Getting Outside the "Deficit-Financed Tax Cuts Box" on Tax Policy

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The Obama Administration is now considering a new set of tax cuts, primarily aimed at businesses, to further stimulate the economy.  It’s reported that a permanent extension of the research and experimentation tax credit is one of these new proposals.  This is just the latest sign that the Administration is stuck in its own “deficit-financed tax cuts box.”

The Obama Administration is now considering a new set of tax cuts, primarily aimed at businesses, to further stimulate the economy.  It’s reported that a permanent extension of the research and experimentation tax credit is one of these new proposals.  This is just the latest sign that the Administration is stuck in its own “deficit-financed tax cuts box.”

My first complaint about these new ideas for tax cuts is that they’re not really new at all; they’re repeats of essentially permanent tax cuts that are repeatedly renewed.  They are “temporary” in name only. The administration seems to have adopted the mindset that many policymakers in Congress (and not exclusively those from one side of the aisle) have long had — that the prescription for any kind of economic ailment should be more deficit-financed tax cuts.  But given the fiscal and economic outlook, and how the CBO explains they interact over the longer term (large deficits reducing economic growth), there’s no justification for deficit financing permanent tax cuts. That’s true even for tax cuts that may be good for longer-term growth (via the supply side of the economy) like the research tax credit.  Deficit-financing is only justified for policies that are designed to effectively and immediately boost economic activity where idle capacity exists — that is, policies designed to stimulate aggregate demand.

But let’s set aside that complaint and assume that administration officials think they have some good new ideas, better ideas, for effectively and immediately jump-starting the economy.  My suggestion:  If these types of tax cuts (or spending increases) have greater bipartisan support than other current proposals for additional stimulus, and if economists believe some of these ideas would be more stimulative than any portions of the expiring Bush tax cuts, why don’t we start considering these proposals as substitutes for the (already presumed) deficit-financed extensions of the Bush tax cuts?  Why consider these proposals only in addition to the deficit-financed Bush tax cuts, which continue to get a “free pass” in this town?  Substituting policies that are better at boosting the economy in the short term (i.e., policies better at the “three Ts” in being more “timely, targeted and temporary”) would maximize the stimulative “bang per buck” while avoiding an additional, more permanent increase in the deficit that could undermine the longer-term economic effects.

In coming up with a smart package of fiscal policies intended as short-term stimulus, policymakers ought to put together a list that ranks fiscal policies (tax cuts and spending increases) from most effective to least effective — including the various elements of the Bush tax cuts that are scheduled to expire at the end of this year. Then policymakers should settle on how much of a short-term increase in the deficit they are willing to put up with (and that our economy can tolerate), and only accept the proposals (and the necessary deficit financing) that fall above the cut-off line.  And I mean regardless of the low bar they have already set for the full complement of the Bush tax cuts via the administration’s policy baseline and the exemptions under statutory PAYGO rules.  We should be “leveling the policy playing field” and letting the Bush tax cuts “compete” with the rest of these proposals under fair terms.

And in terms of optimal tax policy for the longer-term economy, the federal tax system needs fundamental reform.  It so happens that a week and a half ago the President’s Economic Recovery Advisory Board — sometimes affectionately(?) referred to as “pee-rab” (PERAB) — issued its  long-overdue tax reform report.  I was on a long drive to visit family in Michigan, but fortunately Dan Shaviro and Howard Gleckman, two of my favorite tax policy experts and commentators, got right on the case and blogged on the report, right through their yawns.  Both were disappointed as well as bored.

In my mind this report was always doomed to be a boring disappointment — a pretty useless rehashing of academically non-controversial tax reform ideas that would do little to advance the political debate in the direction it desperately needs to go.  That’s because the effort began with the implicit premise that tax revenues don’t need to be raised — that we need revenue-neutral tax reform (raising the same level of revenue but more efficiently), when in fact the fiscal outlook makes it clear that we need revenue-gaining tax reform to support the spending needs of our aging population.  (While the largest pressures on the federal budget come from rising spending associated with the health care programs — Medicare and Medicaid — the longer-term budget projections make it clear that even with the health care reform already passed and our continued best efforts to “bend the health cost curve,” it seems highly unlikely that Americans would put up with the severity of the benefit cuts that would be needed to get to sustainable deficits relying on spending-side cuts alone.)  On top of that, the PERAB was told it not only couldn’t raise taxes on average, it couldn’t raise taxes on any households with incomes under $250,000 — i.e., all but the top 2-3 percent of households.  This restriction makes it hard to do anything to address the major sources of economic inefficiency/distortions in the tax system, because people all over the income distribution benefit from the various and very expensive tax expenditures (“holes” in the tax base) under the current system.

As a result, the PERAB tax reform report is like the tax-side equivalent to a no-pain, “cut (only) waste, fraud, and abuse” report.  It doesn’t tell it like it is in terms of what really needs to be done via tax reform (and all that can be done on the tax side of the budget rather than having to rely on severe benefit cuts from a spending-side-only approach) to help our nation fiscally and economically.  What we need to do isn’t complicated at all; it’s just kind of painful to hear.  Here’s my list that is simple if not sweet:

  1. Raise More Money. Raise revenues as a share of our economy above their “historical average” of 18 percent. The 18 percent figure is not the “right” number just because it’s been the average one.  In fact, we need to raise it above where current-policy extended would take us (just read the CBO reports to understand why). That means we have to start thinking of tax reform as how to raise more revenue, not just the same amount of revenue, in the most economically efficient and equitable way possible.
  2. Even Things Out. Raise revenues more efficiently by broadening and “leveling the playing field” called the federal income tax base. Raising revenues by filling in the “holes” in the income tax base (reducing tax preferences or “tax expenditures”) keeps overall marginal tax rates low by raising marginal rates only on those forms of income that currently face very low or even zero tax rates.  Raising effective marginal rates on those forms of income that are currently under-taxed would reduce rather than increase the distortionary effects of the income tax.  There are also fairness concerns that motivate such “leveling” of effective tax rates.
  3. Broaden Our Perspective. Compared with other developed nations, the U.S. federal tax system is very limited in what we tax: mostly productive forms of income that we’d really rather not have to tax.  As a result, we need to tax that income at a higher average rate than if we taxed more things. We should consider taxing more things that are — if not more pleasant to tax — at least less economically harmful to tax than the things we tax now.  International surveys of tax systems (such as reports by the OECD) make clear two major activities the U.S. mostly does not include in its federal tax base: (i) environmentally-harmful activities (e.g., carbon-based energy via a carbon tax), and (ii) consumption (via a value-added tax).  This is really a corollary to the “even things out” directive: by adding tax bases that are more efficient to tax but are currently under-taxed relative to taxable income, we can raise more revenue while leveling effective marginal tax rates (i.e., reducing distortions) across different sources and uses of income.

In being asked to stay away from any proposals that would raise revenue overall or would increase tax burdens for any households with incomes less than $250,000, the President’s tax reform panel was unable to come up with recommendations that follow these three essential tax reform principles.  I hope the President’s fiscal commission will be less constrained, because tackling the much broader task of achieving fiscal sustainability makes tax reform according to these simple “truths” about what’s needed even more critical.

At any rate, it’s clear that the Obama administration needs to pay closer attention to its own criticisms of Bush administration deficit-financed tax policies, because the current administration’s own tax policy agenda seems to be mostly more of the same. And although economic circumstances are now worse, most of these old prescriptions are still no more effective or justified.

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