The Financial Times | September 17, 2012
One of the few issues on which Barack Obama and Mitt Romney agree is the need for tax reform. Since the last overhaul in 1986, loophole after loophole has been added, producing a tax system that is complex, unfair, inefficient and detrimental to growth. Today, tax reform must also address three major challenges: escalating federal debt, rising income inequality and intensifying global competition.
Addressing the long-run deficit and stabilising the debt will require more revenue. Even after the economy recovers, current tax policies will not generate enough revenue to cover future spending on social security, health, defence and debt interest, let alone basic government operations and investments. In 2012, federal tax revenues are likely to be less than 16 per cent of gross domestic product, compared with an average of more than 18 per cent in the 20 years before the crisis hit in 2008.
When the US economy is operating near capacity, total tax revenues – federal, state and local – are much smaller as a share of GDP than in other developed countries. And there is scant evidence that taxes as a share of GDP and economic growth are negatively correlated. Indeed, there is a small positive correlation between income per capita and tax revenue as a share of GDP.
Special tax rates and allowances are a major reason why tax revenues are comparatively low in the US. So-called tax expenditures amount to about 7 per cent of GDP; more than what the federal government spends individually on defence, health and social security. Reducing the number and limiting the size of tax expenditures would simplify the tax code, remove distorting incentives and raise revenue. Mr Obama proposes to use some of the revenue from reforming tax expenditures for deficit reduction; Mr Romney would use all of it to cut tax rates, with disproportionate benefits to high-income taxpayers.
But tax reform should not come at the expense of progressivity. Income inequality is greater in the US than in the other developed countries of the OECD. The US tax system is considerably less progressive than it was a few decades ago and it does less to counteract pre-tax income inequality than other OECD systems.
Widening inequality is reflected in opportunity gaps between children born into different income groups and a decline in intergenerational mobility: an American child’s future income is more dependent on his or her parents’ income than in most other OECD nations. Mr Obama’s plan counters these trends. The Romney-Ryan plan exacerbates them.
Proponents of greater progressivity often call for an increase in corporate taxes but this would lead to slower growth and fewer jobs. The US has the highest statutory corporate tax rate in the developed world. Even after tax expenditures are included, its effective marginal corporate tax rate is one of the highest in the world. Business decisions about where to locate investments are responsive to differences in taxes and have become more sensitive over time. Of all taxes, corporate income taxes do the most harm to economic growth.
Both Mr Obama and Mr Romney advocate corporate tax reform that lowers the rate and broadens the base. The economic benefits could be significant. The current system has large unjustifiable differences in effective tax rates that influence business choices about what to invest in, how to finance an investment, where to produce and even what form of organisation to adopt. These differences distort capital allocation, add complexity, increase compliance costs and reduce corporate tax revenues.
A lower rate would stimulate investment, narrow the tax preference for debt over equity financing and weaken the incentives for international companies to move production to lower-tax locations. But lowering the corporate tax rate is expensive – each percentage point reduction would cut revenues by about $120bn over 10 years. Scaling back the three largest corporate tax expenditures to pay for a cut could increase the cost of capital, thereby reducing investment and growth.
A more efficient and progressive way to pay for a lower corporate tax rate would be to increase taxes on dividends and capital gains. This would shift more of the burden towards capital owners and away from labour, which bears the burden in the form of fewer jobs and lower wages. Mr Obama proposes to raise rates on capital gains and dividends for the top 2 per cent of taxpayers. Most capital gains and dividends go to this group. Mr Romney would leave these rates unchanged for this group.
The US economy needs efficient and progressive tax reform and it needs more revenues for deficit reduction. Revenue increases have been a significant component of all major deficit-reduction packages enacted over the past 30 years. This must be the case now, too. Additional revenues as part of a credible long-run deficit-reduction plan and supported by progressive tax reforms will boost economic growth and job creation.
The Atlantic | December 12, 2011
A solution to pay for $300 billion of stimulus that doesn't include the words "tax hike" or "spending cut"
It's become a Christmas tradition for Congress to end the year by extending all the policies which expire at year's end. There is the Alternative Minimum Tax, which has to be "patched" every year so that it reaches only four million taxpayers instead of thirty million. There is the looming 27% cut in Medicare payments to doctors which policymakers will need to protect with a "Doc Fix." And on top of that, this year, we're dealing with the expiration of a payroll tax holiday and extended unemployment benefits meant to help boost a weak economy.
