The Bottom Line
Should Social Security cost-of-living adjustments (COLAs) be trimmed? In a recently released CQ Researcher Report focusing on government spending, CRFB Senior Policy Director Marc Goldwein answers yes, if that means that COLAs better reflect inflation.
In his op-ed, Goldwein explains that the chained CPI is supported by economists across the political spectrum since it is a more accurate measure of inflation.
The so-called chained Consumer Price Index (CPI), a far more accurate inflation index than the one used now, would better reflect retirees’ actual spending patterns and the cost increases they encounter. Economists from the left, right and center broadly agree on that, and their view is affirmed by the nonpartisan Congressional Budget Office (CBO) and the Bureau of Labor Statistics. Adopting this improved measure would also generate more tax revenue, slow government spending growth and strengthen the Social Security system.
Goldwein continues by addressing some of the potential concerns with the reform.
So how can anyone oppose this change? Some special-interest groups do so for their own financial benefit, while others argue that seniors face faster price growth or the most vulnerable would be hurt by this change. Yet alternative measures that purport to show seniors spending more are highly flawed — including in the ways they measure housing and health care — to the point that the CBO has concluded, “It is unclear...whether the cost of living actually grows at a faster rate for the elderly than for younger people.”
Even if a better measure were produced for measuring cost increases affecting only retirees, adopting it would raise serious fairness concerns. Should the one-third of Social Security beneficiaries who are not retirees receive smaller cost-of-living adjustments so seniors can receive larger ones? Should New Yorkers, with their high cost of living, receive a higher percentage than Detroiters? Should each government program get its own index or only those backed by powerful interest groups?"
Social Security will need to be reformed if the program is to survive and switching to the chained CPI is one of the easiest choices lawmakers can make. This should be the first step in reform to ensure the program can remain solvent for future generations. Goldwein concludes:
Ultimately, the best thing we can do for the most vulnerable in society — at least within Social Security — is to make the program sustainable and solvent and avoid the 23 percent across-the-board benefit cut currently scheduled for when the program’s funds dry up. If we can’t even measure inflation correctly, how can we hope to make the hard choices necessary to keep Social Security funded for future generations?
Click here to read the full piece.
"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.
Why is the long-term debt problem important for the country? And why should lawmakers care about it now? Those are the two main questions the Peterson Foundation answers in its new report on the long-term outlook, Why Long-Term Debt Matters. The Peterson Foundation report shows where the problem came from, who is affected, and why the problem needs a solution in place now. They have also created an infographic capturing many of the notable facts and figures that characterize the long-term debt problem.
[Click to view full infographic]
Our CRFB Realistic Baseline projects debt to rise to over 100 percent by 2038, while the Peterson Foundation, using more pessimistic assumptions, projects even higher levels. Along with a point we made before on this blog, the Peterson Foundation argues that while recent developments have improved our medium-term outlook, much more is needed on the long-term front. Population aging and excess health care cost-growth will push debt up significantly over the longer term.
A result of that debt will be rising interest payments which will "crowd out" other government priorities. Under the Peterson Foundation's projections, interest payments will actually exceed total revenues by 2064. This should be a great concern to future generations since that would likely result in less research and development, infrastructure investment, and weaker economic growth.
Lastly, the Peterson Foundation makes the case for why we should solve the deficit problem now. The longer we wait, the larger and more abrupt the required changes will need to be. Agreeing upon a solution today allows for gradual, phased-in changes that can protect the vulnerable and give people time to plan. Given the size of the problem and the importance of a solution for long-term growth, that would be the right way to go.
As Senator Finance Chairman Max Baucus (D-MT) and Ranking Member Orrin Hatch (R-MI) continue to work through tax reform using their "blank slate" approach, their Senate colleagues have 11 days left to submit “add-backs.” As we’ve written before, many tax preferences are expensive, regressive, economically distorting, and do not pass the cost-benefit analysis.
Surely, though, policymakers will want to add back some of the more popular tax preferences and when they do they should find ways to redesign them to be better targeted. Fortunately, lawmakers do not need to start from scratch in designing these add-backs. We’ve written in the past about more efficient ways to design mortgage interest deduction, the charitable deduction, and employer health exclusion.
In the tables below we’ve compiled many of these options along with ten-year budget estimates (or our own rough guestimates) offered at the time. Note that these estimates are compared to current law, not a blank slate, and they are very rough since they use different ten-year windows and estimated against different baselines, with different pieces of legislation enacted since the estimate was calculated.
First, we take a look at the mortgage interest deduction, which in theory promotes homeownership, but in reality largely subsidizes the construction of more expensive homes and benefits higher-income earners. Some proposals would add limitations to the current deduction including not allowing it to be used for second homes and home equity loans, while others would redesign the provision such as turning it into a refundable or nonrefundable credit. A unique option from Tax Policy Center could reduce the tax expenditure's value while increasing house prices as well.
Options to Reform the Mortgage Interest Deduction
[Click to expand and for links]
Like the mortgage interest deduction, the charitable deduction also intends to promote a desirable goal, in this case increasing contributions to charities. However, it may be subsidizing donations that would have been made anyways and only benefits those who itemize, mostly higher-income earners. Popular reform approaches include turning the deduction into a credit or creating a floor to limit the "windfall" provided to taxpayers.
Options to Reform the Charitable Deduction
[Click to expand and for links]
There are a number of options for addressing the health exclusion, both within the income tax and the payroll tax. Options include turning the exclusion into a credit, capping the exclusion as a percentage of premiums, linking the exclusion to the Affordable Care Act exchanges, and other reforms.
Options to Reform the Health Exclusion
[Click to expand and for links]
By no means is this a complete list of proposals to replace the three tax expenditures, but it shows that many plans have come up with viable ways to make these provisions more efficient. Provisions to promote homeownership, charitable contributions, and employer contributions to health insurance may be kept in a reformed tax code, but hopefully lawmakers will look at the alternatives to current provisions and maximize fairness and efficiency while reducing their costs.
With all of the new developments in tax reform it may be easy to forget about entitlements. But Michael Boskin, former chairman of the Council of Economic Advisers, reminds us in a recent piece that we really do not have much time to wait on Social Security Disability Insurance (SSDI) reform.
Unlike the old-age trust fund, which is expected to be depleted by 2035, and Medicare Part A's trust fund, which is expected to be depleted by 2026, SSDI's insolvency date is in only three years, at which point benefits would have to be cut by 20 percent unless funds are transferred from the old-age program. If they are, the combined trust fund would be exhausted in 2033. The former two entitlement programs should be reformed to ensure a gradual transition, but with SSDI, we barely even have that luxury.
