Association examine the federal governments role in disaster assistance in their paper, "Reforming Federal Support for Risky Development." It calls for a review of the federal government's role in responding to disasters, as a considerable amount of spending is involved which may not being spent efficiently. The proposal raises a number of concerns with the National Flood Insurance Program (NFIP), enacted in 1968 to insure Americans living in flood-prone areas. Conrad and Thomas seek to reward good conduct and discourage risky development that may further increase the damages that follow national disasters. They estimate that altogether the reforms could reduce deficits by $40 billion over the next ten years. Their proposal contains three main reforms:

  • Incentivize and implement higher disaster-resistant development standards: This would include lowering the premium subsidy for crop insurance, eliminate subsidies for risky development, investing in preventive measures, and imporoving zoning and enviromental regulations.
  • Improve federal cost-sharing: The federal government often outspends state and local governments in disaster assistance, reducing incentives for state and local goverments to invest in mitigation programs. Options to improve cost-sharing would include removing tax deductions for damaged property not in compliance with federal standards, tying federal relief to communities' future disaster mitigation, working with private insurance companies to promote more effective coverage
  • Further reform of the NFIP: The proposal names a number of opportunities in the insurance program that could be used to reduce the likelihood of, and costs related to, dealing with floods. They include:
    • Charging risk-based premiums and update risk assessments for the effects of climate change.
    • Phasing in actuarial rates for 800,000 subsidized older, primarily residential properties, which have a higher risk of flood damage.
    • Phasing in actuarial rates for future increasing shoreline erosion hazards and incorporate erosion setback requirements for new or reconstructed buildings on erosion-prone coasts, including the coasts of the Great Lakes.
    • Phasing in actuarial rates for areas that will be impacted by inevitable sea-level rise or inland flood-height increases due to improper development upstream.

Reforming Transportation

In "Funding Transportation Infrastructure With User Fees," Tyler Duvall, an Associate Principal at McKinsey & Company and Jack Basso of the American Association of State Highway and Transportation Officials consider how to shore up the transportation trust fund. Although federal transportation spending is just about 2 percent of total outlays, the Highway Trust Fund, the principle trust fund for surface transportation programs is projected to run out in 2015.


As such, it has become necessary for a number of reforms to bring highway spending and revenue in line. Key in their proposal is the case they make for direct road-pricing system as a form of revenue generation. In this system, practiced only narrowly in the US, motorists would pay fees to drive on certain roads. The benefits of such a system is highlighted below:

Economists from all backgrounds have strongly supported some form of direct pricing for roads, similar to the way other utilities are priced. In fact, Nobel Prize–winning economist William Vickrey proposed a specific road-pricing system to reduce congestion in Washington, DC, as far back as 1959 and in the New York City subway system in 1952. Vickrey said, "You’re not reducing traffic flow, you’re increasing it, because traffic is spread more evenly over time. . . . People see it as a tax increase, which I think is a gut reaction. When motorists’ time is considered, it’s really a savings" (quoted in Trimel 1996).

According to the U.S. Department of Transportation, an effective road-pricing system—once fully implemented— could generate between $38 billion and $55 billion annually in revenue while simultaneously reducing road congestion and reducing environmental impacts. Singapore’s broad use of fully electronic road pricing is one of the key reasons the World Bank perennially ranks it number one in the world in terms of logistics performance. With a population of more than 5 million and only 250 square miles of land, Singapore’s transportation system achieves free flow speeds on its expressways and arterials every day. Indeed, the key strength of such a solution is not only that it raises revenue to support surface transportation investments and operations, but also that it does so in a way that confers additional benefits including reduced congestion and pollution.     

Such a proposal could reduce the deficit by $312 billion in the next 10 years.

Reforming the Temporary Work Visa System

In "Overhauling the Temporary Work Visa System," Pia M. Orrenius, Giovanni Peri and Madeline Zavodny argue that the current immigration system is complex and outdated and therefore imposes "significant inefficiencies and costly restrictions on the inflow of foreign-born workers."

This leads to highly inefficient economic outcomes. The problem with the system is that instead of employment-based visas being given to immigrants on the basis of how economically productive they can be, they are instead granted on a first-come, first-served basis or through a lottery. Other difficulties in securing employment-based visas discourages highly skilled and educated immigrants from staying on to work and increase the productivity in the US.

As a result, the authors have come up with some proposals to make the acquisition of employment-based visas an easy and efficient process. They advocate an auctioning visa allocation system that would lead to significant revenue inflows:

Auctioning permits to hire foreign workers would offer a number of economic benefits. It would lead to a more efficient allocation of foreign workers across employers while protecting workers through visa portability and employer competition. Permits would be allocated to employers who value these workers’ contributions the highest and who hence would bid the most for permits.

