Given that columnist Paul Krugman relied on Tax Policy Center estimates to level claims that Congressman Paul Ryan is a “flimflam man” and that Ryan’s plan to address our fiscal problems is a “fraud,” I think a defense of the Congressman is in order.
First, it is worth citing budget estimates from the Congressional Budget Office (CBO). According to CBO, Congressman Ryan’s Roadmap for
On the spending side, Congressman Ryan’s plan achieves these substantial reductions in our long-term debt through such things as progressive reductions in Social Security benefits, increases in the eligibility age for Medicare, and the replacement of Medicare benefits with a voucher starting in 2021 (with an average initial voucher value for 65-year-olds of $5,900 in 2010 dollars).
On the revenue side, Ryan has proposed creating an alternative income tax system that has two marginal tax rates, eliminates most deductions and credits, and exempts all interest, dividends, and capital gains from the individual income tax. Filers would get to choose between the existing income tax and the new system. Ryan would also replace the corporate income tax with a business consumption tax (essentially a value-added tax).
Krugman alleges fraud because CBO did not score the revenue side of the Congressman’s plan. (This is correct as the Joint Committee on Taxation is responsible for providing the official revenue score of tax legislation.) Instead, CBO assumed that total federal tax revenues will be equal to “those under CBO’s alternative fiscal scenario … until they reach 19 percent of gross domestic product in 2030, and to remain at that share of GDP thereafter.” Contrary to Krugman’s claims, this assumption is not unjustified. Ryan has explicitly stated that he is willing to work with the Treasury department to adjust the rates on his tax reform plan to “maintain approximately our historic levels of revenue as a share of GDP.” Since 1980 the federal tax revenue has been about 18 percent of GDP.
TPC did analyze Ryan’s tax-specific proposals and found they would fall short of this revenue goal. For example, Ryan’s proposal would lead to federal tax revenue of approximately 16 percent of GDP, which amounts to a $4 trillion revenue shortfall over ten years compared to the alternative fiscal scenario. But that doesn’t mean that Ryan’s plan is a fraud. Instead, it shows that Ryan’s vision of broad-based tax reform, which essentially would shift us toward a consumption tax, needs to be adjusted in order to meet his stated goal of matching historical levels of revenue as a proportion of GDP. This indeed poses a challenge to Congressman Ryan to make specific changes to his tax reform plan in order to meet his revenue goal. Reasonable people can disagree about whether we should close our long-term fiscal gap primarily through spending reductions or tax increases, but Congressman Ryan’s proposal makes a useful contribution to this debate.
Senators John Kerry (D-MA) and Joe Lieberman (I-CT) introduced a climate bill yesterday that, among other things, establishes a cap-and-trade program for greenhouse gases. The virtue of a cap-and-trade program is that it establishes a market price for a pollutant and allows flexibility within and across regulated entities in how to reduce emissions. But any cap-and-trade program must decide whether to allocate the pollution allowances for free or through a government auction, as well as how to distribute both the allowances and any auction revenue.
As I wrote previously for TPC’s “Desperately Seeking Revenue” event, a full auction of allowances, which in turn uses the revenues to reduce high marginal tax rates or reduce deficits, lowers the overall cost of any cap-and-trade program. In this link, I show how the Senate bill distributes the allowances. Unfortunately, the measure gives away most for free and devotes very little revenue to reducing either high marginal tax rates or deficits.
I share Howard’s criticism of the Senate proposition that characterizes a Value Added Tax (VAT) as “a massive tax increase that will cripple families on fixed income and only further push back America’s economic recovery.” However, my problem with the Senate vote isn’t that it opposes a VAT; rather, it’s that it rules out any VAT, even one that is part of a broader tax reform that reduces distortionary income and corporate taxes.
