William G. Gale
William Gale is the co-director of the Tax Policy Center alongside Eric Toder. Gale is the Arjay and Frances Miller Chair in Federal Economic Policy at the Brookings Institution. He is a former assistant professor of economics at UCLA and senior economist at the Council of Economic Advisers. He is coeditor of Economic Effects of Fundamental Tax Reform, Rethinking the Estate and Gift Tax, and Private Pensions and Public Policies. Gale is also director of the Retirement Security Project at the Brookings Institution.
Unlike many previous Republican proposals to cut taxes, the Michigan congressman specifies how government would pay for them. This is critical, but it’s not pretty.
On Wednesday, U.S. Rep. Dave Camp (R-Mich.), chairman of the House Ways and Means Committee, unveiled an ambitious plan to overhaul America’s complicated tax code. This is both a technical and a political feat. The number of changes is immense — the table of contents listing the provisions runs for 8 pages. The number of political enemies created is probably equally immense.
The news that people will want to hear is the proposed cut in tax rates. Officially, income tax rates would fall to 10% and 25%. The alternative minimum tax would be repealed. For corporations, the tax rate would be reduced to 25% from 35% and the tax treatment of international income would be changed almost all the way to a system that exempts foreign income.
Unlike many previous Republican tax-rate-cutting proposals, Camp’s actually specifies how he would finance these changes. This is vital, but it is not pretty. Here’s why:
- First, the effective rates that people would face will be higher than they might look. There is essentially a third bracket, at 35%, for those with high income. The proposal would phase out a variety of benefits as income rises and impose surtaxes on high-income households. These provisions raise revenue but they also raise the effective marginal tax rate to higher — and possibly significantly higher — levels compared to the “official” tax rates. They also complicate tax planning and filing.
- Second, the state and local income tax deduction would be eliminated. Mortgage interest deductions would be restricted.
- Third, Camp adopts President Obama’s proposal to limit the value of itemized deductions. Camp would cap them at 25%, slightly less generous than Obama’s proposed cap of 28%.
- Fourth, literally, scores of targeted provisions are slated for deletion. Lobbyists will howl, but this is what tax simplification looks like.
- Fifth, there are some items that can only be described as budget gimmicks, such as an increased emphasis on Roth IRAs versus conventional saving incentives. Because Roth IRA contributions are not deductible, a switch from traditional, deductible IRAs to Roths will raise revenue within the 10-year budget window, even though it reduces long-term revenue by even more. Thus, what looks like a revenue increase is actually a long-term tax cut. A number of other provisions, like phasing in the corporate tax rate cuts and reducing depreciation allowances have the same effect. They induce long-term budget shortfalls that are not accurately represented in the 10-year figures.
With all of these changes and caveats, the Joint Committee on Taxation scores the proposal as roughly revenue – and distributionally neutral over 10 years. If this conclusion holds up over time, it is an important one, since the proposals invokes many changes moving in different directions. For example, the personal exemption is eliminated, but the standard deduction is raised. The earned income credit is reduced but the child credit is increased. The net effect of these changes on low-income households is estimated to be roughly a wash. But it will be important for policy makers and the public to think of these changes as a package. If provisions are cherry picked, by policy makers or advocates, the proposal can be made to look much more regressive or progressive than it is. Likewise, there are numerous provisions affecting the well-off that the proposal offers as a package.
Interestingly, despite the pro-business aura of the proposal, the proposal would cut individual income taxes and raise revenue collected from business. The proposal does little to change Obamacare. In fact, it would retain the high-income surtaxes that the Affordable Care Act created, though it does propose to repeal the medical device tax.
While the basic contours of the proposal are clear, there remain a lot of unanswered questions in understanding the potential impact of the proposals, in particular in terms of how the various provisions would interact.
What seems more certain is there will be immense political opposition to the changes proposed. That is the Achilles heel of tax reform proposals that aim to broaden the base and take away people’s cherished deductions.
Still, Camp’s proposal opens the door for a potential conversation. While it seems extremely unlikely that anything could happen soon on tax reform, it also seemed that way in the 1980s for a long time leading up to the tax reform act of 1986.
The year in taxes started with the nation toppling, briefly, over the fiscal cliff. And it ended with some interesting policy proposals on tax reform though little political progress.
