Ben Harris is a Senior Research Associate at the Urban Institute. Harris focuses on federal tax and budget policy, state and local public finance, and retirement security. He was previously a senior economist with the President’s Council of Economic Advisers, a research economist with the Brookings Institution, and a senior economist with the House Budget Committee.
Congress’s latest flirtation with debt-limit default caused barely a ripple in the financial markets. Rates on short-term Treasuries spiked in early October, before quickly subsiding to more normal levels. The spread between one- and three-year Treasuries temporarily widened, but quickly fell back to a more normal trend. All told, financial markets barely blinked. Unfortunately, the next time may be worse. Here’s why.
If Congress is going to threaten the country with defaulting on bond payments, late October is a relatively good time to do it. In the year spanning October 1, 2013 to September 30, 2014, just 0.8 percent of interest payments were due on October 15st and only 6.3 percent were due on October 31st. (These calculations include Treasury bonds and notes, but not T-Bills.)
The small share of interest payments due in October meant that financial markets could absorb the threat of default—however small—without causing too much disorder. Money market funds could request that collateral come from the vast majority of bonds that would not be in default if no agreement were reached by the end of the month. Repo markets could charge higher rates on the small share of bonds scheduled to receive a payment on these days without disrupting the market for Treasuries too much.
The key point is that the threat of default does not affect all Treasuries equally, especially if the default is expected to be short-lived. If the market expects the fiscal disturbance to last only, say, a few weeks, payments would be missed (or more likely delayed) on only those bonds due to receive payment in the given timeframe. While a missed or delayed payment would undoubtedly have dire consequences for all Treasury securities, the expectation of a missed or delayed payment appears to have more severe effects only for those Treasuries with payments due near the expiration of Treasury’s borrowing authority.
Under the last-minute agreement reached on October 17th, the debt limit is suspended through February 8th. Unlike last October, large shares of Treasury interest payments are in mid- and late-February. As shown below, about one-third—32.8 percent—of Treasuries are owed payments on February 15th and another 5.5 percent are owed payments on February 28th (see chart). This time, money market funds and the repo markets might have more trouble handling the threat of default.
With such a large share of Treasuries potentially becoming toxic from the perspective of repo market and money market funds, the worry is that yields might spike. Demand for Treasuries not owing interest on February 15th or February 28th could rapidly increase, and market players might seek to replace these Treasuries with other highly rated securities. If this happens, we could see the differentiation between those Treasuries with payments due in February 2014 and those without.
The folks at the Bipartisan Policy Center, who have been closely tracking government cash flows, estimate that a binding borrowing limit will be reached sometime towards the end of February or early March, but this date could be moved up if expected tax revenues fall short. The Congressional Budget Office expects the hard borrowing limit to be hit in March, but notes that this date could fall to April, May, or early June if tax receipts exceed expectations. Judging by the chart below, a mid-May borrowing limit would be much worse than April or June.
The country’s last go-round with the debt limit was resolved before catastrophe, perhaps indicating that members of Congress do indeed understand the dire consequences of failing to pay bills owed. But the real point here is that even kicking the tires on default might be costly, and that the costs will probably rise if the budget mess resurfaces in February or May. Let’s not find out
When it comes to property taxes, location matters. In a new TPC report, my colleague Brian David Moore and I look at just how much property taxes vary across states and counties.
Using self-reported American Community Survey data, we find that residential property taxes tend to be close to $1,000 per year, with a small share of households paying substantially more, especially in Connecticut, New Jersey, New York and New Hampshire. In recent years, 48 percent of homeowners paid between $750 and $1,750 in property taxes. About one-third—31 percent—paid less than $750 and 21 percent paid more than $1,750. Just 3 percent paid more than $4,000, with a miniscule share of homeowners (0.2 percent) paying more than $8,000.
These tax burdens vary by state and county. As shown below, seven states—Connecticut, Illinois, Massachusetts, New Hampshire, New Jersey, New York, and Rhode Island—had per household property tax collections in excess of $3,500. Five states—Alabama, Arkansas, Louisiana, Mississippi, and West Virginia—had per household property taxes of $750 or less. In dollar terms, property taxes tend to be highest in counties in the northeast and the west.