Without reform, Boskin states, the program will only become more difficult. From 1980 to 2012, the number of SSDI beneficiaries has increased by 187 percent, and the drivers of this increase make inaction threatening. The rise is not only a result of aging demographics, a growing population, and women entering the labor force, but also, Boskin states, three fundamental problems within the program.
For one, Boskin argues, Congress has progressively loosened disability insurance eligibility reviews. Not only has this increased the sheer number of beneficiaries, but it has also changed the type of beneficiary. Broadening eligibility has resulted in a big transition in SSDI from circulatory and musculosketal disabilities in the 1980s to a focus on things like mental disabilities today. These disabilities are all given the same weight within the program, but the latter group is generally much more difficult to identify, diagnosed young, and generally incurable.
Second, because disability insurance benefits have gradually increased relative to wages, work incentives have gradually weakened. Because of this, Boskin argues that "disability insurance has clearly become, in part, a form of extended unemployment insurance and early retirement, with Medicare benefits."
Lastly, Boskin argues that states are pushing people from low-income programs like Medicaid onto SSDI because some of the costs of the former are paid by states while the latter is paid entirely by the federal government.
Source: Social Security Trustees
The result, combined with the demographic forces, is a fourfold increase in the number of beneficiaries since 1970 and an eightfold increase in costs (adjusted for inflation) since 1970, with revenues unable to keep up. Boskin offers several potential solutions that work towards financial sustainability while attempting to leave the goals of the program intact (click here for more options). He proposes creating a more uniform definition of "disability" and redesigning decisional procedures for administrative law judges. Once applicants are admitted into SSDI, Boskin calls for more frequent re-evaluations. To strengthen work incentives within the program, he believes that a combination of early intervention programs, providing more information on job options, and varying DI employer taxes with the rate of disability incidence would encourage more beneficiaries to return to or stay in the workplace.
In only three years, the SSDI program will have exhausted all trust fund reserves, at which point, the program will have to begin transferring funds from the old-age trust fund or face a 20 percent cuts to benefits. Clearly, something needs to be done on disability insurance. There are many options for reform, including those presented by Boskin, our Social Security simulator "The Reformer," the Hamilton Project, the CBO, and CRFB senior policy director Marc Goldwein.
There is a clear consensus across the political spectrum that reforming the tax system will require going after the many tax expenditures that litter the code. However, many observers have commented that political difficulties could derail the process or signficantly scale back reform efforts. But some have also observed that a uniform limit applied to certain tax expenditures may be a more politically expedient option than going after specific ones. This approach garnered particular attention during the 2012 Presidential campaign when Republican candidate Mitt Romney floated the idea of a cap on deductions. It also became part of the discussion during the fiscal cliff negotiations as a way to raise revenue.
Tax Policy Center has now added to the discussion with its latest paper "Evaluating Broad-Based Approaches for Limiting Tax Expenditures" by authors Eric Toder, Joseph Rosenberg, and Amanda Eng. The paper looks at a number of different tax expenditure limitations, many of which were included in our revenue options report, and evaluates them on the revenue raised and the distribution of the tax change. The six limitations they examine are:
- A percent of income cap (like the Feldstein-Feenberg-MacGuineas cap)
- A fixed dollar cap (like Gov. Romney mentioned)
- A "rate limit" on the value of preferences (similar to the President's budget)
- A percent "haircut" in preferences
- Replacing each preference with a refundable credit
- Including preferences in the Alternative Minimum Tax (AMT)
The authors model a number of scenarios with these six limitations. They show what the effect would be of applying these to just itemized deductions, and also to the health insurance exclusion and the exclusion for interest earned on municipal bonds. They also evaluate the provisions if they are enacted in conjunction with a repeal of the AMT and the "Pease" limit which indirectly phases out itemized deductions for high earners (the limits are made less generous when these repeals are included to replace the lost revenue.
Given the specific parameters the authors choose, each proposal raises between $1 and $1.2 trillion of revenue over ten years. In terms of progressivity, the refundable credit is the most progressive, since it actually cut taxes for the bottom two quintiles while raising them the most on the highest quintile. Most options effectively hold the bottom two quintiles harmless since they would either not hit the specified limit or they do not benefit much from itemized deductions or the exclusions in the first place.
From a policy standpoint, it would be better to evaluate each tax expenditure and decide whether to reform, retain, or eliminate it. But the political appeal of using a broad-based limit is clear as well. At the least, the TPC paper shows that these kind of limits can both raise a significant amount of revenue and be prgoressive. As House Ways and Means Chairman David Camp (R-MI) and Senate Finance Chairman Max Baucus (D-MT) move forward with their efforts to reform the tax code, they may serve a useful purpose either as a primary reform or as a backstop to a more sweeping tax reform plan.
The sequester has always been a blunt and mindless way to reduce the deficit, and for the Defense Department, its effects are now clearly being seen. On Monday, the Defense Department began furloughs for its civilian workers, which will eventually affect more than 650,000 workers according to the Washington Post. Eleven furlough days are expected to be needed in order to meet targets or around one without pay per week until the end of September.
On Wednesday, Secretary of Defense Chuck Hagel sent a letter to Congress warning of the consequences of the sequester and outlining a contingency plan for next year should the sequester remain in place. The contingency plan contains $52 billion in cuts to the Defense budget, in order to meet sequester levels. While the across-the-board cuts are hampering operations in the Defense Department (as well as many other departments and agencies), next year the sequester will sets a level for discretionary appropriations rather than implementing automatic cuts. But Hagel does not believe that additional flexibility will be a cure:
These serious adverse effects occur even if Congress provides flexibility in administering budget cuts and sequestration. Flexibility in this instance would mean that Congress approves program cuts denied in the past and allows reallocation of funding , without regard to existing budget structures or limitations on transfer authority. However, the cuts are too steep and abrupt to be mitigated by flexilbility, no matter how broadly defined.
The contingency plan shows that military personnel cuts would likely be modest, as reducing troop levels would yield little savings next year. Involuntary separations would especially be costly given the compensation associated with that decision. Hagel argues the challenge will be even greater if Congress approves a military pay raise above the 1.0 percent proposed by the Defense Department, like the 1.8 percent raise approved by the House.
Day-to-day operations, Hagel argues, have already been hit with cuts in FY 2013, and further cuts would be difficult. Operations and Maintenance (P&M) appropriations makes up around 40 percent of DoD's overall budget and thus would likely face cuts similar in magnitude to the rest of the defense budget, at around 10 percent. DoD would attempt to avoid furloughs, but would still require reductions in the civilian labor force. Training exercises, limited by this year's sequester, would be further reduced.
