The Bush Tax Cuts

Filed Under (U.S. Fiscal Policy) by Don Fullerton on Oct 8, 2010

Editor’s note: With Bush-era income-tax rates set to expire, Democrats want to return the rates that high-earners pay from 33 and 35 percent to Clinton-era levels of 36 and 39.6 percent. Republicans counter that raising taxes during a recession would bring an already sluggish economy to a standstill. Finance professor Don Fullerton, a former deputy assistant secretary of the U.S. Treasury Department who studies tax policy issues at the U. of I. Institute of Government and Public Affairs, discusses the potential impact in an interview with News Bureau reporter Phil Ciciora.

What are the big-picture economic implications for extending the Bush-era income-tax rates?

The question is complicated, because the choice is not just between extending the Bush tax cuts or letting them expire. A lot of other options are available. In particular, President Obama would make the tax cuts for lower- and middle-income families permanent – specifically, those who make less than $250,000 per year – while letting tax cuts expire for those making more. In other words, let the tax rates go back up to their previous level for the rich, but keep the tax cuts for everyone else.

A lot of the discussion relates to the business cycle and recession, but I think that discussion is misplaced. No extra stimulus is provided by cutting taxes on the rich more than on the poor. The real issue here is distributional fairness – who ought to bear more or less of the tax burden – and that’s a topic about which economists do not have any special expertise. Whether we should take more or less from the rich or from the poor or middle class is an issue of social justice rather than economic policy.

And those questions of social justice don’t have anything to do with the recession. More important for the recession is whether to cut tax rates, or to increase government spending, or to provide some other temporary tax relief. Some of the suggestions would temporarily allow businesses to expense investments immediately instead of taking depreciation deductions over time. All of those topics are mixed together in this debate.

Advocates for sun-setting the tax cuts argue that taking taxes back to Clinton-era levels for those making more than $250,000 might actually stimulate growth by decreasing our deficit. Proponents of keeping the rates the same say raising taxes during a recession would cause consumer spending and investment to dry up. Which side is correct?

The semantics here are somewhat confused.

We’re not really raising taxes relative to current law; maintaining current law means that the rates will rise at the end of 2010. That is the law passed during the Bush administration, namely, that rates would fall for 10 years and then rise again.

However you want to frame the argument, allowing higher rates just on those making more than $250,000 is not a huge tax increase that would injure the recovery or extend the recession. By the same token, taking a bit more from the rich by letting their tax cuts expire – that alone won’t cut the deficit or make the recession any better either. It’s just not going to have that huge of an impact. More impact on the recession would be provided by other options, such as extending unemployment compensation, stimulus spending on infrastructure, or faster depreciation deductions.

A lot of this debate is coming to a head, obviously, because of the mid-term elections.  Maybe some of these choices should have been made earlier, in the original stimulus bill. And if Congress does nothing, then all the tax cuts will expire, with a large impact that might slow the economy. But if politicians agree on keeping most of those tax cuts, then I don’t think our hopes of revitalizing the economy depend on keeping all of them.

One of the arguments for extending the Bush tax cuts or even making them permanent is that businesses and individuals need tax certainty. Is that a valid argument?

No, I think that’s wrong. Right now things are uncertain, but that uncertainty could be resolved by making any tax rates permanent. It doesn’t mean the lower rates must be made permanent.

It was the original tax bill 10 years ago that provided this uncertainty. In that bill, Congress played a cheap trick. The bill was to written to make the budget numbers look better than they really were. Politicians wanted to cut tax rates, for political reasons, but they didn’t want to appear irresponsible by causing a long run budget deficit with huge fiscal problems down the line. So they decided to have their cake and eat it, too, by enacting a tax cut that would expire in 10 years. The tax cut gave them the political gains they wanted, and providing for the expiration of those tax cuts would make the long run budget look good. Yet nobody ever really thought that the politicians who come along later would allow all those tax cuts to expire! So, those earlier politicians could get their own political gains from the tax cut, and appear to be fiscally responsible, but they left the later politicians between a rock and a hard place. Current politicians now must hurt themselves by allowing the tax cuts to expire, or else hurt themselves by adding to the huge budget deficit.

In other words, the decision 10 years ago was cynical, and it was completely disingenuous; they passed a law saying the tax cuts would expire, but they knew the tax cuts would not expire. It’s a Ponzi scheme. Didn’t Bernie Madoff go to jail for that?

The True Size of Government

Filed Under (Environmental Policy, U.S. Fiscal Policy) by Don Fullerton on Sep 25, 2009

In 2008, the federal government’s receipts were 17% of GNP, and its expenditures including transfer payments were 21.4% of GNP (implying the budget deficit was 4.4% of GNP).  If State and Local taxes and expenditures are added to those numbers, they become 30.5% and 35.2% of GNP, respectively.  For many reasons, however, government’s reach is wider than reflected in those numbers.  Government does not just spend its own tax revenue; it spends other people’s money as well.

For just one example, consider environmental regulations.  I have not seen a recent estimate of the total costs of environmental protection, so I will rely on some older numbers.  Note, however, than none of this discussion is meant to imply that the environment should not be protected!   Maybe protections should be more limited, or expanded.  The point is just that measured dollar expenditure by government does not accurately reflect its true size.

