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.
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.
Today, President Obama outlined proposals to reduce the medium-term federal budget deficit. His proposal would pay for the $447 billion stimulus package he proposed last week and reduce the 10-year federal budget deficit by an additional $3.2 trillion, according to OMB estimates.
The $3.7 trillion ($3.2 trillion + $447 billion) in budget savings is categorized as follows:
–$257 billion in mandatory spending
–$320 billion in health care spending
–$1,084 billion in defense spending (overseas contingency operations)
–$1,573 billion in tax revenues
–$436 billion in net interest savings
The proposals would bring the deficit down to about 2.7 percent of GDP by 2014, where it would hover and then eventually fall to about 2.3 percent of GDP by 2021. The debt/GDP ratio would peak at just under 77 percent of GDP in 2013 and would fall to 73 percent by 2021. The budget would be in primary surplus by 2017 and reach a primary surplus of 0.9 percent of GDP by 2021 (all data according to OMB).
Some initial reactions:
(1) Going big
The debt-limit deal signed in August had two parts. OMB estimates that the first part will reduce spending by $1.2 trillion (this may seem confusing, because the commonly-used figure for this part was $900 billion originally).
In combination with the debt-limit deal, then, the new proposals would (a) pay for the stimulus package the President proposed and (b) still reduce 10-year deficits by $4.4 trillion. Changes of this size constitute “going big” in current budget parlance and should be applauded.
In contrast, the Joint Select Committee needs to come up with “just” $1.5 trillion in deficit reduction to avoid the automatic second-round cuts. The President is asking Congress to go well beyond that and make a much more significant dent in the fiscal problem now.
(2) Compared to what?
The baseline that OMB uses is a measure of “current policy”: it assumes the extension of all of the 2001 and 2003 tax cuts, the indexation of the AMT for inflation, the non-reduction of Medicare provider payments, and the continuation of military operations at full throttle in Iraq and Afghanistan (it does not appear to assume that the run-of-the-mill temporary tax policies, the so-called “extenders,” are extended).
I have argued elsewhere that, in many ways, it makes more sense to use current law as the baseline. (http://www.brookings.edu/events/2011/0817_deficit_committee.aspx) Ultimately, the most important thing is where the proposal ends up in terms of deficits, debt, taxes, and spending. The President’s proposal would put the country on a more sustainable fiscal path and buy significant time to deal with long-term problems.
The combination of the President’s stimulus proposal and the medium-term deficit reduction measures would raise the deficit by $300 billion in 2012, and then would reduce the deficit (all, relative to baseline) by $23 billion in 2013, by almost $300 billion in 2014, and by increasing amounts thereafter. If the economy has fully recovered by 2013, it will be able to bear the burden of changes in the direction and magnitude of the deficit. But if the economy is still weak, the increase in fiscal drag in 2013 and 2014 may cause significant problems.
(4) The Role of Taxes
The President is right to call for tax increases as part of medium-term deficit reduction. As I described last month, any credible proposal to solve our fiscal problem will include an increase in government revenue.
–All major durable deficit reduction packages enacted in the last thirty years, including the 1983 Social Security reforms and the 1990 and 1993 budget agreements, included both tax increases and spending cuts.
–The only way to provide shared sacrifice is by including tax increases in the package. Spending cuts do not require any significant sacrifice from very high-income households.
–The notion that government can be reduced in size by holding taxes low has not fared well over the last 30 years. The “starve the beast” approach was tried by Presidents Reagan and George W. Bush, who cut taxes, but ended up raising spending. In contrast, when President Clinton raised taxes, government also reduced spending, resulting in better fiscal discipline on both sides of the budget.
–Tax increases will be needed, too, because historical revenue levels will not be sufficient to pay for the costs of an aging population with rapidly rising medical costs. Even with significant reforms of Medicare and Medicaid, health costs will place a significant burden on the federal budget.
–Because the debt-limit deal focuses only on spending cuts, adding tax increases as one part of the new package will help, in all of the ways described above. The overall package looks to have about a 2:1 ratio of spending cuts to tax increases.
–A combination of tax increases and spending cuts is in accord with the wishes of the American public, who vastly prefer a combination of the two types of budget solutions to a solution that involves spending cuts alone.
(5) Taxes on high-income households
It is appropriate to include tax increases on high-income households as part of the fiscal package.
–High-income households have seen enormous income growth over the past 30 years, which has not been reflected fully in the tax revenue statistics. The share of total income going to the top 1 percent has more than doubled, rising from 9.3 percent of pre-tax income in 1979 to 19.4 percent in 2007. In a progressive tax system, where average tax rates rise with income, one would expect that such a massive increase in income would be coupled—in the absence of any change in tax law–with significantly higher average tax rates (since more income is taxed at the highest rate as income skyrockets). Instead, the average federal tax rate on the top 1 percent of households fell over the time period from 37 percent in 1979 to 29.5 percent in 2007. (As a result, the share of federal taxes paid by the top 1 percent went up by less than double (even though the income share more than doubled) to 28.1 percent in 2007, up from 15.4 percent in 1979.)
