The Bottom Line
One area of controversy in the last election was the percentage of American households that pay no federal income tax, often cited as 47 percent. The number actually peaked at 50 percent in 2009, but that proportion will fall to 43 percent this year.
But before one makes a quick judgment about what that really means, they should watch the Tax Policy Center's new whiteboard video. In the video, Roberton Williams of TPC explains what role our tax policy plays and who makes up the 43 percent. As our readers know, the story is much more complicated than it is often made to appear.
Whether this fact is a concern to policymakers or deemed an appropriate outcome of tax policy, it is something that lawmakers should figure out when they take up tax reform this fall.
Click here for the full piece from TaxVox.
When lawmakers return from August recess in a few weeks they will turn their attention to FY 2014 government funding, which requires appropriations to be passed by October 1 to avoid a government shutdown. But an article on Federal News Radio shows the executive branch is already planning for the following year, FY 2015, and the uncertainty over how the FY2014 appropriations will play out is causing issues. While being unable to fully anticipate agency budgets an additional year in advance is not all that uncommon, the problem is particularly acute because of uncertainty over how the sequester will be handled for FY 2014, let alone successive years.
While many people might naturally associate February as the beginning of the budget process, with the usual release of the President's Budget around that time (this year and the beginning of new administrations being exceptions), the reality is that the process starts far in advance. Agencies must submit their initial requests to the OMB by next month, starting a back-and-forth as agencies and OMB haggle over funding levels and priorities. Complicating matters for FY 2015 is, of course, the sequester, which will reduce discretionary budget authority in that year by $91 billion. Considering that there are many possible ways the sequester could be resolved, if it is at all, it is difficult to anticipate what kind of spending limit will bound the executive branch.
The article quotes former OMB official Robert Shea:
What that means is we're not able to focus spending cuts on programs that aren't working as well and re-allocate those funds to programs we know to be working...We also don't have a lot of good information to use to cut programs. That's why you see across-the-board furloughs rather than more targeted spending cuts at things that really wouldn't impact performance.
Of course, lawmakers' frequent last minute solutions and haggling over funding levels has made the appropriations process increasingly difficult. It would be best for planning and policy purposes for them to settle funding levels by coming up with a permanent solution to the sequester, so that there is some predictability in discretionary spending.
The broad outlines of tax reform have always been clear. Lawmakers trim or eliminate certain tax expenditures and use some or all of the additional revenue to lower tax rates. As a general concept, most economists can agree that this approach of broadening the tax base and lowering rates will have positive economic benefits, reduce economic distortions from our tax code, and put the country on a more secure fiscal footing.
But the general consensus around tax reform becomes contentious when the conversation moves from general concepts to specific tax breaks. As Reuters reported yesterday, billions of dollars of tax breaks for energy and manufacturing companies have been placed on the table by the duo leading the charge to reform the tax code: Senate Finance Committee chairman Max Baucus (D-MT) and House Ways and Means Committee chairman Dave Camp (R-MI).
The duo are considering trimming a slew of tax deductions and other breaks to offset the cost of cutting the top corporate and individual rates to as low as 25 percent, say aides and others. The corporate rate now tops out at 35 percent, while the highest individual rate is about 40 percent.
Baucus and Camp found the most common ground in potential corporate tax code revisions while working together on the congressional "supercommittee," a group of lawmakers who tried but failed to forge a debt deal in 2011.
"There were a lot of areas of agreement when they delved into the code," said a senior legislative aide involved in the supercommittee effort.
The article describes three of the largest corporate tax breaks -- accelerated depreciation, the domestic production deduction, and LIFO accounting -- as candidates to eliminate in the name of raising revenue and reducing the corporate rate. According to our Corporate Tax Rate Calculator, eliminating those three provisions alone would provide enough revenue to drop the corporate rate below 28 percent. Eliminating the first, accelerated depreciation, provides three-quarters of the rate reducution. The article quotes CFRB senior policy director Marc Goldwein saying, "It is pretty much impossible to design a corporate tax reform proposal which reduces the rate to the mid-20s without touching depreciation."
Most can agree in principle to tax reform which cuts special provisions and lowers the rate, especially on the corporate side. But when Congress returns in September, they will face increasing pressure to keep specific provisions as they tackle comprehensive tax reform of both the individual and corporate tax code. However, every provision they take off the table will make it that much harder to lower rates or raise revenue for deficit reduction. That's why we've applauded the clean slate approach adopted by the Senate Finance Committee, which starts by assuming all tax breaks are removed from the code. The burden of proof is shifted to the advocates of tax breaks, who must justify why a particular tax break is worth raising marginal rates to support one specific provision.
We've been profiling these tax breaks in our new blog series, The Tax Break-Down. We've previously profiled Last-In, First-Out (LIFO) accounting rules, one of the major corporate tax breaks mentioned in the article. We'll be discussing many more corporate and individual tax provisions throughout the fall.
This is the fourth post in our blog series, The Tax Break-Down, which will analyze and review tax breaks under discussion as part of tax reform.
The child tax credit (CTC) is a flat-dollar tax benefit offered to most households to help offset the cost of children. It has been in the tax code since 1997, and was significantly expanded under President Bush in 2001 and President Obama in 2009. Today, the credit covers almost 60 million children and 35 million families. Many other OECD countries offer a child tax credit, either to all families or to those below a certain minimum income.
The credit allows taxpayers to reduce the amount of taxes they owe by $1,000 per child age 17 and under. For example, a two-child family owing $5,000 before the credit would owe only $3,000 after the credit. Currently, the credit is partially refundable for households that don’t have any tax liability – meaning the IRS will send those families a check. Specifically, a household can receive a refund up to 15 percent of income above $3,000. After 2017, the refundability threshold will increase from $3,000 to approximately $13,200. Alternatively, families with at least three children can get a refund up to their entire payroll tax liability not already offset by the Earned Income Tax Credit (EITC). The CTC currently phases out starting at $75,000/$110,000 (individuals/couples). A two-child family would lose the credit entirely at $115,000/$150,000 of income.
The CTC was originally enacted as a part of the balanced budget agreement of 1997 as a nonrefundable $400 credit. It was raised to $500 in 1999 and increased to $1,000 and made partially refundable in 2001. In the 2009 stimulus act, the CTC’s refundability was expanded significantly on a temporary basis. This expanded refundability was extended for two years in 2010 and further extended through 2017 at the beginning of this year.
How Much Does It Cost?
The child tax credit is the sixth largest tax break today, according to the Joint Committee on Taxation (JCT). It costs $57 billion in revenue this year, $290 billion over 5 years, and an estimated $550 over ten years. Of that total, slightly more than half is spent on refunds to taxpayers who have no tax liability. OMB estimates a smaller figure: the credit cost $47 billion in 2012.
If the current provisions were extended permanently instead of expiring in 2017, the CTC would cost an additional $12 billion per year starting in 2018, or more than $600 billion total over the next decade.
The Tax Foundation estimates that if the Child Tax Credit was eliminated and the revenue was used to reduce rates, all tax rates could decrease by 4.8 percent (so the top 39.6 bracket would become 37.7 percent).
Who Does It Affect?
As opposed to some of the other tax breaks we’ve profiled, the child tax credit is relatively progressive, particularly in its current form. It boosts after-tax incomes for the bottom 40 percent of taxpayers by 1.5 percent. Since it provides a flat per-child benefit, an upper-income household sees a smaller percentage change in income. The top fifth of taxpayers only see a 0.2 percent increase in after-tax income. Because of income phase-outs, the top 1 percent generally do not benefit from the child tax credit.
Much of the credit’s progressivity comes from the law’s 2009 expansion to provide greater refunds to low-income households. If the expansion expires as scheduled at the end of 2017, taxpayers in the bottom quintile would lose most of their benefit, though those in the second quintile would retain much of their benefit and taxpayers in the top 60 percent would see no change.
