A Responsible Approach to Tax Reform

Last month, Senate Finance Committee Chairman Max Baucus (D-MT) released three tax reform discussion drafts. One of the most commendable elements in these discussion drafts is Baucus’ focus on the long-term impact of reform – ensuring it will not add to the deficit in future decades.

In a recent paper, we wrote about the importance of measuring long-term fiscal impact and the many ways it could be measured. While precise estimates of a policy become increasingly uncertain beyond the ten-year budget window, several measurement tools can provide policymakers with an indication of the fiscal impact of a policy beyond the ten year window.Senator Baucus adopted one of these measures, “steady-state analysis,” as the standard for tax reform to ensure that his corporate tax reform package is revenue-neutral even after temporary effects fade. As we explained in our paper:

A steady-state analysis shows the budgetary effect of a policy, disregarding aspects that result in temporary effects or timing shifts. This type of analysis is particularly useful for policies with both permanent and temporary effects. In those cases, the steady-state analysis would measure the effect of the former while ignoring the latter. The measurement can be expressed in dollar terms or as a percent of GDP. An advantage to this approach is that it controls for the “noise” associated with timing shifts. On the other hand, it ignores the fact that these shifts can create noticeable increases or decreases in  borrowing levels upfront that – though temporary – can continue to have effects in later years in the form of higher or lower debt levels and, thus, interest payments.

By focusing on the steady state, Senator Baucus can avoid the fiscal folly of paying for permanent corporate tax rate cuts with provisions which increase revenues temporarily. In particular, four sets of provisions proposed by Senator Baucus have significant temporary effects. All of these provisions generate at least a portion of their revenue from a timing shift or temporary increase in revenues that diminishes or disappears over time:

• Repealing last-in-first-out (LIFO) accounting rules (see our tax break-down on LIFO here and our write up of Baucus’s proposal here);
• Repealing accelerated depreciation in favor of a simpler schedule (see our tax break-down on accelerated depreciation here and our write up of Baucus’s proposal here);
• Repealing “full expensing” for research and experimentation, intangible drilling, and advertising (see our discussion of intangible drilling here, information on the advertising deduction here,  and write up of Baucus’s proposal here); and
• Imposing a one-time transition tax on corporate profits being held overseas, (see our write up of Baucus’s proposal here)

Most of these measures would continue to raise revenue over the long-run, but the revenue will fall as a percentage of GDP after the first decade. For example, repealing LIFO rules is likely to raise less than one quarter as much in the second decade as it does in the first. And studies suggest that revenue from repealing accelerated depreciation will modestly decline early in the second decade, and eventually begin to grow in nominal dollars, but still decline as a share of the economy. A steady-state analysis clears away these temporary revenue effects and measures whether the long-term revenue will increase or decrease.

It is also important to remember that some types of policies operate in the opposite direction. New “expensing” provisions (Baucus proposes a few for small businesses) cost more in the short-run than in the long-run, as does most transition relief. Policies that broaden the tax base that are phased in or grandfather existing property (for example, changing the deductibility of interest for new loans only), will raise more in the long-run than in the first decade. Temporary revenue gains could be used entirely to offset temporary revenue losses and still meet the goal of steady-state neutrality.

Steady-state analysis is not the only method to ensure that temporary revenue is not used to pay for permanent rate cuts that ultimately add to the deficit. Policymakers have a number of options for looking beyond the standard 10-year scoring window. As an example, they could look at the second decade impact – when most (though not all) of the timing shifts will have faded. Or they could use present-value analysis to determine revenue-neutrality over a long period of time – say 50 years.

Of all these approaches, steady-state analysis is the strictest way to approach reform that temporarily raises money – erring the most on the side of fiscal responsibility. All temporary revenue and the interest it produces represent permanent gains for the government that is never returned in the form of lower corporate rates.

This is not to say that the “steady state” measure is the absolute right one. Like every other measure, it has many flaws. This is also not to say that corporate tax reform has to meet this target if part of a broader plan – what matters most is the package as a whole, not each individual part. However, this measure does help ensure fiscal responsibility over the long-term.

The importance of a long-term focus should not be understated.  As we’ve explained, our long-term debt problems are very far from solved. Whether talking about tax reform, sequester replacement, or entitlement reform, policymakers should focus their efforts beyond the next 5-10 years in order to put us on a sustainable fiscal path.