Extending these provisions every year is really expensive. It comes out to about $275 billion for a single year. That's more than a quarter-trillion dollars added to nation's credit card.
But here's the good news. For the first time in a long time, our politicians are actually talking about finding spending cuts and tax increases to finance the costs of these extensions. Democrats are focusing on a new tax for millionaires. Republicans are focusing on cuts that will impact the size and cost of the federal workforce. With our debt already on a dangerous path, anything worth having is also worth paying for. But Democrats will balk at an all-cuts solution, and Republicans have made it clear they don't want to raise taxes.
I have a different solution. It's a single, simple change. It wouldn't drastically cut domestic spending. It wouldn't change tax rates. Instead, it would pay for a payroll tax cut, AMT patch, and unemployment extension with a slow, phased-in policy called "chained CPI." Don't know what that is? Let me explain.
WHAT'S CHAINED CPI?
Every year, wages and prices go up. The government wants to measure this inflation to index everything from Social Security checks to tax brackets. The government makes these measurements by focusing on a "basket of goods" to compile its so-called consumer price index, or CPI.
The weakness of regular CPI is that we don't account for when consumers start changing their relative buying habits. If the prices of apples skyrocket, the regular CPI assumes cost-of-living will go way up. But in the real world, most people just buy fewer apples and more oranges.
Moving to the "chained CPI" corrects for this technical flaw by trying to provide an honest assessment of each month's basket and creating a "chain" between them. Moving to a more realistic measure of inflation would save well over $200 billion over the next decade, including from Social Security, other inflation-index programs, and from the tax code.
5 REASONS IT'S A GREAT IDEA
1) Social Security Savings Pay for Social Security Losses: Since the payroll tax is used to finance Social Security benefits, a payroll tax holiday necessarily takes revenue out of the system -- about $120 billion worth. Last year, we made up that money through a transfer from general revenue; but those types of transfers -- necessary as they might be -- threaten the contributory nature of the program. The chained CPI, though, would lead to savings within the Social Security program from lower COLAs. This would allow the Social Security trust funds to make up the lost revenue in ten years; and after that the chained CPI would help to close over a fifth of the long-term funding cap.
2) Income Tax Revenue for an Income Tax Cut: Patching the AMT will cost us $90 billion worth of income tax revenue over the next year or so. But because the income tax has so many parameters indexed to inflation, switching to the chained CPI can help us make that money back. The main reason chained CPI raises revenue is because of something called "bracket creep," where growing incomes push people into higher income tax brackets over time. Because we over-measure inflation, though, income is not being pushed as fast as they should in an inflation-indexed tax code. Using the chained CPI to index the tax code would reduce the deficit by about $60 billion through 2021, and make future AMT patches roughly $40 to $50 billion cheaper.
3) Other Spending Cuts for Other Spending: In addition to the Social Security and revenue savings, switching to the chained CPI would save over $50 billion over a decade by slowing the growth of various government benefits and eligibility thresholds. This mandatory savings should be enough to pay for an extension of unemployment benefits.
4) A Pro-Growth Phase-In: Sharp immediate deficit reduction could prove economically dangerous in a time of weak growth, but the markets also need to see a credible plan to reduce the deficit over the medium and long-term. The chained CPI saves money because it grows a tiny 0.25% slower than the current CPI measure. Because of this, savings are very small up front but compound and grow over time in a way that provides substantial deficit reduction over the long-term.
5) It's a No Brainer: The chained CPI is the right measure of inflation -- economists and experts from the left and right agree on that. Ideally, it shouldn't even be an offset for new deficit spending -- we should just do it. Of all the hard and painful choices we need to make to right out fiscal situation, measuring inflation right is not one of them. We should get it done now, and move on to the serious choices.
The Atlantic | October 22, 2011
We've spent a quarter-century undoing the smart, simple tax reforms of 1986. Here's to hoping Washington can act like its old self before it's too late.
