The Bottom Line
As our national debt and deficit continue to rise, a question that continues to be on many people’s minds is how rising debt levels impact the economy, especially as the American economy remains far from a full recovery. A report from the Organization for Economic Cooperation and Development (OECD)’s Economics Department on Debt and Macroeconomic Stability explains how rising public and private debt levels are related to macroeconomic instability.
Noting that both public and private debt levels in OECD countries are currently high relative to historical averages, the report lists a number of findings, most notably that high debt levels can exacerbate macroeconomic vulnerability and the likelihood of an economic downturn increases when private sector debt levels rise above trend. The report’s authors cite a trend of rising debt as a share of GDP in OECD countries since the mid-1990s, peaking now with average total economy financial liabilities—public and private debt taken together—over 1300 percent of GDP following the financial crisis.
The chart below shows the rise in OECD area financial liabilities as a percentage of GDP:
The report argues that higher debt could lead to a higher likelihood of recession, especially high levels of houshold debt. But government debt is also important, especially for limiting the effects of large shocks to the economy. Fiscal policy, one tool that governments can use to respond to crises, is limited when governments carry high levels of debt. From the report:
Government borrowing rises during a downturn due to the automatic stabilisers and, possibly, discretionary fiscal policy, thereby damping the propagation of the shock. In this context, temporarily increasing government debt helps ensure macroeconomic stability. However, there appear to be limits to the ability to stabilise the economy, when government debt is high. In fact, government financial liabilities and output volatility are correlated which suggests that the stabilising role of fiscal policy becomes weaker at higher levels of debt. This reflects that debt dynamics may threaten to become unstable and that household behaviour – expecting that greater government debt will eventually result in higher taxes – will reduce the effectiveness of fiscal policy in smoothing economic fluctuations. When debt levels are high,fiscal policy may even be forced to become pro-cyclical.
Hence the need to bring down government debt levels to prudent levels during good times. Institutional frameworks, such as fiscal rules and fiscal councils, can help maintain prudent government debt levels, which allow fiscal policy to react to shocks.
Limited flexiblity in the face of a crisis is not the only downside to high levels of debt. In a recent New York Times column, MIT economist Robert Solow argues that one of the concerns of high debt levels is that it may "crowd out" private investment, therefore slowing growth. Although he says that Treasury debt is only soaking up excess private savings right now with the economy facing an output and employment gap, the crowding out will become a factor when the economy recovers. Writes Solow:
The real burden of domestically owned Treasury debt is that it soaks up savings that might go into useful private investment. Savers own Treasury bonds because they are seen as safe, default-free assets, and the government can borrow at lower rates than corporations can. If there were less debt, and fewer bonds for sale, savers seeking higher returns would invest in corporate bonds or stocks instead. Business investment would expand and be more profitable.
Solow concludes that we need a long-term plan to reduce the deficit. Such a plan could put debt on a sustainable, clear downward path and phase in most of the deficit reduction so it occurs after the economy has had time to recover.
In the long run we need a clear plan to reduce the ratio of publicly held debt to national income. But for now the best chance to reinvigorate the economy, spur business investment and encourage consumer spending is through public borrowing and spending. Instead, we’re heading into an ill-advised, across-the-board austerity program.
As Solow's argument highlights, sequestration is not the right way to reduce the deficit. It is mindless, abrupt, frontloaded, too heavily concentrated on cutting investments, and not focused enough on addressing entitlements. But simply repealing the sequester would send the message we are not serious about controlling our debt, which is why it should be replaced with a much smarter deficit reduction plan.
We brought up a couple of weeks ago that there were a number of plans to replace the sequester for either a year or permanently. Now, CBO has given us detailed scores of three proposals: the Senate Democratic plan (the American Family Economic Protection Act, S. 388), a plan (S. 16) by Sen. Pat Toomey (R-PA), and a plan by Sen. Kelly Ayotte (R-NH) (the Sequester Replacement and Spending Reduction Act, S. 18). The Senate Democratic one failed to get the requisite 60 votes in the Senate last week, only receiving 51, while the Toomey proposal was voted down 38-62 last week. The Ayotte plan did not get a vote. However, these plans still provide some insight into each party's current approach to replace sequestration.
