Donald Marron
In this 2005 file photo, trays of printed social security checks wait to be mailed from the U.S. Treasury's Financial Management services facility in Philadelphia. Budget experts are in a dispute over just how much the 2010 changes in medicare would add to the federal deficit. (Bradley C. Bower/AP/File)
What is medicare 'double counting,' and why are budget experts fighting over it?
The recent double-counting dispute isn’t just about politics; it also reveals a flaw in budgeting for Medicare Part A.
Budget experts are waging a spirited battle over the Medicare changes that helped pay for 2010’s health reform. In April, Chuck Blahous, one of two public trustees of the program, released a study arguing that the Affordable Care Act (ACA) would increase the deficit by at least $340 billion by 2021, a sharp contrast from the $210 billion in deficit reduction estimated by the Congressional Budget Office (CBO).
Chuck bases his estimates on several factors, but the item that has garnered the most attention is his charge that the ACA’s spending cuts and revenue increases in Medicare Part A are being double counted: once to help pay for the ACA’s coverage expansion and a second time to improve the finances of the Part A trust fund, whose predicted exhaustion was delayed by several years.
Chuck notes that those resources can be used only once: They can either offset some costs of health reform or strengthen Medicare, but not both. He believes those resources will ultimately finance additional Medicare spending and thus can’t offset any health reform costs. For that reason, he concludes that the ACA would increase deficits, rather than reduce them.
That argument inspired a host of commentary from leading budget experts, ranging from denunciation to affirmation. See, for example, Jeffrey Brown, Howard Gleckman, Peter Orszag, Robert Reischauer (as quoted by Jonathan Chait), and Paul Van de Water, and a follow up by Chuck and Jim Capretta.
Why does this dispute exist? It can’t just be politics. If it were, we’d have double-counting disputes about every program. But we don’t. We thus need an explanation for why this debate has erupted around Medicare Part A, which provides hospital insurance, but not around other programs. Part A is not unique in controlling spending by a “belt and suspenders” combination of regular program rules (the “belt”) and an overall limit (the “suspenders”). Such budgeting also applies to Social Security, Medicare Parts B and D (which cover physician visits and prescription drugs), and the National Flood Insurance Program. The federal debt limit acts as “suspenders” for the entire budget. But none of those give rise to double-counting disputes.
That suggests that there is something unusual—perhaps flawed—about budgeting for Medicare Part A. To see what that is, it helps to boil the dispute down to two basic questions about programs subject to “belt and suspenders” budgeting.
First, can spending reductions or revenue increases in the program offset spending increases or revenue reductions in other programs? In short, can budget savings pay for other programs? Or must they stay within the program itself?
Second, would hitting the overall budget limit affect program operations? In other words, do budget savings extend the period during which the program can operate at full capacity? Or is the limit operationally toothless?
As shown above, policymakers have answered these questions differently for different programs (for further details, see the appendix).
This comparison reveals the unique feature of Medicare Part A: It is the only one of these programs that allows budget savings to pay for other programs and has a trust fund with real operational teeth. It alone answers Yes to both questions. That is why Medicare Part A is the only program that creates the possibility of double counting and suffers from the reality of a double-counting dispute.
Double counting isn’t possible in Social Security or the NFIP because budget rules require that savings stay in the program. It isn’t possible for the budget as a whole since there are, by definition, no other programs to fund. And double counting isn’t possible in Medicare Parts B and D because its trust fund does nothing to limit operations.
But double counting is possible in Medicare Part A. That happens whenever someone claims that the health reform legislation both reduces deficits and provides additional resources to Medicare Part A. I will leave it to others to adjudicate whether any health reform proponents committed that error. I will note, however, that every budget expert, including Chuck Blahous, agrees that CBO didn’t do so (its baseline ignores the trust fund, so savings reduce deficits and have no effect on program operations).
Bottom line: The peculiar budget rules for Medicare Part A make it possible for analysts, pundits, and policymakers—whether willfully or inadvertently—to double count budget savings in Medicare Part A. That needless confusion is a significant flaw. To correct it, Congress could adopt the budget practices it uses in Social Security, Medicare B & D, or the NFIP. In a follow-up post, I will examine the pros and cons of these alternatives.
