Tax VOX

Senate Majority Leader Harry Reid of Nev., talks to reporters about the impasse among the payroll tax conferees, Tuesday, Feb. 14, 2012, on Capitol Hill in Washington. (J. Scott Applewhite/AP)

Why Congress actually failed on payroll tax

By Howard Gleckman, Guest blogger / 02.15.12

It looks like Congress is about to assume its default position: In the face of an intractable partisan dispute over how to pay for a government initiative, don’t. If Democrats won’t cut spending, and Republicans refuse to raise anybody’s taxes, there is always the solution they both can agree upon—just borrow the money and increase the deficit.

The matter at hand is the payroll tax, of course. And after months of squabbling, it looks as if Congress is about to extend a “temporary” tax cut for another 10 months. And it will borrow $100 billion to do it. That would be OK if this was a short-term stimulus. But I don’t think it is.

How did we get here? To briefly review the bidding, in late 2010 Congress backed a plan by President Obama cut the employee share of the Social Security payroll tax from 6.2 percent to 4.2 percent for 2011 only.

Just as the tax cut was about to expire, Republicans and Democrats locked themselves in their usual fiscal death grip. But in a nice bit of political jujitsu, Democrats stole the GOP’s best anti-tax rhetoric. Letting the temporary tax cut expire as planned, they thundered, would raise taxes on 160 million working people.

The talking point was wildly successful. Just before they headed home for the winter holidays, Republicans went into duck and cover mode and Congress voted to extend the payroll tax break for two months—without paying for the extension, of course. The theoretically temporary tax cut is due to expire again in a couple of weeks. And until this week, Ds and Rs were rehashing the same old argument. Except for some tea party conservatives, most lawmakers insisted they wanted to extend the payroll tax break, but nobody would budge when it came to paying for it.

On Monday, the House Republican leadership announced it would support a 10-month extension without offsetting spending cuts. Problem solved. Just put another $100 billion on the tab.

This wouldn’t bother me if I thought the payroll tax cut was really going to expire in 10 months. But I don’t.  Given the Democrats’ politically successful claim that allowing the tax break to expire was akin to a tax increase, it is hard to imagine them abandoning the provision–or the issue– anytime soon.

And if Congress can’t agree on how to pay for it now, how will it do so at the end of the year? That’s exactly when lawmakers will be locked in an epic fiscal policy battle over what to do about trillions of dollars of other expiring tax cuts, how to dodge $1.2 trillion in automatic spending reductions that were mandated by Congress’ failed deficit reduction efforts last year, and how to increase the debt limit.

I can imagine the payroll tax extension becoming another version of the Alternative Minimum Tax patch–extended year after year with borrowed money.  To make matters worse, a permanently temporary tax cut further damages the credibility of the Social Security system which the payroll levy is supposed to fund. The government can fill the hole by shifting general fund dollars into the system, but this bit of legerdemain is not going to boost confidence in the retirement program.

Perhaps Congress will find a way to sort out this mess without adding trillions more to the budget deficit. Perhaps it will somehow let the temporary payroll tax cut quietly fade away at year’s end. But, somehow, I doubt it.

President Barack Obama speaks about the "Community College to Career Fund" and his 2013 budget, Monday, Feb. 13, 2012, at Northern Virginia Community College in Annandale, Va. According to Gleckman, Obama's tax proposals contain some good principles, but lack specifics. (Susan Walsh/AP)

Obama's budget: What it means for your tax bill

By Howard Gleckman, Guest blogger / 02.14.12

When it comes to taxes, President Obama has proposed what might best be called a conceptual budget—a powerful call for tax reform that is long on principles but, at least when it comes to individual levies, woefully short on specifics.

This is understandable with what is effectively a reelection manifesto. In high campaign season, specifics get a candidate in nothing but trouble. Still, this framework is at once disappointing and illuminating.

It sets up a powerful contrast with whomever the GOP nominates to replace Obama: Should tax reform be used to raise revenues, an explicit goal of this budget, or should it be a vehicle to cut taxes and increase the deficit—the specific aim of every remaining GOP presidential contender?

