Reforming Taxes as Part of Budget ReformTestimony before the National Commission on Fiscal Responsibility and Reform

June 23, 2010

C. Eugene SteuerleInstitute Fellow & Richard B. Fisher Chair

The Urban Institute

Outline

Taxes & the Budget

Principles of Public Finance

More on Tax Subsidies & “Expenditures”

Tax Gap & Tax Havens

Thinking Comprehensively & Lessons from Past Tax Reform

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Taxes & the Budget Reforming taxes involves dealing with:

Entire revenue side of budget, including special taxes for:• Social Security & Medicare & highways

Complex measurement issues (e.g., cost of business) Incentives for work & saving (which affect future revenues) Tax rates About 1/4 to 1/3 of all “spending” or subsidies

• More housing subsidies (e.g., mortgage interest) than HUD• A larger low-income subsidy (EITC) than welfare (TANF)

Thousands of provisions Like expenditures, each provision a different rationale

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Relationship Between Tax &Budget Reform Four ways to reduce deficits

(1) Reduce direct spending (2) Raise tax rates (3) Spend less on tax subsidies(4) Work more (& save more)

• Example: Raise early retirement age • Biggest budget effect: income tax revenues• Actually increases Social Security benefits

All except (1) related to taxes

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Taxes & Spending per Household($2010)

2011 2020

Taxes per household $ 20,000 $ 26,000

Total Spending per household $ 30,000 $ 35,000

Tax Expenditures per household $ 9,600 $ 12,400

Interest Spending per Household $ 2,000 $ 7,000

Source: S. Rennane and C. E. Steuerle, the Urban Institute, 2010. CBO Alternative Baseline, with author adjustments for health reform. 5

Relationship Between Tax &Budget Reform

A common problem: permanent built-in growth Many mandatory spending (entitlement) programs Most tax programs

Throughout all U.S. history until today, the long-term budget under current law was in surplus

E.g., huge 1980 surpluses under 1970 law E.g., huge 1954 surpluses under 1944 law

Today, revenues spent before new Congress assembles6

Steuerle-Roeper Index of Fiscal Democracy:-- % of Revenues Not Yet Committed to

Permanent (Mandatory) Programs--

Source: S. Rennane, T. Roeper and C. E. Steuerle, 2010. Data from OMB and CBO, with author adjustments for health reform. Excludes TARP. 7

Principles of Public Finance--Apply to Taxes & Expenditures--

Equal Justice (equal treatment of equals)

Efficiency (competitiveness, growth, bang per buck, no special favors)

Progressivity (e.g., don’t tax those who can’t pay; subsidize needs, not everyone)

Simplicity (includes transparency, ability to administer)

Individual Equity (entitled to rewards from own efforts)

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Opportunities for Reform:Adhering to & Balancing Principles

(1) Special candidates for reform: a principle violated

without furthering other principles• Preferences by industry, consumption, taxpayer

(2) Check for balance

How strong is policy rationale for intervention? How much can base broadening deter rate increases? What are the real marginal tax rates—direct & indirect? What are the error rates? Do we need multiple “programs” for education, capital gains rates, etc.? What is the evidence for effectiveness? Who really benefits? Does form (e.g., credit or deduction) matter? Are floors or caps reasonable? 9

Tax ExpendituresExpenditure-like preferences in tax code Exclusions, deductions, credits, special rates, timing shifts Goals: social, economic, redistributive

Usually targeted at specific groups or for specific activities

Other Issues Accounting for them doesn’t make them good or bad per se

• Like expenditures, do affect behavior Often not “neutral” or efficient

• E.g., favor one form of energy production over another• E.g., favor one form of saving over another

Some controversy over which to count • Most conflicts over capital income taxation• For example, should base be income or consumption?

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How Tax Expenditures Differ From Direct Spending

Enactments show up as tax cuts, not spending increases

Removals show up as tax increases, not spending cuts

Administered by IRS, not spending agencies

Other Considerations “Authorized” by tax-writing committees Most are permanent (“tax entitlements”) and many intended to

be permanent (“tax extenders”) Use annual accounting period (e.g., EITC based on annual wages,

welfare based on monthly income) Most (other than EITC and child credits) not “refundable”

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Income & Corporate Tax Expenditures: Comparison to Income Tax and Total Revenues

(2010, $ billions)

Total Income Tax Expenditures 1,099

Total Income Tax 1,093

Total Revenues 2,126

Income Tax Expenditures as % of Total Income Tax 101%*

Income Tax Expenditures as % of Total Revenues 52%*

*Percentages especially high in 2010 due to recession

Source: Urban-Brookings Tax Policy Center, 2010.12

Tax Expenditures: Largest in 2009(Billions, $2009)

Source: OMB Analytical Perspectives. Income Tax Expenditures only.

Employer contributions to health insurance* 144Exclusion for pensions & retirement plans(income tax only) 85

Deductibility of mortgage interest 79

Accelerated depreciation-machinery & equipment 57

Capital gains 53

Earned income tax credit 49

Deductibility of non-business state and local taxes 45

Child credit 45

Step-up basis of capital gains at death 41*Income tax only. At least $60 billion more in Social Security tax expenditures (own estimates).