Appendix: How “Belt and Suspenders” Budgeting Works
In Medicare Part A, spending is determined by rules about benefit eligibility and provider payment rates. If the Hospital Insurance (HI) trust fund balance falls to zero, however, spending faces a separate, hard limit: payments can’t exceed receipts. Program operations would thus be disrupted if the trust fund became exhausted. Congressional budget rules ignore the trust fund and assume that spending will continue at scheduled levels regardless of its balance. Under that approach, any spending reductions or revenue increases in Medicare Part A generate new budget resources that can be used to pay for changes in other programs.
Social Security operates differently. It faces the same operational limitations as Medicare Part A if its trust fund balance falls to zero. But Congress enacted special rules that forbid any Social Security spending cuts or revenue increases being used to pay for other programs. Such savings therefore accrue in the trust fund. The trust fund thus matters for operations, and savings cannot be directed to other parts of the government. (Social Security actually involves two programs, one for retirement and one for disability, and two corresponding trust funds; these comments apply equally to both.)
Medicare Parts B and D operate in a third way. Like Part A and Social Security, their spending is determined by eligibility and payment rules and gets paid out of a trust fund (the Supplementary Medical Insurance or SMI trust fund). But that fund has unlimited right to draw on general tax revenues. A zero balance thus results in general revenue transfers, not operational disruptions. Reforms don’t increase the life of the trust fund (since it can never go broke), and savings can be used to finance other programs.
The National Flood Insurance Program operates in yet another way. The NFIP is required to finance itself out of its insurance premiums; if its costs exceed those premiums, it can borrow from the federal government up to a specified limit. Once that limit is reached, payments can’t exceed its revenues, and operations are disrupted. The borrowing limit thus acts like the trust fund balance in Medicare Part A or Social Security, except that it allows the program to go a fixed amount into the red.
Congressional budget rules treat the borrowing limit as a fundamental restraint on NFIP spending. If the program is expected to run annual deficits, as it is today, those deficits exist only until the borrowing limit is reached. After that, the NFIP is projected to break even, with spending restrained to equal revenues. If Congress reduces the annual deficits in the NFIP (e.g., by increasing premiums), those savings allow the program to operate longer before reaching its borrowing limit. Any temporary budget savings thus get offset by increased NFIP spending in later years. Those temporary budget savings thus cannot be used to offset spending in other programs (unless hitting the borrowing limit is pushed beyond the budget window).
The debt limit, finally, acts as a “suspenders” restraint on deficits incurred by the entire federal budget. As we saw last summer, the debt limit threatens real operational restraints. Spending reductions and revenue increases can delay when the debt limit is reached. But they cannot be used to pay for other programs. Why? Because there are no other programs. The debt limit thus operates like the Social Security trust fund: it imposes an important operational restraint, and budget actions used to avoid it cannot pay for other programs.
This file photo shows American Airlines planes at Ronald Reagan National Airport in April 2012. An "unlimited first class flying" pass offered to a small group of customers cost the airline millions in revenue. (Kevin Lamarque/Reuters/File)
The frequent flyer deal that was American Airlines' worst nightmare
Companies often run into trouble when they offer a service at a zero price.
Not always, of course. Many all-you-can-eat buffets continue to thrive even though the marginal cost of the next chicken nugget is zero. And many content providers manage to stay in business by selling radio, TV, or display ads against the free content users enjoy.
But all too often, a zero price attracts bad customers and encourages excessive consumption. Marco Arment of Instapaper, for example, discovered that a zero price attracted “undesirable customers” for his app. And AT&T famously discovered that offering unlimited iPhone data could overwhelm its capacity.
Thanks to Ken Besinger of the Los Angeles Times, we now have another juicy example: the lifetime passes that American Airlines sold to a small group of customers:
There are frequent fliers, and then there are people like Steven Rothstein and Jacques Vroom.
Both men bought tickets that gave them unlimited first-class travel for life on American Airlines. It was almost like owning a fleet of private jets.