Howard says that conservatives’ arguments against the VAT don’t “make a lot of sense.” It’s important to remember that conservatives by and large have favored a shift towards a consumption tax. But consumption taxes take a variety of forms, and many conservatives have advocated for a Hall-Rabushka flat tax, which also has a consumption base and can easily be designed to be more progressive than a VAT. The reason for preferring consumption rather than income as the base for taxation is fairly straightforward: unlike an income tax, a consumption tax does not distort savings decisions, and thus is more efficient.
The conservative argument against a VAT is primarily political. The concern is that a VAT is less visible and less salient to the electorate than other taxes, and will therefore inure citizens to an inefficient growth in government. Milton Friedman famously regretted his role in helping to introduce income tax withholding because he felt that it led to growth in government. He also opposed a VAT because it “would be concealed in the total price the consumer paid and hence not perceived as a direct tax burden.” Another Nobel Laureate, James Buchanan, observed that excise taxes, which are included in the prices of goods, leave taxpayers “quite ignorant of the amount of tax that is paid,” and thus “the opportunity cost is not sensed by the taxpayer.” It is worth noting, however, that this “fiscal illusion” concern can work both ways – if the benefits of government programs are not visible, then the size of government can be inefficiently small due to lack of citizen support.
Unlike Howard, I don’t think this concern is baseless. The evidence for the fiscal illusion hypothesis is indeed mixed (Wallace Oates offers a good survey), as it is difficult to identify the direction of causality between the prevalence of insalient taxes and the size of governments. But a recent study by Amy Finkelstein, appearing in the Quarterly Journal of Economics, does offer some interesting evidence. Finkelstein examined the effect of tax salience by studying the impact of the adoption of electronic toll collection on toll rates. Electronic toll collection automatically deducts tolls as cars drive through toll plazas, and is thus less salient than manually paying cash at a toll booth. Finkelstein finds strong evidence that toll rates increased due to the adoption of the less salient electronic toll collection, supporting the hypothesis that there is a link between tax insalience and the size of government.
That said, concerns about the insalience of a VAT should not torpedo any consideration of a consumption tax. A Hall-Rabushka flat tax shares the efficiency advantages of a VAT and is more salient than a VAT because households have to file an annual tax return. More generally, with any given tax, policymakers have some control of the level of salience. With a VAT, for example, salience to taxpayers can be increased by such things as separately identifying the tax level on each sales receipt. Whether policymakers want to deliberately increase the salience of a tax is an interesting question.
Finally, I note in passing that given that the anti-VAT proposition passed with 84 (!) votes in the Senate, it seems odd that the title of Howard’s blog post is “Conservatives and the VAT.” Clearly, concerns about the possible negative effects of a VAT are widespread.
Increasingly generous tax subsidies for homeowners are doing little to help the housing market. The U.S. Census Bureau reported yesterday that housing starts for October were down 10.6 percent from the previous month to a seasonally adjusted annual rate of 529,000. After rebounding from a historical low of 479,000 in April, starts have largely moved sideways and reflect a still-anemic housing market.
Houses are not being built because too many homes remain on the market. This surplus was created by a surge in construction during the housing bubble, combined with a drop in household formation during the recession. There is currently a 7.5 month supply of new homes for sale, down significantly from the January peak of 12.4 months but still elevated by historical standards. The homeowner vacancy rate, which measures the percent of vacant homeowner inventory for sale, was 2.6 percent in the third quarter. This was down only slightly from the peak of 2.9 percent in the fourth quarter of 2008.
Those expecting the recently extended and expanded homebuyer tax credit to improve this situation are likely to be disappointed. As I’ve written previously, most people who will receive the tax credit would have bought a house without it. And, of the additional sales spurred by the credit, most are likely to shift renters into owners, which does not help absorb the excess supply of houses.
Indeed, the credit may unintentionally be weakening the rental market. The rental vacancy rate for the third quarter was 11.1 percent, which is a historical high. The Consumer Price Index showed a decline in rent by 0.1 percent for October. The weak market was also reflected in the housing starts data, as starts with two or more units fell by 34.6 percent in October.