Military modernization would likely be hit the hardest by sequester cuts in FY 2014, with Hagel suggesting that cuts as high as 15 or 20 percent would be required. Procurement would be reduced as would research and development.
To help ease the burden faced by DoD, Hagel requests that Congress accept the President's TRICARE fee changes. He also asks Congress to allow the immediate retirement of seven cruisers, two dock-landing ships and ending the C-27 aircraft program. Previous rounds of Base Closure and Realignment (BRAC) are credited with saving $12 billion a year, and another round is suggested to provide future savings.
Click here for the letter and contingency report.
Just as they have for tax reform, the House Ways and Means Committee has begun organizing and pressing forward on entitlement reforms, starting with a discussion draft of a proposal to switch to the chained CPI. As with all of their discussion drafts, they are allowing for public comment, in this case until August 10. The draft is a welcome entrance into the debate about how to implement the chained CPI.
Switching to the chained CPI would better achieve the federal government's goal of accurately measuring inflation by better incorporating consumer preferences as the relative prices of goods change. It also is a positive for the budget, saving $340 billion over ten years. Our resource page provides more information.
The discussion draft includes a switch to the chained CPI for Social Security cost-of-living adjustments (COLAs) only, so it does not include provisions in the tax code and other mandatory programs. Ideally, a final proposal would extend to these areas as well.
In addition to the adjustment, the draft includes options for three different old-age benefit bump-ups to mitigate the effect of the chained CPI for older, more vulnerable beneficiaries. The bump-ups are from the President's budget, the Simpson-Bowles plan, and the Domenici-Rivlin plan. They are as follows:
- President's budget: The President's bump-up starts the earliest and is the most gradual of the three. People in their 15th year on the program or reaching age 76 get a bump-up equal to 5 percent of the average retiree's benefit, phased in over ten years. Ten years after that bump-up fully phases in, the retiree is eligible for a second bump-up.
- Simpson-Bowles: The Simpson-Bowles plan includes a five-year bump-up equal to five percent of the benefit received by a worker with average earnings. The bump-up starts after a person has been receiving benefits for 20 years.
- Domenici-Rivlin: The Domenici-Rivlin plan is similar to Simpson-Bowles in that the bump-up is over five years and equals five percent of the average retiree benefit, but it starts at age 81.
The proposal demonstrates a few ways that the switch can protect the most vulnerable, though there are others as well. We applaud their effort to move the process forward and look forward to seeing what else they release.
The recent announcement from Senators Baucus and Hatch to pursue tax reform via a "blank slate" approach is incredibly encouraging. As CRFB Board Member Gene Steuerle has argued, it could be revolutionary. Starting by eliminating all tax preferences and requiring policymakers to justify and pay for any add-backs may represent the best chance for reducing tax rates, broadening the tax base, promoting economic growth, and reducing the deficit.
Rate-lowering, base-broadening corporate and individual tax reform can significantly improve competitiveness and economic growth. However, failing to reduce the deficit in the process would be a huge missed opportunity for economic growth down the road.
As we’ve explained before, our debt problems are still far from solved. To put the debt on a clear downward path as a share of the economy, by our calculations, at least $2.2 trillion of savings is needed over the next decade. Though much of those savings can and should come from spending cuts and entitlement reforms, it would be a mistake to radically overhaul the entire tax code without making some dent in our country’s debt problem.
In 2013, there will be about $1.3 trillion of spending in the tax code, leaving plenty of funds for both rate and deficit reduction if we eliminate or reform many of the tax expenditures. For reference, the new Simpson-Bowles Bipartisan Path Forward dedicates the equivalent of about $60 billion per year of tax expenditures to deficit reduction.
Source: CBO, Joint Committee on Taxation
Achieving this revenue target relative to the “blank slate” approach would mean that of the $1.3 trillion of base broadening, only 5 percent would go to deficit reduction; the remaining 95 percent could be dedicated to rate reduction or tax expenditure restoration.
In comparison to the size of the tax expenditure budget, this amount of additional revenue is small. But relative to our debt problem, it can make a real difference – moving us more than one quarter of the way toward the $2.2 trillion in savings needs to put debt on a downward path.
Importantly, tax reform should be seen as a complement to, not a substitute for, entitlement reform. The aging of the population and growing health care costs are causing the real pressure on the budget and necessitates structural entitlement reform to bring our long-term debt problem under control and protect the beneficiaries who rely on these programs. Failure to reform our entitlement programs will necessarily result in a failure to achieve long-term fiscal sustainability.
On the other hand, opportunities to put $1.3 trillion of annual revenue on the table are few and far between. To not dedicate a small portion of that revenue to help pay down the debt would be a missed opportunity we may not see again for quite some time.
One of the reasons CRFB and other budget hawks have touted the benefits of putting debt on a downward path this decade -- in addition to the economic benefits, future budget flexibility, and the benefits of getting a running start on long-term debt -- is that it can help guard against overly optimistic projections. It is no secret that budget and economic projections can change, given that they always do. Putting the debt on a downward path, however, gives some wiggle room for the potential that projections deteriorate going forward. If estimates turn out to be overly pessimistic and the level of deficit reduction turns out to be unnecessary, policymakers are quite adept at finding ways to use that "extra" money, but they are not too adept at enacting additional deficit reduction when conditions warrant it.
OMB's latest projections of the President's proposals, released in the Mid-Session Review early this week, is a perfect example of how our stance works. This outcome stood in great contrast to the big story in May of CBO's improving medium-term projections in their budget baseline. In addition, looking at an apples-to-apples comparison of current policy shows that using MSR's numbers has current policy on an upward path throughout most of the projection window (more on that below).
The MSR's projected debt is more than five percentage points higher in 2023 than CBO's estimate of the President's budget. A way to illustrate the difference in projections is to show how the same set of policy assumptions differs between CBO's numbers and OMB's numbers. In the graph below, we show the CRFB Realistic baseline assumptions using each agency's economic and technical assumptions. In both cases, debt is on an upward path in the later years of the ten-year window, but the levels differ by about the same as mentioned above.
One interesting thing that the new "OMB" Realistic baseline shows is that the decline in the level of debt as a percent of GDP that CBO anticipates following 2014 is almost non-existent using their numbers. The debt path does flatten out and decline by a tiny amount in the middle of the decade but then resumes on an upward path and a slope similar to CBO's path. Thus, even the short-term decline in debt that most people take for granted in CBO's projections is not a certainty if their economic projections don't play out.