We described the Senate Democrats' plan previously. Its main elements, in addition to a one year cancelation of the sequester, include enacting the Buffett Rule ($53 billion), eliminating direct payments for agriculture ($31 billion), and reducing defense spending caps by $28 billion. The net savings from the bill total $2 billion.
|Ten-Year Score of Senate Democratic Plan (billions)|
|2013-2023 Savings/Costs (-)|
|Reduce Net Agriculture Spending||$28|
|Enact Buffett Rule (30% Minimum Tax on Millionaires)||$53|
|Enact Other Revenue-Raisers||$2|
|Reduce Defense Spending Caps||$27|
The Toomey bill, rather than replacing the sequester with different policies, allows the President to allocate the cuts however he wishes. The President would be required to report this allocation by March 15, and the plan would be subject to Congressional disapproval by a majority vote. The CBO determined that the legislation's budgetary impact was unknown, since it would depend on how the cuts were allocated. However, they said that it was more likely than not that the result would be to increase spending relative to current law because the President could end up cutting spending that would not have been spent anyway.
The Ayotte plan that CBO scored has a number of different elements. These include a one-year repeal of the discretionary sequester (the sequester to certain mandatory programs remains in place); an extension of the federal employee pay freeze through 2014; an increase in recapture of exchange subsidies that are overpaid; a requirement that taxpayers claiming the refundable portion of the child tax credit provide a Social Security number; an increase in federal employee retirement contributions; a $20 billion reduction in the 2013 discretionary cap; a food stamp change that restricts qualification for the Standard Utility Allowance (an increase in benefits for energy assistance) to those who specifically receive low-income energy assistance payments (excluding those who simply apply or intend to apply); and a change to the Consumer Financial Protection Bureau which would subject it to the appropriations process and reduce its budget. Overall, the plan reduces ten-year deficits by $105 billion.
|Ten-Year Score of Ayotte Plan (billions)|
|2013-2023 Savings/Costs (-)|
|Repeal Discretionary Sequester||-$71|
|Recapture More Exchange Subsidy Overpayments||$58|
|Require SSN for Child Tax Credit||$27|
|Increase Federal Employee Retirement Contributions||$35|
|Reduce Discretionary Caps||$37*|
|Make Food Stamp Allowance Dependent on Receipt of Payments||$13|
|Reduce CFPB's Budget||$6|
*Involves reductions in discretionary spending related to the pay freeze and $20 billion reduction in the 2013 cap net of reduced federal government contributions to federal employees' retirement. The decrease in retirement contributions is not accompanied by a reduction in the discretionary caps, so the funds instead "fill in" some of the cuts from the other two policies.
As we have pointed out before, there are also many other plans out there in the House and the Senate that would replace the sequester. Lawmakers should get moving on coming to an agreement because there are much smarter and less economically harmful ways to reduce the deficit.
In a move that had been anticipated for a while, the Obama Administration has nominated Sylvia Mathews Burwell to be the next OMB director. Jeff Zients had been serving as acting director since early last year, when current Treasury Secretary Jack Lew filled the President's chief of staff role.
Burwell previously served as deputy OMB director in the late 1990s and early 2000s under Lew's first go-round as director. She also had numerous other policy-related and economic-related positions in the Clinton Administration. In the intervening 12 years since she left OMB, she served in the Gates Foundation for a decade and more recently as president of the Wal-Mart Foundation for a year and a half.
Burwell's prior experience with budgetary matters will be very useful as the Administration and Congress look to come to an agreement to reduce the deficit. Assuming that she is confirmed, we wish her luck as director.
Friday at 11:59 PM, sequestration officially began, triggering sharp across-the-board cuts without much progress on bipartisan replacement plan. Our current debt path is unsustainable and we need to address the deficit, so sequestration is better than nothing even if it is poor policy. But it doesn't address the future drivers of federal spending: entitlement programs.