In terms of the distribution of the benefit of the child tax credit, more than three quarters of the benefit goes to the bottom sixty percent of the income spectrum, including about 22 percent to the bottom quintile and almost 30 percent accruing to the second quintile. The wealthiest fifth of taxpayers receive less than 5 percent of the benefit.
What are the Arguments For and Against the Child Tax Credit?
Proponents of keeping or expanding the child tax credit argue that a family should be held harmless for the costs of having children, an equity goal the credit helps to achieve (though some argue it does not do enough and some argue it already overcompensates). Some suggest the credit accomplishes a laudable and fiscally important goal by encouraging people to have more children. Finally, proponents argue that the child tax credit, along with the earned income tax credit, provides crucial support for low-income families. According to the Center for Budget and Policy Priorities, the Child Tax Credit and EITC lifted more than 9 million people, including 4.9 million children, out of poverty. They continue by pointing out each dollar of income earned through tax credits improves children’s school performance and increases future incomes by more than a dollar.
Opponents of the child tax credit argue that children should not be subsidized by the government and such favoritism in the tax code is inappropriate. According to this argument, the decision to have children is a parent’s choice on how to consume income, and therefore should not be favored under an income tax. The phase-out of the refundable portion adds 5 percent to the marginal tax rates of households above $75,000/$110,000 of income, which can disincentivize work. Opponents also argue the credit is wrought with fraud, often pointing to a 2011 Treasury Inspector General report that describes how $4.2 billion in child tax credits were refunded to individuals who were not authorized to work in the United States, but allowed to claim the credit under current law. Furthermore, some anti-poverty advocates argue that the $57 billion annual cost could be much better targeted, since much of the child tax credit (particularly at 2018 levels) goes to middle-class rather than poor families.
What are the Options for Reform?
A number of options exist to reform the existing Child Tax Credit. The President’s Budget plans for the CTC low-income expansions to be extended past 2017, which would cost almost $65 billion.
Because there are many overlapping tax incentives for children, including the dependent exemption, deduction for child care expenses, EITC, and exclusion for employer-provided child care, several tax reform plans (described below) consolidate and simplify these incentives into a single, larger child credit.
The credit could also be reduced in a number of ways. Complete repeal would raise more than $500 billion, enough revenue to lower tax rates by 4.8 percent. The credit could be reduced back to 2001 levels of $500, with a $10,000 refund threshold that rises with inflation, eliminating much of the benefit to low-income families.
A number of options make smaller CTC changes. Senator Ayotte proposed a bill this year to require taxpayers claiming the credit to include their Social Security numbers, effectively banning illegal immigrants from claiming the credit, even if their children are U.S. citizens. Options to simplify the credit’s definitions and calculations also raise small amounts of revenue.
The below table measures the cost of each option against current law, and against current policy, which assumes the child tax credit is extended at current levels past 2017.
|Ten-Year Revenue from Reform Options on the Child Tax Credit (billions)|
|Policy||Current Law||Current Policy
|Extend current law refundability past 2017||-$65||$0|
|Repeal Child Tax Credit||$505||$570|
|Make Child Tax Credit Non-refundable||$210||$275|
|Revert Child Tax Credit to pre-Bush era levels of $500/child, raising the refund threshold to $13,200 and indexing it to inflation||$375||$440|
|Lower eligibility age to 13 and younger||$100||$115|
|Require taxpayers to include their Social Security Number when claiming refundable credits for their children||$25||$30|
|Establish a single definition of children as below 19 for CTC, EITC, and Dependent Exemption||$20||$25|
|Restrict the refundable portion of the CTC and the EITC to taxpayers with less than $1,650 of investment income||$10||$10|
|Reduce computational complexity for CTC||$5||$5|
|Make the Child Tax Credit fully refundable, regardless of earnings||-$110||-$45|
|Repeal income phase-out for high-income taxpayers||-$110||-$110|
What Have Tax Reform Plans Done With It?
Most tax reform plans retain support for children, either through the child tax credit or other means. Many use tax reform as an opportunity to simplify and combine provisions regarding children. The Fiscal Commission’s illustrative tax reform plan eliminated most tax expenditures, but retained the child tax credit to enhance the code’s progressivity, as did the Wyden-Coats tax reform legislation. The Domenici-Rivlin plan combined the standard deduction, personal exemptions, CTC, and EITC into separate work and family credits (the family credit being larger than the current CTC), an approach also taken by tax reform advisory panels in 2005 and 2010. The Center for American Progress combines the credit and the dependent exemption into a new $1,600 child tax credit (along with a $600 credit for non-child dependents) while raising the income phase-out from $75,000 to $200,000. The Economic Policy Institute would make the credit fully refundable.
Where Can I Read More?
- Congressional Research Service – The Child Tax Credit
- Center for Budget and Policy Priorities – Policy Basics: the Child Tax Credit
- Treasury Inspector General for Tax Administration - Individuals Who Are Not Authorized to Work in the United States Were Paid $4.2 Billion in Refundable Credits
- Urban Institute - Tax Simplification: Clarifying Work, Child, and Education Incentives
- Tax Foundation – Case Study #9: Child Tax Credit
- Center for American Progress – Separating Fact from Fiction About the Child Tax Credit
- American Enterprise Institute – Raising kids? Your taxes are far too high
The child tax credit is one of the most widely-used tax breaks in the code today. It is available to nearly all taxpayers with children, is retained by most published tax reform plans, and is an important driver of the current progressivity of the code. Although Congress may not wish to remove this provision, they should remain open to reforming it. The tax code currently subsidizes family and children in a number of different ways, leading to unnecessary complexity. The child tax credit costs over half a trillion dollars over ten years and the dependent exemption (which is a NTEBP, not a tax expenditure) costs another half trillion. Tax reform represents an opportunity to simplify these provisions, curb abuse, and in the process can provide revenue to cut rates or reduce the deficit.
Note: This post was updated on August 30 to correct typos regarding the President's policy and the scores for certain options, and to clarify the credit's phase-out range and use by non-citizens.
While many in Washington are bracing for more partisan brinksmanship in the upcoming negotiations over the debt ceiling and a potential government shutdown, it is easy to overlook the fact that these fiscal debates present an opportunity for a bipartisan compromise on a comprehensive deficit reduction deal. This morning, the Orlando Sentinel published an editorial making that case for including Social Security in the debate:
Any credible strategy can't exclude the largest federal program, Social Security, with a budget topping $800 billion this year. Social Security has been paying out more in benefits than it collects in payroll taxes since 2010, drawing on its trust fund.
Social Security's trust fund is on track to be depleted by 2033, when all beneficiaries in the program would face an abrupt 23-percent cut in benefits. And the longer Washington waits, the greater the cost of keeping Social Security solvent for the long term — whether it's with tax hikes, benefit cuts or some combination.
This echoes the argument laid out in CRFB's recent paper, Social Security Reform and the Cost of Delay, which has received considerable attention in the press. Delaying Social Security reform will force policymakers to put greater burden on fewer people, reduce the accumulation of interest in the Trust Fund, make cuts to real benefits harder to avoid, and give workers less time to plan and adjust.
The Sentinel's editorial board also argues that Congress should consider adopting the chained CPI, which was included in President Obama's FY2014 budget request and the Simpson-Bowles and Domenici-Rivlin plans. As we have written before, the chained CPI is a more accurate measure of inflation, and it could help preserve Social Security for future generations while also protecting benefits for vulnerable seniors. But any proposal to avoid insolvency over the long term must also include broader revenue and benefit reforms. You can try your hand at fixing Social Security using our interactive Reformer tool.
This is a critical moment. Our hope is that Congress returns from August recess with a newfound ambition to solve these problems once and for all.
