Will Taxmageddon (aka Jan 1, 2013) spur a deal?

Joe Minarik’s plausible and demoralizing take on what will (likely not) happen in a lame duck session after the November election.

Historical look at top marginal tax rates

Timothy Taylor (h/t @tylercowen) has an interesting post on the revenue raised by different the U.S. tax code from 1958-2009 (total revenue and the distribution). This point in his review of this Tax Policy Center piece caught my eye:

2) Raising tax rates on those with the highest incomes would raise significant funds, but nowhere near enough to solve America’s fiscal woes. Baneman and Nunns offer this rough illustrative estimate: “If taxable income in the top bracket in 2007 had been taxed at an average rate of 49 percent, income tax liabilities (before credits) would have been $78 billion (6.7 percent of total pre-credit liabilities) higher, taking into account likely taxpayer behavioral responses to the rate increase.”

We need a fairly comprehensive tax reform that makes clear about how much revenue we need to raise (which is of course linked to the spending we want), and which not only focuses on marginal tax rates but the tax expenditures that are allowed to remain. We are entering a higher spending period by default given the baby boomers moving into Medicare and Social Security, with a lower-than-average tax code in terms of revenue collected. It seems likely that the effective tax rate will rise for most everyone.

More on frames for tax reform

Austin and Mark Spohr with interesting comments on my post yesterday arguing that you need to pick a level of GDP at to seek a balanced budget to be able to have a meaningful discussion about the important (but I say secondary) goals of fairness and economic growth. They got me to thinking and I try and work through some of it below.

Austin’s most basic comment/question is:

I don’t see why one must decouple and order as you (Don) did: fairness, economic growth, and the level of taxing and spending. What’s the objective (evidence or theoretical) basis for that? Aren’t the choices and framing here just manifestations of personal preference or values?

I don’t think they should be de-coupled, they are linked, but I was giving a rank order of the three frames through which to view tax reform. In terms of choices, preferences and values, I think in the tax reform/balanced budget debate there are a mixture of:

  • facts (with no change of current policy we will continue to have large deficits)
  • preferences/beliefs that at some point could become facts (if the debt-to-GDP ratio gets too large it will harm the economy). There is some evidence about this and theory as well, but at least some of it is cross national that makes it trickier to apply. This of course says nothing about appropriate level.
  • just plain preferences (I would prefer a more progressive tax code, all else equal)
  • predictions (without a net tax increase we will never have a balanced budget given any plausible level of spending that will be agreed upon). The key prediction is what is a plausible level of spending in an area, and then in total.

While Mark is correct that in theory we could have a balanced budget at almost any percentage of GDP (and there is tremendous cross-national variation), when thinking about the plausible levels of federal spending what any person is doing is making a series of predictions about spending on defense, health, social security, everything else combined, with interest on the debt being relatively fixed. Once you add the given “plausible spending decisions” to defense, health and social security (and debt service), you are then talking about ~15-16% of GDP in federal spending at minimum.

The most complete “liberal” deficit reduction plan is Center for American Progress that aims for balance at ~24% of GDP, while the Heritage and Senate Republican plans linked to a balanced budget amendment aim for ~18% of GDP.

For me to engage in a debate about fairness and economic growth in the tax code, I would need to roughly know which part of the 18%-24% of GDP range we were discussing. To do so, you have to make predictions about the plausible levels of spending on the big categories. We could have a more abstract discussion about fairness, for example, but I have trouble engaging it or viewing it as important without knowing what level of spending we are discussing, and the many answers to other questions that implies. That is how I think about it.


Three tax reform frames

There are three key frames that are needed to best think about tax reform: math, fairness and economic growth.

First math. Tax receipts must go up if we are ever going to have another balanced budget. There is some consensus that a tax reform that “broadens the base and lowers the rate” is the way to achieve this, and I agree. However, it is important to understand that we must have a net tax increase across all federal tax sources, or we won’t have a balanced budget ever again given any plausible spending scenario. The first frame for tax reform is math.

Second, the components of federal tax receipts could be changed, which raises the key issues of fairness and economic growth. In making trade-offs between these two values, it is useful here to recall the historical share of different sources of federal tax revenue (personal income and payroll taxes, corporate taxes, and all other taxes including excise and estate taxes). From the CBO’s latest report (p. 81):

Corporate taxes have been a relatively small proportion of total federal tax receipts for 30 years (~10-13% of total receipts) while income and payroll taxes have been much larger sources of federal receipts with income taxes being the more volatile of the two. Excise and estate taxes have been small and declining (note: these shares would be very different in 1950, with corporate and excise taxes much larger).

The projected increase in income taxes as a percent of GDP shown in the figure after 2012 is simply the tax code reverting to pre-2001 levels on January 1, 2013, and the dip in payroll taxes and subsequent increase in 2012 is the enactment of the payroll tax cut in 2011 and the sun-setting of same (above it is shown as ending on February 29, 2012 as is current law).

A great deal of discussion of the tax code and tax reform has focused on fairness, which is a key concept, but fairness needs to be anchored to a bottom line percent of GDP to be collected in taxes (the Fiscal Commission suggests 21% of GDP). Once a target percent of GDP to be collected in taxes is set, fairness must be discussed along side the impact of the tax code on economic growth (higher growth is better for the deficit and for jobs). If we are going to develop a plan that can produce a sustainable budget, all three of the following frames must be an explicit part of the tax reform discussion.

  • math
  • fairness
  • economic growth

The bottom line for tax reform if you want a sustainable budget is how will federal tax receipts be increased, not if.



Should charitable contributions be tax deductible?

CBO outlines 11 options for reforming the tax treatment of charitable contributions, 9 of which are designed to lessen the revenue lost from how the current tax code treats such contributions. The tax subsidy in 2006, the year CBO used for their detailed simulations, was 40.9 Billion on total contributions of 203 Billion.  CBO also estimates the impact of two policies (options 3 and 6) that would expand the tax benefits of charitable giving, by extending them to taxpayers who do not itemize deductions. Table 3 provides the essential overview:

The bottom line of this detailed analysis is that for the 9 options simulated that would lessen the current tax preference provided to charitable giving, CBO finds that the deficit reduction achieved is larger than the subsequent reduction in charitable giving. None of these reforms would eradicate our budget deficit by any stretch, but they would be a move toward balance, and charitable contributions would not decline by that much.

In the budget talks that are ongoing, tax reform may be the only politically possible way in which to raise revenue. While most everyone says they want to reduce the deficit, and many say that we need tax reform, once you get down to ending specific subsidies in the tax code, most people head for the hills (well, not that tax preference….). It is unimaginable to me that a reduction in the tax preference of charitable giving could pass both Houses of Congress as a stand alone measure. As part of a larger package, then maybe. That is why a bigger tax reform deal seems more likely to me than a small one, though I wouldn’t bet the farm on either.