Yet, Obama’s fiscal plan is disappointing because it is so vague. There is simply no chance Congress will make the tough votes necessary to enact any serious tax reform without a president who is prepared to take the heat for specific, deeply controversial cuts in popular middle-class tax preferences.

But Obama’s budget contains little more than gauzy promises for a “simpler, fairer and more progressive” tax system or, elsewhere, a “simpler, fairer and more efficient’ system. Know anybody against those principles?

There are plenty of proposals to end corporate tax breaks, but when it comes to individual taxes, the Obama budget is the Oakland of tax policy. To borrow from Gertrude Stein, there is no there there.

Yes, he’s proposed taxing dividends at ordinary income rates and found a new way to tax investment firm partners so they could no longer treat their compensation as capital gains. Talking to you, Mitt Romney.  But otherwise, the White House has done little more than rehash some Golden Goodies—allowing the 2001/2003/2010 tax cuts to expire for those making more than $200,000, and capping the economic value of itemized deductions at 28 percent.

This adds up to little more than raising taxes on “the fella behind the tree” and ignores those deductions, exclusions, and credits that benefit middle-income households, pervert the tax code, and keep tax rates high.

Even the much-ballyhooed “Buffett tax” is an empty vessel. After making a major fuss in his State of the Union address about requiring those making a million dollars a year to pay their “fair share” in income taxes, President Obama has proposed…nothing.

As a result, the only plan on the table is one proposed by Senator Sheldon Whitehouse (D-RI). With all respect to the senator, a plan by Whitehouse is not the same as a bill from the White House.

Obama’s unwillingness to get down and dirty with legislative specifics seems ingrained in his DNA. He did the same thing with the health reform law, which Congress turned into a mess. And he did it with financial reregulation which, despite whining from Wall Street and the banks, has done little to prevent a rerun of the financial abuses of the past decade.

Still, pay attention to Obama’s principles for tax reform. They set the stage for what could become an epic battle, if Obama gets reelected and is serious about pursuing tax reform (I wouldn’t bet on either at the moment).

Obama laid out five principles. Three–lowering rates, increasing job creation and growth, and cutting “inefficient and unfair tax breaks” –are the mom and apple pie of tax reform.  It’s just that nobody can agree on what inefficient and unfair means.

But numbers 3 and 5 will generate a political donnybrook. Number 5 is the Buffett rule. Number 3 is to use tax reform to cut the deficit by $1.5 trillion over the next 10 years.

The last one will do the most to separate Obama from his GOP challenger. Rather than shying from the charge that he’s a tax-hiking Democrat,  Obama explicitly vows to use reform to raise revenues—but says he’d get the money almost entirely from rich people. This promise alone will make for an interesting campaign.

Investor and philanthropist Warren Buffet receives the Medal of Freedom from President Barack Obama at the White House in this file photo. Obama has called for a new minimum tax called the "Buffett Rule" for American households that make more than $1 million annually. (Kevin Lamarque/Rueters/File)

The Buffet rule won't work in practice

By Roberton Williams, Guest blogger / 02.11.12

In his State of the Union speech, President Obama’s called for a new law that would require high-income people to pay at least 30 percent of their income in taxes. In response, Senator Sheldon Whitehouse (D-RI) and Representative Tammy Baldwin (D-WI) have introduced the Paying a Fair Share Act of 2012, a proposal designed to meet the Buffett Rule: That the wealthy pay at least as much tax as middle-income households.

That sounds straightforward but it’s not.

First, there’s the matter of how to measure income. The rule would define income as adjusted gross income minus a modified measure of charitable contributions. The adjustment avoids discouraging charitable donations.

Measuring taxes is more complicated. The proposal defines taxes to include the regular income tax, the individual alternative minimum tax (AMT), the employee’s share of payroll taxes that finance Social Security and Medicare, and the 3.8 percent tax on investment income and the 0.9 percent tax on earnings imposed on high-income taxpayers to help finance healthcare. That’s a broader measure than what most people see on their tax returns today, but it still excludes other taxes that people pay indirectly like corporate income taxes and the employer’s share of payroll taxes.