–In contrast, the middle and lower ends of the income distribution have shown very small gains over the past 30 years. According to the Census, median family income after adjusting for inflation only increased 7.3 percent since 1979. More recently, median real family income has declined over the past decade, with median income in 2010 7.1 percent below its 1999 peak.
–The President’s proposal would return tax rates for high-income households to their late-1990s levels, a period of strong economic growth. Even though the tax rates of the 1990s did not cause the strong economic growth, it is clear that they did not get in the way of the strongest growth period the nation has had in several decades.
–Proposed taxes on high-income households seem to always generate two responses – it will hurt small business and it constitutes class warfare – which are discussed below.
(6) Small business
There will be concerns voiced that raising taxes on high-income households will hurt small businesses. However, the case can be vastly overstated.
–First, the proposed tax rates will not affect the vast majority of small businesses. According to the IRS’ 2009 Statistics of Income, only 9.9 percent of tax returns reporting business income were filed by taxpayers with an adjusted gross income greater than $250,000. Second, businesses in the upper income brackets are naturally larger than those in the lower brackets, and account for almost half of the aggregate income of so-called “small business,” but it is unclear that many of these businesses are indeed small. (For example, when Goldman Sachs was a partnership, the income of its managers would show up as “small business” income.) Moreover, most of the income in those income groups is not business income.
–Those statistics aside, the effective tax rate on small business income is likely to be zero or negative, regardless of small changes in the marginal tax rates. This is for three reasons. First, small businesses can expense (immediately deduct in full) the cost of investment. This alone brings the effective tax rate on new investment to zero, regardless of the statutory rate. Second, if they can finance the investment with debt, the interest payments would be tax deductible, making the effective tax rate negative. Third, they can deduct wage payments in full, so the marginal tax rate should have minimal impact on hiring.
(7) Class Warfare
Proposals to raise taxes on high-income households inevitably generate claims of “class warfare.”
–But it seems reasonable to ask for some fiscal sacrifice from a group that (a) is very well off, (b) has seen meteoric income gains relative to the rest of the population over the past 30 years, and (c) has nevertheless seen their average tax burden fall, not rise, during that period. It does not seem fair to let the wealthiest escape from sharing the burden of closing the fiscal gap; nor is there a way to impose that burden without tax increases.
–Ironically, proposals like Rep. Ryan’s recent plan to address long-term fiscal issues would impose more than the full burden of closing the fiscal gap on low- and middle-income households and, at the same time, give high-income households a tax cut. That seems much less justified on fairness grounds than asking high-income households to share in the burden of closing the fiscal gap.
(8) The Buffett rule
As a guideline for future tax reform (but not as a specific proposal now), the President described “the Buffett rule,” (named with reference to Warren Buffett, who has commented that he faces a lower average tax rate than many of his employees) as implying that no one with income over $1 million should pay a smaller share of his income in taxes than middle class families pay.
–The notion that people with income above $1 million should pay higher average tax rates than those in the middle class should not be a controversial proposition in principle. It is simply an extremely mild form of progressive taxation.
–However, the guidelines say “no household” with income above $1 million, which might create issues.
–The mild form of progressivity may not hold in the current system because different income types have different tax rates. These income types are concentrated in certain income groups more than others. For example, wages and salaries, which are a big share of low- and middle-income households’ income but not of high-income households’ income, are taxed at a flat payroll tax rate (up to a maximum) and graduated income tax rates. Capital gains and dividends are taxed at very low rates (15 percent maximum) under the individual income tax; these constitute less than 1 percent of the income of the bottom 80 percent of the income distribution, but more than 30 percent of the top 1 percent of households (in 2007, the figure will vary from year to year). According to Tax Policy Center estimates, the top one-tenth of one percent of households receive almost half of the benefits from preferential rates on capital gains and dividends. Low- and middle-income households cannot benefit from these tax breaks like millionaires, nor can they exploit other tax loopholes and deductions like high-income households.
–The Buffett Rule could be implemented in different ways: via a surtax on those whose income exceeds $1 million; via a reformed Alternative Minimum Tax (which would ensure that high-income, not middle-income, households are primarily affected); or via elimination or reduction of preferential rates for dividends and capital gains. The goal of a progressive tax system is laudable and should be pursued, especially as the greatest income gains have benefitted the top while median incomes have stagnated.
William G. Gale is the Arjay and Frances Fearing Miller Chair in Federal Economic Policy and Codirector of the Urban-Brookings Tax Policy Center.