The auctions would generate revenue for the federal government. Baseline estimates suggest that auctioning of employer permits would generate from $700 million to $1.2 billion in revenues annually, with the higher end of the range possible if more visas are available for high-skilled workers. In the long run, a more efficient immigration system would have an even bigger budget impact by increasing productivity and gross domestic product (GDP).

They expect this proposal to reduce the deficit by $7 to $12 billion in the next 10 years.

Reforming Housing Finance

In "Increasing the Role of The Private Sector in Housing Finance," Philip Swagell of the University of Maryland proposes reforms to increase private funding of housing and reducing the federal government's role. With the federal government through its sponsored enterprises (Fannie Mae and Freddie Mac) guaranteeing more than 90 percent of new mortgages and refinances, the private sector may be taking too small of a role in the housing market. Swagell believes this reliance of federal goverment backing would be unwise if there was another housing collapse and that the savings from the reforms could save $134 billion over the next ten years. He proposes the following:

  • Establishing a secondary federal insurance program for qualifying mortage-backed securities (MBS) and selling secondary insurance to securitization firms to foster competition.
  • Using the proceeds of the insurance premiums to capitalize a federal insurance fund with which to cover losses on guaranteed MBSs.
  • Winding down the legacy Fannie and Freddie investment portfolios. The Federal Reserve would henceforth act as the buyer of last resort for guaranteed MBSs if monetary policymakers judge that elevated mortgage interest rates warrant policy action for the purposes of macroeconomic stability.
  • Selling Fannie and Freddie’s securitization and guaranty operations to private investors who will compete with other entrants.
  • Empowering the housing finance regulator to carry out its broad array of responsibilities, including ensuring that mortgage quality remains high for guaranteed loans, that adequate private capital is ahead of the guarantee (notably at the level of the firms carrying out securitization), and that premiums for the secondary government insurance are adequate to cover expected future losses on guaranteed MBSs.


These proposals, among the others we have covered this week, are worth considering given our unsustainable debt path. We need to do something about our fiscal outlook, and it would be preferable for lawmakers to focus on areas of inefficiency, rather than relying on dumb and blunt cuts. Hopefully, lawmakers will be willing to consider the good ideas being put forward by the Hamilton Project.

Brookings Rethinks...Disability Insurance

We have been working our way through the “15 Ways to Rethink the Budget” report from the Brookings Institution’s Hamilton Project. Previously, we covered their defense proposals, reforms to Medicare, and tax expenditure proposals. In this post, we will examine a paper that takes a look at the Social Security Disability Insurance system, particularly the misaligned incentives for employers and state governments to discourage disabled individuals from continuing to work when possible and its underinvestment in the administrative capacity of the system.This paper offers two groups of proposals for cutting costs in the DI system that also have the potential to improve outcomes for beneficiaries. These, along with policies proposed by CRFB Senior Policy Director Marc Goldwein, should definitely be on the table as part of disability reform.

Background: What’s Wrong With the Disability Insurance System

Jeffrey Liebman of Harvard University and Jack Smalligan of the White House Office of Management and Budget (OMB) explain that disability insurance is a costly program because it attracts older but pre-retirement age individuals much more so than it does younger workers or those who are eligible for Medicare and the old-age portion of Social Security. As the baby boom generation moves into the latter two programs, the CBO does estimate that DI spending will fall by 0.1 percent of GDP over the next decade.

Regardless, the DI program in its current form is not delivering what beneficiaries need. Essentially, the program offers beneficiaries lifetime cash benefits in exchange for them agreeing not to do substantial work again. The number of people who go on the DI rolls for the rest of their lives has grown in recent years due to changes in low-skill labor markets and a decline in other forms of public assistance. The authors also point out issues with the program’s misaligned incentives, distortion of labor supply, and a disability determination system that moves slowly, forcing beneficiaries to endure long waits for decisions and generating a backlog of applications. 

Source: Social Security Trustees

To resolve the issues with the DI program, Liebman and Smalligan advocate focusing on demonstration projects and providing new tools for a newly appointed Social Security commissioner.

Policy Recommendation 1: Demonstration Projects

Under the category of demonstration projects, they emphasize the need for early intervention with DI beneficiaries, pointing to research that has shown that after someone starts receiving benefits or even begins the application process, it is often too late to get him or her back in the workforce.

One such project that they suggest involves screening the applicant pool for individuals who probably could go back to work and offering them temporary cash benefits, wage subsidies, and other support in exchange for withdrawing their DI applications. This would lessen the need for long-term costs that result from individuals going on DI for life who would otherwise still be able to work.