The counties with the highest property taxes paid per homeowner are those surrounding New York City. Westchester, Nassau, and Bergen counties had the three highest average tax burdens, all in excess of $8,500; this in part reflects higher house prices and higher reliance on property taxes to provide state and local services. In general, the counties with the highest property tax burdens tend to be in New York and New Jersey, with all but three of the top 25 counties being from these two states.
Some of these differences are related to house prices, as rising housing values can increase property tax burdens. As a share of housing price, property tax burdens tend to be less than 1 percent—60 percent of homeowners fall into this group. An additional 37 percent of homeowners had property tax bills between 1 percent and 2 percent of their home’s value, and just 3 percent had property tax bills in excess of 2 percent.
Residents in all but fifteen states pay between 0.5 percent and 1.5 percent in taxes. Residents in four states pay less, while residents in 11 states pay more. The states with the highest average property tax burden as a share of housing price are New Jersey (2.0 percent), Texas (1.9 percent), and New Hampshire (1.9 percent).
Moving forward, the Tax Policy Center will regularly update these calculations as additional data become available.
Tax preferences for housing are under fire, with mounting evidence that these preferences are inefficient, unequal, and too expensive to warrant a place in the tax code. Critics of proposed changes in the tax treatment of home ownership argue that these reforms would slash home prices at the very time they are showing signs of recovery. But in a new paper, I find that changes to the deductions for mortgage interest and property tax payments might not reduce prices much at all, and some reforms might even boost prices.
I estimate the impact on metropolitan housing prices of the higher tax rates imposed this year on high income households as well as three proposed tax changes: President Obama’s 28 percent limit on selected tax expenditures; eliminating deductions for mortgage interest and property taxes; and limiting the tax savings from the mortgage interest deduction to 20 percent while providing a flat credit for closing costs.
The president’s 28 percent limit on itemized deductions would barely move housing prices at all, causing them to fall just 0.3 percent. The higher top tax rates put in place in 2013, which drive up the value of deductions for housing for high-income taxpayers, are estimated to increase home prices by an even smaller margin.
By contrast, completely eliminating the mortgage interest and property tax deduction—a drastic change that probably would only happen if accompanied by a new tax preference for housing—would cause housing prices to fall by an average of 11.8 percent in the 23 cities studied. Estimated price declines would range from 10.3 percent in Seattle to 13.8 percent in Milwaukee.
Some proposed tax changes might even boost home prices. I estimate that limiting the mortgage interest deduction to 20 percent while offering a flat credit equal to two percent of a home’s value would raise prices an average of 3.0 percent. Price gains would vary from 1.5 percent in Pittsburgh to 4.6 percent in Portland.
Price effects could differ from my estimates, depending on how individual markets actually work. The effects could be lower, especially in the long-run, if the stock of owner-occupied housing adjusts to price changes—this can happen through either new construction or conversions between rentals and owner-occupied units. Or the price changes could be larger if metropolitan housing markets are driven by a marginal homebuyer in a high tax bracket, rather than being segmented across taxpayers in various tax brackets.
These findings diverge from prior studies, including one of my own, because they derive from a different way of thinking about housing investment. Earlier studies analyzed only the ongoing costs of homeownership—including mortgage interest, property taxes, and foregone return to housing equity. My approach adds transaction costs such as transfer taxes, title insurance, and realtor and broker fees to the costs of homeownership.
Transaction costs can dominate the cost of homeownership, especially for homes owned for short periods. For a home owned for less than four years, transaction costs are the largest expense, exceeding interest, property taxes, or foregone return to housing equity. For a home owned for 11 years—the median ownership across cities in the study—transactions costs still make up about one-fifth the total cost of homeownership (see chart).
The findings offer two important lessons for the tax expenditure debate. First, although completely eliminating the tax preferences for owner-occupied housing would reduce home prices substantially, curbing those preferences probably would not. Second, reform that limits deductions for mortgage interest while subsidizing the cost of housing transactions could actually raise home prices.
There are lots of barriers to a more efficient tax code. This research suggests that concern over lower home prices should not be one of them.
Until the Great Recession, state and local governments played a remarkably constant role through down business cycles. For four decades, when the economy turned sour, state and local governments boosted their spending—mitigating the depths of recessions and adding to growth when the economy revived. (Of course, this growth was partially offset by the negative effect of taxes collected to pay for that extra government spending.)