Source: CBO, OMB, CRFB calculations
This divergence does not mean necessarily that one projections is inherently better than the other. But it does mean that no projection is set in stone, so lawmakers should be cautious and prudent in dealing with them. The difference between CBO's and OMB's projections show that there is no one way to see the budget going forward, so we must be prudent in preparing, and thus budgeting, for the future.
On Monday, the Office of Management and Budget released its re-estimate of the President's Budget in the Mid-Session Review. OMB's new estimates of the President's plan look worse than they did in April, largely due to change in economic projections. The MSR projects debt to be 75.4 percent of GDP in 2023, compared to 73.0 percent of GDP in the original projections. This is much higher than CBO's scoring of the President's Budget, which estimated it would reduce it to just below 70 percent of GDP by 2023 and roughly comparable to CRFB's Realistic baseline based on CBO's assumptions (at 75.5 percent of GDP in 2023, but on an upward path).
The most important goal for lawmakers is to put the debt on a downward path as a share of the economy, and like the House and Senate, the President's Budget would do so under OMB's revised estimates, although to a lesser extent than in April.
While total receipts in dollars are lower than in the original budget projections, the lower level of output in the Mid-Session Review projections means that revenues make up a greater share of GDP in the MSR projections. Revenues are projected to rise from 17.3 percent in 2013 to 20.1 percent by 2023. Spending levels as a share of GDP are slightly higher than in the original budget, falling from 22.0 percent in 2013 to 21.5 in 2017 before settling just over 22 percent of GDP by the end of the decade. The caveat about the smaller economy applies to the spending side as well.
|Spending and Revenue Under the President's Budget (Percent of GDP)|
Driving much of the revisions were changes in the OMB's economic projections. While the MSR expects unemployment to fall more quickly, reaching 5.4 percent in the fourth quarter of 2017 compared to 2018 in the original budget, output is expected to grow more slowly in the near term. Real GDP growth is only 2.0 percent in the MSR compared to 2.3 percent the original projections for 2013. As a result of the slower rate of growth, output is expected to be nearly $400 billion lower by 2023. Inflation and interest rates rise slightly more slowly in the MSR than in the original budget projections, offsetting some of the increase in net interest payments.
|Legislative, Economic, and Technical Changes|
|Area||2013-2018 Savings/Costs(-)||2013-2023 Savings/Costs(-)|
|President's Budget Deficit||-$2,784||-$6,244|
|Economic and Technical Changes||$56||-$321|
|Mid-Session Review Deficit||-$2,725||-$6,562|
The deficit in 2013 is actually expected to be $214 billion lower, due to $65 billion in greater than expected tax revenue, $43 billion in less discretionary spending due to sequestration, $71 billion in higher collections from dividend payments from Fannie Mae and Freddie Mac, and other smaller changes. However, this short-term revision is outweighed by a $540 billion increase in deficits over the following ten years.
There has been little legislation passed since the release of the April budget except for the FY 2013 Continuing Resolution passed in March. The CR increased 2013-2023 deficits by $3 billion, with a reduction in the 2013 deficit offset by an $8 billion increase over the following ten years. Overall, the bulk of changes in the Mid-Session review were on the revenue side due to slower economic growth in the next few years. 2013-2023 revenues are $319 billion lower in the MSR while 2013-2023 primary spending is $32 billion lower. Spending on Medicare is higher, primarily due to higher than expected Medicare Advantage enrollment. For Medicaid, spending is higher due to higher expected base year (2013) spending, which pushes up projections of Medicaid over the next years. This is partly offset by lower spending on the Medicaid expansion and lower health care cost growth. Social Security spending is lower primarily due to lower inflation and thus smaller cost-of-living adjustments (COLAs).
Just as we argued that lawmakers and the public should not overreact to downward revisions in CBO's May baseline, the MSR does not change the overall budget picture very much. Under realistic assumptions, the debt remains on a clear upward path and more will need to be down on debt and deficits. We still have more work left to do.
As we begin to enter the dog days of summer, the weather is not the only thing that is heating up. The tax reform debate is beginning to escalate also as Senate Finance Committee Chairman Max Baucus (D-MT) and House Ways and Means Committee Chairman Dave Camp (R-MI) begin their tour of the U.S. to drum up support for reforming the tax system.
There are many different reasons to take up tax reform including making the code simpler, fairer and more conducive to economic growth, but a recent paper by Donald Marron and Eric Toder of the Tax Policy Center makes another point: tax reform could shrink the government's overall role in the economy even as it raises revenue. Marron and Toder argue that the true size of government may be hidden by traditional statistics, since most tax expenditures count as tax cuts in the budget instead of spending programs:
How big a role the government should play in the economy is always a central issue in political debates. But measuring the size of government is not simple. People often use shorthand measures, such as the ratio of spending to gross domestic product (GDP) or of tax revenues to GDP. But those measures leave out important aspects of government action. For example, they do not capture the ways governments use deductions, credits, and other tax preferences to make transfers and influence resource use.
We argue that many tax preferences are effectively spending through the tax system. As a result, traditional measures of government size understate both spending and revenues.
The Joint Committee on Taxation estimated the total value of tax expenditures at nearly $1.3 trillion in 2013, and that total is projected to rise to almost $1.6 trillion by 2017. While there are various types of tax expenditures, they refer specifically to two categories of tax expenditures: clear spending substitutes and broad choices of tax structure. In their words, clear spending substitutes are defined as, "tax expenditures that encourage selected activities or aid specific groups of taxpayers and could be replaced by similar programs delivered as direct outlays." On the other hand, "broad choices of tax structure" refer to choices in the tax policy design, such as savings preferences which could be said to be a move towards taxing consumption rather than income, and are not associated with any clear spending objective. They explain:
Policy makers have long recognized that many social and economic goals can be pursued using tax preferences, not just government spending programs. Such preferences are recorded as revenue reductions, making the government appear smaller, but often have the same effects on income distribution and resource allocation as equivalent spending programs (Bradford, 2003; Burman and Phaup, 2011; Marron, 2011). A complete measure of government size should treat these preferences as spending, not revenue reductions. Doing so raises measures of both spending and revenues, without affecting the deficit, and gives a different picture of the economic resources that the government directs.
Making these adjustments requires caution, however. It is tempting, for example, to simply add together all the provisions that the federal government identifies as “tax expenditures” and treat those as effectively spending. But that goes too far. Not all tax expenditures are the functional equivalent of spending.
When spending-like tax provisions are included as outlays (and revenues), the federal government in recent years appears about 4 percentage points of GDP larger than traditional budget figures indicate. If tax reform is done in a smart and agressive manner, there is the distinct possibility that smaller government could technically be a result, even if the traditional measure of revenue is increased.