The authors also note the value of early intervention projects targeted to states and employers, calling for empowering states to reorganize funding streams in order to target populations who are at risk of going on DI permanently with programs that reduce the likelihood of their becoming dependent on disability insurance payments. In order to create an incentive for employers to keep workers from resorting to disability insurance quickly, they propose replacing federal disability insurance with mandatory private disability insurance for the first two years that an individual receives benefits and creating an experience rating system for benefits payments similar to that used in the unemployment system.

Policy Recommendation 2: New Tools for the Social Security Commissioner

The tools that Liebman and Smalligan call for the new Social Security commissioner to have are aimed at eliminating the current problem of underinvestment in the administrative capacity of the disability system, in part by making the Disability Determination Services (DDS) program a mandatory, rather than discretionary, expenditure. They note that actuaries have estimated that every dollar spent on disability determination reviews saves $9 in benefits expenditures in the future, which is a clear argument for avoiding the kind of backlog of applications that has built up lately.

Looking Forward

The Brookings report closes with a three-part case on why now is the time to act on DI reform. The need for deficit reduction has brought entitlement reform issues to policymakers’ attention. The new presidential term and the appointment of a new Social Security commissioner provide the chance for a fresh start. Finally, the DI trust fund will be exhausted by 2016, at which point benefits will be cut automatically by 20 percent, so something needs to be done before then. Liebman and Smalligan argue that they present a set of measures that will save money and also help beneficiaries either get back to work or have their claims resolved more efficiently if working is not an option. If this is true, following their recommendations would be a wise step to both safeguard our fiscal health as well as better serve the beneficiaries of the disability program.

CRFB has previously written about the importance of addressing the DI program and not resorting to a transfer from other parts of the Social Security budget in order to fund it when its trust fund runs out in 2016. The logic is straightforward: we need to either reduce the benefits that the DI program pays out, or increase its revenues. Liebman and Smalligan’s report advances a proposal that minimizes the benefits that must be paid out in the years to come without depriving beneficiaries of the support that they need.

Sen. Graham And Others Call for Entitlement and Tax Reform

Sen. Lindsey Graham (R-SC) put revenue on the table Monday night, in an interview on CNN's The Situation Room. Graham spoke out against sequestration and the damage that it would do to the Department of Defense, but also said that it brought an opportunity to agree upon a comprehensive plan.

Speaking on the sequester, Graham said:

To me this is a bipartisan problem. I voted against this deal because it is a lousy way to cut $1.2 trillion, which is imminently achievable. This is a chance to do the big deal. I'm willing to raise $600 billion in revenue if my Democratic friends are willing to reform entitlements and we can fix sequestration together.

We know the a comprehensive deal will require both tax and entitlement reform in order to reduce future deficits. It was good to see Graham call for both last night, but he has not been the only one. Sen. Mark Warner (D-VA) called for more revenues and spending cuts on CBS's This Morning. Sen. John McCain suggested that he would be willing to look at "revenue closers," or tax expenditures, in a interview on Fox News Sunday. And Rep. Scott Rigell (R-VA) recently said that he was willing to consider additional revenue in order to avoid sequestration.

Supporting both more revenue through tax reform and cutting spending through entitlement reform will be difficult for many lawmakers. But as we've said frequently here on The Bottom Line, the only way we are likely to solve our deficit problem is through bipartisan compromise that does both. Lawmakers need only to look at the recent framework from former Fiscal Commission co-chairs Erskine Bowles and Alan Simpson - it is difficult to come up with a plan that contains the needed $2.4 trillion in deficit reduction without taking a hard look at our tax code and growing health care spending.

My VIEW: Bill Frenzel

We've talked a great deal about how sequestration is bad policy, but that the worst outcome would be to cancel the sequester without offsets. In the Fix the Debt Campaign's new sequester deal scoring system, that is the option that would receive their "F" grade. In a recent article at Forbes, CRFB board member and former Representative Bill Frenzel (R-MN) explains why lawmakers should not kick the can down the road, despite the sequester's drawbacks.

Frenzel agrees that the sequester is a less than ideal way to reduce the deficit: it doesn't address the drivers of the federal debt and doesn't distinguish between good cuts and bad cuts. But it does have value as a way to bring both parties to the table. Frenzel explains:

The worst feature of the sequester is that it is the wrong way to reduce spending. The cuts are mandated across-the-board in most discretionary spending areas. The good programs will be cut along with the bad. The most hard-hit casualty will be the Defense Department (DOD). It can stand cuts, but they need to be carefully selected. The sequester does not select. The sequester meat-axe slices muscle along with the fat.

It is hard to believe that allegedly smart people could have agreed to such a device. The President and the leaders of both houses signed off on the sequester in the belief that because it was so bad it would force them into a compromise deficit/debt reduction plan despite their philosophic disagreements.

As it seems to be turning out, our representatives’ philosophic disagreements are more precious to them than the health of the nation’s economy. Republicans want to protect tax rates and Democrats want to protect entitlement programs. They would prefer the sequester, admittedly smaller than the tax cliff, to any form of compromise.