President Obama Friday called for a balanced approach to put our deficits on a downward trajectory as a share of the economy. Given projections of our debt, Bloomberg View columnist Jonathan Alter argues that even the strongest supporters of entitlement programs should consider reform to strengthen these programs going forward. He argues that reform, contrary to the popular rhetoric, should make these programs sustainable within the context of the budget while ensuring a good return from these programs. The current approach of sequestration hits the discretionary budget too hard, and will reduce government investment and research that will help with our future growth prospects. He writes:
To hold the line on harmful cuts to discretionary spending, Obama and the Democrats must educate the public about the necessity of entitlement reform. Otherwise, the poor and needy -- largely spared by the automatic reductions under sequestration -- will get hit much harder down the road.
Liberals are right to reject Republican proposals that would slash social-welfare programs even as they refuse to consider closing tax loopholes for the wealthy. And I agree that the sequestration will cut into the bone of important government functions and investments in the future.
That makes two more reasons to start talking seriously about how we will pay for the insanely expensive retirement of the baby boomers.
How expensive? Anyone reaching retirement age in the next 20 years (including me) will take more than three times as much out of Medicare as he or she contributed in taxes. By 2030, the U.S. will have twice as many retirees as in 1995, and Social Security and Medicare alone will consume half of the federal budget, with the other half going almost entirely to defense and interest on the national debt. It’s unsustainable.
An approach that doesn't consider any reforms will make it difficult to move forward. Alter uses the example of Social Security, due to become insolvent as soon as 2033, at which point beneficiaries will experience an automatic 25 percent cut in benefits. There are many combinations of reforms that could make Social Security solvent, but once lawmakers start leaving options off the table, agreeing upon a solution becomes difficult.
Today, only the first $110,000 in income is subject to the 7.65 percent tax that pays for Social Security and Medicare. Lifting the cap to higher income levels (say $250,000 or $400,000) could eventually generate hundreds of billions of dollars.
Republicans consider this a tax increase. That’s only true outside the context of these programs. The change could be structured so that no one paid in more than actuarial tables say they would take out. That would still raise billions and be consistent with the idea of paying for your own retirement if you can afford it.
For lifting the cap to have any chance, it would have to be matched by reforms such as adopting the chained consumer-price index, a new way to measure cost-of-living adjustments that Obama apparently favors. Liberals oppose chained CPI because it would theoretically result in lower benefits. But less frequent cost-of-living increases aren’t the same as cuts, especially if the current system is, as many experts believe, based on an inaccurate assessment of inflation.
Indeed, CRFB has discussed a number of ways for tacking the rising costs of entitlements. For Social Security, we have talked about switching to the chained CPI to accurately measure for inflation since it better accounts for consumer substitution among similar goods. For Medicare and Social Security, we have discussed raising the eligibility age. Not everyone will agree with all of the reforms out there, but there are enough good ideas that we should start discussing. If we want to avoid the sharp cuts under sequestration, we should put everything on the table. As Alter concludes, "Maybe there are better ideas for reforming social insurance. The point is, we better start talking about them."
Throughout the week we have been breaking down the new report from the Brookings Institution's Hamilton Project, "15 Ways to Rethink the Federal Budget." Proposals have included reforms to the military, tax expenditures, Medicare, Social Security Disability Insurance, and Natural Disaster Assistance, Transportation, Visas & Housing Finance. In our final blog we take a look at two proposals to create new taxes -- a value-added tax and a carbon tax, that unlike our income and corporate tax systems, would tax behavior that economists generally do not want to promote and create better incentives.
William Gale of the Brookings Institution and Benjamin Harris propose instituting a 5 percent broad-based value-added tax (VAT) in their proposal, "Creating an American Value-Added Tax." VATs are in place in 150 countries, including every OECD country besides the U.S. Economically, the VAT is like a sales tax in that it taxes consumption and therefore incentives saving. However, unlike the sales tax, which is only applied at the final point of sales, the VAT is collected at every stage of production, making it easier to administer and increasing compliance. A VAT would be applied to imports but not on exports, allowing for neutral treatment.
However, the VAT has been criticized on two fronts. The first is that it is regressive, since lower income households consume more of their income than wealthier households, and consumption is taxed at a flat rate regardless of income level. The other common reservation with VATs is the "low profile" of the VAT, being automatically build into the price of a good, that could allow governments to increase spending with less taxpayer awareness than with income taxes.