The Peterson Foundation has been releasing a Fiscal Confidence Index every month since December of last year, an index which measures public opinions about the federal government's fiscal policy. Its latest results for the month of August show the same picture since it was first introduced: little confidence from the public on the issue of debt.
Overall, the index scored a 43 on a 200 point scale, with 200 being the most positive score, a slight dip from July's score of 45. Respondents (1,002 registered voters) were asked six questions in three categories about their concern over the debt, how much of a priority addressing it is, and what their expectations are going forward. The specific results showed that the public is very concerned about the debt and thinks that lawmakers should spend more time addressing it. However, they were more mixed on whether they would make progress on the debt in the next few years, with about the same number of people being somewhat or very optimistic as they were somewhat or very pessimistic.
The index has stayed very stable since its initial dip from December 2012 after the fiscal cliff deal passed. You can see what has happened to it since it was established below.
The Fiscal Confidence Index has changed little since we last discussed it at the end of April. That's not surprising since there has been little fiscal progress, and the appropriations process fell apart earlier this month. Still, the fall may prove to be a pivotal moment to see whether lawmakers can improve our fiscal picture or continue to kick the can down the road.
This is the third post in a new CRFB blog series The Tax Break-Down, which will analyze and review tax breaks under discussion as part of tax reform. In previous posts, we've written about the State & Local Tax Deduction and Last-in-First-Out (LIFO) Accounting rules.
For most of the income tax's history, capital gains have been taxed at lower rates than ordinary income, such as wage earnings. This preferential rate is considered to be a tax expenditure, and is one of the most expensive in the tax code, with the highest earners paying about half the taxes on capital income as earned income. Although the 1986 Tax Reform Act eliminated this preference and taxed capital gains as ordinary income, the tax break re-appeared when ordinary income rates were raised in 1990 and 1993 without similar raises in the capital gains rate and as capital gains rates were reduced in 1997 and 2003. Nearly every OECD country has preferential rates on capital gains, and 11 do not tax capital gains at all.
Source: Tax Policy Center
A capital gain is profit from the sale of an asset, like a business, stock, piece of art, or parcel of land. Though assets frequently increase in value, taxes on them are deferred until the item is sold and the profits are realized. If the item is held for less than a year, the gain is taxed at ordinary rates (up to 39.6 percent). If an item is held for over a year, it is taxed at long-term capital gain rates. Taxpayers in the bottom two brackets pay a zero percent rate on these gains, those in the middle brackets pay 15 percent, and those in the top bracket pay 20 percent. Taxpayers with over $200,000 of income (or $250,000 for married couples) will also pay an additional 3.8 percent tax on unearned income starting this year as a result of the Affordable Care Act, bringing the effective top rate up to 23.8 percent. This tax is not paid on the entirety of revenue from an asset sale, but rather the difference in value between when the asset was bought and when it was sold.
Although most long-term capital gains are taxed under the 0%, 15%, 20% rate schedule, some capital gains are taxed differently. For example, corporate capital gains are taxed as ordinary income and pay the corporate rate of 35 percent; small business stock and collectibles are taxed at 28 percent, a portion of depreciated real estimate investment is taxed at 25 percent, and a certain amount of the purchase of small business stock can be excluded, further lowering the effective rate.
The preferential rate is also extended to some income not universally thought to be capital gains. Royalties by coal companies and sale of livestock, for example, are both counted as long-term capital gains. Certain types of salaries are technically paid out from the sale of stocks and bonds (“carried interest”) can also be counted as capital gains.
Below, we answer other questions about the preferential tax rates on capital gains. We will discuss related preferences for dividends and “step up basis” of capital gains at death in a different post.
How Much Does It Cost?
Although CBO does not separate the cost of the preferential rate on capital gains from dividends, by our estimates the capital gains preference costs an average of $120 billion per year from 2013-2017 and will cost about $1 trillion from 2014-2023. Other smaller capital gains preferences, such as exclusions for coal royalties, timber, and agriculture cost about $1 billion per year, combined.
Importantly, the value of the capital gains tax preference is significantly higher than the potential revenue raised from eliminating it. Tax expenditure estimates do not account for a taxpayer’s behavior. Because realizing capital gains is completely voluntary, many investors will reduce their realization as the rate goes up, mitigating or possibly even reversing the potential revenue gain.
Who Does It Affect?
Even though those in bottom brackets receive a large advantage with a zero percent rate, nearly all of the benefit of the reduced rates on capital gains flows to the top of the income spectrum. According to the Tax Policy Center, nearly 95 percent of the benefit of the preferential rate goes to those making over $200,000 per year and more than three quarters of the benefit goes to those making over $1 million per year. The driver of this regressivity has to do almost entirely with the fact that wealthier Americans own the vast majority of assets in this country. In 2011, half of all capital gains were earned by 0.1 percent of taxpayers.
Source: Tax Policy Center
As the Tax Policy Center estimates, taxpayers making under $75,000 see very little (< 0.05 percent) change in their after-tax income, where taxpayers making over $1,000,000 see a 4.7 percent boost in their after-tax income due to these preferential rates.
What are the Arguments For and Against Lower Rates on Capital Gains?
Proponents of lower rates on capital gains argue they provide an important incentive for investment, which ultimately is the key to long-term growth. Many proponents argue that ideally the United States would shift to a consumption tax with no tax on capital gains, and a preferential rate represents a step in that direction. Proponents also worry that taxing capital gains as ordinary income would effectively lead to “double taxation” since profits are already taxed at the corporate level. In addition, they point out that capital gains levies tax not only on real gains but also increases in asset price due only to inflation. Finally, most observers find that a high level of capital gains tax creates a lock-in effect, where investors who would sell assets keep them instead to avoid taxation. Estimating agencies believe this lock-out effect is so strong that taxing capital gains as ordinary income would actually lose revenue relative to current law.
Opponents of the lower rates on capital gains respond that preferential rates are a poorly targeted solution to the much overblown double-taxation issue, that the cost of taxing inflation is largely offset by the benefits of allowing deferral of taxation, and that while there may be a theoretical basis to assume lower capital gains rates will encourage growth, there is little evidence this relationship exists. Critics also argue that multiple rates on different types of assets and income creates unnecessary complexity, encourages tax arbitrage, and distorts investment decisions. Finally, critics argue that lower capital gains rates have been a key driver of growing wealth and income inequality in the United States.
What are the Options for Reform?
A number of options exist to address capital gains preferences in a variety of ways. However, the $1 trillion ten-year cost of the tax preference dramatically overstates the amount of revenue available from modifying the capital gains rate – particularly in isolation. In fact, fully eliminating that tax preference by taxing capital gains at a top rate of 39.6% may actually lose revenue relative to current law. Both JCT and Treasury’s Office of Tax Analysis are believed to rely on a revenue-maximizing rate somewhere around 30 percent.
Short of taxing capital gains as ordinary income, a number of other options would broadly modify capital gains taxation. Gains could be taxed as ordinary income with a cap (i.e., at 28%), with an exclusion (i.e., making one-third of gains tax-free), or at a fixed-percentage point differential (i.e., tax capital gains at ordinary income minus 10 percent). Rules for when a sale qualifies as long-term capital gains could also change, either broadly by modifying the one-year holding period or narrowly by changing the special rules for certain kinds of income, like coal royalties and livestock.
