Tax reform and fiscal sanity

Reuters

U.S. President Barack Obama holds up a signature pen as he delivers a statement on the U.S. "fiscal cliff" in the East Room of the White House in Washington, November 9, 2012.

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  • Budgetary spending caps have led to the improved near-term fiscal outlook, despite future uncertainty. @AlexBrill_DC

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  • That effective government programs are being cut alongside wasteful ones will reduce your fiscal sanity @AlexBrill_DC

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  • Beyond the 10 year budget window, the long-term outlook of the federal deficit remains a grave concern @AlexBrill_DC

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  • Could realistic tax reform boost the economy? Like so many policy matters, the devil is in the details @AlexBrill_DC

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  • We need tax reform to diverge from the income-based system that discourages present and future growth. @AlexBrill_DC

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Federal policymakers have been consumed lately with various efforts-productive and foolish alike-to reduce the federal deficit and tame long-run debt projections. After the severe recession and a large amount of stimulus spending drove the deficit to $1.4 trillion in 2009, many lawmakers, economists, and concerned voters began a renewed effort to curb the size of government and put the federal budget on a sustainable path. Substantive, structural changes to federal health and retirement policies are necessary to achieve this goal.

Yet, such entitlement reforms are not the only changes necessary to improve the fiscal outlook and secure the well-being of future generations. A vigorous pursuit of strategies geared towards promoting economic growth is an important complement to any reforms to Medicare, Social Security, and other mandatory spending programs.

This article analyzes the economic growth prospects for tax reform in particular, offering a brief sketch of where we are today and an assessment of the potential impact that plausible, pro-growth tax reform could have on the federal fiscal outlook. 

The near-term fiscal outlook has improved.

The near-term budget outlook has modestly improved due to budgetary spending caps enacted in 2011, a significant tax increase enacted in January 2013, and the sequestration provisions that took effect in March 2013. Taken together, these provisions are likely to keep the debt burden roughly constant as a share of GDP a decade from now. In other words, the debt as a share of the economy is now forecast to remain steady for the coming decade instead of rising, as had been predicted. However, this is a fairly precarious forecast as it assumes:

1. No new spending initiatives withou offsetting cuts;
2. No continuation of various tax provisions that regularly expiree, such as the R&D tax    credit; and
3. The economy will continue to grow without interruption.

In short, the future is far from certain; more must be done.

Recent deficit reductions were generally ill-designed.

While the near-term fiscal outlook has improved, it is likely at the expense of long-term growth. First, the American Taxpayer Relief Act of 2013 raised the highest effective marginal income tax rates by 7 points. Capital gains and dividend tax rates are now also 7 percentage points higher than last year. Higher tax rates make the myriad deductions in the tax code even more distortionary.

Second, the sequester, which is scheduled to reduce outlays by $1.2 trillion over the decade, forces proportional cuts across virtually every defense department budget and equal (but smaller) proportional cuts across virtually every non-defense discretionary program. The net cut in spending is affordable and is unlikely to result in any meaningful economic impact, but the manner in which these cuts will occur is arbitrary and highly inefficient. Valuable and effective government programs are being cut alongside inefficient and wasteful ones.

The long-term outlook remains a serious concern.

Beyond the ten-year budget window, the federal deficit is scheduled to increase dramatically. Last November, the Congressional Budget Office stated that, left unchecked, "spending on major federal health care programs would grow from more than 5% of GDP today to almost 10% of GDP by 2037 and would continue to increase thereafter." Despite a recent slowdown, federal spending on healthcare is projected to increase faster than the overall growth rate of the U.S. economy in the coming decade.

It is mathematically impossible to establish fiscal balance only with tax increases while chasing spending policies that are outpacing the economic growth rate. Such an approach, in addition to adversely affecting economic growth, would require that tax burdens also grow faster than the overall economy. In short, an unsustainable spending problem cannot be solved with an unsustainable tax policy.

Tax reform is a critical component of fiscal reform.

While indiscriminate tax hikes cannot put Medicare and Social Security on solid ground, tax policy remains a key component of any fiscal reform agenda. Tax reform debates often revolve around the appropriate level of federal taxation and its distribution impact on households. Equally important, however, is resolving the way the tax code serves as an impediment to economic growth.

In broad terms, there are two primary ways that the current tax system discourages growth. First, the base of the tax system is all income. This means that the returns to savings and investment are taxed and therefore discouraged. Because the income tax lowers the return to savings, rational taxpayers will substitute higher levels of consumption in the current period for savings and investments in the future. As a result of lower savings, the economy will grow more slowly in the longrun.

Second, myriad provisions in the current income tax system lead to the misallocation of resources across the economy. The erosion of the tax base in the form of tax credits, deductions, and exclusions also leads households to shift resources in ways that would not naturally occur in a truly free market. For example, the tax benefit afforded to employer-provided health insurance has undoubtedly fueled growth in fringe benefits at the expense of wages. Other policies, such as various tax credits and deductions afforded to individuals, require higher marginal tax rates than otherwise would be needed for any revenue target. Perhaps the most economically damaging of all tax policies is the corporate tax, which stands at 35%, the highest among all industrialized countries. This high tax rate impedes global competitiveness, induces leverage, and discourages corporate investment.

Even modest growth effects from tax reform can have a meaningful impact on the deficit.

Economists have long-studied the potential growth effects of tax reform. Some models predict that certain "idealized" tax reforms could boost the U.S. economy by up to 10%, or $1.5 trillion based on the size of the U.S. economy today. In my view, though, a more realistic high-end prediction would be perhaps a 5% boost in GDP realized over ten years or more, given that these "idealized" reforms face almost zero political prospect.

Based on figures made available by the Office of Management and Budget (OMB), even accelerating the growth rate of the U.S. economy by just 0.1 percentage point per year has a substantial impact on the deficit. OMB estimates that such a boost in GDP growth would reduce the cumulative 10-year deficit by about $300 billion. Put differently, the deficit reduction achieved by the American Taxpayer Relief Act could have been realized by boosting the economy's potential growth rate over the coming decade from 2.2% to 2.4%. Tax reform can serve that goal by removing the disincentive to save and eliminating distortionary provisions in the tax code.

Prospects for tax reform.

The last fundamental overhaul of the U.S. tax code occurred in 1986, when marginal tax rates were reduced and many tax deductions, credits, and preferences were eliminated. During the 1990s, the tax reform debate shifted toward the economic advantages of a consumption tax over an income tax. In 2001 and 2003, tax rates and tax burdens were reduced significantly but without offsetting changes to eliminate existing preferences. More recently, the tax reform focus has returned to the 1986 framework: broadening the base and lowering the rates. The President's Fiscal Commission, chaired by former Senator Alan Simpson and former White House Chief of Staff Erskine Bowles, strongly advocated for this approach, and many in Congress have been investigating the prospects for such a reform.

Could realistic tax reform really boost the economy?

Like so many policy matters, the devil is in the details. As my colleague Alan Viard and I point out in a recent article, "The Benefits and Limitations of Income Tax Reform," revenue-neutral tax reform is unlikely to encourage more labor supply, but that's not to say that beneficial growth effects are not within reach. As Viard and I note, "When different goods are taxed at different rates, efficiency is impeded because the allocation of resources is based partly on tax considerations, rather than costs and preferences."

In other words, cleaning up the tax code and creating tax neutrality across classes of investments, types of goods, and forms of compensation will allow the freemarket to allocate resources based on the fundamental tenets of supply and demand, instead of the preferences imposed by government policy. If tax reform pursues those goals, a tangible boost to economic growth can be realized.  

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