Regardless of the preferences of lawmakers on the size of government, there is a clear opportunity to eliminate or redesign many tax provisions that have had little oversight. Doing so in the context of revenue-raising tax reform would have significant for the budget and the economy.
Recently, there has been some discussion of taking the employer-sponsored health exclusion off the table in tax reform. But for those interested in tax reform, health reform, or deficit reduction, doing so would be a mistake.
The exclusion of employer-paid health insurance premiums from the income tax is the single largest tax expenditure in the code. CBO estimates it will cost $250 billion in 2013 and $3.4 trillion over ten years. The income tax portion alone will cost $140 billion in 2013 and something in the range of $2 trillion over ten years. Out of $1.3 trillion of individual tax expenditures, this represents more than one tenth of the entire pie -- and a larger percent of the achievable pie when taking into account behavioral effects (for example, in the context of capital gains) or practical concerns (in the case of existing employer pensions). In other words, it would be difficult to get the necessary revenue for reform with the health exclusion off the table.
The exclusion is important not just for the revenue potential but also for its effect on the health care system overall. In a June 2009 letter to then-Senate Budget Committee chairman Kent Conrad (D-ND), CBO director Doug Elmendorf cited reforming the health exclusion as one of two strategies -- the other being delivery system reforms -- the federal government could undertake to make health care more efficient.
Changes in the tax exclusion for employer-sponsored health insurance can affect the efficiency of health care financed by the private sector, by giving workers stronger incentives to seek lower-cost health insurance plans. Those steps could well have spillover effects on Medicare.
The Affordable Care Act does contain a provision which addresses the tax treatment of employment-based insurance in a roundabout way: it imposes a 40 percent excise tax on high-premium insurance plans starting in 2018. A recent New York Times article has indicated that insurers are already scaling back insurance plans in anticipation of the tax, demonstrating that these incentives do work as intended. However, limiting the exclusion would be a much more direct and transparent way to produce these incentives.
Notably, the question of what to do with the health exclusion, as with other provisions, is not just a case of keeping it or getting rid of it entirely. There are many options that would reform the exclusion to better target its benefits and/or encourage lower-cost plans. The President's budget would cap the value of the exclusion at 28 percent, limiting its value for higher earners. Both the Simpson-Bowles and Domenici-Rivlin plans would cap the exclusion at a certain level of premiums and phase it out. This policy could also be done without the phase-out -- in other words, keeping the cap in place -- or by having a phase-out based on income. The exclusion could also be turned into credit.
Even though these options are short of eliminating the exclusion, they still gain substantial revenue. For example, CBO estimated in December 2008 that replacing the income and payroll tax exclusions with a 25 percent credit would raise $600 billion from 2009-2018. Granted, the estimate would have changed since then due to the health care law, the fiscal cliff deal, the different timeframe evaluated, and the potential repeal or reduction of the 40 percent excise tax in conjunction with these reforms. Still, it is likely significant revenue can be gained from replacement policies.
There are many ways to reform federal health care spending to make it more efficient and slow the overall growth of it. Reforming the health exclusion may be a central element of both tax and health care reform. Taking it off the table would undermine efforts in both of those areas. And it would open the door to taking other treasured preferences off the table. Yet the more we take off the table, the less likely tax reform becomes. Failing to reform the tax code would represent a major lost opportunity.
Note: Blog updated at 7:00 PM on 7/9/2013.
Yesterday, Senator Max Baucus (D-MT) and Representative Dave Camp (R-MI) kicked off their summer tour of the country in order to bring the tax reform debate to the American public. The tour started in St. Paul, Minnesota, and two former Minnesota Congressmen are excited that tax reform could be a real possibility.
CRFB board member and former Congressman Tim Penny (I-MN) co-authored a piece in the Pioneer Press yesterday with former Senator Mark Kennedy (R-MN) on the new developments. Penny and Kennedy praised the leaders of the tax reform effort, especially the recent decision from Senate Finance Committee Chairman Max Baucus (D-MT) and Ranking Member Orrin Hatch (R-UT) to use a "blank slate" approach similar to the "Zero Plan" included in the Fiscal Commission's recommendations. They write:
Eliminating all tax preferences in the past allowed us to reduce the top two rates to 23 percent while setting aside a small portion of the savings for deficit reduction. Starting with a clean slate, and requiring those who wish to add back tax preferences to pay for them with rate increases, would lead politicians to subject tax expenditures to much greater scrutiny and, if desired, then to restore worthwhile tax expenditures in a more efficient and cost-effective manner.
The decision by Sens. Baucus and Hatch to use this approach makes us hopeful that Washington can enact tax reform to attain lower rates, level the playing field, improve simplicity, promote robust economic growth, and reduce the deficit.
This is a positive first step, and the bipartisan support for this approach is especially encouraging. Penny and Kennedy call for lawmakers not only to make the code simpler and better for growth, but to also do something about our debt problem:
We see this as an notable case of bipartisanship and hope that other leaders in the House and Senate will rise to the challenge and act responsibly in using the savings from eliminating the $1.3 trillion in annual "tax expenditures" to lower rates in a progressive manner, reduce the deficit, and restore those tax provisions they consider worthwhile in a more efficient, cost-effective manner.
Now is the time for D.C. to get their act together and make this type of action the new norm. Our nation's future and the lives of our children depend on it.
"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.
Today, the Office of Management and Budget released its Mid-Session Review, revised estimates of the President's 2014 budget incorporating legislative, economic, and technical changes in projections since the budget was released in April. The new estimates show a deterioration in the outlook that CBO's most recent scoring of the President's Budget and slightly worse than OMB's original scoring.
Instead of debt falling to 73 percent of GDP in the original budget by 2023 or below 70 percent of GDP in CBO's estimate, OMB now projects debt to rise to 75.4 percent of GDP by 2023. Deficits are smaller in 2013 in the MSR compared to the original estimate but 2014-2023 deficits are over $500 greater. For comparison, debt would be 75.5 percent of GDP in 2023 under CRFB's Realistic Baseline, although the President's Budget would be on a very modest downward path while the Realistic baseline is on an upward path.
Source: OMB, CBO
The Mid-Session Review is a reminder that while changes in projections can make the budget outlook appear better, revisions can also make it appear worse depending on how different agencies view what is happening with the budget and economy. While budget estimates should be taken seriously, they are not set in stone, and lawmakers should be cautious when dealing with them. Recent revisions have improved prospects for 2013, but both CBO and OMB currently show that the long-term problem is left to be solved. The President's Budget remains a serious proposal, but more needs to be done on both entitlement and tax reform if lawmakers are going to be able to put debt on a downward path.