None of the below options modify the 3.8 percent surtax on investment income.
|Revenue from Reform Options on Capital Gains|
|Tax capital gains as ordinary income capped at 28%.||$55-$90 billion*|
|Tax capital gains as ordinary income with a 30% exclusion||($50-$100 billion)†|
|Tax capital gains at 10 points below ordinary income||($50-$100 billion)†|
|Raise capital gains rates by 2 percent||$55 billion|
|Tax carried interest as ordinary income||$15 billion|
|Require that derivative contracts be taxed annually at ordinary rates||$15 billion|
|Repeal capital gains treatment for sale of livestock||$5 billion|
|Repeal capital gains treatment for coal royalties||< $1 billion|
|Repeal capital gains treatment for small business stock||< $1 billion|
|Provide complete exemption for investment in small business stock||-$5 billion|
* This estimate was prepared at our request by Jane Gravelle, Senior Specialist in Economic Policy at the Congressional Research Service, but do not reflect the views of the Congressional Research Service. The range reflect the difference between assuming revenue maximizing rates (including the surtax) of 28.5 percent and 32 percent.
† Both of these options will raise the top effective tax rate on capital gains to around the revenue-maximizing rate.
What Have Tax Reform Plans Done With Capital Gains Rates?
Two bipartisan deficit reduction plans, proposed by the Fiscal Commission and the Dominici-Rivlin panel, recommended eliminating the preferential rate for capital gains altogether. While both plans would tax capital gains as ordinary income, they would also both reduce the top ordinary rate, to 28 percent.
Other plans have chosen to revise the tax break without fully eliminating it. The tax reform plan by Senators Wyden and Gregg replaced it with a partial exclusion. Capital gains would be taxed normally, but 35 percent would be excluded from income; with a top rate of 35 percent, the Wyden-Gregg plan had a top capital gains rate of 22.75 percent. The 2005 Tax Reform panel recommended either keeping the rate at 15 percent, or taxing capital gains as ordinary income with a 75 percent exclusion for capital gains from U.S. companies, so the effective rate would be between 3.75 and 8.25 percent.
The Center for American Progress would tax capital gains as ordinary income with a 24.2 percent cap (28 percent including the surtax). The Congressional Progressive Caucus would tax all capital gains as ordinary income, and raise the top rate above 45 percent for incomes over $1 million. At the other end of the spectrum, The American Enterprise Institute would shift towards a consumption tax, entirely eliminating taxes on capital gains, dividends, and other forms of saving. The President’s Framework on Business Tax Reform, though not focused on the individual side of the tax code, did recommend repealing the carried interest loophole.
- Committee for a Responsible Federal Budget - Capital Gains and Tax Reform
- Committee for a Responsible Federal Budget - More on Capital Gains and Tax Reform
- Marc Goldwein - To Get the Top Rate to 28 Percent, Cut Investment Tax Breaks
- Tax Policy Center - Capital Gains and Dividends: What is the effect of a lower tax rate?
- Center for Budget and Policy Priorities - Raising Today’s Low Capital Gains Tax Rates Could Promote Economic Efficiency and Fairness, While Helping Reduce Deficits
- Marty Feldstein - Taxes on Investment Income Remain Too High and Can Lead to Multiple Distortions
- Martin Sullivan – Are Capital Gains Double Taxed?
- Leonard Burman – Testimony on Tax Reform and the Treatment of Capital Gains
- Tax Policy Center – Should We Eliminate Taxation of Capital Income?
- Jared Bernstein - Dividends, Capital Gains, and the Growth of Income Inequality
- Joint Committee on Taxation – Present Law and Background Information Relating to the Taxation of Capital Gains
- Congressional Budget Office (1988) - How Capital Gains Tax Rates Affect Revenues: The Historical Evidence
As we’ve written before, reducing the tax preference for capital gains in concert with other changes to the tax code offers an opportunity to tackle three, sometimes opposing goals: increasing revenue, increase or maintain progressivity, and lower tax rates. However, raising capital gain rates could disincentivize some investment and increase the severity of certain double taxation while raising a relatively small amount of revenue. Lawmakers will have to carefully consider impacts on saving and investment, but taking the capital gains preference off the table would make the rest of tax reform that much harder.
On Friday, we discussed the President's recent speeches on his policy proposals for higher education. With most K-12 schools and university funding coming from state and local governments, it's easy to forget the role the federal government has in supporting education. In addition to many federal programs that supplement or support primary and secondary education, the federal government plays a central role in providing aid and financing for higher education. In this post, we will take a broad look at the federal budgetary commitment to education, some of the major policy changes that have affected the education budget, and a preview of what lies ahead.
A Breakdown of the Education Budget
The Department of Education received appropriations of $68.0 billion for FY 2013, but mandatory programs and student loans complicate matters somewhat. The Pell Grant program is the largest at a total of $30 billion, funded through an annual $22 billion discretionary appropriation and also a mandatory fund. The majority of the remaining $42.9 billion of discretionary funding goes to K-12 education programs, special education programs, and education programs for the disadvantaged. The Department of Education has six grant programs for higher education, 14 programs to support K-12 teachers, five student loan programs, and dozens of other programs to support disadvantaged populations and special education (more information can be found here).
Note that included in the remaining discretionary and mandatory total in the chart below are student loans, which in 2013 will count as a over $40 billion net gain for the government under the Federal Credit Reform Act (FCRA) accounting method. But this gain from student loans is a result of extraordinarily low interest-rates and will not last when the economy returns to full capacity. Using fair-value estimates, student loans would be a $10 billion cost to the federal government at normal interest rates.
But looking at only the Education Department would far understate the federal government's budgetary support of education. Some programs related to education are managed by other departments; the early childhood education program Head Start is managed by the Department of Health and Human Services and the National School Lunch and School Breakfast programs are part of the Department of Agriculture.
We've also said before that tax expenditures can be better thought of as spending through the tax code. When thought of this way, provisions related to education will cost $46 billion in 2013. In fact, the 17 tax expenditures related to higher education rival the Pell Grant program in size. We've said before that many of these tax provisions are poorly targeted, often delivering a windfall to wealthier families. The largest tax provision, the American Opportunity Tax Credit (AOTC) will direct a quarter of its total benefits to families making over $100,000.
Federal Support for Education
Source: Joint Committee on Taxation and Department Congressional Justifications
Note: Department of Education Funding Includes Student Loans
Recent Policy Changes in the Education Budget
Since President Obama took office, a number of significant policy changes have been made that affect education spending. The stimulus bill included the creation of the AOTC, which expanded the existing Hope Credit and made it fully refundable. The AOTC was due to expire at the end of 2012 but was extended for five years as part of the American Taxpayer Relief Act. In addition, Pell Grants awards were increased and temporary funding for some provisions and state relief were also included as a part of the 2009 stimulus. While some of the smaller provisions have since expired, the Pell Grant and AOTC expansions appear to be permanent but will add to the deficit unless offsets are found.
There have also been changes made to the income-based repayment (IBR) formula for student loans. In 2010, Congress passed the Health Care and Education Reconciliation Act of 2010, which reduced the rate of repayment for student loans from 15 percent of AGI to 10 percent and allowed forgiveness of the loan after 20 years in repayment (previously 25). In 2011, the President applied the new formula to student loans that had been issued since 2008. Some critics of the program have argued that its aid is poorly targeted and suggested the funds be reallocated to better targeted programs like Pell Grants.
Since the President took office, some provisions which save money in student loans have also been enacted. The largest change to education in the Budget Control Act, of course, was the creation of overall discretionary caps. But the BCA also eliminated the in-school subsidy for graduate students and applied the savings toward the Pell Grant program. The most recent change was the passage of the student loan bill, which linked rates to ten-year Treasury rates. The bill will only save $715 million over ten-years, but could potentially save more in the long-run as interest rates return to their historical averages.
What Lies Ahead for the Education Budget
The student loan bill resolved the most urgent temporary policy in the education budget, but many other issues will need to be addressed in the next few years. For next year, lawmakers still need to decide what to do with sequestration, which is creating a substantial gap between the House and Senate on funding levels for the Education Department. The House Appropriations bill would provide $121.8 billion for Labor-HHS-Education, while the Senate would provide $164.3 billion. Post-sequester funding for Labor-HHS-Education was $149.6 billion. With the FY 2013 continuing resolution due to expire at the end of September, lawmakers will need to make a decision in the next month.