Remember the fiscal cliff? While that crisis was resolved on New Year’s Day, it really began in 2001, when President George W. Bush signed the Economic Growth and Tax Relief Reconciliation Act (EGTRRA). The big tax reductions in that law were originally slated to expire by or before the end of 2010. After various extensions, they were to expire at the end of 2012, along with a variety of other temporary tax cuts related to the payroll tax, the alternative minimum tax, and tax benefits for workers and families with children.
President Obama wanted to extend EGTRRA’s middle-class tax cuts but vowed to let income tax cuts for the top two brackets to expire. Most Republicans had signed the No New Taxes pledge and wanted to extend all the Bush tax cuts though they were willing to let the payroll tax cut and other economic stimulus provisions expire. The looming expirations led to last winter’s fiscal cliff
In the end, Congress did not approve an extension of most of the tax cuts until late on New Year’s Day. Because all the Bush tax cuts had technically expired, Republicans could say they had not violated their No New Taxes pledge. After all, now they were cutting taxes for most people. President Obama signed the American Taxpayer Relief Act of 2012 (ATRA) on January 2, 2013. The law included:
- An increase in the individual marginal tax rate from 35 percent to 39.6 percent for individuals with taxable income over $400,000 and for couples over $450,000.
- An increase in the rate on long-term capital gains and qualified dividends from 15 to 20 percent for high-income taxpayers.
- A permanent increase of the AMT exemption amount to $50,600 in 2012 for individuals and $78,750 for married taxpayers filing jointly, with indexing of the AMT for inflation.
- A higher effective estate and gift tax exemption in 2011, indexed for inflation, with a marginal estate tax rate of 40 percent.
- Permanent extension of tax benefits for having children, education, being married.
- Repeal of the phase-out of personal exemptions and limits on itemized deductions for individuals with income over $250,000 and couples with income over $300,000.
- Extension through 2017 of expansion of the EITC, increased refundability of the child tax credit, and the American Opportunity tax credit (for college expenses), all of which were part of the 2009 economic stimulus act.
ATRA did not extend the 2 percent of wages payroll tax cut that had been in effect in 2011 and 2012.
Although ATRA is described usually as a tax increase, the R in ATRA actually stands for “relief” that is, a tax cut. The confusion arises because there were so many expiring provisions at the end of 2012. ATRA could be described as either a $618 billion tax increase (relative to maintenance of all of the provisions that had been in place – that is, relative to so-called “current policy”) or a $4 trillion tax cut (relative to the actual law — the R in ATRA stands for “Relief.”)
Compared to current policy, the act increased taxes on high income taxpayers. The distributional effects of ATRA affected largely those in the top 1 percent . They saw an average federal tax increase of more than $50,000 (about 3 percentage points increase in their average tax rate) while those in the top 0.1 percent faced an average increase of about $320,000 (equal to about a 4 percentage point average rate increase).
The rest of the year was quieter, but saw discussion on tax reform. Ways and Means Committee chair David Camp (R-MI) issued a number of working papers on the taxation of corporate and non-corporate businesses, territorial taxation, and the taxation of financial products. While Camp had said he wanted to introduce a tax reform bill in 2013, he never did.
In November, Senate Finance Committee chair Max Baucus (D-MT) laid out his ideas for reforming the corporate tax code, both domestically and internationally. However, Baucus has not said when his committee would consider the measure.
Although Camp and Baucus do not appear to have reached agreement on how much revenue should be raised or on how to raise it, the two leaders have nonetheless raised some interesting ideas. But the sorry state of tax reform can probably best be summed up by a small business owner who attended the New Jersey stop of a listening tour that the two chairmen held last summer. She urged the two leaders to “get rid of the deductions that don’t affect me.” As long as that attitude prevails, meaningful tax reform will not happen.
In the aftermath of the recent government shutdown and the painful negotiations that brought the country perilously close to defaulting on government debt, policy experts are searching for a way to avoid a replay of this crisis.
After all, the recent congressional agreement only delays the next potential shutdown till January 15 and lifts the debt ceiling only until February 7.
While many Republican officials were willing to breach the debt limit, most economists and policymakers agreed that deliberately defaulting on the government debt would be an historic mistake, with long-lasting negative consequences. Even cutting other spending while paying bondholders would have carried significant downside risks.