The moment of truth is only a week away. Most odds-makers believe the Sequester will actually occur. However, the policymakers do have other choices: (1) they could postpone it, in hopes of making a later deal (2); they could trash the sequester, and sacrifice long-term growth for another short-term fling; (3) they could give the Executive Departments leeway to make the cuts where best tolerated; or (4) they could live with the sequester for a few weeks or months, and then holler “uncle” and opt for (1) , (2), or (3) above.

But Frenzel argues that despite sequestration's limitations, it will force lawmakers to do something about our unsustainable debt problem. Lawmakers have a clear incentive to replace the sequester with smart deficit reduction, but should they fail to compromise, it's better than nothing. Frenzel writes:

This writer believes that the sequester will happen. However, when airport security lines triple, the national parks open later and close earlier, and our military tours abroad are extended, there is a good chance that Congress will begin to rethink the problem, particularly with respect to DOD. If so, at that point, it is critical that Congress replace a dumb cut with a smart cut of equal value, rather than deferring or repealing the sequester.

Our debt is already high. CBO sees it going higher rather than stabilizing under the most likely budget scenarios over the next 10 years. The President’s budget drives the debt ratio up around 80% in 10 years. That’s one reason why cancelation, or deferral, of the sequester would be unwise. Over 10 years, the sequester would save well over $1 trillion. Another reason is that it makes no sense to swap short-term faster growth for long-term reduced growth.

If no comprehensive compromise (one with total 10-year reductions of Bowles-Simpson proportions) is in sight, it is better to accept the stupid cuts of the sequester than to postpone deficit/debt reduction plans again. The best plan would be smart cuts. The sequester is a distant second choice, but, clearly, it is better than nothing.

The full blog post can be found 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.

Brookings Rethinks...Tax Expenditures

We have been working our way through the "15 Ways to Rethink the Budget" report from the Brookings Institution's Hamilton Project, first covering their defense proposals and reforms to Medicare. In this post, we will examine four papers that take a look at the nation's tax code, particularly the many credits and deductions. These papers offer some good ideas about how to best reform or eliminate many tax expenditures, which will cost the federal government nearly $1.3 trillion in forgone revenues in 2013. Let's examine each paper in turn.

Broad-Based Limits to Tax Expenditures

The first proposal is from Diane Lim of The Pew Charitable Trusts entitled "Limiting Individual Income Tax Expenditures." In this paper, Lim argues that broad based reforms to limit the value of tax expenditures could be nearly as effective and politically easier than eliminating individual tax expenditures in the code.

Lim identifies two categories of ways to reduce income tax expenditures across the board, by either reducing the subsides at the margin or by capping or limiting the total value of tax provisions. Options that could reduce the value of tax provision at the margin include limiting tax deductions to a lower marginal rate, converting deductions into credits, or reducing tax expenditures by a set percentage. Options that could reduce the value of tax expenditures without changing incentive at the margin include capping the total dollar value of deductions, limiting tax provisions to a percentage of income, or phasing down tax expenditures at higher incomes. Lim argues that a comination of changes from the two approaches could be useful to avoid the drawbacks of each. Many of these ideas are similar to ones we discussed last year.

Reforming Savings Incentives

The second proposal comes from Karen Dynan of the Brooking Institution, "Better Ways to Promote Saving through the Tax System," and, as one would imagine, takes a look at many tax expenditures designed to promote saving, costing an estimated $136 billion. However, there is some evidence that some of these tax provisions provide windfalls, promoting retirement savings among those who would have done so anyways. As the chart below shows, personal saving has continued to fall in the U.S., despite these provisions in the tax code.

Source: Dynan (Data from Bureau of Economic Analysis)

With that in mind, Dynam recommend the following changes, which together would save $40 billion in net deficit reduction:

  • Capping the rate at which deductions and exclusions related to retirement saving reduce a taxpayer’s income tax liability at 28 percent (Saves $75 billion).
  • Taking steps to ensure that more workers are covered by some type of retirement savings plan by increasing the small employer pension startup tax credit and establishing an automatic IRA program (Saves $3 billion-$6 billion).
  • Making the Saver’s credit refundable and easier to understand (Costs $30 billion).
  • Removing obstacles to firms establishing expanded savings platforms that would allow employees to save for both retirement and non-retirement purposes (Negligible Savings).

Eliminating Fossil Fuel Subsidies

The third paper, "Eliminating Fossil Fuel Subsidies," comes from Joesph Aldy of Harvard University. Aldy argues that the nearly $4 billion of revenue annually forgone in tax provisions for oil and gas companies is no longer justified given the economic rewards and advances in technology. The proposal calls for the elimination of 12 tax provisions that promote oil, gas, and coal production, saving over $41 billion over ten years.

