The Hill | May 9, 2013
Over the last few days, politically driven critics have called on the president to abandon his support for changing the way the government indexes provisions in the budget to inflation by switching to “chained CPI.” Looking beyond politics, we’re here to say that these critics’ arguments are wrong on their merits.
As economists from opposite ends of the political spectrum, we would strongly urge the president and leaders in Congress to continue to support moving to chained CPI, which represents the most accurate available measure of inflation and cost-of-living increases. Switching to this more accurate measure of inflation represents the right technical, fiscal and retirement policy — and policymakers should not delay any further in making this improvement.
From a technical sense, the current CPI — or consumer price index — that is used to index many parts of the budget and tax code is widely understood to overstate inflation. This is because it fails to account for so-called “substitution bias,” in which consumers reallocate their purchases depending on the relative prices of similar goods. For example, if the price of apples goes up, consumers will buy more oranges. However, this behavior is not accounted for in standard CPI measurements.
The Bureau of Labor Statistics, which calculates the CPI, is very aware of this shortcoming, which is why it has developed and refined the chained CPI for more than a decade. The nonpartisan Congressional Budget Office states that the chained CPI “provides an unbiased estimate of changes in the cost of living from one month to the next.”
Some argue that using the chained CPI to index Social Security benefits is inappropriate because it does not reflect inflation for retirees, which critics suggest is higher than it is for working-age adults because of the elderly’s higher rate of spending on healthcare. However, the CBO has said that based on the available research, it is unclear whether the cost of living actually grows at a faster rate for the elderly than for younger people, and that the CPI-E —“E” for “experimental” — which was intended to provide a more accurate measure of inflation for seniors, has several methodological flaws that overstate inflation, including underestimating the rate of improvement in healthcare.
Beyond the technical case for the chained CPI, there is a strong fiscal case. Because current measures currently overstate inflation by about 0.25 percent per year, moving to a more accurate measure would result in real deficit reduction. Measuring inflation more accurately would generate savings from throughout government: about $390 billion in the first decade alone. Roughly one-third of those savings would come from slower growth in Social Security benefits, another third from revenue increases (as certain tax provisions such as the cutoff points of income tax brackets are indexed to inflation) and the remaining savings from a combination of other spending programs and lower interest payments on the debt. Given the very real need to begin to put our debt on a sustainable path, this would be a small but important contribution. The savings would be gradual, with only a small amount in the near term, thus protecting our fragile recovery from immediate austerity.
Finally, switching to chained CPI is the right retirement policy — or rather, a small piece of it. The Social Security program is on a path to exhaust its trust fund. Current projections indicate that this will occur in 2033, threatening cuts for all beneficiaries, including the very rich and the very poor, the very young and the very old, veterans, disabled workers and others. Improving the way we measure inflation won’t prevent the program’s looming insolvency, but it will eliminate a full fifth of the long-term funding gap.
To the extent that the overpayments under the current formula offset the shortcomings of our current retirement system for the lowest-income and most-elderly beneficiaries, a switch to chained CPI can and should be accompanied by targeted policy changes providing benefit enhancements designed to help the affected populations, rather than providing higher-than-justified inflation adjustments for all beneficiaries.
The federal government should not knowingly continue to measure inflation inaccurately, especially given the costs to the budget and to the Social Security program. Changes that cut Social Security benefits are a tough sell for Democrats, and changes that increase revenue are a tough sell for Republicans. But if they cannot even agree to a technical correction to those areas of the budget, how will they be able to make the hard choices to control our debt and reform our government over the long term?
The Hill | April 30, 2013
In his recent blog entry on chained CPI (Chained CPI: Unfair and inaccurate, April 26th), AARP President Robert Romasco highlights his groups opposition to the change, charging that it would be “Unfair and Inaaccurate.” In fact, nothing could be further from the truth.
A coalition of strange bedfellows, including Grover Norquist’s Americans for Tax Reform and Moveon.org, have announced their opposition to this policy, even as many responsible policymakers from both sides of the aisle and at the highest levels of government continue to support it – notably, the president and the Speaker of the House.
It is no surprise that groups from the left and right have mobilized to defend the status quo in order to avoid the tough choices that must accompany any responsible deficit reduction plan. Yet, the resistance to a reform as simple and obvious as using the most accurate measure of inflation for price-indexed provisions in the budget is both astounding and disappointing.
