September 3, 2014

Tax Policy in the President's Budget

In his Fiscal Year 2013 budget, President Obama proposes an array of tax proposals. Some of his suggestions are new and would move the country’s unfair, inefficient and overly complex tax system in a positive direction. But some of the most costly proposals are the ones we’ve seen many times before. Four points stand out in the tax proposals in the Obama budget:

(1)    The budget raises revenues only relative to the administration's policy-extended baseline and not relative to current law.

Under the Obama budget, revenues would rise from their current 15-16 percent of GDP to 19 percent by 2015, and to just over 20 percent by 2022. But under current law, all the 2001 and 2003 tax cuts are scheduled to expire at the end of this year -- so that revenues would exceed 20 percent of GDP by 2015, and 21 percent by 2022. Thus, relative to current law, the president is proposing a net reduction in taxes. Compared with the CBO's projections of the cost of extending all of the Bush tax cuts (and the “adjusted baseline” the administration prefers to start with), however, the president's proposals raise revenue. That’s because Obama proposes to let the high-income Bush tax cuts expire and to add some other tax increases on the rich and certain types of corporations.

Sorting the revenue gains from the losses, the Obama budget proposes tax policies that raise $1.91 trillion, and others that lose $352 billion, for a net tax increase -- relative to the policy-extended baseline -- of $1.56 trillion over 10 years. But this means that relative to current law, Obama proposes to cut taxes by $2.94 trillion.

(2)    There are more tax incentives for middle-class households and job-creating businesses than tax increases for rich households and “outsourcing” businesses.

The tax proposals in the Obama budget seem to easily sort out into: (i) tax cuts for middle-income households and certain types of businesses touted by the administration as good for creating American jobs; and (ii) tax increases (whether expiring tax cuts or new revenue increases) for highest-income households and certain other types of businesses suggested by the administration to be American-job losing or otherwise involving social costs.

Continued tax cuts for middle-income households: extensions of most of the expiring Bush tax cuts ($1.3 trillion) and Alternative Minimum Tax relief ($1.9 trillion), and extended or expanded new tax cuts "for families and individuals," including the American opportunity tax credit ($179 billion). Total: $3.4 trillion less revenue over 10 years.

New tax cuts for certain job-creating activities and industries: manufacturing tax incentives for domestic activity ($121 billion); tax cuts for small businesses ($25 billion); and new markets tax credit and growth zones preference ($8 billion). Total: $153 billion less revenue over 10 years.

Expiring tax cuts for the rich: letting the Bush tax cuts expire for these upper-income households, and in a slightly more aggressive way this year (more below) ($849 billion); and restoring 2009 estate tax rules ($143 billion). Total: $992 billion in new revenue over 10 years.

New tax increases for the rich and their activities, and for outsourcing and climate-changing industries: a new, more ambitious base-broadening proposal to reduce tax-rate-dependent, upside-down tax subsidies ($584 billion); taxing “carried interest” as ordinary income ($13 billion); international tax reform ($147 billion); financial and insurance industry tax reform ($19 billion); and elimination of oil and gas and coal industry tax preferences ($30 billion). Total: $794 billion in new revenue over 10 years.
In the Obama budget, the tax cuts for certain households and businesses outnumber the tax increases for the other types of households and businesses by about 2 to 1—by my calculation, $3.6 trillion vs. $1.8 trillion over 10 years.

(3)    The administration still fails to offset  the cost of its proposed extension of the bulk of the Bush tax cuts.

After all these years of policymakers insisting that the relevant starting point on tax policy is to assume full extension of all of the deficit-financed tax cuts, it's easy for us to forget that the extension and future financing of the tax cuts are policy choices that have to be legislated by Congress and signed by the President. Federal budget experts often quip that the fiscal outlook would be improved dramatically if lawmakers just stayed home so that they couldn't extend the Bush tax cuts. But the choices to extend and deficit-finance the tax cuts don't have to be all-or-nothing propositions. Extension of any portion of the Bush tax cuts -- or any other expiring tax cuts -- could be done in a more fiscally responsible way by sticking to strict, no-exceptions, pay-as-you-go rules. If policymakers won’t offset the cost of extending the tax cuts, they should let them expire. Having to pay for policies is a great way to be forced to consider if they're actually worth their cost.

It seems ironic that Congress had such a hard time agreeing to ultimately deficit-finance the extension of the payroll tax cut—a temporary tax cut designed to stimulate the economy at a cost of around $100 billion—but in late 2010 easily compromised on the deficit-financed extension of all of the 2001 and 2003 tax cuts—which had a price tag of nearly $3 trillion over 10 years, even without the cost of associated relief from the Alternative Minimum Tax or interest costs.

(4)    The Administration's new emphasis on enforcing the "Buffett rule" by reducing tax expenditures--rather than raising tax rates--could serve as a segue to achieving base-broadening tax reform.