Gale and Harris attempt to solve these two problems. They propose to add a new 5 percent VAT that would tax all consumption apart from spending on charities, education, Medicare and Medicaid, and state and local government. However, to prevent making the tax code less progressive, they recommend that the VAT be paired with a cash payment of $450 per adult and $200 per child. This would be approximately equal to refunding the VAT tax for the first $26,000 of consumption for a two-parent, two-child household. To avoid disrupting the economic recovery, the VAT wouldn't go into effect until 2017, when the CBO projects the economy will return to trend. Even with the VAT implemented in 2017, it would still raise $1.6 trillion in revenue over the 2014-2023 period.
Gale and Harris argue that the VAT doesn't have to be invisible, citing the example of Canada requiring the VAT to be shown on each receipt (as sales taxes currently are in the U.S.). They also challenge the idea that a VAT would lead to lead to increasing government spending as the average VAT revenue has remained relatively constant among OECD countries since the 1980s. If the VAT were also accompanied by spending targets or long-term entitlement reforms, this could also prevent the government from becoming too reliant on the tax.
Just as most budget experts argue that the unsustainable budget deficit represents a great threat to our future, most climate scientists believe that climate change presents a similar threat. Adele Morris of the Brookings Institution argues in her proposal "The Many Benefits of a Carbon Tax" that there is an opportunity to address both at the same time. A carbon tax could raise new revenue for deficit reduction while also encouraging abatement of CO2 emissions.
Morris's proposal recommends a tax of $16 per ton of CO2 emmissions, increasing by inflation plus 4 percent. A carbon tax should ideally be priced at the social cost of carbon according to Morris, but the social cost is unknown. Still, the $16 tax falls within the range of U.S. government estimates. The tax is set to increase by 4 percent plus inflation to make it easier for businesses to plan and invest, while also discouraging quick extraction of fossil fuels to minimize tax liability. In total, this carbon tax would raise $1.1 trillion in revenue over the next ten years.
The U.S. has the world's highest statutory corporate rate and Morris proposes using some of the savings from the carbon tax to reduce that rate from 35 percent to 28 percent, at the cost of $800 billion over ten years. Morris would also offset the increase in the regressivity of the tax code by reserving 15 percent of revenue to benefit the poorest households. Finally, Morris recommends making the tax code simplier by eliminating many tax expenditures that promote renewable energy and fuels at a savings of $60 billion over ten years. Since the carbon tax would already provide strong incentives to abate emissions, these tax expenditures would become redundant. Altogether this proposal would reduce the deficit by $199 billion over the next ten years, and $815 billion over the next twenty.
As we look to solve our unsustainable debt problem, it is clear that additional revenue will be needed. But increasing marginal income tax rates, which many economists believe would reduce incentives to work, is not neccessary. One approach might be to consider alternative taxes, like the ones above. Another approach, which we talk about frequently on The Bottom Line, would reduce the size of tax expenditures that litter our code, making it more complex, less efficient, and costing the federal government nearly $1.3 billion in forgone revenues according to the JCT. We can make reforms to make the tax code more favorable to growth and raise revenue for deficit reduction. We just need to take a look at the many ideas out there.
We've written extensively on the chained CPI, which represents both a more accurate measure of inflation and a policy change which would result in substantial deficit reduction. We've shown many of the arguments in favor of this idea and demonstrated that many of the criticism are misguided.
Prior to the fiscal cliff deal, we estimated chained CPI would save about $250 billion over ten years, $290 billion including interest. The CBO has updated its estimate, and it now estimates $340 billion in primary savings -- which would be about $390 billion including interest. Specifically, switching to the chained CPI would save $127 billion from Social Security, $38 billion comes from other programs with COLAs, $51 from other spending programs with inflation calculations (especially health programs), and $124 billion from revenue.
|Savings from Chained CPI (billions)|
Source: CBO, CRFB calculations
CBO's estimates have changed for a number of reasons, but the largest is the the enactment of the American Taxpayer Relief Act (ATRA). To understand why, it is important to understand how switching to the chained CPI generates revenue. The main reason has to do with the fact the threshold of the tax brackets are indexed with inflation, so "real bracket creep" pushes income into higher brackets as people become richer. Measuring inflation more accurately leads to slightly more real bracket creep.