Passes in hand, Rothstein and Vroom flew for business. They flew for pleasure. They flew just because they liked being on planes. They bypassed long lines, booked backup itineraries in case the weather turned, and never worried about cancellation fees. Flight crews memorized their names and favorite meals.
Each had paid American more than $350,000 for an unlimited AAirpass and a companion ticket that allowed them to take someone along on their adventures. Both agree it was the best purchase they ever made, one that completely redefined their lives. …
But all the miles they and 64 other unlimited AAirpass holders racked up went far beyond what American had expected. As its finances began deteriorating a few years ago, the carrier took a hard look at the AAirpass program.
Heavy users, including Vroom and Rothstein, were costing it millions of dollars in revenue, the airline concluded.
How did things go wrong? American Airlines miscalculated how pass holders would behave:
“We thought originally it would be something that firms would buy for top employees,” said Bob Crandall, American’s chairman and chief executive from 1985 to 1998. “It soon became apparent that the public was smarter than we were.”
In economic jargon, American fell victim to both adverse selection and moral hazard. What customer wants to buy an unlimited, lifetime pass? One who’s happy to spend a great deal of time flying about in first class with friends, family members, or a random person they just met at the gate. And how will they behave? As though first class seats are costless, easy to book, free to cancel, a great gift for friends and strangers, and even, in some cases, as a revenue source.
What happened next shouldn’t be surprising. First, the passes went through a death spiral with American raising the price in a vain effort to make them profitable. When last offered, a single pass cost $3 million and was purchased by a grand total of nobody. Second, American sicced its “revenue management executives” on the most flagrant of the frequent flyers. As a result, several had their passes revoked for misuse. And American faces some lawsuits that make one wonder whether it crossed the line in trying to rid itself of these outrageously expensive customers.
Sihil, an ocelot from the Cincinnati Zoo, lays on the ground as nature photographers and enthusiasts view the cat at Santa Ana National Refuge in San Juan, Texas in this April 2012 file photo. Marron uses the example of encountering an ocelot in the wild to illustrate that experiences, while often short-lived and occasionally a hassle, are a lasting investment because of the memories they make. (Gabe Hernandez/AP/The Monitor/File)
Memories are a durable investment
A recurring theme of recent happiness research is that when it comes to seeking pleasure, people should “buy experiences rather than things.” People are happier when they skip the shiny baubles (or new high heels) and do something memorable.
Over at the Atlantic, Garett Jones gives one economic explanation for this finding: memories are a durable good.
[M]emory, wholly intangible, is quite durable.
People often shrink from driving to a distant, promising restaurant, flying to a new country, trying a new sport–it’s a hassle, and the experience won’t last that long. That’s the wrong way to look at it. When you go bungee jumping, you’re not buying a brief experience: You’re buying a memory, one that might last even longer than a good pair of blue jeans.
Psych research seems to bear this out: People love looking forward to vacations, they don’t like the vacation that much while they’re on it, and then they love the memories. Most of the joy–the utility in econospeak–happens when you’re not having the experience. …
[P]eople treat memories somewhat like durables, but most of us could do a better job of it. Yes, it’ll be a hassle to find that riad in Marrakech when your GPS fails you, but complaining about it with your sibling years later will be a ton of fun. Get on with it.
A corollary: if memory really is a durable, then you should buy a lot of it when you’re young. That’ll give you more years to enjoy your purchase.
So it’s worth a bit of suffering to create some good memories, since the future lasts a lot longer than the present.
That’s good advice. But I can’t help thinking that people who are unhappy on vacation are doing it wrong. Then again, maybe my recollection is blurred by selective memory?
In any case, the little feline above is a great example of Garett’s thesis. Since I was a child, I had always wanted to see an ocelot in the wild. And last summer, Esther and I found one in Brazil. Our entire encounter lasted about 15 seconds and produced a couple of mediocre photos. But until my brain gives out, I will always cherish seeing the little critter.
P.S. About 20 years ago, I recall someone attributing the “memory is a durable good” idea to Milton Friedman. If anyone’s got a cite to that, please post in the comments.