The largest include allowing expensing of intangible drilling costs (like labor and fluid) instead of depreciating them over the life of the well ($13.9 billion), the portion of the domestic production activities deduction that goes to oil and gas ($11.6 billion), and percentage depletion for wells, which allows companies to deduct a percentage of their revenues of a well ($11.5 billion). These subsides, according to Aldy, are doing little to stimulate additional production and should be looked at given our fiscal realities.

Reforming the Mortgage Interest Deduction

The final paper on tax expenditures, "Replacing the Home Mortage Interest Deduction" is authored by Alan Viard of the American Enterprise Institute. As Viard explains, if homes were taxed in the same manner as business capital, imputed rent (the return from owning and occupying a home) would be taxed while mortgage interest payments would be deductible. Our current tax system does not tax imputed rent, but still provides a mortage interest deduction, serving mostly as an inefficient subsidy for more expensive homes.

Viard proposes converting the current mortage interest deduction into a 15 percent refundable credit, a change included in the Domenici-Rivlin tax plan. The credit limited to interest on a $300,000 mortgage (the current limit is $1.1 million) and would not be allowed on second homes. The current deduction would be reduced by 10 percent each year, with an option to switch to the new credit at any time. Overall, this change could result in $300 billion in savings over ten years, a substantial amount of deficit reduction.

We've mentioned frequently on this blog that tax expenditures deserve a thorough look. Not only do they represent a significant amount of forgone revenue, in some cases they may not be fulfilling their policy goals effectively. A simpler, pro-growth tax code could be less economically distortionary and raise revenue without raising tax rates. Our tax code needs to be reformed, and many of the ideas above should be considered in the conversation.

Brookings Rethinks...Medicare

As promised, the Brookings Institution's Hamilton Project has released the remaining papers in its series "15 Ways to Rethink the Budget." We will be discussing the papers a series of blog posts. We covered two defense proposals on Friday, and next we focus on their Medicare proposals which affect both beneficiaries and providers in the program.

The first proposal comes from MIT economist Jonathan Gruber in a paper on "Restructuring Cost Sharing and Supplemental Insurance for Medicare." Gruber describes the value of his proposal as follows:

Traditionally, efforts to control the costs of the Medicare program have focused on the “supply side,” changing the method and amount that Medicare pays its providers. There has been much less focus on the “demand side,” using financial incentives to encourage less medical spending by enrollees....Yet efforts both to improve the value of the Medicare program for beneficiaries and to lower its costs to the government would benefit from some focus on the demand side.

Gruber describes the current cost-sharing system in Medicare as "both variable and uncapped, with an overall structure that is hard to rationalize." The confusing nature of Medicare's cost-sharing and the potential for unlimited costs to beneficiaries has led the majority of beneficiaries to seek supplemental insurance, which has been shown to increase over utilization and consequently Medicare spending.

Thus, this proposal seeks to improve cost-sharing through changes to Medicare and supplemental insurance, somewhat similar to what the Simpson-Bowles proposal did. First, Gruber builds upon a 2008 CBO option that would replace current cost-sharing rules with a single combined deductible of $525, a 20 percent coinsurance rate, and a $5,250 out-of-pocket (OOP) maximum. Instead of a $5,250 OOP maximum, Gruber proposes instituting a progressive out-of-pocket limit on payments. The limit would be a sliding scale fraction of the Health Savings Account limit based on the beneficiary's income, going from one-third of the HSA limit ($1,983) for people making between 100 and 200 percent of the poverty line to the full HSA limit ($5,950) for people making over 400 percent. In addition, he proposes reducing the deductible to $250 for seniors below 200 percent of poverty.  Second, to address the supplemental insurance issue, he proposes an excise tax of up to 45 percent on premiums for Medigap plans and employer-sponsored retiree coverage (for those over 65). Gruber roughly estimates the proposal would save about $125 billion over ten years, although he acknowledges this depends on the exact level of the excise tax and other uncertainties.

The second Medicare proposal, "Transitioning to Bundled Payments in Medicare," from Harvard Medical School's Michael Chernew and USC's Dana Goldman focuses, as you would expect, on the provider side of the equation. The paper proposes reforming Medicare's payment system to align provider incentives with efficiency and quality of care. They describe the problems with the current system as follows:

The existing FFS portion of Medicare, which enrolls almost 75 percent of Medicare beneficiaries, relies on a byzantine system of fee schedules. There are thousands of codes for different services; setting the appropriate fee is enormously complex. Mispriced fees create incentives leading to the overuse (or underuse) of medical services. As a result, resources flow to overpriced activities and infrastructure. Importantly, the FFS system reduces incentives for providers to be efficient over the entire episode of care (Chernew, Frank, and Parente 2012; Landon 2012).