We will dive deeper into the Mid-Session Review later in the week.
The lead up to July 4th brought an exciting development in fiscal policy discussions: a commitment from Senate Finance Committee Chairman Max Baucus (D-MT) and Ranking Member Orrin Hatch (R-UT) to use a "Blank Slate" approach in tax reform. The Blank Slate approach, similar to the "Zero Plan" that was key in the Fiscal Commission's recommendations, would start by eliminating all tax expenditures in the code, thereby putting the onus on lawmakers to justify which should be added back in at the cost of higher tax rates.
Urban Institute fellow and CRFB board member Gene Steuerle, who worked at the Treasury Department during the 1986 Tax Reform Act process, argues in a recent blog post that this approach could potentially be "revolutionary." Steuerle explains:
Baucus and Hatch must accomplish two goals. First, they must shift the burden of proof from those who favor reform to those who would retain the status quo. Second, they must force members to pay for their favored subsidy, denying them the opportunity to pretend it is free.
As a veteran of the Tax Reform Act of 1986, I always emphasize the crucial role of process. Sure, serendipity smiles or frowns unexpectedly on any endeavor, but the ’86 effort took off when Treasury, President Reagan, House Ways & Means Chair Dan Rostenkowski (D-IL), and Finance Committee chair Bob Packwood (R-OR) all put forward proposals that started with specific rate cuts and removal of many tax preferences.
Their plans were all somewhat different, but each changed the burden of proof. Lobbyists won many later battles, but now they were forced to explain why they needed to retain special preferences when others would not be so favored. Moreover, given a fixed revenue target, restored preferences had to be paid for. Lawmakers had to acknowledge that the price of adding back tax preferences was a higher tax rate.
It is this acknowledgement of trade-offs that is so important and what makes a blank slate approach appealing. In addition, by forcing lawmakers to consider both the costs as well as the benefits, the tax provisions lawmakers choose to keep will likely be redesigned to be fairer and more efficient. If lawmakers truly follow this process, Steuerle suggests this method could be repeated elsewhere in the budget, moving toward the comprehensive approach that we support:
This process not only gives new life to a broad rewrite of the tax code but also makes it much easier to reform specific provisions. For instance, tax subsidies for homeownership, charity, and education can be much more effective and provide more bang per buck out of each dollar of federal subsidy. But politicians largely ignore such ideas because they create losers who scream loudly. Thus, the default for elected officials who fear negative advertising and loss of campaign contributions is to do nothing to improve these tax subsidies.
But when the burden of proof changes, a lobbyist can appear to be helping his masters simply by saving a subsidy, even if the net benefit is smaller than in the old law. After all, preserving a preference in some form is success relative to a zero baseline. Of course, as we learned in 1986, this argument grows stronger as the probability of tax reform grows. Can Baucus and Hatch change the burden of proof and force members to pay with higher rates for the subsidies they want to keep? They can certainly lead their committee and Congress in that direction, but only by specifying precisely a chairman’s mark that sets revenue and rates while slashing tax preferences.
If they do, Baucus and Hatch may force fellow senators to acknowledge that every subsidy must be paid for. And that, in turn, will open a window to design alternative tax subsidies that are fairer and more efficient. This sort of process revolution could remake policy in ways that extend well beyond tax reform.
Click here to read the full piece.
"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.
In a Brookings Institution piece, CRFB board member and former Representative Bill Frenzel (R-MN) addressed the next biggest item emerging on the Congressional agenda: tax reform and its relation to the national debt. Senate Finance Chairman Max Baucus and his Republican counterpart, Sen. Hatch, have already begun working on a tax bill, and with roughly 60 percent of the nation ranking tax reform as a top priority, they have much of the country behind them.
Although Baucus and Hatch are taking a page out of the Simpson-Bowles report by beginning with the highly praised "blank slate" approach, Frenzel argues that big challenges will still await.
Huge obstacles remain. No process, however inspired, can overcome the fact that tax reform is still an essential part of a budget bargain. Each party’s sharply conflicting budget visions are dependent on tax reform. The Democrats need tax reform to fund their “investments” and control their deficits. The Republicans need it for tax cuts to stimulate growth.
Those differences mean that a stand-alone tax reform bill is almost impossible. Tax reform is too big a part of the budget to move by itself. It must be a part of the budget bargain. A good start is welcome because, at best, tax reform is a difficult and time-consuming effort. But, it will remain inextricably linked to a budget agreement. If there is no budget agreement, there will be no tax reform.
Therefore, it is folly for tax reformers to get over-enthusiastic now. Sen. Baucus and Hatch, and Rep. Camp, ought to be commended for bravery, and encouraged. They have a couple of years of hard work ahead of them with a high risk of failure.
Frenzel argues that tax reform must come in the context of a budget bargain not just because of the role tax reform could play in reducing the deficit, but also because it cannot be passed without assurance that the public will know what to expect from future budgets.
A budget bargain requires negotiation and compromise on macro-accounts. Thereafter, the details can be thrashed out by the various committees. Tax reform has the same negotiation requirements, but, in addition, each petty little micro-detail has to be worked out in advance of passage. The devil is said to lurk in the details, and tax reform is the epitome of detail.
Perhaps an even greater problem is timing. A budget agreement and tax reform need to march together. If a tax bill is perfected long before a budget agreement is made, it will be subjected to a furious attack from all the losers in the preference game. No bill, however cleverly constructed, can withstand the full fury of a strong lobby scorned.
First created about 100 years ago and last reformed 27 years ago, it is clear that America’s individual and corporate tax systems are in need of significant reform in order to promote economic growth, fairness, and simplicity. Yet, as Representative Frenzel argues, it may only come to fruition when placed and addressed side-by-side with the looming national debt.
Click here to read the full op-ed.
Former CBO director and CRFB board member Alice Rivlin was interviewed by the Fiscal Times Sunday on the state of our budget and economy. Rivlin emphasized that while short-term improvements have been made in terms of the current fiscal outlook and economic recovery, there are still numerous long-term problems that remain. She was hopeful of the slow, but steady, recovery of the economy but identified current fiscal policy measures as one of the many continued weak points.
The standard forecast of moderate growth in the two-and-a-half percent range for the rest of the year – maybe getting to 3 percent by the end – is right. If nothing bad happens, that’s sort of the standard forecast. It’s perking along; it’s not very rapid. But it does seem to be improving. And there seems to be considerable momentum in the private sector of the economy, considering that federal fiscal policy is so negative.