The new budget deal comes in two main parts. The first imposes cuts in discretionary spending of almost $1 trillion over the next decade. The second creates a Congressional commission that, by the end of the year, would offer a plan to cut entitlements and “reform” (as opposed to “raise”) taxes and reduce future deficits by $1.5 trillion. Congress would vote up or down on the plan and if the plan failed, a cut in federal spending would be enacted to save that amount. The cut would be split 50-50 between defense and everything else, except Social Security, Medicaid, and Veterans’ benefits. Medicare would be limited to a 2 percent programmatic cut, which would be placed directly on providers, not beneficiaries.
Let’s give our political leaders credit for reaching an agreement. After years of cutting taxes and raising spending, reducing the medium-term debt is clearly a step in the right direction.
But it is only the first step of a long journey and it is a problematic one at that.
The Deficit and the Economy
The $3 trillion in savings over the next 10 years will put a dent in the overall debt picture but is nowhere near enough to solve the whole problem. That’s not a criticism – it would have been too much to expect the whole problem to be solved all at once – just an assessment. We are not out of the woods, though we may be a little closer to finding a path.
One has the feeling, especially given the final agreement was a complete capitulation by Democrats – and more on that below – that the whole drive-the-economy-to-the- point-of-crisis approach could have been avoided. It certainly should have been. By stringing the negotiations to the very end, our elected leaders created enormous and wholly gratuitous uncertainty, at a time when the economy could ill afford it. They may have created lasting damage to the economy by shaking the foundational belief that theU.S.obligation to pay its debts is totally sound.
The extended debate about fiscal policy also detracted attention from policies that could help the economy now, while it is limping along with sluggish growth, high unemployment and extremely high long-term unemployment.
An even bigger problem is the deal itself. The deal is all spending cuts, no tax increases. In practical terms, that means that the burden of closing the gap will be placed on poor and middle-class households, rather than high-income or wealthy households. It’s true that the second part of the deal involves the potential for tax reform, but the Republicans have been united in their “no new taxes” pledge and the Democrats accommodated them both directly, in requiring no new taxes, and indirectly, in stating that the trigger mechanism, in case the Commission’s report is not enacted, will be all spending cuts, no tax increases.
It does not seem fair or reasonable to impose virtually the entire cost of this part of the fiscal burden on poor and middle-class households, but that is what a bipartisan act of Congress and the White House just did. Without tax increases in either part of the current deal or in the foreseeable future, there is no way to get the well-off to pay anything close to their fair share of the fiscal burden. The top 1 percent own 33 percent of the wealth and receive about 15 percent of the income in the country. These shares have risen over the past 30 years. They are being asked to bear none of the burden of closing the fiscal gap. News flash – rich people don’t get direct spending from the government. Instead, almost 100% of the burden will be borne – via spending cuts – by the poor and the middle-class. Low- and middle class households have seen stagnating or declining earnings over the past few decades, they have been hit hard in the Great Recession by the housing market collapse and the job market collapse. Now, they are being asked to shoulder – via spending reductions – all of the fiscal reduction agreed to so far. To paraphrase Tevye in Fiddler on the Roof, such households might be wondering why policy makers “couldn’t choose someone else once in a while.”
The Politics of the Deal
And that leads directly into the remarkable politics of the situation. The deal that was enacted is, politically, a complete capitulation by the Democrats. There are no tax increases as part of the initial trillion dollar package. That package is all spending cuts, which was the original Republican position that the deal should only involve spending cuts.
It’s particularly notable that the deal is all spending cuts when public opinion clearly wanted a mix of tax increases and spending cuts. In just the most recent example of this fact, a July 18-20 CNN/ORC International poll showed that almost two-thirds of respondents preferred a deal with a mix of spending cuts and tax increases. Only 34% preferred a debt reduction plan based solely on spending reductions. Also, the plan that was enacted was significantly to the right of the Gang of Six proposal and the Bowles-Simpson commission. It’s as if the two parties each started out on their own 25 yard line. The Dems moved to the 50 yard line, while the R’s moved back to their own goal line. Then the agreement was settled on the Republican’s 25 yard line, right where the Republicans started.
The proposal to enact the new commission’s policies or enact an automatic trigger virtually guarantees no new taxes because the automatic cuts are all on the spending side. The Administration’s defense of this is, in Gene Sperling’s words, quoted by CNN: “You want to make it hard for them just to walk away and wash their hands. You want them to say, if nothing happens, there will be a very tough degree of pain that will take place.” While I have affection and respect for Sperling, and his comment reflects a sound strategy, that strategy has nothing to do with the actual outcome in this case. If the Democrats wanted the Republicans to bear “pain” or to pay attention to a “reform or else” situation, they would have been well-advised to include tax increases in the “or else” part. It is certainly not going to be easier to negotiate with the Republicans when the do-nothing alternative is all spending cuts.
The good news is that a default crisis was averted, though it could have been averted much more easily, and that a deficit reduction plan has been put in place. The bad news is that the plan imposes the full cost of deficit reduction on low- and middle-income households, gives the wealthy a free pass, and bodes poorly for future negotiations, which, like it or not, will require tax increases or draconian cuts in entitlements.