Also unaddressed is a near $50 billion Pell Grant shortfall between projected award grants and funding levels. The Bipartisan Path Forward used a variety of policies to achieve savings, including eliminating the in-school interest subsidy to shore up the Pell Grant shortfall. The President's Budget and the New America Foundation's Education Policy Program have also proposed reforms that would address the shortfall, with the latter going further to redirect education resources from poorly targeted tax provisions to the more effective Pell Grant program.
As mentioned previously, lawmakers will need to decide whether to allow the AOTC to expire or to find a permanent expansion when the refundable credit expansion ends in 2018. If lawmakers decide that the AOTC expansion should be continued, they will need to find savings to offset those costs.
While the majority of funding for education is handled by state and local governments, the federal government support for education is still a significant matter, particularly for higher education. Whether the Congress decides to move forward with the President's policies or not, some decisions will need to be made over the next few years.
Late last week, the Washington Post's David Fahrenthold published a piece claiming that "big government is mostly unchanged" since 2010, when lawmakers turned their attention towards fiscal issues and Republicans took control of the House. One of the facts Fahrenthold used is the nominal dollar level of spending, which is roughly the same in 2013 as it was in 2010 ($3.455 trillion versus $3.457 trillion, respectively). Some commentators took issue with using this measure to show that there was little change in the size of government, since it does not account for inflation or express figures against the size of the economy (although it does say that the inflation-adjusted decline in spending is about 5 percent). Using those measures would show federal spending shrinking in the past three years. In this blog, we'll take a close look at these numbers and provide additional context.
Meaningfully comparing numbers from recent years can be difficult due to the effects of the Great Recession and the resulting policy response. A number of temporary factors can greatly affect the numbers when removed. For example, the graph below shows outlays in billions of dollars and outlays excluding "automatic stabilizers" which are automatic policy responses to the business cycle, the 2009 stimulus, TARP, Fannie Mae and Freddie Mac support, and extensions of unemployment insurance. The numbers are presented both in nominal dollars and inflation-adjusted 2013 dollars. As you can see, the lines tell different stories, with a smoother growth rate of federal spending when the financial and fiscal response to the Great Recession is removed.
It is true that the more common way to compare budget numbers across different years is as a percentage of GDP (adjusting numbers for inflation is another way). In that case, spending has declined by 2.6 percentage points, from 24.1 percent of GDP in 2010 to 21.5 percent in 2013. This decline has occurred in both discretionary and mandatory spending, although 70 percent of the decline is concentrated in the discretionary portion. Interest spending as a percent of GDP has remained roughly stable as lower interest rates have offset the increase in debt.
If we were to examine the nominal dollar calculations, though, there are a few things to consider. One thing, which we have pointed out before, is that financial-type spending, particularly for TARP and the FDIC, may distort some of these totals. In 2010, TARP recorded a huge negative outlay of $110 billion as the CBO drastically adjusted their cost estimate of the program downward. In addition, the FDIC required that member banks prepay premiums for the next three years, a timing shift which showed up in FY 2010. These temporary factors resulted in a $140 billion swing which essentially deflates 2010 spending relative to 2013.
There are also factors which have the opposite effect, mostly related to stimulus spending and the recession. Some temporary discretionary stimulus spending would show up in 2010, but would have mostly been spent by 2013. Some other programs, in particular unemployment insurance and Medicaid, have a lower nominal level of spending since 2010 as temporary stimulus spending has expired or economic conditions have resulted in lower outlays.
There have been many other non-stimulus/recession-related factors which come into play as well. The spending caps and sequester adopted in 2011 have been reducing discretionary spending. In addition, war spending has continued to decrease, with that effect also showing up in the discretionary budget. Social Security and Medicare spending have continued to increase, although the pace of the growth of the latter has slowed in recent years. It remains to be seen whether the Affordable Care Act, as it takes effect, or other structural health care changes will play an even greater role in slowing the growth of health spending.
Note: All spending-to-GDP ratios use old GDP numbers since CBO has not officially released budget data for 2013 with the new GDP numbers.
The National Association for Business Economics (NABE) conducted its semi-annual survey recently, surveying 220 economists on questions of fiscal, monetary, and regulatory policy. On fiscal policy, they showed remarkable consensus that the long-term deficit, rather than the short-term deficit, is the government's primary fiscal challenge.
In the survey, only 6 percent of economists thought that there was no fiscal challenge facing the federal government, and only 12 percent thought that the current deficit was the primary challenge. Meanwhile 37 percent of economists thought that ten-year deficits were the main issue, and 43 percent thought that deficits beyond this decade were the primary concern.
In terms of addressing the longer-term deficit, a plurality (39 percent) favored a mix of tax increases and spending cuts, while 32 percent favored mostly spending cuts, and 20 percent favored policies to encourage economic growth. In terms of what specifically should be done, 43 percent of economists favored targeting federal health care spending while 19 percent offered up defense and 18 percent wanted to tackle other entitlement programs. Of course, those surveyed could have also favored addressing multiple areas. In terms of taxes, 42 percent favored broadening the individual and corporate tax bases, while smaller groups favored a carbon tax or a value-added tax.
Perhaps the most salient result of the survey is that more than two-thirds of economists thought that uncertainty over fiscal policy was holding back the economic recover. Given the events coming up in the fall, that issue will be brought to the forefront once again. But judging by the results of the survey, at least a plurality of economists favor easing up on the deficit reduction pedal (i.e. the sequester) in the short term and making changes to entitlement programs and the tax code to make the long-term fiscal picture sustainable.
Update: A new note from the Office of the Chief Actuary of the Social Security Administration finds that allowance rates actually fell during the Great Recession. The Coe and Rutledge brief appears to have been removed from the website for the time being. This blog includes an extra paragraph discussing the SSA's findings.
Recently, Norma Coe and Matthew Rutledge from the Center for Retirement Research at Boston College published a brief that examined the Social Security Disability Insurance program and how it was affected by the Great Recession. One concern of those advocating on behalf of the DI program is that it could create a disincentive to work and serve as a more costly version of unemployment assistance.
Coe and Rutledge explain that economic conditions can affect individuals' decisions to apply for disability insurance. During a recession, applying for disability insurance benefits becomes more attractive as individuals are more likely to be unemployed. Unemployed individuals' health is likely to worsen, which can increase the likelihood of receiving disability insurance. The brief cites other studies which have found that individuals with borderline health problems are less to apply during good economic times and more likely to apply during recessions.
Consistent with expectations, applications for Social Security Disability Insurance rose by around 33 percent from 2007 to 2010. However, allowance rates, the rate of applications that are granted disability benefits, also rose during this period from 42 percent to 50 percent. This is surprising, as traditional thinking suggests that as relatively healthier people enter the applicant pool due to economic distress, the rate of payout will decrease.
Coe and Rutledge did not find a correlation between education level and allowance rate that was significantly different from the allowance rate during an economic expansion, and were unable to identify the cause of the growth in allowance rates.
Notably, the Social Security Administration's Chief Actuary found results to the contrary. According to their data, allowance rates fell from 58 percent in 2008 to 54 percent in 2011 (based on preliminary data). According to their data set, the 2011 allowance rate would be the lowest since 1995, when it was 53 percent. They also found that allowance rates were lower than would be expected given two different models of the relationship between unemployment rates and allowance rates.
The Social Security Disability Insurance trust fund is due to be exhausted by 2016, according to the latest Trustee's Report. At that point, benefits will either need to be cut by 20 percent or funds will need to be transferred from the Old-Age Fund, which has its own solvency problems. With many possible reforms that could improve the program as well as make it solvent, it does not make sense to wait three more years before giving DI needed attention.