The ATRA permanently indexed the Alternative Minimum Tax (AMT) exemption to inflation -- pulling tens of millions of taxpayers out of the AMT (where the brackets are not indexed and there is no "bracket creep") and also creating a new "AMT creep" which would be affected by the chained CPI. In additional, the ATRA increased the number of brackets from 5 under current law to 7, meaning that income is "creeping" through more brackets. And finally, the ATRA extended a number of provisions in the tax code which rely on inflation indexing.
Regardless of the budgetary impact, switching to the chained CPI should be done in keeping with the government's goal of measuring inflation as accurately as feasible. Most economists agree that the chained CPI is a superior price index compared to the CPI-U or CPI-W because it better accounts for consumer substitution across similar goods. We expanded on this topic in the paper "Measuring Up: The Case for the Chained CPI."
When you combine the fact the chained CPI is more accurate with the $390 billion of deficit reduction from all areas of the budget and tax code which come from utilizing it, the policy becomes almost a no brainer. Policymakers should enact this change, and should do so as soon as possible.
We've said frequently on this blog that controlling health care spending will be a crucial part of putting the debt on a sustainable path. After all, federal spending on health is expected to grow from 4.9 percent of the economy in 2013 to 6.4 percent in 2023 under our realistic baseline and to much higher levels thereafter. While rising health care costs are certainly a major driver of the future deficits, the aging of the population is actually a larger debt driver over the next three or so decades.
A recent post from Joshua Gordon, policy director of the Concord Coalition discusses the issue of rising health care costs. He explains:
Spending can grow either because more people are getting their health care services paid for -- a growth in beneficiaries -- or because those services are becoming more costly and numerous. In the political debate, when people use the phrase “it is a health care problem,” they usually are not arguing that the federal government provides health insurance for too many people. Instead they are trying to say that the problem is the growth in the cost of health care from too many services at too high a price.
This growth, either called "health care inflation" or the even more technical term "excess cost growth," is the bogeyman of the "health care problem" story. The story is that our nation’s health care system doesn’t do a good job at keeping health care costs down. That the best measurement of that failure is the per-person growth rate above the per-person rate of growth in the economy (GDP) -- the "excess" in the term "excess cost growth." And, that this explains why federal budget spending is projected to rise so dramatically in the future.
But given the recent slowdowns in health care cost growth, Gordon notes that this factor isn't the dominant driver in the increase in health care spending over the next decade. Rather, it is demographics; the retirement of the "Baby Boom" generation will increase the number of seniors served by Medicare by 17 million in ten years. Gordon uses a chart from the Medicare Actuary that shows that excess health care cost growth will make little contribution to the increase in health care spending in the next decade, and demographic factors will dominate for the next two.
Source: Richard Kronick and Rosa Po
Aging will, of course, be the dominant factor in the growth of Social Security spending as well, although Medicare is projected to grow by more over the long term. It will also be somewhat of a factor in the growth of other health spending, particularly Medicaid.
At least for Social Security and Medicare, one way to mitigate the factor of aging is to adjust the eligibility ages for these programs. This would ensure that both program's resources are targeted towards the population most likely to need them (the "old-old"). Such a change would also be beneficial for the economy by increasing the labor supply and near-retirees' savings, lessening the strain of the demographic shift on the budget and economy overall.
Although aging will be the bigger factor in terms of entitlement spending growth in the next few decades, excess cost growth will become the dominant factor over the longer run. As the CBO said in its latest long-term budget outlook:
Over the longer term, however, the situation changes. Beyond 2037, the age profile of the population will stabilize, and the effect of aging on the programs’ spending growth will diminish. As a result, excess cost growth accounts for an increasing share of the total projected growth in spending for the health care programs and Social Security and becomes the dominant factor in explaining the growth of spending on the health care programs alone.