Economists from the left, right, and center are in broad agreement that chained CPI more accurately reflects cost-of-living increases by accounting for the small-sample and substitution biases in the current inflation measure. This view is shared by experts at the non-partisan Congressional Budget Office as well as the experts at Bureau of Labor Statistics who are responsible for measuring inflation. Adopting the chained CPI doesn’t represent a policy change, but rather would best reflect the current intent of the law to index various provisions to inflation.
And while some argue that seniors face faster cost-growth than other populations, there is little evidence of a significant difference when one accounts for the fact that seniors are more likely to own their own homes mortgage free, have different shopping habits than younger populations, are able to take advantage of senior discounts, and receive constantly improving health treatments. Indeed, according to the Congressional Budget Office, “it is unclear, however, whether the cost of living actually grows at a faster rate for the elderly than for younger people.”
Moreover, offering seniors a preferential inflation measure raises more fairness concerns than it answers. If seniors receive a higher inflation measure, should non-seniors on the Social Security program receive a lower measure? Geographic inflation disparities are far larger than alleged age disparities (inflation has averaged 2.7 percent in New York and 1.8 percent in Detroit over the last decade); why protect seniors and not New Yorkers? What about other government programs and tax provisions? Should each be indexed to costs within its population? Or only those backed by powerful interest groups?
Indeed, it would be highly unfair to politicize inflation indexing or to exempt any government program or tax provision from the most accurate available measure of inflation.
More unfair would be ignoring our fiscal and retirement challenges and leaving the job to a future politicians. According to the left-leaning Center on Budget and Policy Priorities, the President’s chained CPI proposal would result in benefit levels 1 to 2 percentage points lower than under current law – and it accompanies the switch with benefit enhancements for the old that actually reduce poverty among that group. By comparison, there is a 25 percent cut scheduled to occur under current law when the trust funds dry up in 2033. The greatest unfairness would be allowing this across-the-board benefit cut to hit every beneficiary regardless of age or income – when this cut could be easily avoided through a balanced package of revenue and benefit adjustments.
Mr. Romasco is right, we need a national conversation on improving retirement security, including how to make Social Security sustainably solvent in order to avoid abrupt benefit cuts and ensure the system is better protecting those who rely on it. Ideally, we’d have this conversation now. However, the overheated reaction to a technical correction in cost of living adjustments suggests that the political system may not be ready to tackle comprehensive Social Security reform. Continuing to index benefits improperly while we wait for this reform to materialize would be a costly mistake that will only make future Social Security changes more painful.
The Hill | April 11, 2013
The Senate and House of Representatives both have passed budgets that represent the preferences of the majority party in each chamber. Now it’s time to agree on a plan that can attain support from both parties.
Tax reform can be the key that unlocks the puzzle.
On Wednesday, President Obama released a budget request that offers some entitlement savings in exchange for additional tax revenue.
While many assume that getting an agreement on additional revenue is impossible, reform that cleans up the tax code, makes it more efficient and enhances competitiveness — along with significant structural entitlement reforms — could provide the breakthrough we need for a plan that addresses long-term national debt while promoting economic growth. That is a lot of pressure for an undertaking that is both desperately needed and treacherously complicated.
There is support in both parties for reforming the more than $1 trillion a year in tax deductions, exemptions and other loopholes known as “tax expenditures,” which are essentially spending through the tax code.
Many of these tax expenditures are only enjoyed by select taxpayers and distort the economy by disproportionately benefiting some activities, companies or industries over others. We can both reduce tax rates and the deficit by eliminating, limiting or reforming these loopholes that adversely affect the budget and the economy.
The Simpson-Bowles debt commission illustrated one way to deal with tax expenditures: Its plan outright eliminated most expenditures and reduced tax rates to much lower than they are today.
If lawmakers want to reinstate a tax break, they would have to pay for it by buying the rates back up. I love this approach and would hope lawmakers would have the fortitude to start with a clean slate and limit the number of tax breaks they layered back in. But the political pressure to protect and preserve every single tax break would be mind-boggling.
The home mortgage interest deduction pushes housing prices up, and it subsidizes the lending and building industries. And the healthcare exclusion is a major contributor to escalating healthcare costs. But people love their tax breaks — the industries that benefit love them even more — and there is real cause for concern that the massive lobbying effort to preserve these breaks could derail tax reform entirely.
Another approach designed by myself, Marty Feldstein and Daniel Feenberg of the National Bureau of Economic Research, which would cap tax expenditure benefits at a set level of household income, might be more politically plausible. The advantage of this approach is that it eliminates the haggling over which tax expenditures to keep, which should make this reform easier to enact, given the political realities we face.