P.P.S. Will Wilkinson also comments on Garett’s thesis.
IRS employees exit the US Internal Revenue Service building in Washington, DC, in this file photo. Marron estimates that the current tax code includes $1.3 trillion in tax preferences, but warns that tax expenditure estimates do not translate directly into potential revenue. (Ann Hermes/The Christian Science Monitor/File)
What exactly do tax preferences add up to?
The tax code is chock full of credits, deductions, deferrals, exclusions, exemptions, and preferential rates. Taken together, such tax preferences will total almost $1.3 trillion this year.
That’s a lot of money. But it doesn’t necessarily mean that $1.3 trillion is there for the picking in any upcoming deficit reduction or tax reform. In fact, even if Congress miraculously repealed all of these tax preferences, it would likely generate much less than $1.3 trillion in new resources.
Where did I come up with that number? For a short piece in Tax Notes, I simply added together all the specific tax expenditures identified by the Department of Treasury; these were reported in the Analytical Perspectives volume of the president’s recent budget.
Treasury doesn’t report this total for a good, technical reason: some provisions interact with one another to make their combined effect either larger or smaller than the sum of their individual effects. As a result, simple addition won’t give an exact answer. That’s an important issue. In the absence of a fully integrated figure, however, I think it’s useful to ballpark the overall magnitude using basic addition.
In your travels, you may find other estimates that do the same thing but come up with a figure of “only” $1.1 trillion. Why is mine higher? Because it includes some important information that Treasury reveals only in footnotes. Treasury’s main table estimates how tax expenditures reduce individual and corporate income tax receipts; those effects total $1.1 trillion. But they also have other effects. Refundable credits like the earned income tax credit increase outlays, for example, and some preferences, like those for employer-provided health insurance and alcohol fuels, lower payroll and excise taxes. I include those impacts in my $1.3 trillion figure.
Budget hawks and tax reformers have done a great job of highlighting tax expenditures in recent years. I fear, however, that we have lifted expectations too high. Just because the tax code includes $1.3 trillion in tax preferences doesn’t mean it will be easy to reduce the budget deficit or pay for lower tax rates by rolling them back. Politics is one reason. It’s easy to be against tax preferences when they are described as loopholes and special interest provisions. It’s another thing entirely when people realize that these include the mortgage interest deduction, the charitable deduction, and 401(k)s.
Basic fiscal math is another challenge. Tax expenditure estimates do not translate directly into potential revenues. Indeed, there are several reasons to believe that the potential revenue gains from rolling back tax preferences are less than the headline estimates. One reason is that the estimates are static—they measure the taxes people save today but do not account for the various ways that people might react if a preference were reduced or eliminated; those reactions may reduce potential revenues. Second, most reforms would phase out such preferences rather than eliminate them immediately. That too reduces potential revenues, at least over the next decade or so.
Finally, the value of tax preferences depends on other aspects of the tax code, most notably tax rates. If a tax reform would lower marginal tax rates, the value of deductions, exclusions, and exemptions would fall as well. Suppose you are in the 35 percent tax bracket. Today, each dollar you give to charity results in 35 cents of tax savings—a 35-cent tax expenditure. If the top rate were reduced to 28 percent, as some propose, your savings from charitable donations would be only 28 cents. The 20 percent reduction in tax rates would thus slice the value of your tax expenditure by 20 percent. That means that the revenue gain from eliminating the deduction—or any other similar tax expenditures—would also shrink by 20 percent, thus making it harder for tax expenditure reform to fill in the revenue gap left by reducing tax rates.
My message is thus a mixed one. Tax expenditures are very large—$1.3 trillion this year alone if you add up all the individual provisions – and deserve close scrutiny. But we need to temper our aspirations of just how much revenue we can generate by rolling them back. It isn’t as though there’s an easy $1.3 trillion sitting around. In coming months, the Tax Policy Center will explore how to translate tax expenditure figures into more reasonable estimates of the potential revenues that tax reformers and budget hawks can bargain over.