The disparity between the low average tax rate paid by multi-billionaire Warren Buffett and the higher one paid by his middle-income secretary motivated the so-called “Buffett rule,” which seems to be the most fashionable concept in tax policy right now.  The administration’s version of the Buffett rule, as stated in its budget, says that "no household making over $1 million annually should pay a smaller share of its income in taxes than middle-class families pay."

There are lots of ways to exercise this general version of the Buffett rule to raise average tax burdens on millionaires.  Some of those ways are economically smarter than others. A specific surtax on incomes exceeding $1 million would increase the distortionary effects of the tax system by raising effective marginal tax rates on income already counted as taxable. Another proposal to create yet another alternative minimum tax targeted to millionaires would add another layer of complexity to the already complicated definition of taxable income and would neither broaden the tax base nor raise revenues from the vast majority of millionaires who already pay more than the specified minimum tax rate (30 percent in the proposal by Senator Sheldon Whitehouse (D-RI)).

Economists would prefer to raise millionaires' taxes by including more of their total income in what counts as fully taxable income, or by reducing the subsidies given to them through various tax expenditures. The Obama Administration should be commended for choosing to pursue these base-broadening ways to raise tax burdens on the rich, and avoiding the more “brute force” rate-increasing ways above, in their tax proposals designed to honor the Buffett rule.

I've recently discussed the limit of itemized deductions to 28 percent as a base-broadening, economically-efficient way to raise burdens on higher-income households.  President Obama has proposed this in all four of his budgets. But he went further in this year's budget to propose reducing a wider array of tax expenditures for higher-income households, including the exclusion of employer-provided health benefits. The proposal sticks to the idea of ensuring upper-bracket taxpayers benefit no more from these tax expenditures than they would if they were only in the 28 percent bracket. Administratively, limiting exclusions isn't as easy as limiting deductions, however, because additional information would need to be reported on individual tax returns. But the expanded proposal would improve the bottom line significantly; compared with the limit on itemized deductions only, the new version would raise about double the amount of revenue -- $584 billion over 10 years, according to the administration.

Also new this year is the proposal to not just let the tax rate on dividends go up to a less-preferred rate but to eliminate the preference entirely for high-income households, treating dividends as ordinary income.  This is also a way to broaden the tax base and reduce tax expenditures, while bringing up average tax rates for the rich, who are most likely to have investment income as a significant portion of their total income.

The Obama Administration’s  “Framework” for Business Tax Reform

This week the administration released a report on corporate and small business tax reform.  The theme is similar to the whole package of tax proposals in the budget:  keep statutory marginal tax rates low (or even lower) on everyone, but pay for those lower rates by broadening the tax base in ways that raise burdens on certain types of businesses--those who currently take the most advantage of the tax-expenditure holes in the tax base.  

Most of the proposals in this business tax reform framework were included in their budget, and are in the spirit of reducing tax burdens on small businesses and job-creating manufacturing companies, and raising tax burdens on certain types of industries and especially those corporations which have foreign employees and profits--as discussed in point #2 above.  Some of the ideas go further than the proposals included in the budget in terms of broadening the corporate tax base, and are essential in order to achieve the 28 percent revenue-neutral corporate tax rate the administration claims, but are not fully developed or explicitly included in the proposal. (For example, the reduction of corporate interest deductibility is part of the administration’s suggested “menu of options that should be under consideration in reform,” but no specific proposal to do that is described.)  The business tax reform framework also adopts its own Buffett-type rule applied to large, multinational corporations by proposing a minimum tax on firms with overseas profits as well as the reduction of tax expenditures benefiting such firms.  Taken as a whole, it is not clear that the package of corporate tax reforms explicitly proposed here would substantially reduce the economic distortions in the present tax system.  Without including more specific base-broadeners to support a lower marginal tax rate, the business tax reform “framework” would simply pay for new tax expenditures by reducing old tax expenditures.

An Overall Mixed Review

To conclude, to this deficit hawk looking at just the tax proposals in the Obama budget, it’s a mixed review.  It’s disappointing that yet again the administration cannot come close to sticking to the current-law levels of revenues—which would be possible even with extended tax cuts if the costs were offset under strict pay-as-you-go rules.  Without adherence to current-law revenue levels, it’s difficult to see how longer-term deficits can come down to sustainable levels, given the economic and political obstacles to achieving more large spending-side cuts.  And it does seem like typical election-year tax policy fare to propose a generous variety of new tax cuts that only add to the debt. But a very positive contribution of this budget to the tax policy debate is the administration’s version of the Buffett rule, which appears to emphasize the base-broadening, tax-expenditure-reducing type of revenue increases which are consistent with the goals of a bigger and broader fundamental tax reform effort for the individual income tax.  For its business tax reform framework to have similar merit, the administration will need to develop more specific proposals for the reductions in business tax expenditures that it now only suggests for consideration.