The Feldstein-Feenberg-MacGuineas tax expenditure cap represents a straightforward way to limit tax breaks. You basically set the limit that no taxpayer could have more in tax breaks than a percentage of his or her income (we generally assume 2 percent, but this could vary) and then don’t have to pick and choose which of the existing tax breaks to eliminate.
This approach has the potential to raise hundreds of billions or even trillions of dollars over a decade, generating revenues that can be used both to bring tax rates down and reduce the deficit. It meets a general test of fairness that some people should not benefit disproportionately from the tax code as they do now. Additionally, it can be adjusted in several ways to make it more progressive or meet a variety of different tax objectives, such as by altering which tax breaks are included in a cap.
Thankfully, tax reform appears to be moving forward this year. Senate Finance Committee Chairman Max Baucus (D-Mont.) and House Ways and Means Committee Chairman Dave Camp (R-Mich.) have been preparing for over a year to rewrite the tax code. The bipartisan, bicameral duo is committed to fundamental tax reforms and the lawmakers are closely coordinating with each other.
The support and cooperation of the leaders of the congressional tax-writing committees is a positive sign that tax reform can happen.
Agreeing on tax reform that relies on a tax expenditure cap could help pave the way for a comprehensive agreement to alter the unsustainable trajectory of our national debt. Hopefully, such an approach could open the door to a truly bipartisan, comprehensive deal.
Brookings | April 4, 2013
Throughout our population, experts and non-experts alike, the verdict is nearly unanimous. The U.S. tax code is a hopelessly complex mess, antithetical to growth, and is crammed with conflicting incentives, which screams for reform. But there is little agreement on how to repair it. My preferences are necessary, just, and ordained in heaven. Your preferences are unnecessary, unjust and counter-productive.
Tax reform is the most difficult and complicated piece in the U.S. budget battle. It is integral to both the Republican House and the Democratic Senate budgets. As in every budget item, there is a conservative vs. liberal confrontation, but tax reform is loaded with more confusing detail, and it adds extra layers of difficulty to the budget debate.
Some liberal and conservative inclinations tend to intersect when the conversation focuses on elimination of tax preferences. But, both sides have their favorite exceptions. Democrats love tax expenditures for the less affluent. Republicans love the preferences they suspect will stimulate growth.
Additionally, there are wide divergences about how the deficit savings from eliminated tax preferences should be used. Republicans like deficit-neutral solutions which invest all savings in lowering rates for growth. Democrats would like to spend those savings, either for compassionate spending or for Keynesian growth stimulus.
More real difficulties arise when tax preferences, individual and corporate, are considered one at a time. This is where powerful lobbying interests intervene. These are the interests that finance campaigns and parties. Regional factors arise, too. The normal political “rules” are often overridden. In some committee votes, it is hard to distinguish Democrats from Republicans.
Three of the four largest individual preferences are interesting examples. The first is the homeowners’ preference, which allows deductions for mortgage interest and real estate taxes. Homeowners’ enthusiasm for those benefits is exceeded, exponentially, by the real estate lobby, including real estate and mortgage firms, sun-belt governors, etc. The lobby, with bi-partisan support, easily defended its prize in the 1986 Tax Reform Act, and again, more easily, in President Bush’s Commission on Tax Reform in 2005.
The other two large preferences are charitable deductions and medical insurance (untaxed income for employees, and a deduction for corporations). Taking on the Little Sisters of the Poor, the big universities, or the United Fund is a fool’s errand. And standing up to powerful unions and corporations is not much easier.
Because these three big preferences, and others, are so well defended, many observers have suggested that placing a limitation on total individual preferences, a la Martin Feldstein, is a better approach. That strategy offers some hope, but it’s no piece of cake, either.
Reforming individual preferences is tough, but corporate preferences are, in some ways, even more perplexing. The last tax reform was achieved, at least partly, by shifting individual tax burdens on to corporations. That was okay in 1986. Today the common wisdom in both parties, and among knowledgeable observers, is that the U.S. corporate income tax rate must be reduced for reasons of international competition.
The task would be easier if individual and corporate income tax reform could be considered separately. Here again, there is a problem. Much of American business is transacted by small companies taxed as individuals. Separating these companies from their corporate competitors may not be practical.
Business operations are scattered over the U.S. supply chains extend everywhere. The tentacles of strong lobbying organizations also extend everywhere. Our system of territorial representation in Congress makes nearly every member a special defender of certain companies, industries, or unions. This factor tends to upset tax reform strategies. Sub-contracts loom large. Majorities appear, and disappear, unexpectedly.