What should be done to avoid another flirtation with default? (Let’s leave avoiding a shutdown for another day.) Some commentators, most recently the New York Times have proposed making the so-called “McConnell rule” the law of the land. The idea, named after Senate GOP Leader Mitch McConnell (R-KY), would allow the President to raise the debt ceiling unilaterally. Congress’s role would be limited to voting its disapproval of that increase. (McConnell’s suggestion to do this this was made originally in the context of a broader discussion that linked spending cuts to debt limit increases, but now his name has been applied to this part of his overall proposal.) This is essentially how debt ceiling issues were resolved earlier this year.
But making the McConnell rule law would be a mistake. It would enshrine the irresponsibility of all of those elected officials who have said they would never raise the debt limit to continue avoiding the responsibility for their actions. And it is based on a misunderstanding of why the debt ceiling has to be raised periodically.
Congress does not raise the debt ceiling periodically because the President likes the idea. Congress must increase it in response to actions (such as spending authorizations and tax laws) it has already taken. Allowing the president to raise the debt ceiling (because Congressional actions made it necessary) so Congress can then vote its disapproval makes no more sense than having Congress require the President to order a pizza and then vote to object that it has too many calories.
Forget about the animosity and mistrust between House Republicans and Obama. Just think about the Congress and the executive branch of government. The Constitution indicates that the government can not spend money, raise revenues or borrow funds without prior congressional approval. But when Congress OKs a budget where revenues are not sufficient to pay for spending (which it has done year after year for decades—with just a few exceptions) it does not concurrently approve the debt measures needed to fill the gap.
So, for example, Congress can legislate $100 in spending and $60 in taxes, but this does not automatically enable government to borrow the $40 difference. It can only do that by raising the debt ceiling. Implementing the McConnell rule would be asymmetric in that it would let the President authorize borrowing independently of Congress, but not revenues or spending.
A better solution would be to stipulate that when Congress authorizes spending, it is also authorizing the borrowing needed to finance that spending should tax revenues be insufficient. Like the McConnell rule, this would avoid showdowns over the debt limit. Unlike the McConnell rule, it would be consistent with the constitutional authority given to the Congress and it would require members of Congress to actually take responsibility for their actions and acknowledge that whatever spending they authorize does in fact have to be financed.
If you recently heard the news that Congress is debating the merits of raising the debt ceiling, don’t think you have time-traveled back to 2011 or to 2012. In the absence of Congressional action, and barring some extraordinary measures, the debt ceiling is set to be breached sometime in the next several weeks, and the U.S. stands to gain nothing by not raising it.
The debt limit “debate” is not about limiting the size of government, entitlement reforms, or tax reform. The proof of that is that there are no major items like that on the table right now.
Instead, Republicans in Congress are yet again debating whether Congress should authorize the government to pay for spending—wait for it—that Congress has already authorized the government to undertake! Yes, it really is that silly of a situation.
It is also cowardly—if the Republicans don’t want the spending to occur, they should specify the spending cuts, not put the United States in a literally impossible position by saying “you must spend this amount of money, but you are not authorized to finance that spending via taxes or borrowing.” When other countries authorize spending, they typically proceed by implicitly authorizing the increase in borrowing needed to fund such spending. Of the advanced economies, only Denmark has a mechanism like our debt ceiling, and it has never been used as a negotiating tactic for spending cuts.
While it is difficult to predict the precise magnitude and composition of the economic effects of hitting the debt ceiling, it is clear that the effects will not be good ones. At the broadest level, creating a politically manufactured crisis that threatens the full faith and credit standing of government debt hardly seems like a smart or patriotic thing to do. In recent testimony to Congress, my Tax Policy Center colleague Donald Marron (of the Urban Institute) noted that not raising the debt ceiling (or even toying around with the idea) could raise interest costs, and create economic uncertainty thus hurting the ailing economy.
The U.S. recently suffered economic costs just by flirting with the idea of not raising the ceiling. The debt ceiling showdown of 2011 has been estimated to have cost taxpayers $1.3 billion for that fiscal year and $18.9 billion over 10 years.
Actually hitting the debt ceiling would result in either a default or reduction in spending. If the U.S. were to default on its debt, even for the short-term, the economy could suffer the negative consequences. As Donald Marron has pointed out, the United States defaulted on some Treasury bills in 1979, and this small technical default caused T-bill interest rates to increase by about 60 basis points and remain elevated for at least several months thereafter. The effect of a sustained debt ceiling breach on interest rates could be significantly larger this time around. And with debt equal to 70 percent of GDP now, the overall effects of interest hikes could be substantial. Moreover, an increase in government rates will raise other interest rates on other lending that is keyed to Treasuries.