The Fiscal Times also asks if the short-run improvement is a good reason to put the budget debate aside, as Paul Krugman and others have argued. But Rivlin dispels this myth that the budget problems are now solved:
We knew near-term deficits would come down as the economy improved. They’ve come down faster than anybody expected, but that’s mainly because of two temporary factors: One is that we got a lot of tax revenue in calendar 2012 because of the fiscal cliff and the anticipation that rates would go up in 2013, which they did. So a lot of people pushed income into calendar 2012. And the other was much bigger than anticipated repayments from Fannie Mae and Freddie Mac. But again, for the longer term, deficits will go up again as the demographics [of retiring baby boomers] come into play, in 2017, 2018 and so forth.
None of us thought there was a need for short-term action. The long-term action is still necessary and the sooner the better with these things. We still need to put Social Security on a firm foundation, and every year that passes makes it a little harder to do that. The liberals would argue that may be true, but it can wait. I think it’s better if it doesn’t wait, because the changes can be smaller if you don’t wait. Senator [Richard] Durbin has floated the idea of a Social Security commission with a fairly short timeline to separate it from the budget discussions. I think that’s quite a good idea; we ought to do it.
One issue that Rivlin was optimistic about was the renewed possibility of comprehensive tax reform that would reduce tax expenditures in the code. Rivlin praised the recent actions of Chairman Max Baucus (D-MT) and Chairman David Camp (R-MI) for making tax reform a priority and for taking up ambitious measures to achieve it.
It’s encouraging that the [Senate and House] tax committees are both talking about serious tax reform. I don’t know where that will go. But the statement from [Senate Finance Committee] Chairman Baucus and [House Ways and Means Committee] Chairman Camp was very much in line with what we said in the Simpson-Bowles and Domenici-Rivlin commission reports: Namely, blow up the tax code and start over, and only put back the special provisions that can really be justified.
Lastly, on the upcoming fiscal deadlines, Rivlin expressed her hope that lawmakers would begin to shift their focus to achieving a compromise. There are plenty of issues on Congress's plate from the looming debt ceiling deadline to the large gap between the appropriations bills, but the greater concern is whether lawmakers will be able to agree on both entitlement and tax reform.
Well, I hope we’ve learned lessons [from the 2011 debacle] and that we will get a compromise of some sort that will not have us threatening to default...The thing that worries me is that if you look at the projections now, non-defense discretionary spending keeps slowing over time to levels lower than we’ve ever seen before. And my worry is we squeeze down the basic functions of government. It’s also very hard on state and local government. And we aren’t thinking through what we want government to do or not do.
We should be concerned that they can’t get together on a lot of things. The budget is a symbol, I think, of the breakdown of the congressional process. But I’m more concerned about their inability to, for example, come together around entitlement reform or tax reform, than about the budget itself.
Yesterday, the Obama administration announced the one-year delay of a key provision of the Affordable Care Act that requires coverage reporting and penalizes large employers who do not offer health insurance. The so-called shared responsibility or employer mandate provision would have required employers with 50 or more full time workers to pay $2,000 to $3,000 per employee if any of their workers (exempting the first 30) obtained subsidized health insurance coverage through a health insurance exchange. The goals of this provision were to incent employers from free riding and dumping their employees into the exchanges, and to provide revenue to help offset spending in the legislation.
In a Treasury blog, the administration said its decision to delay the employer requirements would give them greater time to simplify the new reporting requirements, adapt health coverage and reporting systems, and extend transition relief to the employer shared responsibility penalty. Part of this transition relief is the hope that some businesses around the 50-employee threshold will not reduce full-time employee hours and jobs to avoid paying the penalty, at least for one more year.
As for what kind of budgetary effect this delay might have, we looked at CBO’s past and current estimates for the employer penalty. CBO’s last estimate of a repeal of the ACA from July 2012 estimated that repealing the employer penalty would mean a loss of $4 billion in 2014 and $9 billion in 2015. In the most recent May baseline, however, CBO estimated the penalty would yield nothing in 2014, but $10 billion in revenue in 2015 (when most businesses would be filling their taxes and paying the penalty for 2014). It’s unclear whether CBO’s latest estimate was made under the assumption that the penalty would be delayed or at least not fully implemented, but the comparison below of CBO’s past estimates of 2014 revenue between $3-5 billion would suggest their 2014 assumptions did change.
There remain a number of questions on how this regulatory change will affect the deficit. It’s unclear exactly how many businesses will drop plans to provide new health benefits in 2014. Some employees who would have received employer coverage due to the employer mandate, but will not in 2014 with the delay, will stay uninsured and potentially pay the individual mandate penalty. Other employees might seek private health insurance in the exchanges, which they will now have access to, and potentially qualify for a subsidy. These decisions will also affect dependents of employees who employers would have had to expand coverage to under the mandate, meaning more children may qualify for CHIP, Medicaid, or a subsidy in the exchanges.
Changes in the price of employer coverage, how individual penalties exert pressure on firms to offer coverage, and the relative cost of offering employer benefits compared to the exchange or Medicaid will all play a role in determining employers’ decisions to begin to offer coverage without the employer mandate. CBO has previously said the individual mandate appears to be the largest deterrent to incentives to not offer coverage. The declining generosity of exchange subsidies for higher-income individuals will prevent many employers from not offering benefits as well. This may mean the one-year delay in the employer mandate may not have as large of an effect on coverage as some commentators have suggested.
Another issue the regulations will need to specify is how exchanges and the IRS will verify whether an employer’s coverage is inadequate or unaffordable without the reporting requirements in place in 2014. Under the law, subsidies in the exchanges are only available to individuals who are either not offered health insurance or have employer coverage that costs more than 9.5 percent of household income or covers less than 60 percent of health care costs. Also, the individual mandate penalty applies if an employee does not accept coverage from their employer that meets the minimum value requirement and costs 8 percent or less of household income. The lack of reporting requirements in 2014 might mean more individuals will access exchange subsidies and fewer individuals will pay the individual mandate penalty. Hopefully, these issues will be addressed when the administration releases the proposed rules later this summer.
Although much is still uncertain about how this will play out and we cannot fully measure all of the interactions, we can make a vague estimate using a 2011 CBO analysis of the employer penalty. The 2011 analysis assumed the employer mandate had the effect of increasing employer-based coverage by 0.5 to 1 million people (note: this estimate is for 2019 and was projected prior to last summer’s Supreme Court ruling). Using this estimate along with the (large) assumption that these individuals would cost the same as average exchange enrollees at $5,300 per person in 2014, we can very roughly estimate an additional $2.65-$5.3 billion in spending could result from a one-year delay. This would come on top of any revenue loss from the employer mandate.