Some budget observers believe that tax reform could be the key to long term fiscal compromise. Instead, some of these extra dimensions could make it the enemy. The devil is always in the details. Tax reform teems with details. Its politics are sometimes treacherous, even for seasoned politicians.
On the positive side, the tax committees of both houses are primed and ready to move forward. Chairman Camp and Baucus, while not exactly political soul-mates, have some similar ideas, a good business relationship, and regular communications. Both parties seem to want to try it.
Speaker Boehner has assigned tax reform the precious number of H.R. 1. If President Obama can extend his Congressional charm offensive, tax reform will never be the odds-makers’ favorite, but it is not out of the question for 2013.
Los Angeles Times | April 2, 2013
In his March 22 blog post criticizing proposals to switch from the consumer price index to "chained CPI" to determine cost-of-living adjustments for Social Security beneficiaries and other items in the federal budget, Michael Hiltzik claimed that there were "no grounds" for the statement made in a recent paper from the Moment of Truth Project ("Measuring Up, The Case for Chained CPI") that the chained CPI provides a more accurate measure of inflation than the measure currently used.
In fact, experts across the ideological spectrum agree that the chained CPI is indeed more accurate. In his 2005 book "The Plot Against Social Security," Hiltzik listed various proposals for reforming Social Security, among them chained CPI. He wrote, "Many economists maintain that CPI consistently overstates inflation ... because it doesn't account for so-called substitution effects." Hiltzik doesn't explicitly endorse the proposal, but this is certainly a far cry from his objection that there are "no grounds" for the claim that chained CPI is a more accurate measure of inflation.
Advocates for using chained CPI to more accurately index government programs to inflation include Austan Goolsbee, who served as chairman of the president's Council of Economic Advisors under President Obama, and Michael Boskin, who held the same position under the President George H.W. Bush. Their view is shared by the overwhelming majority of economists. A report by the nonpartisan Congressional Budget Office stated that the chained CPI "provides an unbiased estimate of changes in the cost of living from one month to the next." Two of the most respected and prominent defenders of Social Security, the late Sen. Daniel Patrick Moynihan (D-N.Y.) and the late Robert Ball, the longest-serving Social Security commissioner, who founded the National Academy of Social Insurance, both supported the use of chained CPI to more accurately achieve the goal of providing inflation protection for seniors and disabled beneficiaries.
The Bureau of Labor Statistics has noted the shortcomings of the current inflation indexing and specifically designed the chained CPI to be a closer approximation to a cost-of-living index. The bureau has developed and refined the chained CPI over more than a decade.
The government indexes benefit programs such as Social Security as well as provisions in the tax code to ensure they keep pace with inflation. Using a more accurate measure of inflation is not a benefit cut, but rather ensures that the benefits increase by the proper amount to achieve the desired policy goal. This change does not single out Social Security, as Hiltzik implies, but would apply to provisions throughout the federal budget. Social Security accounts for slightly more than one-third of the $390 billion in total savings over the next decade that would result from switching to chained CPI, with a similar amount of savings from revenue and the remainder from other government programs indexed to inflation along with interest savings.
To the extent that the overpayments under the current formula provide important help to certain low-income and elderly individuals, a switch to the chained CPI can and should be accompanied by targeted policy changes providing benefit enhancements designed to help the affected populations rather than providing higher-than-justified inflation adjustments for everyone. Every significant bipartisan deficit reduction effort, including the Simpson-Bowles plan, the Domenici-Rivlin plan and the negotiations between Obama and House Speaker John Boehner (R-Ohio) has proposed using chained CPI to index spending programs and the tax code, with a portion of the savings used to provide enhancements for low-income, elderly and other vulnerable populations.
Addressing our fiscal challenges will require many tough choices and policy changes, but the chained CPI represents neither. Eliminating the unjustified increases in spending and reductions in revenue that have resulted from using an inaccurate measure of inflation should be at the top of the list for any deficit reduction plan.
This report was originally published 05/11/2011 and has been updated on 12/12/2012 and again on 3/19/2013.
Project Syndicate | November 26, 2012
America’s recent presidential election answered the question of whether an increase in revenues will be part of the country’s long-run deficit-reduction plan. The answer is yes: there is now bipartisan agreement on the need for a “balanced” approach that includes revenue increases and spending cuts.