Today marks the 25th anniversary of the Tax Reform Act of 1986, the last major overhaul of the federal tax code. Signed into law by Republican President Ronald Reagan and championed by Democrats such as Bill Bradley and Richard Gephardt, the enactment of the law was a remarkable bipartisan achievement. It dramatically lowered marginal rates with a top rate of 28 percent, removed millions of working poor off the tax rolls, and simplified the tax code by closing a myriad of tax loopholes.
Unfortunately, many of the loopholes that the 1986 reform eliminated have returned, with a few extra ones slipped in for added measure. Since the law's enactment, more than 15,000 changes have been made resulting in a tax code that is several volumes longer than The Bible and requires 71,684 pages to spell out the rules. Because of this complexity, 80 percent of American households use a tax preparer or tax software to help them prepare and file their taxes.
But complexity is only part of the problem. The other is cost. Year-after-year, elected officials in Washington shovel more tax breaks into the trough (tax breaks now account for $1.1 trillion) causing both deficits and marginal tax rates to be higher than is necessary or optimal for the economy.
Despite the obvious need for tax reform, some in Washington are advocating that congressional Super Committee charged with finding a balanced deficit reduction package not tackle tax reform. They claim it's too complicated, too hard, or too long-term.
They're wrong. Delaying tax reform will only make implementing the solution harder and more painful. There has never been a better time in which to enact tax reform. The Super Committee was created as part of last summer's debt ceiling agreement to require Congress to vote up or down, without amendment, on tax reform as part of its plan to address the federal government's medium and long-term fiscal imbalance. This BRAC-like power is designed to limit the influence of special interests whose work in the past has littered the tax code with loopholes. This opportunity is not likely recur anytime soon. It is, therefore, in the Super Committee's interest to act now rather than wait.
Tax policy is complicated. But lawmakers on the Super Committee don't have to start from scratch. There are already a number of plans that would dramatically lower marginal rates for individuals and businesses, eliminate tax expenditures, and grow revenues for deficit reduction. For example, the Zero Plan put forward by the Bowles-Simpson Fiscal Commission (what some refer to as 1986-style tax reform on steroids), would lower marginal rates and simplify the tax code from six to three tax rates, tax capital gains and dividends as ordinary income, eliminate the burdensome Alternative Minimum Tax, align the corporate and the top individual rate, move our corporate tax code to a territorial system, and eliminate all or most of the $1.1 trillion in tax expenditures.
Furthermore, the Super Committee does not to choose between writing a full tax reform bill in two months or agreeing to an open ended process for tax reform in the future. The Bowles-Simpson Fiscal Commission, Gang of Six, and others have proposed setting up a procedure for expedited consideration of tax reform that sets out parameters and criteria for what tax reform must include in addition to the revenue target while leaving details to the Senate Finance and House Ways & Means committees. Such an approach ensures true tax reform will be voted on while leaving the details to those who have the expertise to get the job done.
In addition, fundamental reform, which broadens the base by reducing deductions, credits, exemptions, and other tax expenditures; simplifies the code; and lowers individual and corporate tax rates, has the potential to substantially improve economic growth. The Joint Committee on Taxation has estimated that income tax reform that wipes out most tax expenditures in order to lower marginal rates, could increase the size of the economy by 1.2 to 1.9 percent of GDP over the medium-term, and even more over the long-term.
Finally, the new revenues generated by fundamental tax reform would help the Select Committee to achieve substantial deficit reduction. The Super Committee is charged to identify $1.5 trillion over ten years in deficit reduction, though $1.2 trillion over ten years would be enough to avoid an automatic sequester. While this would represent significant savings, members should be shooting t at least double, or triple this target in order to put the debt on a sustainable course. Relative to a realistic budget baseline, it would take about $3 trillion in deficit reduction just to reduce the debt to below 70 percent of GDP by 2021 and put it on a modestly downward path. Identifying an amount of deficit reduction significant enough to put the debt on a downward path will almost certainly require looking beyond discretionary spending to major entitlements, other mandatory programs, and ways to produce more revenue.
No doubt taking up tax reform will be a difficult challenge for the Super Committee. But the benefits of enacting fundamental reform are worthy of the effort. Besides, enacting tax reform is a whole lot better for the economy, and for politicians of both parties, than continuing the on-going fight over extending the Bush and Obama tax cuts for another year.