If the employer penalty is permanently repealed, as some commentators have called for, then that would have more significant fiscal implications. By our (again, very rough) estimates a permanent repeal could increase spending by roughly $31 to $63 billion over ten years, and decrease revenues by roughly $140 billion. The administration did not indicate plans to extend the delay, and in fact strongly encouraged employers to voluntarily implement the reporting requirements in 2014 in preparation for full implementation in 2015. However, if the administration does decide to delay these provisions beyond 2014 or lawmakers in Congress enact a repeal, then that will have a much larger effect on increasing the deficit and should be offset.
Both the Social Security Chief Actuary and the CBO have already weighed in on the Senate's immigration reform bill, showing that it would give a short-term boost to Social Security and a slight cost to the rest of the budget. Now that the bill has passed the Senate, the CBO and the Chief Actuary have put forth more in-depth analyses of the legislation.
First, we'll start with CBO's estimate. They show that the bill would reduce total deficits by $158 billion over ten years, about $40 billion lower than their initial estimate. This is due to the extra border security money that was added into the final bill. The on-budget deficit increase has now risen to about $50 billion, making it more necessary for the final version to offset this on-budget cost to make it compliant with PAYGO rules. The off-budget portion is estimated at $210 billion of deficit reduction, about the same as the previous estimate.
|CBO Final Estimate of S. 744 (billions)|
|On-Budget Deficit Effect||-$6||-$5||-$5||-$5||-$6||-$6||-$6||-$5||-$5||-$6||-$52|
|Off-Budget Deficit Effect||$1||$5||$14||$20||$22||$24||$26||$29||$34||$37||$210|
|Subtotal, Deficit Effect||-$6||*||$10||$15||$17||$18||$20||$24||$29||$31||$158|
Note: Positive number denotes deficit reduction.
*Less than $500 million
CBO also updated its rough estimate for the second decade, projecting $685 billion in deficit reduction from 2024-2033, similar to what they previously estimated. Unlike in the first decade, the on-budget effect is a net $110 billion of deficit reduction rather than a deficit increase, and the off-budget estimate contains $575 billion of deficit reduction. For context, as a share of the economy, the total impact of deficit reduction in the second decade is small, at 0.2 percent of GDP.
|Comparing the Old and New CBO Estimates (billions)|
|2014-2023 Deficit Reduction||$197||$158|
|2014-2023 Deficit Reduction with Interest||$229||$182|
|2024-2033 Deficit Reduction||$690||$685|
Given that the entirety of the deficit reduction in the bill comes from the Social Security portion of the budget, it is perhaps no surprise that the Chief Actuary finds that the bill would be a positive for Social Security over 75 years. It would reduce the 75-year shortfall by 0.21 percent of taxable payroll -- the amount of payroll subject to the payroll tax -- or 8 percent of the projected shortfall. It would extend the life of the Social Security trust fund by two years to 2035. Most of the positive effect is upfront when immigrants are paying payroll taxes, but most are ineligible to receive benefits or are only receiving small benefits due to a short official work history. By the end of the 75-year window, the effect is largely a wash.
Somewhat counter intuitively, the improvement is shown as a 0.25 percentage point reduction in benefits as a percent of payroll and a 0.04 percentage point reduction in revenue. Even though both benefits and revenue increase in dollar terms, the denominator in this case, taxable payroll, increases enough to actually lower the overall ratio for benefits and revenue. In the graph, we did our best to estimate what spending (cost) and revenue (income) would look like if they were evaluated based on the current taxable payroll.
Social Security Costs and Income as a Percent of Current Payroll
Source: SSA, CRFB calculations
In addition, we have also shown how the trust fund ratio (the ratio of trust fund assets to benefits) would change. As you can see, it is not a significant amount.
Trust Fund Ratio
Source: SSA, CRFB calculations
The American Enterprise Institute's Andrew Biggs, though, argues here and here that the estimate is somewhat overly optimistic because the Social Security Administration's model assumes that immigrants will have similar characteristics to native-born workers. Generally, immigrants earn less than natives, which matters since Social Security pays low earners higher benefits relative to their earnings and taxes. Biggs also cites a 2001 study showing that immigrants live about three years longer than natives. Using a model that accounts for these differences, he estimates that immigration reform would be a wash, reducing the 75-year shortfall by less than 1 percent.
What we said before about needing to offset the on-budget cost of the bill is even more necessary now with the added border money. The off-budget deficit reduction will (at least without other action) go to Social Security, so it cannot be used to simultaneously reduce the deficit. Otherwise, immigration reform appears to be a slight positive for the budget and Social Security program over the long term, although obviously it is only a drop in the bucket compared to the size of the problem.
As the tax reform debate begins to heat up again, a new report released by the General Accountability Office (GAO) contributes some telling information regarding our outdated and inefficient corporate tax code. For tax year 2010, profitable corporations that filed a Schedule M-3 (those that have assets greater than $10 million) paid 12.6 percent of their reported worldwide income in U.S. federal income taxes. Including unprofitable corporations, the effective rate is 22.7 percent, but both pale in comparison to the top statutory marginal rate of 39 percent including state and local corporate taxes (35 percent is the statutory federal rate). Statutory rates differ from effective rates in that they only represent the rate that taxpayers pay on their taxable income (before credits) while effective rates incorporate the effects of deductions and credits.
While the U.S. possesses the highest marginal corporate tax rate among fellow OECD countries, the corporate code contains many tax expenditures so that the actual tax rate paid is much lower. These tax provisions are costly and cause business decisions to be made according to what will minimize tax burdens rather than what will maximize profits. This is the reasoning behind eliminating many or all of the corporate tax loopholes and exemptions, which would allow the overall rates to be lowered while still raising sufficient revenues.
Granted, the recession may have put some damper on recent years' effective rates. Lawmakers have enacted some temporary tax breaks like bonus depreciation for certain investments which reduce effective rates upfront (although bonus depreciation has continued to be extended). In addition, even profitable corporations may have losses carried over from previous years which would reduce their effective rates. Still, 2006 effective rates are not all that much higher than 2010 rates.
The conclusion drawn from this GAO report therefore should lend support to the fact that our current tax code is woefully inadequate for the reasons mentioned above. With the elimination of the many economically distorting provisions which exist, it will open up the opportunity to lower statutory rates. Thus, the blank slate approach proposed by Senators Max Baucus (D-MT) and Orrin Hatch (R-UT) is a much welcomed sign. By starting from a blank slate, lawmakers will have to make their case as to the benefit of certain tax provisions and why they should be kept in the code.
Click here for the full report.
Click here to access our Corporate Tax Reform Calculator to reform the corporate tax code yourself.