Women prepare to compete in a race in high heels in central Moscow in this file photo. (Sergei Karpukin/Reuters/File)
A tax on high heels?
Among my idiosyncracies are two footwear anti-fetishes: I hate flip flops and high heels. I have never mastered the dark art of walking in flip flops, and I have always been troubled when women teeter at the edge of falling because of shoes designed for fashion (allegedly) rather than function.
Nonetheless, I enjoyed Thursday’s Wall Street Journal piece about the engineering, some would say architecture, of contemporary high heels. I was also pleased that columnist Christina Binkley emphasized some of the negatives early in her piece:
High heels can exact a heavy toll on the body, pushing weight forward onto the ball of the foot and toes and stressing the back and legs. Most doctors recommend a maximum height of 2 inches.
But with heels, many women trade comfort for style. Women spent $38.5 billion on shoes in the U.S. last year, according to NPD Group, and more than half of those sales were for heels over 3 inches high. High heels are seen as sexy and powerful. Stars on the red carpet clamor for the highest heels possible–leading designers who want their shoes photographed into an arms race for height.
That “arms race” comment got me to thinking. Perhaps there’s an externality here? Are women trying to be taller than other women? If Betty has 2 inch heels, does that mean Veronica wants 2 and a half inch heels? And that Betty will then want 3 inch heels? If so, high heels are an example of the kind of pointless competition that Robert Frank highlights in his recent book, “The Darwin Economy“. As noted in the book description:
[Such] competition often leads to “arms races,” encouraging behaviors that not only cause enormous harm to the group but also provide no lasting advantages for individuals, since any gains tend to be relative and mutually offsetting. The good news is that we have the ability to tame the Darwin economy. The best solution is not to prohibit harmful behaviors but to tax them. By doing so, we could make the economic pie larger, eliminate government debt, and provide better public services, all without requiring painful sacrifices from anyone.
Hence today’s question: Are high heels an example of such misguided competition? If so, should we tax them? (Bonus question: Should we tax noisy flip flops?)
P.S. The book description is not correct about the absence of “painful sacrifice.” Someone out there will still purchase such goods (otherwise there would be no revenue to ”eliminate government debt”), and there’s a good chance they will view their tax payments as a sacrifice.
A stack of Dictionaries of American Regional English, volume V: SI-Z, sit atop a desk during a press conference in Washington earlier this month. Marron argues that the words used to describe an economic policy may be justy as important as the policy itself. (Kevin Lamarque/Reuters)
Fiscal policy and the importance of word choice
Rhetoric matters in economic policy debates. Would allowing people to purchase health insurance from the federal government be a public option, a government plan, or a public plan? Would investment accounts in Social Security be private accounts, personal accounts, or individual accounts? (See my post on the rule of three.) Are tax breaks really tax cuts or spending in disguise? Is the tax levied on the assets of the recently departed an estate tax or a death tax?
In an excellent piece in the New York Times, Eduardo Porter describes another important example, how we characterize differences in income:
Alan Krueger, Mr. Obama’s top economic adviser, offers a telling illustration of the changing views on income inequality. In the 1990s he preferred to call it “dispersion,” which stripped it of a negative connotation.
In 2003, in an essay called “Inequality, Too Much of a Good Thing” Mr. Krueger proposed that “societies must strike a balance between the beneficial incentive effects of inequality and the harmful welfare-decreasing effects of inequality.” Last January he took another step: “the rise in income dispersion — along so many dimensions — has gotten to be so high, that I now think that inequality is a more appropriate term.”
The Nasdaq Composite stock market index is seen inside their studios at Times Square in New York in this file photo. Marron argues that linking financial managers' pay so closely with market performance is unwise because of the amount of luck involved in market fluctuations. (Shannon Stapleton/Reuters/File)
Why finance heads shouldn't be judged by the market
Harvard Business School professor Mihir Desai believes American companies and investment firms have erred–horribly–by linking manager compensation so tightly to financial market performance. In the current Harvard Business Review, he identifies this as a giant FIB, a Financial Incentive Bubble:
American capitalism has been transformed over the past three decades by the idea that financial markets are suited to measuring performance and structuring compensation. Stock-based pay for corporate executives and high-powered incentive contracts for investment managers have dramatically altered incentives on both sides of the capital market. Unfortunately, the idea of compensation based on financial markets is both remarkably alluring and deeply flawed: It seems to link pay more closely to performance, but it actually rewards luck and can incentivize dangerous risk-taking. This system has contributed significantly to the twin crises of modern American capitalism: governance failures that cast doubt on the stewardship abilities of U.S. managers and investors, and rising income inequality.