To address these issues, Chernew and Goldman would create a global payment model within Medicare, which would involve paying provider systems or Medicare Advantage plans a fixed per beneficiary payment to cover all medical services. While the level of these payments can be dialed, they recommend as a default setting them equal to current law Medicare spending (which would be $100 billion lower than current policy spending). In addition, they suggest creating as much regulatory neutrality as possible between Medicare Advantage (MA) plans and Accountable Care Organizations (ACOs). Such neutrality would involve allowing ACOs to act like MA plans in controlling benefit design and charging above benchmarks for higher quality plans (to attract beneficiaries). Finally, they would drop various fee-for-service regulations (i.e. self-referral rules) for providers who accept global payments, since efficiency gains under a global payment model would eliminate the need for them.

Both proposals are welcome ideas that not only have potential for savings, but could modernize Medicare to operate more efficiently. Success in containing federal health care spending depends on making Medicare more efficient to encourage higher value.

Tax Expenditures For Higher Education Rival Spending on Pell Grants

One of the lesser known provisions of the American Taxpayer Relief Act is the extension of the refundable American Opportunity Tax Credit (AOTC) through 2017. The AOTC was created in the 2009 stimulus to replace the non-refundable Hope Credit, and provides a tax credit equal to spending on tuition, up to $2,500. A recent post by Elaine Maag on TaxVox shows the growth of education-based tax expenditures over ten years, a trend that has accelerated with the creation of the AOTC.

Tax expenditures for higher education aid have grown significantly in value since the Hope and Lifetime Learning Credits were created in 1997, quadrupling in value between 2000 and 2010. Tax expenditures for higher education totaled $34.2 billion in 2012, compared to the $35.6 billion in spending on Pell grants.

Maag also shows that the AOTC may be less effective in reaching low-income students. For one, the AOTC is not received until a tax return is filed, meaning the benefits often don't reach filers until well after tuition is paid. Also, the Tax Policy Center estimates that half of the benefits from the tuition and fees deduction and a quarter of the AOTC's benefits will go to families making over $100,000. This is a significant amount of foregone revenue to subsidize those who likely would have attended college without the AOTC. Many lawmakers may want to promote higher education, but it may be worth questioning if these resources can be directed in a better way.

Tax expenditures may get less scrutiny than direct government spending does, and it is worth examining some of these credits and deductions to see if they are achieving their policy goals in a cost-effective way. A report from the GAO discussed things to think about when evaluating tax expenditures. In doing so, the report suggested that there were many ways to improve or eliminate many deductions and credits, paving the way for a simpler and more efficient tax code. The GAO especially highlights the prevalence of tax windfalls, where much of a tax expenditure's value is going towards promoting behavior that would have taken place anyway. Tax-based student aid may be one of those areas the way many credits are currently designed.

About a month ago, we highlighted a report from the New America Foundation's Education Policy Program on reforming federal financial aid. Not surprisingly, tax expenditures were targeted in recommendations, and the report recommended eliminating higher education tax benefits (i.e. the American Opportunity Tax Credit) and tax advantaged education savings plans (i.e. 529 plans) and redirecting the savings to the Pell Grant program.

Lawmakers may chose to keep some tax expenditures around to achieve worthwhile policy goals, such as promoting education, homeownership, and donations to charity. But tax expenditures will also total nearly $1.3 trillion in forgone revenues, and given unsustainable debt projections, lawmakers will need to find additional revenues in addition to controlling spending growth in entitlement programs. Not all deductions and credits need be eliminated, but many will have to be reformed. Tax reform could create a more efficient and effective tax code, and that will require taking a serious look at tax expenditures.

Line Items: Sequester Edition

Sequester Week – It’s all about sequestration this week as the March 1 deadline for the $85 billion in across-the-board cuts looms (read all about the sequester here). The deadline at the end of the week is the culmination of a chain of events begun a year and a half ago with the Budget Control Act (BCA). The BCA avoided a national default by raising the debt ceiling in exchange for some spending cuts and mechanisms to ensure further deficit savings, including sequestration. The reasoning was that the sequester would be so unpalatable to both parties, with abrupt spending cuts equally divided between domestic and defense spending, that lawmakers would seek a deal on a more thoughtful and comprehensive approach. That logic failed both when the Super Committee was unable to come up with a plan to replace the sequester and at the beginning of the year when the deadline for the sequester was delayed for two months. The sequester is a symbol of the failure of our leaders to compromise and work together in the best interests of the country. The Fix the Debt Campaign has a handy report card you can use to grade the performance of our policymakers.