It was different this time. State and local governments addressed looming budget gaps by cutting expenditures. Instead of contributing to growth, their budget cuts dragged down the recession even further. And when the economy turned a corner in mid-2009, state and local government consumption (i.e., current spending on government programs like police and fire departments, education, and health) and investment remained depressed—a big reason why the recovery has been so weak.
In a new paper, my Tax Policy Center colleague Yuri Shadunsky and I show what happened. Never before had the state and local consumption and investment been negative three years into a recovery, but in 2009, it was down by about 4 percent (see chart immediately below).
What was different? First, the Great Recession was longer and more destructive than any other post-war recession. The severity meant that many state rainy-day funds, which had been replenished after the 2001 recession and are designed to help states weather downturns, were insufficient to protect against the slump. Second, state and local governments were reluctant to sufficiently raise taxes to cover the decline in revenue (many states did raise taxes through higher rates or base broadening, but these measures replaced only a fraction of the lost revenue due to the recession). And third, the steep decline in housing prices meant that property tax revenues collapsed, though this took a while because assessments often lag changes in market value.
Like the decline in state and local consumption and investment, this fall in property tax revenue was unprecedented. In prior recoveries, inflation-adjusted property tax revenue typically grew by 10 percent three years after the recession had ended. But in 2009, property tax revenue was down by 1 percent (see chart below).
These trends reinforce what millions of homeowners and the long-term unemployed already know: This recession and subsequent recovery are very, very different.
The president’s FY 2014 Budget would limit tax benefits for workers with high-balance retirement saving accounts. Although critics call the plan a blow to workers’ retirement saving, I consider the plan a smart way to roll back the billions in tax breaks that go to investors who don’t need tax incentives to save for retirement. (As a recent senior economist with the President’s Council of Economic Advisers, my support for this provision might not come as a surprise, but note that I didn’t work on this proposal during my tenure at the White House.)
Under current law, annual defined-benefit distributions are limited to $205,000 per plan. The president’s proposal extends the limitation to defined-contribution accounts like 401(k)s and IRAs and recognizes that, unlike in the past, individuals may have multiple pensions. If the combined value of a worker’s retirement accounts exceeds the amount necessary to provide a $205,000 annuity, they can no longer receive tax benefits for retirement saving. As under current law, the maximum benefit level would be indexed to the cost-of-living and would be sensitive to interest rates, which determine the price of an annuity. This year, the cap would affect individuals with defined-contribution account balances exceeding about $3.4 million.
The absence of a cap on defined-contribution accounts allows some high-income workers to shield large amounts of saving from tax. A worker and his employer can contribute up to $51,000 each year to a workplace retirement account (a worker can contribute up to $17,500 on their own) and a worker without a retirement plan can generally contribute $5,500 annually to an IRA. Limits are higher for workers over age 50, and contributions can be made regardless of an account’s balance. The president’s plan would disallow new contributions if account balances exceed the limit, although balances could still grow tax-free.
One analysis estimated that the cap would apply to only one in a thousand current account holders aged 60 and older and would eventually affect just one in a hundred current workers later in their careers. While there are caveats with the analysis—the data are for 2011 and do not include defined-benefit pensions—the point remains that the proposal would affect few workers now or in the future.
Wouldn’t the president’s limit discourage saving? Probably not. Research has found that tax incentives for retirement saving have only miniscule impacts on overall net saving—contributions to retirement accounts mostly represent saving that would have happened anyway.
Besides, whether the president’s limit would reduce incentives to save is the wrong question. We should be asking whether it’s worth nearly $10 billion in tax breaks over the next decade—the amount of revenue this provision would save—to encourage wealthy, mostly elderly households to save perhaps a little bit more. The answer, especially for those who think the tax code is too riddled with tax expenditures, is that it’s not.
Finland’s government recently announced a broad fiscal reform package that cuts corporate tax rates—financed in part by higher taxes on corporate dividends. The plan makes sense for Finland and is worth considering here at home.
Finland will lower the corporate rate to 20 percent in 2014, down from the current rate of 24.5 percent (and 26.0 percent in 2011). The move follows rate cuts in competing European nations, including the UK and Sweden, and a planned rate cut in Denmark. Finland’s current corporate rate is at about the median in the OECD; dropping the rate to 20 percent will put Finland’s rate close to the bottom for European OECD countries.