Thus, health care reforms must be considered in budget negotiations, as the United States spends far more on health care per capita than any other developed country, and there are many health care reform options that could increase efficiency, federal savings, and even savings for beneficiaries. But more will need to be done than just controlling health care costs. We will need to make changes to the budget that directly account for both aging and health care cost growth and make up for those factors in other ways through further changes to spending and revenue.
The full post can be found here.
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.
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.
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.
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.
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.
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. 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.
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.
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.
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.
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 forgone 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.
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)
- 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.
- 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.
- Bureau of Economic Analysis releases second estimate of 2012 4th quarter and annual GDP.
- Across-the-board cuts to defense and non-defense discretionary spending prescribed in the Budget Control Act, known as "sequestration," will take effect.
- Dept. of Labor's Bureau of Labor Statistics releases February 2013 employment data.
- Dept. of Labor's Bureau of Labor Statistics releases February 2013 Consumer Price Index data.
- Current continuing resolution (CR) funding the federal government expires.
- Bureau of Economic Analysis releases third estimate of 2012 4th quarter and annual GDP.
- Dept. of Labor's Bureau of Labor Statistics releases March 2013 employment data.
- 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.
- Dept. of Labor's Bureau of Labor Statistics releases March 2013 Consumer Price Index data.
- Bureau of Economic Analysis releases advance estimate of 2013 1st quarter GDP.
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.
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.
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.
Today, a new paper was presented at the U.S. Monetary Policy Forum by David Greenlaw, James Hamilton, Peter Hooper and Frederic Mishkin on a possible tipping point for government debt as a share of the economy, past which a country may be vulnerable to a self-reinforcing cycle.
The paper examines 20 industrialized countries and analyzes how borrowing costs change based on certain levels of debt. Beyond net public debt levels of 80 percent of GDP, borrowing costs begin to rise exponentially to the point that countries may fall into "a debt trap" that is difficult to escape. This happens because lenders demand higher interest rates, leading to higher interest payments and debt. Based on the authors' calculations of net public debt (which appear to be a slightly different meaure than used by OMB and CBO) the U.S. was at the 80 percent threshold in 2011. The effects of rising borrowing costs on debt can be seen in the graph below, where CBO projections are compared to a simulation that doesn't assume constant interest rates as CBO does in its model.
Many papers have studied tipping point or thresholds beyond which a fiscal crisis could take place or economic performance would languish. A paper from Carmen Reinhart and Kenneth Rogoff found that gross debt levels above 90 percent, which the U.S. has already reached, could reduce growth. Other reports from CBO, the IMF, Cecchetti, and others have found similiar effect of debt on growth. The thresholds found in these papers range and may not be exact, but our current debt levels are close enough that we should be paying serious attention, especially given our long-term budget outlook driven by aging and health care cost growth.
As we explained in our report on the topic, fiscal crises can happen and be responded to in different ways. We detail several scenarios about how a fiscal crisis might play out, including:
- A Gradual Crisis: We muddle along with inadequate high value government investments and slower growth.
- A Catastrophic Budget Failure: An abrupt crisis occurs.
- An Inflation Crisis: Higher debt is managed through inflation.
- An External Crisis: A dollar or trade crisis leads to a fiscal crisis.
- A Default Crisis: A series of events leads to a default.
We may not be in a fiscal crisis yet, but that is no reason to be complacent. As Federal Reserve Governor Jerome Powell said in a response to the paper, we are getting closer and closer to a point where the debt could do serious damage:
We may have more room than other economies around the globe, but I do not intend to project any sense of complacency around this topic. The authors' basic message seems just right to me: We don't know where the tipping point is; wherever it is, we are clearly getting closer to it, and the costs of misestimating its location are enormous and one-sided. The benefits to long-term fiscal consolidation--conducted at the right pace, and without jeopardizing the near-term economic recovery--would be substantial.
We don't know exactly at what levels of debt would trigger a fiscal crisis for the U.S., but it would be best if we never found out. There are disastrous risks associated with doing nothing and economic benefits to enacting a comprehensive plan as a solution. We know we will have to solve this problem, so it's time for lawmakers to come together and work toward a compromise.
The full paper can be found here.