Mihir has nothing against well-functioning financial markets. He emphasizes that they “play a vital role in economic growth by ensuring the most efficient allocations of capital,” and he believes that capable managers and investors should be “richly rewarded” when their talents are truly evident.
The problem is that incentive compensation based on financial performance does a lousy job of distinguishing skill from luck. In finance-speak, managers and investors often get rewarded for taking on beta, when their pay really ought to be linked to alpha. In practice, luck gets rewarded with undeserved windfalls (that are by no means offset by negative windfalls for the unlucky). And that, he argues, results in an important ”misallocation of financial, real, and human capital.”
Well worth a read.
This file photo shows the Hortus Bulborum, a museum garden in Limmen Village, The Netherlands. In his book 'The Benefit and the Burden,' Bruce Bartlett suggests that the tax code needs constant tending, like a garden. (Dean Fosdick/AP/File)
How to design a coherent tax system
The tax code is like a garden. Without regular attention, it grows weeds that will soon overwhelm the plants and flowers. Unfortunately, no serious weeding has been done to the tax code since 1986. In the meantime, many new plants and flowers have been added without regard to the overall aesthetic of the garden. The result today is an overgrown mess. There is a desperate need to pull the weeds, cut away the brush, and rethink some of the plantings to restore order, beauty, and functionality to the garden.
So begins Bruce Bartlett’s The Benefit and the Burden, an excellent guide to the promise and peril of tax reform.
Beauty is too much to ask of any tax system, but order and functionality are fair aspirations. As Bruce documents, however, we fall far short. Our code is too complex, unfair, and economically harmful. And it doesn’t raise enough revenue to pay the government’s bills.
Bruce takes readers on a tour of many crucial issues in designing a coherent tax system. How should we measure income? Should capital gains count? How should the tax burden vary with income? Are all tax cuts and increases created equal? What can we learn from other nations? Should we tax income or consumption? How should we think about the inevitable politics of choosing winners and losers?
Bruce’s writing is clear, concise, and crisp. And he provides excellent suggestions for further reading for those who want to delve deeper (I found several items to add to my reading list).
Highly recommended for anyone wanting a pithy introduction to the challenges of designing a tax system we can be proud of.
This chart shows the average tax rates faced by corporations in various industries, using data from the U.S. Department of the Treasury's Office of Tax Analysis for the years 2007-2008. (Donald Marron)
What we need to fix in the corporate tax code
The President’s new Framework for Business Tax Reform is two documents in one. The first diagnoses the many flaws in America’s business tax system, and the second offers a framework for fixing them.
Much of the resulting commentary has focused on the policy recommendations. But I’d like to give a shout out to the diagnosis. The White House and Treasury have done an outstanding job of documenting the problems in our business tax system.
As the Framework notes, our corporate tax system pairs a high statutory tax rate with numerous tax subsidies, loopholes, and tax planning opportunities. Our 39.2 percent corporate tax rate (including state and local taxes) is the second-highest in the developed world, and will take over the lead in April when Japan cuts its rate. But our tax breaks are more generous than the norm.
That leaves us with the worst possible system – one that maximizes the degree to which corporate managers have to worry about taxes when making business decisions but limits the revenue that the government actually collects. It’s a great system for tax lawyers, accountants, and creative financial engineers, and a lousy system for business leaders and ordinary Americans. Far better would be to fill in the Swiss cheese of the tax base and move to a lower statutory rate, just as the President proposes (albeit with much more clarity about the rate-cutting than the cheese-filling and with proposals that would make some of the holes bigger).