All Quiet on the Sequestration Front – Congress is back is in session this week, but policymakers are by no means exhausting themselves in trying to avoid the cuts from taking effect. While Washington has become quite adept at averting disaster at the last minute, every indication at the moment is that sequestration will take effect on Friday even though everyone wants it replaced. With no deal in sight, there are plans to vote on Democratic legislation that will replace the sequester with an even mix of spending cuts and additional revenue and a Republican bill to give agencies more flexibility in carrying out the sequester. Neither measure is expected to garner support from the opposite party. Alan Simpson and Erskine Bowles also put forth a plan for $2.4 trillion in deficit savings that could replace the sequester last week.

On to the Next Deadline – Though they don’t realistically plan to solve the sequester by Friday, policymakers are already looking ahead to the next fiscal deadline. On March 27 the stopgap measure funding federal operations will expire and the federal government will shut down unless agreement is reached. Lawmakers have all but given up on enacting a comprehensive budget blueprint for the rest of the fiscal year, but they will want to agree on another stopgap measure to prevent a shutdown. The battle will be over spending levels, as in if the sequester is reflected or not, and what kind of flexibility federal agencies will have in making cuts to meet the sequester. Currently, agencies have little flexibility in deciding what gets cut and what doesn’t, but a new continuing resolution could re-assign those cuts. There are lots more fiscal speed bumps down the road, as illustrated by our infographic.

Stating the Case – President Obama is on the road making the case for his approach to replace the sequester with a mix of spending cuts and revenue increases, with a White House spokesman saying the spending cuts to revenues ratio for a sequester replacement could be 2 to 1. To make the case that sequestration will be harmful to Americans, the White House released fact sheets on how sequestration would affect each state and the District of Columbia. The Administration is also urging state governors to pressure lawmakers to avert the sequester.

No Hiding Fact the Debt Must Be Addressed – A new academic paper indicates that the U.S. may soon reach a point where the national debt seriously impairs the economy. The research implies that debt at 80 percent of the economy could result in a "debt trap" of spiraling interest rates and interest payments to service growing debt. At the same time, a recent survey of economists suggests that a comprehensive debt plan that involves all parts of the budget could boost the economy in 2014.

Lew Committee Vote This Week – The Senate Finance Committee will vote on the nomination of former Office of Management and Budget director Jacob Lew to be treasury secretary on Tuesday. The nomination is expected to go through and Lew will be a key player in the upcoming budget battles.


Key Upcoming Dates (all times are ET)


February 26

  • Senate Finance Committee hearing on the CBO 2013 Budget & Economic Outlook at 10 am as well as an organizational meeting and vote on Jacob Lew to be Treasury Secretary.
  • Senate Budget Committee hearing on the impact of federal investment on people, communities and long-ter meconomic growth at 10:30 am.


February 27

  • House Armed Services subcommittee hearing on the impact of budget constraints on military end strength at 2 pm.
  • Senate Aging Committee hearing on streghtening Medicare for today and the future at 3 pm.


February 28

  • Bureau of Economic Analysis releases second estimate of 2012 4th quarter and annual GDP.


March 1

  • Across-the-board cuts to defense and non-defense discretionary spending prescribed in the Budget Control Act, known as "sequestration," will take effect.


March 8

  • Dept. of Labor's Bureau of Labor Statistics releases February 2013 employment data.


March 15

  • Dept. of Labor's Bureau of Labor Statistics releases February 2013 Consumer Price Index data.


March 27

  • Current continuing resolution (CR) funding the federal government expires.


March 28

  • Bureau of Economic Analysis releases third estimate of 2012 4th quarter and annual GDP.


April 5

  • Dept. of Labor's Bureau of Labor Statistics releases March 2013 employment data.


April 15

  • Congress must pass a budget resolution as specified in the Congressional Budget Act. Also, due to the debt ceiling suspension bill, lawmakers will have their pay withheld after this date until their respective chamber passes a resolution.


April 16

  • Dept. of Labor's Bureau of Labor Statistics releases March 2013 Consumer Price Index data.


April 26

  • Bureau of Economic Analysis releases advance estimate of 2013 1st quarter GDP.


Can Our National Leaders Pass the Test?

Most everyone – from President Obama, Speaker Boehner, and lawmakers from both sides of the aisle, to renowned economists – agrees that allowing sequestration to occur would be a less than ideal way to tackle our debt problem. The across-the-board spending cuts on domestic and defense budgets will lead to furloughs and layoffs, and don't address inefficiencies in entitlement programs and the tax code, the major drivers of the debt in the future. However, we need to do something to reduce the deficits, and the worst outcome would be to cancel the sequester without offsetting it.

These spending cuts need to be replaced with a comprehensive debt deal containing critical reforms that put our national debt on a downward path as a share of our economy. On Friday, the Fix the Debt campaign released a grading scale that shows how to score our national leaders on the deal they reach (or not). The fate of our economy in both the short and long term depends on what lawmakers do.