Cutting more spending from this weak economy would not be a smart strategy. CBO recently estimated that repealing the sequester could create between 0.3 and 1.6 million jobs in the third quarter of 2014 as well as increase real GDP growth by 0.2-1.2 percent.
The political craven-ness of Republican resistance to raising the debt ceiling can be seen by the fact that, even if the recent Republican House of Representatives budget had been enacted, we would still have had to raise the debt ceiling, if not now, then in short order, because even their budget proposes a significant increase in government debt.
If Republican members of Congress seem to be willing to allow the government to hit the debt ceiling, it may be because Republican voters want them to. A recent Washington Post – ABC poll showed that 61 percent of Republicans survey would support “Congress not raising the debt limit and letting the government default on paying its bills and obligations.” This held even though 66 percent of the Republicans surveyed agreed that if the government “cannot borrow more money to fund its operations and pay its debts… it would cause serious harm to the U.S. economy.” This is, to put it mildly, an odd set of opinions to hold simultaneously.
While Republican Congressmen and voters seem willing to negotiate over the full faith and credit of the U.S. government, in the end, the debt ceiling should simply be raised to pay for spending that Congress has already authorized and not used as a tactic that could hurt the United States, with no apparent gains.
Small businesses occupy an iconic place in the public policy debate and benefit from a broad range of tax and spending subsidies. But the economic issues surrounding small businesses and innovation are complex and nuanced, and not well understood. We are learning, however, that if Congress wants to encourage risk-taking, it may be better off focusing on new firms, not small ones.
In an effort to better understand the nature of small businesses and the government subsidies that support them, my Brookings colleague Sam Brown and I have reviewed decades of research in a new paper for the Kauffman Foundation. What we’ve found suggests Congress should tread very carefully as it thinks about how the tax code drives decisions by entrepreneurs to start and expand companies.
Being small, in and of itself, does not confer a special advantage to businesses in job creation or innovation. Rather it is young firms, which by definition start as small businesses, that serve these critical roles. Policies that aim to stimulate young and innovative firms may be very different than those that subsidize small businesses.
Sometimes, the very tax policies and other public programs that are aimed at helping small businesses may discourage their growth. For instance, when pro-small business subsidies or policies are phased out as firm size expands, they may unintentionally discourage businesses from expanding because expansion will lead to loss of those subsidies.
The tax treatment of small business, innovation and entrepreneurship will continue to be a front-line issue in tax reform. For instance, House Ways & Means Committee Chairman Dave Camp (R-MI) has proposed a package of potential changes in the way small business and other firms whose owners report their business income on their 1040s are taxed.
These reforms deserve a careful review. But Sam and I found that there is often a vast gap between the rhetoric that surrounds the tax treatment of small business and the reality.
Looking for a way to improve the operation of the economy, lower our dependence on foreign oil, reduce pollution, slow global warming, cut government spending, and decrease the long-term budget deficit? Then you should support a carbon tax, which could help the nation address all these issues simultaneously. A new paper I’ve written with Samuel Brown and Fernando Saltiel, Carbon Taxes as Part of the Fiscal Solution, argues the tax would even be a good idea if we didn’t have a budget problem.
Although a carbon tax would be new for the U.S. government, it already has been implemented in several European countries (though not always in the manner advocated by economists), Australia, and three Canadian provinces. California recently initiated a cap-and-trade system, which auctions carbon permits to companies and functions much like a tax.
A carbon tax makes good economic sense: Unlike most taxes, it can correct a market failure and make the economy more efficient. Although there are substantial benefits from energy consumption, there are also big societal costs that people don’t pay for when they produce and consume energy – including air and water pollution, road congestion, and climate change. Since buyers of fossil fuels don’t directly bear many of these costs, they ignore them when they decide how much and what kind of energy to buy. And that results in too much consumption and production of these fuels. Economists have long recommended a tax on fossil fuel energy sources as an efficient way to address this problem.
A carbon tax could significantly reduce emissions. Tufts University economist Gilbert Metcalf estimated that a $15 per ton tax on CO2 emissions that rises over time would reduce greenhouse gas emissions by 14 percent. Another study estimated that the European countries’ carbon taxes have reduced emissions significantly.