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Tax Expenditures: Some Comparisons to Spending by Function, 2009 ($, billions)

Source: Center for a Responsible Federal Budget. Tax Expenditure calculations do not include interaction effects.

OutlaysTax

Expenditures* Total

National defense 661 12 673

International affairs 38 46 83

General science, space and technology 29 12 41

Energy 5 5 10

Natural resources and environment 36 2 37

Agriculture 22 1 23

Commerce and housing 292 385 677

Transportation 84 4 88

Community and regional development 28 3 31

Educ., training, emp., and social services 80 109 188

Health 334 168 502

Medicare 430 430

Income security 533 130 664

Social Security 678 31 709

Veterans benefits and services 95 4 100

Other 168 175 343

Total 3,513 1,087 4,60014

Distribution of Major Tax Expenditures

Percent Reduction in After-Tax Income: Eliminating Major Individual Income Tax Expenditures, by Income Quintile

BottomQuintile

2nd

QuintileMiddleQuintile

4th

QuintileTop

Quintile

Without interactions 5.6% 8.0% 6.8% 6.5% 10.7%

With interactions 6.5% 8.2% 6.8% 6.8% 11.4%

Source: Burman, L., E. Toder and C. Geissler, 2008. Urban-Brookings Tax Policy Center. 15

Distribution of Tax Expenditures Throughout the Income Scale

Benefits from high- to low-income taxpayers:

Lower rates on capital gains and dividends Itemized deductions Exclusions for pension & health insurance Student loans & higher education subsidies Above-the-line deductions Child-care expenses & tuition credits Child Credit (partially refundable) Earned Income Credit (fully refundable)

Source: Burman, L., E. Toder and C. Geissler, 2008. Urban-Brookings Tax Policy Center. 16

Examples of Issues Throughout Income Distribution

High income: zero taxes or multiple taxes? Much income accrued & never taxed or taxed at capital gains

rates But also multiple taxation:

• individual, corporate, estate

Middle income: are adjustments appropriate & by how much? Housing, pensions Adjustments for family size—too little or too much?

• Example: family of 4 & family of 2, each making $50,000

Low income: who should administer and how? Earned income tax credit

• Alternative to welfare• But leaves out singles, particularly low-earning males

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Sources of Tax Gap, 2001 ($ billions)

Source: Toder, E. 2007. “What is the Tax Gap?” Tax Analysts.

Tax SourcesNon-filing

Under-reporting

Under-payment Total

Individual Income Tax 25 197 23.4 245

Non-business income   56    

Business income   109    

Adjustments, deductions, exemptions   15    

Credits   17    

Corporation Income Tax   30 2.3 32

Employment Tax (e.g., Social Security)   54 5 59

Estate Tax 2 4 2.1 8

Excise Tax     0.5 0.5

All Taxes 27 285 33.3 345

Memo: Taxes paid by individuals 27 240 25.5 293

Memo2: Taxes on business income of individuals   148    

Source: Internal Revenue Service, "Tax Gap for Tax Year 2001", in Mark J. Mazur and Alan H. Plumley (2007)

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Tax Gap & Tax Havens: Opportunities

Moderate saving relative to deficit, BUT… Tax Gap

Simplification & lower rates = less tax gap More IRS enforcement/resources

• Direct effects: about $4 per $1 of spending• Indirect effects: deterrence

More information reporting + withholding Greater equity, but labor switched out of “productive” activities

Tax Havens• Both evasion (cheating) and legal avoidance (income shifting)• Business income shifting perhaps costs $20 billion to $60

billion• Includes large interest deductions where few assets• Disputes over “transfer pricing” & location of intangibles

• Financial capital extremely mobile

Sources: E. Toder & R. Altshuler, Urban-Brookings Tax Policy Center; H.Grubert, Treasury; IRS; C. E. Steuerle 19

Thinking Comprehensively Inevitable controversy over cuts in spending & tax increases

Headlines same for attacking 5 or 500 special interests Controversy already assured over renewal of Bush tax cuts Might as well claim some major achievement

Lesson from 1984-86 tax reform effort Burden of proof under narrow reform:

• Special interest argue they have been “picked on” unfairly” Switch in burden of proof under broad reform:

• Special interests must argue why principles don’t apply to them Precedent very important

Congress facing fiscal huge challenges for many years20

Opportunities: Interactive Tax & Budget Issues Work longer: more revenues at any given tax rate

Combined private pension & Social Security reform Recent British example

Employee benefit reform: affect income taxes & Soc Sec solvency

Financial reform: tax-induced leverage Corporate debt preferred to equity Individual borrowing for larger houses & second homes Interest deductions, yet excluding interest in 401 (k) plans

Unprecedented opportunity to combine direct spending & tax subsidies (not possible even in 1986 tax reform)

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Consider Broad Rules & Criteria for Action

Limit automatic growth in all mandatory programs

Remove special preferences for particular types of industry, consumption or taxpayer

Trigger action for excessive growth or fiscal imbalance

Goal is to encourage action

Remove needless duplication (& combine programs) Education, capital gains, housing, urban, etc.

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Real Budget Reform MeansLower Taxes & Better Spending

Over long-run, taxes = spending Current spending = revenues collected today

+ revenues collected tomorrow

Bills don’t go away because paid with credit Interest costs reduce funds for alternatives

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