In “The Cost of Clean”, the U.S. EPA in 1990 estimated that the total private cost of required environmental protection was approximately $115 billion (in 1990 dollars) or 2.1% of GNP.  By the year 2000, they said the value could approach 2.8% of GNP.  If I assume the same rate of growth through 2008, then these private costs of environmental protection could be as high as 3.5% of GNP by 2008, a figure that would be $514.0 billion, or 21.6% of non-defense federal expenditures.

This cost of environmental protection comes mainly in the form of mandates imposed on firms.  Examples of mandates include the forced adoption of best practices pollution abatement technology or binding emission rates (e.g. limits on pollution per unit of output).  However, these mandates are just like taxes in two respects.  First, the government imposes these costs on private firms.  Second, the mandates provide “public goods” like clean air and water that we all can enjoy.

In other words, if these costs to private firms were converted into an equivalent tax program with direct government expenditures, then U.S. discretionary spending would appear to be 21.6% higher.  These expenditures do not appear explicitly in the federal budget, so they merit further study.  How do we divide our limited resources between private or public consumption, versus private or public investment?  How much of that environmental spending is in each category?  What are we getting for these outlays?  How can we measure the value of the improved environment?  Do these expenditures provide environmental benefits now, or are they investment in the future?

In order address these questions, a full “environmental budget” would need to show each cost, including the cost of complexity created by mandates.  In addition, some environmental protection programs are required by state and local governments (just like taxes).  Each of the programs has implicit transfers from one state to another, and from one income group to another (just like taxes).  Why are these programs not evaluated just like taxes?

Should a Proposal “Pay for Itself” (and How do We Know if it Does)?

Filed Under (U.S. Fiscal Policy) by Don Fullerton on Sep 18, 2009

A member of Congress who wants to spend additional money often has to say what tax will be raised to pay for it.  Somebody else who wants a particular tax cut for their favorite lobbyist may have to say what other tax will be raised.  As a general principle, this kind of “budget neutrality” is often a good idea.  In all likelihood, the Tax Reform Act of 1986 only succeeded because it was revenue neutral.  It broadened the tax base and lowered tax rates, to fix the tax system without changing the amount collected.

But how is revenue neutrality calculated?  Politicians on both sides of the aisle call upon the non-partisan Congressional Budget Office (CBO) as the arbiter of budget balance.  If important policy choices must pass the CBO’s litmus test, then we need to understand what test is being administered.  According to its website, the “CBO’s [cost estimate] statement must also include an assessment of what funding is authorized in the bill to cover the costs of the mandates and, for intergovernmental mandates, an estimate of the appropriations needed to fund such authorizations for up to 10 years after the mandate is effective” (http://www.cbo.gov/CEBackground.shtml).  This CBO test has a few major problems that could limit the benefits from a policy, or even prevent enactment of a good policy.

First of all, not every act of Congress must be revenue neutral.  But policymakers may want the restriction of revenue neutrality, in order to “prove” they are fiscally responsible.  Recently, President Obama in his health care policy speech to a joint session of Congress promised that he “will not sign a plan that adds one dime to our deficits — either now or in the future.”  Thus, one general problem is: who decides which projects must be revenue neutral?

Second, of course, a project may generate revenue or cost savings after ten years.  President Obama’s health care reform has initial start up costs, but it may “bend” the long-run cost curve for federal expenditures on Medicare and Medicaid, so that cost savings accrue and accumulate over more than ten years.  In general, the CBO’s ten-year balance sheet could say that a policy adds to the debt over ten years, even though it may save taxpayer dollars in the long-run.  On Wednesday, September 16, 2009, the CBO released its official cost estimate for the Senate Finance Committee’s draft health care bill, stating that it would have a “net reduction in federal budget deficits of $49 billion over the 2010–2019 period” (http://cboblog.cbo.gov/?p=354).  However, an additional, unofficial estimate by the CBO concluded that the “the added revenues and cost savings are projected to grow more rapidly than the cost of the coverage expansion”, meaning that over a longer time horizon that the bill further reduces the deficits.

To be clear, the federal debt is a real concern.  Running massive deficits that pile up year after year is unsustainable and irresponsible.  But a strict CBO ten-year cost estimate test may not be the best way to evaluate a potential policy change.

A third problem is that any such test must be somewhat arbitrary, regarding what is counted as “revenue”.  Does it just count actual dollars flowing into government coffers?  What about features of a policy that reduce future outflows?  Some pieces of additional spending in proposed health care reforms are intended to improve future heath and thus to avoid the need for some future medical expenses.  The CBO would count current “preventive care” spending as a cost, but it may not count the fact that this current spending could reduce the need for Medicare and Medicaid to pay for some future medical procedures.

Fourth, and most importantly, even if NOT revenue-neutral, SOME policies are still valuable, important, and worthwhile.  A project may have generalized benefit to everybody in society that exceeds the actual social cost, meaning that it passes a benefit-cost test, even though it requires government spending and is not “revenue neutral”.

Any revenue-neutrality test is a way for policymakers to “tie themselves to the mast” and prevent them from pork spending of the most egregious sort.  Maybe that’s good and worthwhile.  But it may also mean we can’t have some other worthwhile policies either.