The slowdown in health care spending growth in recent years has been a hotly debated topic, as experts try to figure out the source of the slowdown. Some have theorized that it is due mostly to the weak economy, while others have argued that changes in the delivery of care or other factors, perhaps in anticipation of the implementation of the Affordable Care Act, have been the main drivers. Now, CBO has jumped into the action, estimating the specific sources of the slowdown in fee-for-service Medicare in a new working paper. The study of Medicare in particular is interesting because the nature of the program and its beneficiaries should theoretically make it less effected by cyclical economic factors than other forms of insurance.
In particular, CBO compares the 2000 to 2005 period and the 2007 to 2010 period to see why growth in Parts A and B was slower in the latter period; specifically, per-beneficiary spending growth was 3.2 percentage points lower. Unfortunately, they were only able to identify reasons for one-quarter (0.8 percentage points) of the slowdown.
While the 2007 to 2010 period covers the Great Recession, CBO found that the economic downturn had no meaningful effect on spending growth. They found that differences in payment rates accounted for 0.2 percentage points of slower growth, although the periods studied were before provider payment cuts in the Affordable Care Act were implemented in 2011, so that may be a higher contributor going forward. Changes in the health status of beneficiaries, in part due to the average age of the Medicare population declining, contributed 0.3 percentage points to the slowdown. The share of beneficiaries enrolled only in Part A of Medicare also rose during the 2007-2010 period, causing a 0.2 percentage point slowdown. Growth in the use of prescription drugs, which may sometimes discourage the consumption of other medical care, caused 0.1 percentage point of the slowdown. Changes in supplemental coverage like Medigap had no effect.
The authors note that economy-wide inflation was lower in the 2007-2010 period than the 2000-2005 period but that even after accounting for that, there was still a significant slowdown. One thing they did not appear to account for are spillover effects from non-Medicare health care affecting costs.
Based on this data, the authors concluded the following:
In sum, our understanding of the causes of the slowdown in Medicare spending growth between 2000 and 2010, as well as the likelihood of those factors’ persistence, remains incomplete. Nevertheless, we can say that the slowdown appears to have been driven in substantial part by factors that were not related to the economic recession’s effect on beneficiaries’ demand for services; some of the other influences on Medicare spending that could have contributed to the slowdown, such as changes in how care is delivered to beneficiaries, might hold down spending growth for many years.
Obviously, the paper leaves a lot of question marks about the source of the slowdown but indicates that at least some of it may be hear to stay. But it's encouraging to see that CBO has found evidence for more structural and, hopefully, longer-lasting explanations for the recent slowdown in health care cost growth. If this leads CBO to alter some of their long-term budget forecasts for the better, it will be very welcomed news. As we have said many times before, it is better to be prudent and not simply assume that the problem is solved. We have seen seemingly permanent shifts in health care be illusory, particularly in the late 1990s. It would be better to be proactive and make health care spending sustainable considering how central it is to the fiscal outlook.
When Congress returns from recess in early September, they will have to address two major upcoming challenges: pass appropriations for next year before October 1, and raise the debt limit before the nation bumps up against our legal cap on borrowing, which could happen as early as October. An inherent part of this debate is the fate of the sequester--whether Congress will keep the reduced spending levels created by across-the-board cuts, or replace them with a credible long-term plan to replace the deficit.
Former Representative Jim McCrery (R-LA), a member of Fix the Debt's steering committee, explains the recent improvement in short-term deficits. McCrery served as as Ranking Member to the House Ways and Means Committtee, which oversees both taxes and many entitlement programs.
At the heart of both of these issues is a fundamental disagreement among Republicans and Democrats, conservatives and liberals, about federal spending, budget priorities and deficits, and the national debt. Some appear satisfied that the deficit appears on track to narrow substantially for the first time in a long while. So far this year, the government has “only” run a deficit of $607 billion, compared to the $974 billion deficit accrued in the same 10 months of fiscal year 2012.
In addition to the two immediate concerns about the FY 2014 budget and the debt limit, McCrery argues that Congress has not done enough to tackle our nation's long-term debt problems:
The reality is Washington has yet to enact a plan to slow the growth in debt over the long term and promote long-term economic growth. If this inaction continues, our country faces rising interest rates, slow rates of economic growth, less budgetary flexibility in times of national emergencies, an increasingly destructive burden on our children and grandchildren, and a greatly heightened risk of a tragic fiscal crisis.
Therefore, America needs a bipartisan compromise, inclusive of comprehensive tax and entitlement reform, not some poorly conceived stop-gap measure like sequestration. When our Senators and Congressmen return to Washington in September, our budget and fiscal situation should be their top priority.
Read the full post here.
"My Views" are works published by members of the Committee for a Responsible Federal Budget, but they do not necessarily reflect the views of all members of the committee.
As part of an ongoing series of economic speeches entitled A Better Bargain for the Middle Class, President Obama spoke yesterday at the University of Buffalo on higher education, with additional speeches today at Binghamton University and Lackawanna College. Like his previous speeches on housing, the President laid out a series of policies to make higher education more affordable, some of which were included in his 2014 budget, others that are new.
Recent passage of the student loan bill created a permanent solution for student loan rates; by linking them to Treasury rates, they will remain low temporarily until the economy has recovered without adding to the deficit (the bill saved a modest $715 million over ten years, with greater long-term savings in theory). With this budget issue resolved the President has turned to proposing measures that could help foster competition, tie federal funds to performance for students and colleges, and reduce the burden of student debt.
Pay for Performance Measures: Many of these proposals are new, and the budgetary impact is unclear. The President proposes developing a college rating system based on "access, affordability, and outcome" and tying federal financial aid to those rankings. In particular, the White House suggests offering a bonus to colleges with greater numbers of Pell graduates. By itself, the proposal would increase the deficit, but offsets could be found in other areas, such as reducing payments to low Pell Grant schools. Low performing schools would also be required to disburse Pell Grant funding over the course of the semester, instead of in a lump sum, to prevent funding to go to those who drop out. Individual accountability would be enforced by requiring completion of a certain number of class or other progress measure before receiving next semester's Pell Grant. Included in this section is a request for an additional $1 billion in Race to the Top funding for state-based higher education reforms, also proposed in his FY 2014 budget.
Promote Innovation and Competition: Many of these measures will not have a budgetary impact, including greater use of online and "hybrid" courses, incorporating technology, recognizing dual-enrollment and other policies.
Student Debt Proposals: The President's main proposal, also included in his FY2014 budget, would expand Pay-As-You-Earn (PAYE) to all borrowers. PAYE modified income-based repayment plans by limiting federal loan payments to 10 percent of a borrower's income, with a maximum of 20 years of repayment. Currently, those who took out loans before 2008 or have not borrowed since 2011 are not eligible for PAYE, and the proposal would expand the program at a cost of $4 billion over ten years. The New America Foundation's Education Policy Project has previously argued that the IBR changes may be giving a windfall to some wealthier borrowers and suggests a number of reforms that could better target resources.
Unfortunately, missing from the speech and supporting resources was any discussion of the nearly $50 billion funding shortfall that the Pell Grant program faces over the next ten years. The President's Budget allocated $12 billion in mandatory funding to supplement discretionary spending. The Bipartisan Path Forward and the New America Foundation's Education Policy Program also have addressed Pell Grant funding without increasing the deficit by finding other education savings. In order to maintain this program, the funding gap must be addressed.
Last week, we noted that it was the 78th birthday of the Social Security program, but cautioned that reform was needed before we could count on another 78 years of sustainability. According to the latest Trustees Report, Social Security's trust fund is due to become insolvent by 2033, well within the lifetime of many of today's workers, and a 23 percent cut would need to be leveled on all beneficiaries for spending to match revenues. But compared to the decisions that need to be made on sequestration, the expiring government funding bill, and the debt ceiling, one might ask: Why is it important to do this now?