Estimates suggest that a well-designed tax in the United States could raise as much as 1 percent of Gross Domestic Product in new, revenue—money that could be used to reform other taxes, as discussed by Donald Marron and Eric Toder. Alternatively, those new revenues could help reduce the country’s substantial and unsustainable budget deficits.
A carbon tax would also reduce America’s dependence on foreign sources of energy and create better market incentives for conservation, the use of renewable energy sources, and the production of energy-efficient goods. The permanent change in price signals from enacting a carbon tax would stimulate new private sector research and innovation in developing energy-saving technologies and in harnessing renewable energy. The implementation of a carbon tax also offers opportunities to reduce and reform federal spending on other energy-related programs.
One downside: A carbon tax is regressive since low-income households use relatively more of their income to buy energy than those with higher incomes. However, this problem could be addressed by rebating some of the carbon tax revenues as refundable income tax credits or payroll tax credits.
Critics also fear that a unilateral U.S. carbon tax would hurt the domestic economy while doing little to reduce world-wide carbon emissions or levels. This view, however, understates the value of a permanent price signal for research and development and the social and environmental value of emissions reductions that would come from U.S. action. It also discounts the experience of other countries that have unilaterally created carbon taxes. There is no evidence that they paid a significant price, or any price at all, in terms of economic growth. Moreover, if there is ever going to be multilateral action to limit carbon emissions, the US – as the largest per-capita emitter of carbon dioxide – needs to take a leading role.
A carbon tax isn’t perfect. But relative to the alternatives, it has an enormous amount to offer.
The Congressional Budget Office released its latest Budget and Economic Outlook earlier this week. As always, the Outlook provides insight into the fiscal status of the federal government. My three overarching reactions are:
First, because American Taxpayer Relief Act of 2012 (ATRA) instituted tax changes that had been widely expected, the official (“current law”) baseline is now much more reflective of plausible outcomes than it has been in the past. Hence, the baseline is now a more reliable guide to the fiscal outlook.
Second, unlike in long-term budget scenarios – where rising health care spending is the single most important factor – there is no “smoking gun” in the 10-year projections. Mainly, there is “just” an overall continuing imbalance between spending and taxes. Revenue is not projected to collapse, as it did in 2009-12, but rather to grow to higher-than-historical-average levels. Spending isn’t spiraling out of control—it is at the same share of GDP in 2023 as it was in 2012. Large projected cuts in discretionary spending are offset by net interest rising to historically high levels and increases in mandatory spending.
Third, while we do not face an imminent budget crisis, the data in the Outlook imply that we are not out of the woods. The 10-year budget outlook remains tenuous. Even if seemingly everything goes right – in economic terms and in political terms – we are still on the edge of dangerously high debt and deficit levels with little room to spare. For example, under the current law baseline, even if:
- Revenues average almost 19 percent of GDP as projected from 2015 through 2023 (a level higher than revenues in all but 5 years since 1982),
- Revenues from the personal income tax rise steadily to 9.8 percent of GDP in 2023 (a figured exceeded only once in U.S. history),
- Defense spending falls to its lowest share of the economy since before WWII,
- Non-defense discretionary spending falls to its lowest share of the economy since before separate records were kept starting in 1962,
- Significant reductions in projected health care cost growth pan out as projected, and
- The economy returns to full employment in 2017 as scheduled and remains there without recession through 2023,
the implications are, nevertheless, that:
- Net interest payments will rise from 1.4 percent of GDP in 2012 to 3.3 percent in 2023 (tied for the highest level in history and a sign of approaching fiscal unsustainability),
- The full-employment deficit would reach 3.8 percent of GDP in 2022 and 2023 (other than in the 2009-12 period, these would be the highest levels except for four of the past 50 years).
- The debt/GDP ratio would be 77 percent by 2023. The ratio would be more than 20 percentage points higher in every year during the next decade than it was for any year between 1957 and 2007, and it would be more than double the 37 percent level it averaged during the 1957-2007 period.
- It would take $1.2 trillion in additional budget savings (beyond the sequester) to get the debt/GDP ratio in 2023 down to its 2012 level of 72.5 percent, and it would take a total of $4.4 trillion in adjustments to reduce the debt/GDP ratio in 2023 to 60 percent.
