October 31, 2014

Fiscal Cliff's Sticking Point Getting Less Sticky

The long-standing impasse on tax policy has basically boiled down to this: Democrats want more revenue, raised entirely from households with incomes over $250,000. Republicans don’t want any new revenue, and especially not from higher tax rates on the rich. It seems like an irreconcilable difference.

But if you get beyond the predicable partisan rhetoric there is room for optimism that a deal can be reached.

Republicans have begun to shed their single-minded devotion to anti-tax advocate Grover Norquist’s “no new taxes pledge”. Notable examples are Senators Bob Corker (R-TN), Saxby Chambliss (R-GA) and Lindsey Graham (R-SC) along with Representative Peter King (R-NY).

Many Republicans aren’t so enamored with Grover’s “no new taxes” pledge these days, because they don’t agree with the “no new revenue” interpretation. These Republicans recognize the economic difference between raising revenue by raising marginal tax rates, and raising revenue by broadening the tax base and reducing “tax expenditures”– the subsidies in the tax code. The former increases the size and influence of government; the latter reduces it.

For any Republican who feels the same way that Corker, Chambliss, Graham and King do, the common ground they share with the Obama administration on tax policy and deficit reduction is actually very large.

In every one of President Obama’s budgets, he has proposed to limit itemized deductions to the 28 percent rate, which has the effect of reducing (not eliminating) the value of deductions taken by households above the 28 percent income tax bracket (who happen to be, not surprisingly, those households with incomes above $250,000), so that those households just can’t get a larger subsidy on any given dollar value of activity (mortgage interest, charitable donations, etc.) than households with lower incomes would get.

It seems to make “eminent” sense (among economists at least) to eliminate or at least reduce the “upside down” nature of tax subsidies this way. Only because tax expenditures are subsidies brought over to the tax side of the ledger do we have so many government subsidies that are more generous the higher one’s income.

This year’s version of the President’s proposal to limit tax expenditures for higher-income households raises $500 to $600 billion over 10 years. (The Obama administration said $584 billion; the Congressional Budget Office said $523 billion.)

That only covers about one-fourth of the $2 trillion+ cost of extending only the “middle-class” portions of the Bush tax cuts, a tax policy President Obama also proposes in his budget.

For years CBO has scored a more aggressive version of the President’s limit on itemized deductions – one where they would be limited to the 15 percent bracket. This would raise more than a trillion dollars over 10 years ($1.2 trillion in CBO’s March 2011 report) – enough to cover a bit over half the cost of the extended tax cuts, even without extending these limits to the exclusions.

The more one is willing to broaden the tax base and limit or eliminate certain tax expenditures, the more one can “buy” extended lower tax rates. If significant-enough base broadening is too hard to do (politically or economically) to achieve a certain revenue goal, then rates will have to come up to at least somewhere between current policy and current law (with all tax cuts expired).

Both Republicans and Democrats seem to like this general principle of substituting a broader base for lower rates, and even the particular combination of limits on itemized deductions paired with continued, low marginal tax rates for most Americans. The details as to what extent deductions and exemptions will be capped or limited, and which households would be affected, and (therefore) which tax rates would be kept how low, are the specific points that should be the focus of bipartisan negotiations on this sticking point.

But it certainly doesn’t seem to help for Republicans and Democrats to keep emphasizing the tax policies they would each choose to implement if they were “king of the world” – for example, Democrats insisting that tax rates on the rich must come up to pre-2001 levels or even higher, while Republicans keep arguing for just the opposite.

The preoccupation with this particular line in the sand detracts from the broader areas of agreement on the base-broadening approaches, as well as the tax-policy reckoning ultimately facing all politicians and all of us: that tax burdens will probably have to come up on almost everyone, far from the “almost no one” fantasy tax policy world we’ve been stuck in.

We could get closer to a real-world view of tax policy, and to a successful, productive, bipartisan resolution of both the “fiscal cliff” issue and our longer-term fiscal challenges, if our politicians can lead the people this time – rather than be led by the polls that can’t possibly ask the right questions – and focus on the basic and essential math on tax policy that has got to be worked through. The groundwork of bipartisan tax policy ideas is already there though; elected officials just have to stop bickering from the corners and step onto that common ground.

Some of this common groundwork has to be done right away in the negotiations over what to do about the fiscal cliff – which is just the first installment of tough choices regarding the entire future path of the federal budget. Ultimately, for the larger and longer-term deficit reduction goal, however, it’s not just that more Republicans will have to break up with Grover over the “no new taxes” pledge in order to do smart tax reform; more Democrats will have to be willing to consider reforms to Social Security and the health programs (Medicare/Medicaid) that, as Lindsey Graham has recently put it, should be considered “eminently reasonable.”