Finland plans to pay for part of the rate cut by boosting the effective investor tax rate on dividends paid by companies listed on the Finnish stock exchange. (The reform is not a statutory rate hike, but rather a reduction in preferences for dividends.) Effective taxes will increase only on dividends, not on capital gains.
The swap makes sense. A lower corporate tax rate should help attract new business to Finland, which maintains an extremely open and competitive economy. As in other countries, a lower corporate rate will reduce distortions—such as the type and financing of business investment—that become more severe with higher rates. Moreover, the swap is likely progressive, and will help mitigate Finland’s rise in income inequality over the past decade.
The plan is not without drawbacks. One chief concern is that taxing only dividends of companies listed on the Finnish exchange will push firms off the bourse. Still, the reform’s benefits appear to outweigh the costs.
A similar reform would make sense in the United States. There is widespread agreement that the U.S. corporate tax rate is too high. Both President Obama and House Budget Committee Chairman Paul Ryan—a pair rarely in agreement—have called for a lower corporate rate. Despite a jump in tax rates in 2013 relative to last year—the top rate on dividends rose from 15 percent to 23.8 percent—tax rates on investment returns remain at historic lows for most taxpayers.
Moreover, trading a lower corporate tax for higher taxes on investors in the U.S. would be progressive. My TPC colleagues and I analyzed a revenue-neutral plan to tax capital gains and dividends as ordinary income while simultaneously lowering the corporate tax rate from 35 percent to about 26 percent; we found the plan would lower the average tax burden for the bottom 99 percent of taxpayers. (Implementing Finland’s plan today would pay for a smaller drop in the corporate tax rate because of the higher rates in 2013 and the fact that the reform would only raise taxes on dividends, not capital gains.)
Corporate tax reform in the U.S. seems to be inevitable, but questions remain over how to pay for it. Finland may have the answer.
Automatic enrollment is slowly gaining steam as the choice strategy to encourage retirement saving. A bold plan in California would eventually make the practice widespread and could revolutionize the state’s saving landscape.
Last September, the California legislature approved a framework for automatically enrolling private-sector workers in a retirement savings plan. Employers with more than five workers would have to offer a workplace retirement plan, automatically enroll employees in the newly established California Secure Choice Retirement Savings Plan (SCP), or face a fine. Workers enrolled in SCP would automatically contribute 3 percent of their pay to an IRA-like account unless they opted out; like an IRA, benefits would be based on account contributions and investment returns. Employers are only required to set up the plan, not to contribute to the account, and there is no explicit cost to taxpayers.
A third-party—either a private firm or California’s pension administrator (CALPERS)—would administer the plan, investing no more than half the pooled funds in equities. (A private administrator may be the superior option given CALPERS’ recent history of fraud and mismanagement.) Annual administrative expenses would be limited to one percent of fund assets. The framework also calls for a guaranteed return, although the details have yet to be ironed out.
The plan is a long way from becoming a reality. The framework calls for further study of the plan’s feasibility and costs, and additional legislation will be needed to turn the idea into policy. In addition, the IRS and Department of Labor must still rule on the legality of some of the details.
Nonetheless, California’s plan shows exceptional promise. By utilizing automatic enrollment, which has been proven to bolster enrollment in private 401(k) plans, the plan could bring more than 6 million workers into the retirement saving universe. It takes advantage of a pooled investment strategy to lower administrative costs and ensure a balanced investment portfolio. The benefits would be progressively distributed. Workers take the accounts with them if they switch jobs. The plan is entirely self-funded with no extra cost to taxpayers. And it’s entirely voluntary; workers who do not want to contribute may opt out.
But there’s one big drawback: the guaranteed return purchased from private firms. Guaranteed returns would be great if they were free, but they’re not. Workers would have to pay private firms to guarantee the investment return, which would increase investment fees, possibly a lot. The structure of the guarantee dictates the price. Guarantees that exclusively protect against steep losses or those that “collar” the return (i.e., impose a minimum and maximum return) are less expensive. Guarantees that ensure at least a modest return are pricey. One analysis put the cost of a guaranteed 2 percent real rate of return at 29 percent of contributions.
