After the Storm – Winter Storm Saturn moved through the Washington, DC area on Wednesday and was given the nickname "Snowquester" by the inside-the-beltway crowd, named after the budget sequester that kicked in last week. After much hype the storm brought little snow within the Washington city limits, causing many to compare the storm to its namesake as an over-hyped event with little impact. Yet, locations just an hour west of the DC Metropolitan area saw snow accumulation of a foot or more. Is it possible the sequester will have a similar impact? While those inside the DC beltway bubble see little change, those outside it are significantly affected? Only time will tell.

Sequestration Blankets the Landscape – The automatic spending cuts of the sequester officially were triggered on Friday with an order from President Obama as the two sides could not agree on how to replace it. Dueling alternatives both failed in the Senate. The White House also provided some details on how the across-the board cuts will be implemented, with 9 percent cuts to domestic programs and 13 percent cuts to defense to achieve the total of $85 billion in cuts this year. Federal Reserve Chair Ben Bernanke recommended to legislators in congressional testimony that they replace sequestration with a smarter, long-term plan. “To address both the near- and longer-term issues, the Congress and the administration should consider replacing the sharp, front-loaded spending cuts required by the sequestration with policies that reduce the federal deficit more gradually in the near term but more substantially in the longer run.”

Plowing Into the Next Deadline – With the sequester hitting, policymakers moved right on to the next fiscal deadline, the March 27 expiration of the continuing resolution that is funding the federal government in lieu of a budget. The government will shut down without another stopgap measure or more detailed spending plan. While there is talk of using the opportunity as a vehicle to replace or at least alter the sequester, both parties are wary of causing a government shutdown. On Wednesday the House of Representatives passed a stopgap measure that factors in the sequester and provides more flexibility for defense and veterans programs to make the cuts mandated by the sequester. The Senate and White House will seek to expand the bill to provide similar flexibility to other programs. After they negotiate the latest drill, there are plenty more fiscal speed bumps ahead.

Blizzard of Budgets Coming – House Budget Committee Chair Paul Ryan (R-WI) says he plans to unveil his fiscal year 2014 budget blueprint next week. It will balance the budget in ten years. Senate Budget Committee Chair Patty Murray (D-WA) is working on a budget as well that could be released next week. Under a law passed earlier this year, members of Congress will have their pay withheld if their chamber does not pass a budget by April 15. While the two budgets will be worlds apart, the Washington Post points out that conference committee negotiations to reconcile the two approaches could possibly be the impetus for a bipartisan deficit deal. Meanwhile, the White House will not release its budget request until later in the month, possibly March 25. The White House missed the early February deadline for submitting a budget due to the fiscal cliff. Relatedly, on Tuesday the House passed a bill requiring that the annual budget submissions of the President provide an estimate of the cost per taxpayer of the deficit.

President Looks to Thaw Relations – President Obama reached out to rank-and-file Republicans this week with phone calls and dinner and will speak to both party’s caucuses on Capitol Hill. It is part of an effort to bypass the party leadership in garnering support for a deficit deal. The outreach comes as some Republican lawmakers have suggested they would be willing to accept additional tax revenue as a part of a grand bargain and as the President has reiterated his support for entitlement reforms as a part of a deal.

Tax Reform Snowballs – Fundamental tax reform may be the best vehicle for generating bipartisan support for more revenue. The Simpson-Bowles plan showed the way for tax reform that can simplify the tax code, lower rates, and reduce the deficit by eliminating or limiting tax credits, deductions and other loopholes known as tax expenditures. Senator Murray held a Budget Committee hearing on the topic on Tuesday, and her budget proposal may include reconciliation instructions for tax reform, which would make it easier to pass by making it filibuster-proof. Meanwhile, both the House and Senate tax-writing committees are pushing a coordinated reform effort, and Speaker Boehner says that tax reform will be designated a H.R. 1 in the House, a sign that it is a priority. Economists are also signaling support for tax reform.

Key Upcoming Dates (all times are ET)

March 8

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

March 15

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

March 27

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

March 28

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

April 5

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

April 15

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

April 16

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

April 26

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

May 3

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

May 16

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

May 19

• The debt limit is re-instated at an increased amount to account for debt issued between the signing of the suspension bill and this date. After re-instatement, the Treasury Department will be able to use "extraordinary measures" to put off the date the government hits the debt limit potentially for a few months.

On Friday, the Office of Management and Budget (OMB) released its latest detailed report of how the cuts in sequestration will be allocated. The sequester was reduced by $24 billion under the fiscal cliff deal, so the cuts are slightly smaller as a percentage of full fiscal year spending than under OMB's previous report (with the exception of the Medicare cuts).

The percentages by which each category of spending would be cut differ slightly from the previous estimates of the sequester after the American Taxpayer Relief Act (ATRA) from the Center of Budget and Policy Priorities. We have updated those estimates of the sequester reductions below. Defense spending is facing a nearly 8 percent cut, Medicare spending is still facing a 2 percent cut, and non-defense spending is facing about a 5 percent cut. However, the report notes that because the cuts are squeezed into 7 months, the effective percentage reduction for defense programs is closer to 13 percent, and 12 percent for non-defense programs.

^Source: OMB

The report also warns, in harmony with private forecasts, that the sequester could reduce economic growth in 2013 by 0.5 to 0.7 percent. CBO director Doug Elmendorf previously said that the cuts could reduce growth by about 0.6 percent.

The chart below shows where the cuts would fall relative to their proportion of the budget.

^{Source: OMB, CRFB calculations}

Debt on its current path is unsustainable, and deficit reduction needs to be a primary concern for lawmakers are they look to deal with the sequester. A well-designed deficit reduction plan may help grow the economy over the longer term. A report from the Congressional Budget Office estimated that a $2 trillion deficit reduction plan could increase output by nearly one percent by 2023.

Sequestration is a particularly dumb way reduce the deficit. It doesn't distinguish between wasteful and valuable spending, is not slowly phased-in to allow people to prepare and to minimize short-term economic harm, and doesn't address the main drivers of the increase in spending, demographics and health care cost growth. But we cannot send the message that we are unserious about dealing with our debt problem and kick the can further down the road. Hopefully, lawmakers use the sequester as an opportunity to find an agreement with the $2.4 trillion in deficit reduction we need to put debt on a clear downward path.

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:

^{Source: OECD}

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.

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.

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.

Value-Added Tax

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.

Carbon 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 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.

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

Reforming Disaster Assistance

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

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

Reforming Transportation

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

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

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

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

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

Reforming the Temporary Work Visa System

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

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

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

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

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

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

Reforming Housing Finance

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

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

*******

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

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 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.