The Better Base Case

By :: June 5th, 2012

The Congressional Budget Office’s latest update, released today, provides a snapshot of fiscal policy in the short run, the medium term, and the long run. CBO disclosed its short-term analysis in May: If automatic spending cuts and tax increases kick in as scheduled at the end of the year, the U.S. could be thrown back into recession. Meanwhile, few quibble that in the long run, demographics and the continued rapid growth in medical costs will require spending that exceeds the capacity of our current tax system.

CBO’s midterm projection, however, is more controversial. The agency warns that over the next decade, continuing temporary tax policies – in particular the 2001/03 personal income tax cuts – will lead to unsustainable levels of annual deficits and debt.

But there is nothing inevitable about this excessively glum estimate. There is a far better alternative.

What if Congress retained the level of taxation set by current law, but collected the money in a much smarter way?

Of course, Congress could just do nothing. Allowing temporary tax policies to expire as scheduled would result in small and manageable federal deficits over the next ten years. However, many aspects of tax policy implied by “current law” are problematic—most notably, the Alternative Minimum Tax would hit an additional 50 million middle and upper-middle class households by 2022.

There is a better way. In an article published yesterday in Tax Notes, Ed Kleinbard, former Chief of Staff of the Joint Committee on Taxation, and I present an alternative post-2012 personal income tax regime, the “Better Base Case”. Quite simply, the Better Base Case would raise the same level of revenue as the CBO’s current-law baseline, but in a way that addresses the most troubling aspects of reverting to the tax laws in place in 2000. Specifically, we would let the temporary tax cuts expire as scheduled under current law and then make the following changes:


  1. Limit the value of personal itemized deductions to 15 percent
  2. Permanently patch the alternative minimum tax (AMT)
  3. Retain the child tax credit at its 2012 level
  4. Tax qualified dividends at the same 20 percent maximum tax rate that applies to long-term capital gains
  5. Restore the estate tax to its 2009 form ($3.5M indexed exemption and a 45% rate)

The resulting tax system is more efficient, more equitable, and (most importantly) meets the most basic requirement of a tax system—it raises the revenue required to fund the spending needs of the federal government. If nothing else, it provides a useful benchmark against which to measure other competing tax proposals.

We recognize that the level of revenue implied by the CBO baseline is uncomfortable for many to accept. Indeed, it is more than President Obama has proposed in his annual budgets. But we argue that it represents a minimum level of revenue necessary over the next decade to meet our current spending needs. And despite hyperbolic claims to the contrary, it would not significantly impact people’s work effort, or the pace of economic growth and job creation going forward.

We also acknowledge that an abrupt transition to this new regime would be inappropriate in a still weak economy. The Better Base Case is fully compatible with policies that would provide additional temporary fiscal support, either by phasing in tax increases or pairing them with other more stimulative tax and spending changes.

None of this is to say we oppose additional and more ambitious efforts to reform the tax system. However, those discussions, along with more fundamental debates about the role and size of government, should take place in a stable and rational fiscal context. That is what the Better Base Case achieves.

3Comments

  1. Michael Bindner  ::  3:40 pm on June 5th, 2012:

    Long term tax reform involving consumption taxes replacing payroll and some income taxes is one of those Much Better Case scenarios, but absent that, either Bowles Simpson or Rivlin Domenici would work (and are not that different). Indeed, enacting the Obama budget is not far from either. The problem is that no compromise is possible as long as there are pending GOP primaries. Once these have all been held, especially on the Senate side, then the prospect of all the automatic cuts and deductions kicking in will lead to some form of compromise. If Jamie Lynn Radtke wins in Virginia’s GOP primary, it makes it virtually impossible for the GOP to take the Senate – and makes the Democrats getting to 60 votes a real possibility if Collins and Murkowski switch sides. Given this, there will be great pressure to compromise before, not after, the election, along the lines of the base deal made by either the Gang of 6+ or by Obama and Boehner before Durbin and/or Cantor killed the bargain. As for the Better Plan, I expect that Dividend, Capital Gains and Corporate Income Taxes, as well as the top rate, will go to between 24 and 28%. No long term 20% rate is acceptable – indeed, with Pease and the ACA, the real capital gains rate goes to 25% automatically.

  2. AMTbuff  ::  5:33 pm on June 5th, 2012:

    The current law scenario is nothing that the American public support. They never supported, for example, leaving the AMT parameters without any inflation adjustment from 1993 to 2040. That’s what the current law assumes. As a baseline, it’s a complete fantasy.

    Current law tax policy has always been a partial fiction over the long term. Any unindexed parameters are not politically sustainable through decades of inflation. Those parameters will be indexed or they will be modified. What’s relatively new is the increased use of expiration to mask the fiscal effects of maintaining current tax and spending policy. Anyone using current law as a baseline is pretending to be fooled and attempting to fool you into accepting adverse change as if it’s not change at all.

    Only the very sophisticated people can see a huge increase in tax liability from year to year as really not a tax increase. Most of us are too dumb to accept the violations of common sense required to use the current law baseline.

    In reality, major adjustments in current spending and tax policy are required. Appeals to fantasy baselines of Medicare SGR (assumed huge payment cuts to doctors) or tax increase assumed under current law do not advance the necessary frank discussion. The starting point is current policy, period. The current law baseline game is the primary means by which the fiscal imbalance can has been kicked this far down the road by partisans on both sides. Users of current law baseline are enablers, on both sides.

    We have spending promises and current tax rates and exclusions. The two don’t balance now and it’s getting worse fast, even before you account for skyrocketing interest rates if the bond market loses faith. The most important decision is how to credibly achieve balance in the long run. The second question is how to build a bridge to that long-term balance.

    People who put the second question first are playing yet another partisan game, seeking to achieve an advantage in the long run resolution by advancing their position in the short run. That’s an irresponsible tactic which will backfire when the bond market loses faith and explodes the budget deficit.

    First things must come first. Do it for the children(TM). That means controlling government health care spending. Ryan has one way, and strict rationing as in the UK is another way. The public needs to choose. That’s step 1. It cannot be skipped.

    Then a tax reform and spending cut plan like Bowles-Simpson can be step 2. Step 3 is to sit back and watch the economy take flight now that the fiscal sword of Damocles has been permanently sheathed.

    If step 1 is not taken, the bond market will hand us steps 1, 2, and 3 all at once in the form of national bankruptcy. It will be much more painful to everyone, especially the poor. It will be our worst time as a nation since the Civil War. Nevertheless the economy will quickly recover to incredible growth rates once the impossible promises are voided and the unpayable debts are wiped out.

  3. D-Day Tax Roundup: 6/6/2012 « Roth & Company, P.C  ::  9:21 am on June 6th, 2012:

    […] debt would exceed the GDP by 90% in 2022 and would approach 200% in 2037. ” (C-span) Related: The Better Base Case (Joseph […]