An important new study reinforces the benefits of automatic enrollment. In a sample of Danish workers, researchers at Harvard and the University of Copenhagen found that approximately 85 percent of retirement savers are “passive” savers. Passive savers don’t respond to price subsidies like tax benefits, but will save more if automatically enrolled in a savings account. Importantly, the researchers found that under a system without automatic enrollment, 98 percent of contributions to existing retirement accounts were simply offsets to other types of saving—a finding that casts doubt on the billions of dollars in tax expenditures now devoted to encouraging retirement saving.
California’s plan faces several hurdles before enactment. But the evidence suggests that if it ever becomes policy, the plan will go a long towards increasing retirement saving.
In two weeks, about $1 trillion in automatic spending cuts will begin to kick in, a testament to the inability of policymakers to reach a grand fiscal bargain. Allowing these cuts to happen would be terrible policy.
Here’s the background: In August 2011, Congress passed the Budget Control Act (BCA) as a last-minute solution to an impending debt ceiling crisis. BCA averted fiscal and financial disaster by allowing additional Treasury borrowing authority, but also put in place deficit-reduction measures that would cut the deficit by $2.1 trillion over 10 years.
These measures included caps on discretionary spending—cutting outlays by over $900 billion over the decade—and a requirement that Congress achieve an additional $1.2 trillion in deficit reduction. BCA stipulated that if Congress failed to cut the deficit by this amount (and it did), deficit reduction would be automatically achieved by “sequestration”—formulaic cuts in federal spending.
The cuts were originally due to begin on January 2, but fiscal cliff legislation pushed off the official commencement until March 1. On that date, the Office of Management and Budget will implement $85 billion in cuts for the remainder of the 2013 fiscal year—this translates into cuts of about 9 percent for affected non-defense discretionary programs and 16 percent for defense. If no action is taken, sequestration will reduce spending by $109 billion per year for the subsequent eight years. In all, cuts will total $960 billion, with an additional $216 billion in saving coming from lower interest payments.
Allowing sequestration to occur is a mistake. Here are five reasons why:
- It was never intended to take effect. Sequestration was designed to be so unpalatable that Congress would have to devise a better plan. Deep, immediate cuts in defense spending were intended to bring Republicans to the table while broad reductions in domestic programs were meant to push Democrats to compromise. Combined, these cuts were regarded as so severe that they would eventually force a grand bargain.
- It will hurt the economy. In its recently released Budget and Economic Outlook, the Congressional Budget Office (CBO) noted that the scheduled cuts in federal spending were a primary driver of the slow economic growth projected for this year. Cutting billions of dollars in federal spending in the middle of a tepid recovery is a mistake. Thousands of public-sector jobs will be lost; federal contractors will cut even more. (The Bipartisan Policy Center estimates that the sequester will cost one million jobs.) One of the lessons from the Great Depression is not to cut spending in the midst of a recovery. Let’s not repeat the error.
- The sequester slashes funding for discretionary programs to historic lows, but does not cut entitlements. Nearly all of the sequestered cuts come from discretionary programs that fund government operations. Even without the sequester, the caps imposed by the BCA will limit discretionary spending. Sequestration will drive down discretionary spending even further—to 5.5 percent of GDP by 2023—the lowest level in our nation’s modern economic history. Yet mandatory programs, accounting for $29 trillion in spending over the next decade, will be largely immune from cuts.
- The cuts are destructive and unfair. Arbitrary, formulaic cuts mean that federal budgeters have limited discretion in how the cuts are applied. Key public programs, such as Head Start, air traffic control, and law enforcement, will be cut; disaster relief for Hurricane Sandy will be cut as well. Others will be forced to unfairly bear a disproportionate burden. Medicare providers, for example, are on the hook for $112 billion in cuts—one-quarter of the non-defense cuts. There are better ways to cut spending.
- The federal government needs to offset the continuing contraction in state and local governments. If sequestration had been implemented in a typical recovery, it’s likely that state and local governments could pick up the slack. However, unlike in past recoveries, subnational governments have been laying off workers and contracting at an alarming pace. Sequestration, and near-term budget cuts more generally, will compound the problem.