In a timely analysis, the Congressional Budget Office (CBO) just published an overview of all federal programs that support housing. According to CBO, in 2009 the federal government devoted almost four times the amount to support homeowners ($230 billion) compared to renters ($60 billion).
CBO estimates that the homebuyer tax credit will cost $14 billion in 2009. The Joint Committee on Taxation estimates that the extension of the tax credit will cost $11 billion more. But by far the largest tax incentive is the mortgage interest deduction, which cost government coffers about $80 billion in 2009. Aside from the inefficiency of this tax subsidy, it is also not equitable, as over 70 percent of the dollar benefits accrue to households with adjusted gross income greater than $100,000 per year.
Government policies encouraging people to borrow to buy a home partially contributed to our housing and credit market problems. And recent policies that shift renters into buyers have not helped improve housing market fundamentals. The collapse of the housing bubble should lead to a serious re-evaluation of the tax incentives for homeowners.
Our grim fiscal outlook has led to renewed calls for a value added tax (VAT). As discussed by Greg Mankiw, conservatives have conflicting feelings about a VAT. The main appeal is that a VAT taxes consumption, so shifting from our current income tax system (which is actually a hybrid of an income tax and a consumption tax) to a VAT would remove existing disincentives to save, which in turn would promote long-term economic growth.
Yet many conservatives fear that a VAT, which taxes each stage of production, will lead to bigger government. As Milton Friedman wrote in 1980, “Because it would be collected by business enterprises, VAT would be concealed in the total price the consumer paid and hence not perceived as a direct tax burden. That is its advantage to legislators – and its major defect to the taxpayers.”
Friedman’s concern is now very much at the center of the new field of behavioral public finance. In the most recent edition of the American Economic Review, Raj Chetty, Adam Looney, and Kory Kroft, examine the effect of tax transparency – what economists call salience – on economic efficiency.
Traditionally, economists view the structure and application of a tax as unimportant. All that matters is the change in relative prices. But Chetty, Looney, and Kroft find that structure and application do matter. For example, they find that consumers are less likely to buy an item if a sales tax is explicitly listed on the product than if the same tax is instead added at check-out.
This simple finding has great political economy implications. With the traditional view that the magnitude of the tax is all that matters, the left/right debate among economists has focused on how responsive people are to a given tax. For example, would taxing labor lead to a small or large reduction in hours worked? The bigger the response, the more economically harmful the tax. But the new behavioral studies suggest that policymakers can actually manipulate the reaction to a tax. By making a tax less transparent, policymakers can trick consumers or workers into non-response, thus reducing the economic harm.
Chetty, Looney, and Kroft’s theoretical model indeed shows that efficiency increases as a tax becomes less salient. However, their model also shows that reducing the salience of a tax will necessarily harm consumers (albeit not by as much as it helps the government). In other words, tricking consumers into thinking a tax does not exist has two effects: 1) it leads them to poor consumption choices; and 2) it increases tax revenue because more transactions are taxed. In dollar terms, the harm to consumers is less than the increase in revenues. But whether or not you view an opaque tax as a useful policy instrument depends on whether you think the gains to government coffers are worth the reductions in consumer welfare.
As Friedman feared, government can go a step further. If complicated and opaque taxes can dull consumer response, they can also dull the political penalty associated with higher tax rates. An optimizing government could then increase tax rates by more than fully-informed voters would like. Amy Finkelstein, in the most recent edition of the Quarterly Journal of Economics, finds that drivers are less aware of tolls paid electronically and that switching from toll booths to electronic tolls led to a 20 to 40 percent rate increase. In other words, as salience goes down, tax rates go up.
The flourishing field of behavioral economics is improving our understanding of how psychological factors influence economic responses. But the risk is that policymakers will use these insights to deliberately temper healthy economic and political constraints on the growth of government.