- Although not shown in the Outlook, which focuses on the 10-year horizon, debt/GDP would be projected to continue to rise sharply and indefinitely beyond 2023.
Under CBO’s alternative fiscal policy baseline or my own measure of a current policy baseline, all of the budget projections are worse. Read more»
The budget proposal House Budget Committee Chairman Paul Ryan (R-WI) released last week is, essentially, an effort to have low- and middle-class households bear the entire burden of closing the fiscal gap and bear the costs of financing an additional tax cut for high income households.
The Tax Policy Center (which I co-direct) analyzed the revenue policies as proposed by Rep. Ryan. We simulated the effects of repealing the AMT and reducing ordinary income tax rates to 10 and 25 percent. These proposals would cost about $3.2 trillion over ten years, on top of the $0.3 trillion lost from repealing taxes enacted to pay for Affordable Care Act, the $1.1 trillion lost from his desired reduction in the corporate tax rate, and the $5.4 trillion lost from first extending the Bush-Obama tax cuts (which he also supports). By 2022, the tax policies he has specified would lower federal revenues to just 15.8 percent of GDP. Talk about digging yourself a hole.
Ryan claims he can fill this hole by eliminating tax breaks, which he correctly identifies as “spending through the tax code.” At first glance, this sounds like a step in the right direction: broaden the base and lower rates. Yet, like many recent proposals, the devil is in the details. Ryan never specifies which specific tax expenditures he would cut.
At a time when our country faces a daunting fiscal challenge, Ryan asks nothing of the wealthiest Americans. His budget proposal would simultaneously cut tax rates for the rich and corporations while slashing programs for the poor and elderly: he would shift many federal low-income assistance programs to state governments and would transform Medicare into a premium support system that will shift health care costs to seniors if health care inflation cannot be controlled.
Although I agree that spending cuts are necessary to meet our fiscal challenges, so too are additional revenues, for many reasons. They are the only way to get shared sacrifice from the wealthiest Americans. They could reduce the draconian spending cuts that Ryan proposes. Until he specifies which popular tax breaks he would eliminate, the Republican’s budget is clearly a win for the rich and a loss for everyone else.
Lastly, it is worth highlighting that Ryan is gaming the system in creating budget estimates. His budget proposal is too vague to be scored, so he simply told the Congressional Budget Office to determine the effect of his budget proposal **assuming** the proposal achieves its stated goals for spending and revenues. This is not the same as the usual approach – which involves asking CBO to determine whether the proposal actually achieves its stated goals. Instead, Ryan dictates the assumptions he wants and walks away with a seemingly favorable CBO report. This is smoke and mirrors. Ryan may not be the only politician to use the system this way, but that doesn’t make his actions any more forthright or reveal anything informative about this plan.
Amidst the myriad proposals in President Obama’s budget are two “big ideas” that would raise revenue in a progressive manner without raising taxes. These important ideas should be emphasized in the discussion of tax and fiscal reform that the country should be having and will have to have sooner or later. (The President also proposes letting the Bush tax cuts for high-income households expire, which would raise marginal tax rates modestly for high-income households.)
Some background: Revenue increases are going to have to be part of the medium- and long-term fiscal solutions. The required spending cuts from solving the budget problem on the tax side alone would be too draconian to gain public support, and durable budget deals that addressed earlier fiscal problems in the 1980s and 1990s contained a balance of spending cuts and revenue increases. In addition, the public supports having a combination of revenue increases and spending cuts, rather than all one or the other. And, if shared sacrifice is a key theme for fiscal solutions, tax increases are the only way to ensure that households with very high income participate meaningfully in helping to close the fiscal gap the nation faces.
The first “big idea” is a specific proposal in the budget – to limit the benefit from itemizing deductions to 28 cents on the dollar. Current itemized deductions are expensive, regressive, and often ineffective in achieving their goals. The mortgage interest deduction, for example, does not seem to raise home ownership rates. Limiting the benefits of the deductions for top income households is a way of reducing the distortions created by the tax code, making taxes more progressive and raising revenue. All good ideas.