But there are still deep political and ideological divisions about how additional revenues should be raised and who should pay higher taxes. If a preliminary agreement on these questions is not reached by the end of the year, the economy faces a “fiscal cliff” of $600 billion in automatic tax increases and spending cuts that will shave about 4% from GDP and trigger a recession.
The majority of citizens agree with President Barack Obama that tax increases for deficit reduction should fall on the top 2-3% of taxpayers, who have enjoyed the largest gains in income and wealth over the last 30 years. That is why he is proposing that the 2001 and 2003 rate cuts for these taxpayers be allowed to expire at the end of the year, while the rate cuts for other taxpayers are extended.
So far, Obama’s Republican opponents are adamant that the cuts be extended for all taxpayers, arguing that increases in top rates would discourage job creation. This claim is not supported by the evidence. Recent research finds no link between tax cuts for top taxpayers and job creation. In contrast, tax cuts for the bottom 95% have a positive and significant effect on job growth.
During the past three decades, income inequality in the United States has increased significantly; indeed, the US now has the fourth-highest level of income inequality in the OECD, behind Chile, Mexico, and Turkey. At the same time, as the largest tax cuts have gone to high-income taxpayers, the US tax system has become considerably less progressive. The US needs fiscal measures that both curb the deficit and contain rising income inequality – and the inequality of opportunity that it begets.
But how should additional revenues be raised from top taxpayers to achieve these two goals? Most economists believe that increasing revenues by reforming the tax code and broadening the tax base is “probably” better for the economy’s long-term growth than raising income-tax rates. The analytical case for this belief is strong, but the empirical evidence is weak.
In theory, higher marginal tax rates have well known negative effects – they reduce private incentives to work, save, and invest. Yet most empirical studies conclude that, at least within the range of income-tax rates in the US during the last several decades, these effects are negligible.
A recent Congressional Research Service report, withdrawn under pressure from Congressional Republicans, found that changes in the top income-tax rate and the rate on capital gains had no discernible effect on economic growth during the last half-century. A recent review of the economic literature by three distinguished academics found no convincing evidence that real economic activity responds materially to tax-rate changes on top income earners, although such changes do affect their tax-avoidance behavior. So Obama has evidence on his side when he says that allowing the tax cuts for high-income taxpayers to expire at the end of the year will not affect economic growth.
Republicans have proposed tax reforms in lieu of rate hikes on high-income taxpayers to raise revenues for deficit reduction. Obama has signaled that he is willing to consider this approach, provided it increases tax revenues from the top 2-3% by at least the same amount as higher rates while protecting other taxpayers.
The federal tax system is certainly in need of reform. Tax expenditures – which include all deductions, credits, and loopholes – account for about 8% of GDP. Indeed, the US tax code is riddled with special preferences and contains large differences in effective tax rates across individuals and economic activities. These differences distort decisions about investment allocation and financing. Reforms that made the tax system simpler, fairer, and less distortionary would have a beneficial effect on economic growth, although economists concede that the size of this effect is uncertain and impossible to quantify.
Because tax expenditures are so large, limiting them could raise a significant amount of additional revenue that could be used both for deficit reduction and to finance across-the-board cuts in income-tax rates. Analysis of the Simpson-Bowles and Domenici-Rivlin deficit-reduction plans by the nonpartisan Tax Policy Center confirms that this approach is arithmetically feasible. Reducing large regressive tax expenditures like preferential tax rates for capital gains and dividends and deductions for state and local taxes, and replacing deductions with progressive tax credits, could generate enough revenue to finance rate cuts for all taxpayers, increase the tax code’s overall progressivity, and contribute meaningfully to deficit reduction.
But the odds of such an outcome are very low: what is arithmetically feasible is unlikely to be politically possible. Efforts to cap popular tax expenditures will encounter strong opposition from Republicans and Democrats alike. Nonetheless, some tax reforms are likely to be a key component of a bipartisan deficit-reduction deal, because they provide Republicans who oppose increases in tax rates for high-income taxpayers with an ideologically preferable way to increase revenue from them.
Unfortunately, it will take time to negotiate tax reforms – more time than remains until the end of the year, when the 2001 and 2003 tax cuts are scheduled to expire for all taxpayers. But there is still time to negotiate an agreement that extends these cuts for the bottom 98%, and that contains temporary measures to cap deductions and credits for high-income taxpayers in 2013. Such an agreement could help to break the political impasse over whether and how much these taxpayers’ rates should rise next year, thereby preventing the US from falling over the fiscal cliff and back into recession.