Today, CRFB has released a new report that shows the significant costs of waiting. While there are many options that could be combined to ensure 75-year solvency (try our Social Security Reformer to see), the longer policymakers wait to make reforms, the greater the costs. The report presents four main reasons why lawmakers cannot afford to wait with quantitative analysis for each.
- Waiting to Act Places a Greater Burden on Fewer People
- Waiting to Act Reduces the Accumulation of Interest in the Trust Fund:
- Waiting to Act Makes Cuts to Real Benefits Harder to Avoid
- Waiting to Act Gives Workers Less Time to Plan and Adjust
For instance, the percent benefit cut needed to close achive 75-year solvency is one of many examples that we use in the paper to show the advantages of starting early.
Achieving solvency for the program will require tough choices, which lawmakers may wish to avoid, but the challenge will only become more daunting the longer we delay. As we conclude in our paper: The right time to act to reform Social Security was two decades ago. The next best time is now.
Click here to read the full report.
Click here to try our Social Security Reformer.
This is the second post in a new CRFB blog series The Tax Break-Down, which discusses tax breaks under discussion as part of tax reform.
Last-in, first-out accounting, or LIFO, is a preferential method of measuring profits from inventory sales and is one of the ten largest tax breaks in the corporate code. LIFO accounting has been part of the U.S. tax code since 1939, but it is a uniquely American invention; it is not permitted under International Financial Reporting Standards.
To determine taxable profit, a company must subtract costs from gross revenues. LIFO accounting allows companies to sell inventory and calculate the purchase cost of that inventory -- which determines the deduction they may take -- as if the most recent product sold was the most recent bought and stored as inventory.
By contrast, for normal accounting, most companies use first-in, first-out (FIFO) accounting, which assumes that the item sitting on the shelf for the longest is sold first. Since prices tend to rise over time, being able to sell the last product first often allows companies to claim they paid the highest price and therefore achieved the lowest amount of profit for tax purposes.
For many retail industries, where goods are bought and sold quickly, there is little difference between the accounting methods. However, in industries where inventories move slowly and prices change quickly (like industrial equipment or petroleum), the difference can be significant. This difference is most pronounced for companies that bought their first inventories decades ago.
To take an extreme example, assume a company purchased a barrel of oil for $1 in 1939, when LIFO was first adopted, and then purchased an additional barrel each year with the hopes of selling that oil starting in 2013. Under standard accounting "FIFO" rules, the first barrel of oil the company sold would generate about $100 of revenue at a $1 cost, leaving a $99 taxable profit. By comparison, LIFO rules would allow the company to subtract last year’s cost of about $90 and pay taxes on only $10 of profit – allowing a 90 percent reduction in the company’s tax burden.
Though the above example rarely occurs so starkly, many companies keep some inventory indefinitely, leading to a permanent deferral of some of their tax liability.
Below, we answer other questions about LIFO accounting rules.
How Much Does It Cost?
According to Joint Committee on Taxation, the cost of the LIFO tax break is about $5 billion in 2013, which we estimate at $60 to $65 billion over a decade. Most (85 to 90 percent) of the value of LIFO accrues to C-Corporations paying the corporate income tax, while the remainder accrues to pass-through entities which pay through the individual tax. Another related tax expenditure called lower-of-cost-or-market (LCM), which allows companies to deduct losses if inventory costs at market prices are below the purchase price, costs an additional $8 billion or so over a decade.
Because the transition from LIFO to FIFO would lead to the reclassification of current inventory, the revenue raised from repealing LIFO would be more than the value of the tax expenditure in the short run. According to our Corporate Tax Calculator, repealing LIFO on its own would raise enough revenue over ten years to reduce the corporate tax rate by 0.6 percentage points. Importantly, the corresponding rate reduction would be much less significant over the long-run.
Who Does It Affect?
LIFO is used primarily by a select group of companies who have had time to accumulate old inventories. A "LIFO reserve" is the cumulative total of the profit difference between using LIFO and if the company had been using FIFO in that year. It does not represent available cash, but the amount that past profits would be higher under a different accounting system. According to CFO Magazine, energy companies hold over one-third of LIFO reserves, and manufacturers about one-sixth. This chart only measures publicly traded companies ranked by Moody’s, as only publicly traded companies must disclose their LIFO reserve.
|Inventory and LIFO Reserve by Industry (millions)|
|Industry||Inventory||LIFO Reserve||Percent of Total|
|Metals and Mining||$8,876||$4,100||10%|
Source: Moody's Investors Service
What are the Arguments For and Against LIFO?
Repeal proponents argue that LIFO has no value as an accounting system and is only used to reduce tax liability. Put even more bluntly, critics have described LIFO as a "massive tax holiday for a select group of taxpayers." Repeal would end a system where taxpayers can permanently defer taxes on gains from rising prices. In addition, they argue that LIFO encourages an economically inefficient accumulation of inventory. In their view, LIFO is "the equivalent of a deduction for a cost that is never incurred" because of the tax deferral it represents.
Proponents of retaining LIFO, on the other hand, argue that LIFO encourages economically-valuable inventory investment and keeps inventory on comparable footing with other investments like machinery and buildings that benefit from accelerated depreciation. LIFO proponents also argue that LIFO accounting offsets what would otherwise be a tax on inflation, since inventory value may increase simply because prices do. Finally, they argue that repealing LIFO would mean taxing past decisions – as far back as 70 years ago – and claim "the extent of this retroactive reach by the government appears to be unprecedented in the history of the Internal Revenue Code."
What are the Options for Reform and What Plans Have Other Plans Done?
Most comprehensive tax reform plans would repeal LIFO accounting, including the President’s Business Tax Reform Framework, the Simpson-Bowles tax reform plan, the Domenici-Rivlin tax reform plan, and even the 2007 tax reform bill introduced by Charlie Rangel. The Wyden-Gregg bill from 2010 does not repeal LIFO, though it does propose a one-time adjustment for large oil companies which reduces the benefit of LIFO by re-valuing their inventory.
When it comes to repealing LIFO, however, there are a number of questions which have to be answered. For example, what accounting mechanism is it replaced with? And is the repeal accompanied with a repeal of lower-of-cost-or-market rules?
Furthermore, immediately repealing LIFO and replacing it with FIFO would cause companies to claim large one-time profits from their historic inventories, which would be a massive one-time tax increase. Most proposals to repeal LIFO would space out back taxes over a number of years. As a result, revenue estimates will vary based on reform plan – though they will always be substantially larger over the first decade than over the long-run. For instance, CBO estimates that repealing LIFO and spreading the profits over 4 years will raise about $100 billion over that per, but only
|Parameters and Revenue from Different LIFO Options|
|Re-valuate LIFO inventories for large integrated oil companies; repeal LCM||$12 billion (2011-2020)||Wyden-Gregg|
|Replace LIFO and lower-of-cost-or-market (LCM) with FIFO or specific identification method, phased in over 4 years||$112 billion (2014-2023)||CBO Budget Option|
|Replace LIFO with FIFO, phased in over 10 years||$78 billion (2014-2023)||President's Budget|
|Replace LIFO with FIFO, phased in over 8 years||$107 billion (2008-2017)||Rangel Bill (HR 3970)|
|Repeal lower-of-cost-or-market (LCM) method, phased in over 4 years||$5 billion (2014-2023)||President's Budget|
Where Can I Read More?
- Internal Revenue Service – FIFO/LIFO
- Tax Policy Center – 2011 Budget Tax Proposals (Repeal LIFO)
- Kleinbard, Plesko & Goodman – Is It Time to Liquidate LIFO?
- Alan Viard – Why LIFO Repeal Is Not the Way to Go
- Sherry Slater, The Journal Gazette – Is LIFO As We Know Over?