To get an A, lawmakers would have to replace the sequester with a plan that would put debt on a clear downward path as a share of the economy, which our recent analysis found would require $2.4 trillion in additional savings over ten years compared to current policy. The grades fall as the sequester solution gets less comprehensive. Lawmakers earn a B if they offset a permanent repeal of the sequester, a C if they offset a one-year repeal, and an F if they delay the sequester without offsets. Allowing the sequester to happen gets an incomplete grade due to its insufficient amount of long-term deficit reduction.

Hopefully, lawmakers go for the highest grade and make additional reforms to health care and Social Security that would make those programs sustainable over the long term. Given the strong support from American citizens, we hope our national leaders step up to the plate and reach a bipartisan deal to solve our budget problem.

Click here for the full-scale report card.

Unintended Consequences of the Sequester

There has been a lot of talk about the sequester in recent weeks as the latest in a long line of fiscal stand-offs ensues in Washington. In FY 2013, the sequester will hit defense budget authority by $43 billion, non-defense discretionary budget authority by $26 billion, Medicare spending by $11 billion, and other mandatory spending by $5 billion. 

The chart below from the New York Times shows that while the cuts themselves are significant, a good deal of spending is excluded from sequestration, especially spending on entitlement programs. We need to do something about our unsustainable budget and the sequester is better than nothing, but almost everyone agrees that the sequester is a dumb way to reduce the deficit. It includes severe cuts up front that would harm the economy, hinders the federal government's ability to provide basic services through across-the-board cuts, and does not address the drivers of our long-term debt.

Source: New York Times

Scott Lilly of the Center for American Progress points out another way in which the sequester cuts are not smart: in some cases, the cuts may increase the deficit. For one, the sequester's hit to the economy would depress revenue and increase spending on countercyclical programs (although the effect would most likely not wipe out the initial savings fully over ten years). Lilly further points out that the economic contraction may actually be bigger than anticipated, since the sequester may have further ripple effects beyond what a simple multiplier analysis would indicate. For example, cuts to the Federal Aviation Administration (FAA) could lead not just to fewer jobs at the agency and related effects, but it also could hurt the airline industry by reducing the number of flights that they can operate. This kind of disruption is not typically experienced with other kinds of cuts.

Also, because of the way some of the affected spending works, some cuts may actually have no impact or even a negative impact on the deficit. To use the FAA as an example again, since the sequester cuts could reduce the number of flights and the FAA is largely funded by user fees collected on a per flight basis, the agency's savings from the budget cuts would mostly be erased by losses in revenue. This would be a worst of both worlds result -- disrupted service with little or no savings to show for it.

Other examples of counterproductive cuts include the IRS and the Center for Medicare and Medicaid Services (CMS). The IRS, of course, is responsible for collecting revenue, so cuts to their budget would result in less revenue collection, likely an amount that is greater than the initial cuts. We've seen that the reverse is true with the Senate version of the Budget Control Act, which increased funding for the IRS by $14 billion over ten years and was scored as increasing revenue by $44 billion (a net $30 billion gain). In the case of CMS, they preside over an enormous budget that will shrink only a little -- Medicare will be cut by 2 percent and Medicaid is exempt -- while their own budget will shrink by 9 percent, according to Lilly. And even if the size of Medicare payments is smaller, the number of payments CMS must process will not shrink. As a result, it is quite possible that the increase in improper payments would swamp the initial savings from cutting CMS's budget. As you can imagine, there are plenty of other examples of sequester cuts which would hamper agencies' abilities to maintain budgetary discipline.

Clearly, the sequester is not a smart way to reduce the deficit, but that does not mean it should be repealed without offsets--that would be a clear step back in the effort to get our budget on a sustainable path. Instead, lawmakers should make much smarter choices by working to get our debt under control with more gradual changes. This plan should also go much further than the sequester and tackle the long-term drivers of our debt so that, unlike the sequester, it can make our long-term fiscal future much brighter. Lawmakers should take advantage of this moment and enact a smart deficit reduction plan as a replacement, as described in Fix the Debt's report card. The sequester debate is an opportunity as much as it is a problem.

Talking Sequester and Debt in Idaho

CRFB's Maya MacGuineas joined former Sen. Alan Simpson (R-WY), Sen. Mark Warner (D-VA), Sen. Mike Crapo (R-ID) and Rep. Mike Simpson (R-ID) at the University Of Idaho for the McClure Center Symposium on Federal Fiscal Issues on February 19 for a program that was produced by Idaho Public Television.

Much of the discussion focused on the upcoming sequestration and how it is not the best way to address the national debt. There was also a frank discussion on the need for compromise on a comprehensive approach that deals with all parts of the budget.

Watch the program for a better understanding of the sequester and what needs to be done to put the U.S. on a better budget path.