The second “big idea” is to repeal the alternative minimum tax and replace it with the so-called Buffett rule, which would establish a 30 percent tax rate for taxpayers with income above $1 million. As a guideline for tax reform, rather than a specific budget item, this proposal would move the tax system in the right direction, with a caveat. The alternative minimum tax was originally designed to stop taxpayers from taking excessive amounts of deductions or tax-preferred income, chiefly in the form of capital gains. However, as the tax has evolved, it now increasingly falls on middle-income taxpayers, and liability is mainly due to having many children or living in a high-tax state, hardly what most people think of as aggressive tax sheltering techniques. Replacing the AMT with a tax system that truly increased the progressivity of taxes and closed loopholes — what the Buffett rule is intended to do — would be an improvement.
However, there is that caveat — it will not be possible to do that in the existing system, without imposing either a big jump in taxes as households reach $1 million in income, or high effective marginal tax rates over a range in which the tax phases in. That is probably why the Buffett-AMT switch is being a proposed as a guideline for reform, rather a budget line item. Done right, and done as part of a broader reform, the switch would broaden the base, raise revenue, and reduce inequities in the tax system — all the right directions for tax reform.
If we are going to reduce the medium- and long-deficit, new tax revenues must be part of the solution. And those taxes must be progressive and as conducive to economic growth as possible.
Historical revenue levels will not be sufficient to fund the federal government in the future. We will need to control the ballooning costs of Medicare, Medicaid, and Social Security. However, because their enrollment will be growing with the aging population, additional revenue still will be needed.
Past major budget agreements included both revenue increases and spending cuts because using both sides of the budget provides a sense of fairness and shared sacrifice. Americans prefer a balanced approach to spending cuts alone
Interestingly, raising taxes has proved more effective at restraining spending than allowing the government to finance its outlays with deficits. Under presidents Reagan and George W. Bush, taxes fell but spending rose. Spending fell only in the 1990s, when President Clinton and Congress raised taxes. This makes sense, since raising taxes to pay for current spending makes it clear to taxpayers that there is a cost to current spending, whereas the cost of deficit financing, while real enough, are obscured by the fact that it is does not create current tax liabilities.
Done right, higher taxes will not destroy the economy. In 1993, top income tax rates rose to 39.6 percent, and the economy flourished for the rest of the decade. Even the massive tax increases during and after World War II-amounting to a permanent rise of ten to fifteen percent of GDP-did not hamper U.S. economic growth.
The best way to raises taxes is to broaden the tax base by reducing the number of specialized credits, deductions, and loopholes. For example, limiting the tax benefit of itemized deductions to 15 percent would affect mostly high-income households and raise more than $1 trillion over the next decade without raising marginal tax rates.
New revenues should come from a progressive tax, which means the tax burden on high-income, high-wealth households needs to rise. Last year’s debt deal contained only spending cuts that place almost the entire burden of closing the fiscal gap on low- and middle-income households but have little or no impact on high-income households.
Over the past 30 years, the share of total household income for the top one percent of the income distribution more than doubled. Yet, those high-income households have seen their average tax burden fall, not rise, during that period.
The claim that these tax increases will harm small business is often overstated. Most income for high-income households is not business income. Yet, a recent Treasury report shows that just 1 percent of small business owners would be affected by a “millionaire’s surtax.” And even those firms face effective tax rates likely to be zero or negative since they can immediately and fully deduct the cost of new investment, even as they finance it WITH tax-deductible debt.
In addition to income tax reform, our leaders should move the United States toward a system that taxes consumption (using a value-added tax for example) and nonrenewable and polluting energy use (by increasing gasoline taxes or implementing a carbon tax).
The VAT exists in about 150 countries worldwide. It can raise substantial revenue, is easily administrable, and is minimally harmful to economic growth. In addition, a pre-announced, phased-in VAT could accelerate economic recovery. Concerns about regressivity and transparency can be addressed, and concerns that it would fuel an increase in government spending are overstated.
Long-term challenges related to energy production and consumption and long-term fiscal challenges can be addressed together. A far-reaching, upstream carbon tax can reduce the deficit and our dependence on foreign oil, protect the environment, lower the costs of healthcare, and encourage the development of clean, sustainable energy sources without the need for costly, inefficient energy subsidies. In the absence of a full-blown carbon tax, raising the gas tax offers many of the same advantages.
None of this means the United States needs to move to European levels of taxation. But between the very low tax revenues we raise now-the lowest share of the economy in six decades-and the high levels of taxation in other developed countries, there is room to raise revenue in a way that achieves serious medium- and long-term deficit reduction and supports a reasonable level of government.