- Scott Gibson – LIFO vs. FIFO: A Return to the Basics (Oldies, Still Goodies)
- Dopuch & Pincus – Evidence on the Choice of Inventory Accounting Methods: LIFO Versus FIFO
* * * *
Repealing LIFO for inventory accounting would bring the United States in line with international accounting standards while eliminating a major source of tax deferral for businesses. At the same time, LIFO can adjust for gains due solely to inflation and maintain tax neutrality between inventory and other types of capital. With that said, retaining LIFO would take a sizeable amount of revenue off the table, even if more of that revenue is one-time, upfront revenue rather than a long-term permanent gain. But dealing with LIFO isn't just a matter of repeal or retain--policymakers must decide which accounting method works best to determine how inventory is counted in a business's taxable income.
Click here to read more entries in The Tax Break-Down.
With President Obama set to give a speech in the coming weeks on retirement security, the Center for American Progress (CAP) has released a report describing a new retirement account that intends to improve on current 401(k)-type plans. Their report discusses their Secure, Accessible, Flexible, and Efficient Retirement Plan (SAFE), and focuses primarily on the potential merits of collective defined-contribution (CDC) plans, as compared to traditional defined-contribution or defined-benefit plans. The report analyzes how such plans would outperform traditional 401(k)s and thus benefit retirees.
CAP first describes some of the shortcomings of current defined-contribution plans and how CDCs would address them. In short, current 401(k)s put the financial risk on the workers and rely on those individuals to make investment decisions. CAP argues that the latter point often results in adverse economic decisions, generally as a result of participants not weighting the riskiness of their portfolio in the optimal way. In addition, individual 401(k)s have higher management fees than would be the case under a CDC plan.
CAP's SAFE Retirement Plan would instead pool contributions to spread risk around, in addition to having the plan be professionally managed so as to take advantage of better investment strategies than may be the case if individual investors were managing it. In addition, the fund would manage risk by having a flexible reserve fund; one added to when returns exceed a certain amount and depleted when returns are negative.
The report's actuarial analysis shows that the CDC plan would hypothetically have provided a much higher replacement rate for retirees than a "real-world" 401(k) and a slightly higher replacement rate than a theoretical perfectly managed 401(k). They also show that the CDC plan would be less risky, showing that it would have much better protected workers who retired during the Great Recession.
The CAP report is a good reminder that while the three legs of retirement security -- Social Security, pensions, and individual savings -- are affected by different parts of the government, policymakers should keep in mind how the three could best work together when making changes to any individual one. Although the most important thing we can do for retirement security is to make Social Security solvent, it is important to consider all parts of the retirement system.
It's the dog days of August and with Congress in recess, we can do nothing but wait to resolve some of the upcoming fiscal challenges that lie ahead. We have made some progress, particularly in beginning to seriously discuss tax reform, but overall, there is a still a tremendous amount of work that remains to be done in the fall.
Today in Forbes, CRFB board member and former Congressman Bill Frenzel (R-MN) expresses his disappointment with the effort so far:
Just like in the stables, when the job is not done, work begins to pile up. The debt ceiling which reached its limit in May, has been postponed by clever manipulations at Treasury, but it will bite us sometime in the 4th quarter. No progress has been made there. Indeed, other than public statements of no concessions, the matter has hardly been discussed.
September 30 is the deadline for financing the government for Fiscal Year 2014. In its budget, the Senate dismissed the sequester. The House budget etched it in stone. There have been no real efforts to negotiate the differences yet.
No appropriations bills have been enacted, so another set of continuing resolutions will have to suffice, but the same budget differences must be negotiated there. Perhaps the appropriators will be better negotiators than the budgeteers, but there is no evidence of that yet.
The sequester poses a similar, but slightly different, problem. Both parties, and nearly all the policy makers, believe it is a thoughtless way to cut expenses. There is general agreement that it must be modified, but no agreement as to how. The Senate insists on wishing it away. The House demands that the total spending reductions be maintained and that other cuts be substituted for the unwise “meat-axe” approach.
Frenzel goes as far to say that a small deal will be the best possible outcome this fall. That might be too pessimistic, as there have been some signs that the leadership in Washington still sees a grand bargain as a real possibility. And as we showed last week, even a "mini deal" would contain some long-term savings and thus be a better option than one year of sequestration if lawmakers should fall short. Still, our long-term problem demands tax and entitlement reform, which will only get harder the longer we wait. Washington should heed the wake up call from Frenzel.
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.
Frequent readers of this blog will be familiar with projections of long term debt. But the Peterson Foundation has found an interesting interactive way to present that informs the viewers about what the long-term outlook looks like and what the possibilities are going forward.
Peterson's presentation contains both a four minute video explaining the long-term projections and an interactive graph that allows users to look closer at the numbers. The projections appear to be based on CBO's Alternative Fiscal Scenario and show that even with the fiscal cliff deal, the sequester, and some slowing in projected health spending, debt as a percent of GDP would be on a sharply upward path over the long term. This is also true of the CRFB Realistic baseline, although the path is not quite as sharp.
In addition to showing what the status quo looks like, the graphic also shows what the five fiscal plans presented at the Foundation's "Solution Initiatives II" last November do to the debt. As we said last year, all of the plans at least stabilize the long-term debt and generally put it on a downward path. Each plan's label also links to a full description of the policies involved, so viewers can see how the plans got to where they are. The interactive also includes a sliding breakdown of spending and revenue projections over the next 40 years, convincingly showing the growth of entitlements.
The new presentation is a helpful resource for understanding the long-term projections and what some think tanks have proposed to change them. You can see the video and graphic here.
Even though Washington slows down in August, several think tanks are staking out positions in advance of this fall's pending fight over the debt limit and next year's budget. For example, today two organizations - Americans for Prosperity and Americans for Tax Fairness - have put forward two different approaches.
Americans for Prosperity, a conservative group, is encouraging legislators to maintain federal funding at reduced, post-sequester levels. In making their case, AFP highlights the fact that several appropriations bills that have stalled in the House over a seeming lack of Republican consensus regarding how to live within the existing, post-sequester caps. They express concern that if lawmakers remove the sequester without finding any offsetting savings, federal spending will be $1.2 trillion higher over the next 10 years. As the Financial Times reported,
AFP is raising its concern amid signs that a small number of Republican legislators are starting to balk at the tough austerity line the party has adopted since gaining the majority of the House of Representatives in 2010, including the budget mechanism known as "sequestration."
By contrast, Americans for Tax Fairness, a progressive group, released a report today comparing the price of certain corporate tax expenditures with the impact of various spending cuts under the sequester. Their plan suggests repealing certain corporate tax breaks and ending deferral of foreign-source income to raise revenue and offset some of the sequester's spending cuts. Their policy proposals include:
- Repealing accelerated depreciation for corporate jets
- Eliminating oil and gas preferences
- Taxing carried interest as ordinary income
- Limiting the size of retirement accounts for millionaires
- Closing stock option and performance bonus loopholes in rules for the deduction of executive compensation
- Marking derivatives to market and taxing related income and other financial institution reforms in the President's budget
First, we've said before that the corporate tax code is in need of reform, and there are many options on the table for consideration, including those listed above. However, we believe reforming the corporate code should be done as part of comprehensive tax reform that addresses both the individual and corporate side in order to make our tax system more efficient, effective, fairer and contribute to deficit reduction.
Second, we've said the sequester is not a smart way to cut the deficit, and therefore policymakers must come together on a comprehensive debt reduction package that replaces part of the sequester with smarter cuts, coupled with meaningful entitlement and tax reforms. It is encouraging to see think tanks acknowledge that repealing the sequester without offsetting replacements would be costly, and that any replacement should be fully offset. But given the opportunity over the coming months, we hope lawmakers go even further than addressing the sequester, and an agree upon a comprehensive plan that includes entitlement and tax reform that meaningfully addresses our long-term debt problem.