A related problem is that our corporate tax system plays favorites among different businesses and activities, often with no good reason. To illustrate, Treasury’s Office of Tax Analysis calculated the average tax rates faced by corporations in different industries. As you can see in the chart above, the corporate tax really tilts the playing field.
I am at a loss to understand why the tax system should favor utilities, mining (which includes energy extraction), and leasing, while hitting services, construction, and wholesale and retail trade so hard. Why should the average retailer pay 31%, while the average utility pays only 14%?
These disparities are unfair and economically costly. Investors recognize these differences and allocate their capital accordingly. More capital flows to industries on the left side of the chart and less to those on the right. Far better would be a system in which investors deployed their capital based on economic fundamentals, not the distortions of the tax system.
The chart highlights one of the key battlegrounds in corporate tax reform. Leveling the playing field (while maintaining revenues) will require that some companies pay more so others can pay less. The U.S. Chamber of Commerce announced Wednesday that it “will be forced to vigorously oppose pay-fors that pit one industry against another.” But such pitting is exactly what will be necessary to enact comprehensive corporate tax reform.
P.S. The full names of the sector names I abbreviated in the chart are: Transportation and Warehousing; Agriculture, Forestry, Fishing, and Hunting; Finance and Holding Companies; and Wholesale and Retail Trade.
Senate Majority Leader Harry Reid is seen during a news conference to talk about an accord on the payroll tax cut negotiations, Thursday, Feb., 16, 2012, on Capitol Hill in Washington. Tax reform has been a hotly contested issue on Capitol Hill. (Pablo Martinez Monsivais/AP)
Five principles for fixing America's tax system
The International Economy recently invited me to contribute to a forum on how best to fix America’s tax system. Here’s my piece; for eleven other views, check out the complete forum.
America’s tax system is a mess. It’s needlessly complicated, economically harmful, and often unfair. And it doesn’t raise enough money to pay our bills. That’s why almost everyone agrees that tax reform should be a top priority. Democrats, Republicans, and independents. Accountants, lawyers, and economists. Elected officials and ordinary citizens. All know our tax system is deeply flawed.
Unfortunately, they don’t agree on how to fix it. Some want revenue-neutral tax reform, while others want higher revenues to cut deficits and pay for rising entitlement spending. Some want to fix the income tax, while others want to tax consumption. Some want to cut tax rates across the board, while others would lift rates for high earners.
Public discourse, meanwhile, is hung up on the idea of attacking “loopholes” when the real action is in tax breaks that benefit millions of taxpayers. Tax reform isn’t just about corporate jets or carried interest. It’s about the mortgage interest deduction, the tax exemption for employer provided health insurance, and generous tax incentives for debt-financed corporate investment. Those policies have major flaws, but they are not loopholes. They reflect fundamental economic and social choices, and they benefit well-defined constituencies.
Tax reform will thus involve a prolonged political struggle, as reformers seek some compromise that can attract enough support to overcome the inevitable inertia against change. That won’t be easy, but given our sky-rocketing debt, weak recovery, and flawed tax system, it’s clearly worth the effort.
Even as they seek a reasonable compromise, reformers should continue to articulate their visions of an ideal tax system. Mine would reflect five principles. First, the government should raise enough money to pay its bills. That likely means higher revenues, relative to GDP, than we’ve had historically. Second, it’s better to tax bads rather than goods. That means greater reliance on energy and environmental taxes. Third, it’s better to tax consumption than income; policymakers should thus limit how much they tax saving and investment. Fourth, the tax burden should be shared equitably both across income levels and among people of similar means who make different choices (for example, renting versus owning a home).
Finally, the best tax systems have a broad base and low rates. Policymakers should thus emphasize cutting tax breaks rather than raising tax rates. Indeed, some rates, like the 35 percent rate on corporate profits, should come down.
To afford such cuts, policymakers should go after the dozens of deductions, credits, exclusions, and exemptions that complicate the code and narrow the tax base, often with little economic or social gain. Many of these provisions have been sold as tax cuts, but are really spending in disguise. They should get the same scrutiny that policymakers devote to traditional spending programs.
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