Our country is in desperate need of a sensible framework for deficit reduction that includes future cuts to entitlement spending and new revenues from economically efficient tax reform. Arbitrary cuts aimed mostly at one relatively small piece of the budget are no substitute for a comprehensive deficit-reduction package.
The American Taxpayer Relief Act (ATRA), the New Year’s legislation that effectively forestalled the bulk of the January 2013 fiscal cliff, probably staved off a recession. But compared to doing nothing, Congress made the deficit worse by passing ATRA. New Tax Policy Center calculations show how much more deficit reduction Congress will need to approve to fill in the hole created by ATRA.
Had Congress not acted, nearly everyone would have paid more tax in 2013 than in 2012, military spending would have been slashed by about 9 percent, and non-entitlement domestic spending would have been cut by more than 8 percent. Instead, Congress delayed those automatic spending cuts for a couple of months, allowed most 2001-2009 tax cuts to expire only for the highest-income households, and let the 2010 payroll tax cut die.
By adopting ATRA, Congress shifted the deficit path scheduled under current law by extending most tax cuts not just for a few years but permanently. ATRA singlehandedly moved the deficit outlook under current law from one that achieved primary budget balance (where tax revenues equal non-interest spending, roughly the level needed to hold debt constant as a share of the economy) to a budget outlook that has deficits approaching 3 percent of Gross Domestic Product by the end of the decade (see chart 1). Differences in the projected deficit paths pre- and post-ATRA are shown below in chart 1.
Congress clearly is not finished with its deficit negotiations. It may have postponed certain decisions, but the country still faces hundreds of billions in cuts to discretionary spending, steep cuts in Medicare physician payments, and popular but temporary tax cuts scheduled to expire in coming years. My colleagues and I estimate that under a budget policy that extends current practices, deficits will exceed 5 percent of GDP in the later part of the decade (see chart 1). This scenario—denoted “Post-ATRA Plus Likely Policies”—assumes that Congress not only extends the “likely” policies just listed but also ignores the cuts mandated in the Budget Control Act and maintains discretionary spending at or above historical lows for the past few decades.
Congress will need to approve additional sizeable, but not insurmountable, deficit reduction to bring the economy into primary balance. A combination of tax increases and/or spending cuts totaling $150 billion per year from 2015 to 2017, followed by annual cuts of $300 billion, would stabilize the debt in the future(see chart 2).
One lesson of the past four years is that fiscal policy is a critical tool for macroeconomic stabilization. In the absence of the Recovery Act, economic growth would have been much worse, perhaps even negative in the near term. But a cost of using government spending to boost a weak economy, however, is a greater need for austerity during growth years. Running persistently high deficits once an economy recovers makes it much harder to provide effective stimulus the next time a recession hits. On Tuesday, the Congressional Budget Office will release updated economic and budget projections. The new estimates may show slightly different deficits than those shown above, but the song will remain the same: there is more work to be done.
Economic growth estimates released yesterday were not good news: the economy contracted in the fourth quarter for the first time since 2009, albeit by just 0.1 percent. Commentators have mostly attributed the mild contraction to a steep drop in federal defense spending and reduced inventories—each factor cut the quarter’s growth by about 1.25 percent on an annual basis. Those factors are likely temporary and probably won’t drag down future growth unless Congress fails to address the sequester in the next few weeks and defense spending takes a sustained hit.
A less noted problem is the continuing contraction in state and local government spending. State and local government consumption and investment have declined in 12 of the last 14 quarters (see chart). Such a continued contraction is unprecedented since World War II, and is even more surprising considering that these 14 quarters have followed the recession’s trough.
Economic growth over the past two years would have been respectable if not for the drag by local, state, and federal governments. If the government sector had maintained real consumption and gross investment in 2011 and 2012—that is, if its contribution to GDP growth had been zero—overall economic growth in each of those years would have been around 2.5 percent.
Perhaps today’s report will help members of Congress realize that government spending matters for short-run economic growth. Perhaps lawmakers of both parties will see that if the budget stand-off continues, and the deep federal automatic spending cuts now scheduled for March kick in, last quarter’s contraction could turn into a more sustained slump. Perhaps they’ll realize that there may be times for fiscal austerity, but that’s certainly not when our economic recovery is still so weak.