If you make at least $1 million (by the act’s definition) and your tax is less than 30 percent of that, you’ll owe more tax, presumably yet another addition on your income tax return. That’s certainly not tax simplification.

The Tax Policy Center estimates the proposal would increase 2015 taxes for about 116,000 households by an average of more than $170,000, assuming the Bush-era tax cuts expire as scheduled and Congress stops patching the AMT. That’s an overall tax increase of about $20 billion, not chump change but less than a tenth of the projected 2015 deficit. If Congress extends tax law in place this year, about 217,000 tax units would owe an average of nearly $190,000 more, yielding about twice as much additional revenue but still less than a tenth of a larger deficit.

The Buffett rule sounds good in principle. High-income taxpayers should pay at least as large a share of their income in taxes as the rest of us. But most already do. On average, middle-income households will pay 2015 taxes totaling about 15 percent of their income (using the legislation’s definition). Without the Buffett rule, more than 99 percent of millionaires will pay more than that and only about 4,000 will pay less. Barely 10 percent of them will pay less than 20 percent.

The proposed legislation would certainly raise taxes on a lot of high-income taxpayers. But the price would be even more complicated tax code. There are better ways to raise taxes on the rich.

In this file photo senior citizens Jeannie Hochhauser and Seymour Wilens are pictured at her condo in Sunrise, Florida. Many states offer tax breaks to attract retirees, and hopefully their spare cash, to their state. (Melanie Stetson Freeman/The Christian Science Monitor/File)

Should states use tax breaks to woo seniors?

By Howard Gleckman, Guest blogger / 02.10.12

We’ve all seen the articles in Forbes, Kiplingers, or U.S. News trumpeting the best states to live in retirement. A key measure for them all: Low taxes. What you may not know is that states actively compete with one another to provide tax breaks to older residents—especially to wealthy seniors.

This competition is similar to the way states use tax subsidies to woo businesses. It may not make much sense, but it sure is trendy.  

For instance, in 2010 the Georgia legislature voted to exempt nearly all retirement income from tax starting in 2016. Last year, the governor of Maine proposed making all pension income tax-free.

Not all states are headed in this direction. Michigan, which is in deep financial distress, recently rolled back some generous tax exemptions for pension income. But nearly every state offers some tax breaks for seniors.

Why? Many seniors have plenty of money to spend including Medicare dollars, and Social Security and pension benefits. Just as important, they use relatively few state and local services:  The elderly don’t need K-12 education and spend relatively little time in jail. And their health care is largely funded by the federal Medicare program.

This tax race for seniors is described in a fascinating new paper that Karen Smith Conway of the University of New Hampshire and Jonathan Rork of Reed College presented last week at a Tax Policy Center/UCLA Law School conference on state taxes.

States offer seniors three buckets of tax breaks. They exclude some or all Social Security benefits from tax; grant seniors extra deductions, exemptions, or credits; and exempt at least some pension income from tax. Combined, these preferences cost states more than $24 billion annually. The biggest beneficiaries: middle- and upper-income elders–the very people states want to keep or attract.

For instance, Conway and Rork found that 12 states offer a modest tax exemption for pension income, three exempt income of $70,000 or more, and five exempt all pension income from tax.  

Conway and Rork quote Georgia Gov. Sonny Purdue, who said his state’s plan to eliminate taxes on retirement income “will help attract retirees to our state and make our economy even stronger.”  

Is he right? Do low taxes attract seniors and are they worth the revenue cost?

Lots of prior research suggests Purdue is engaged in little more than wishful thinking. Last year, fewer than one percent of seniors moved from state to state after age 65 for any reason. And very few appear to do so to reduce their taxes.

This limited mobility may result in another major downside for states. About 70 percent of seniors will eventually require long-term care services in old age, and 20 percent will need this assistance for five years or more.

Many are middle-income seniors who spend down their assets on personal care and eventually become eligible for Medicaid. About one-third of Medicaid dollars are spent on long-term care services and the program is a growing burden on state budgets.

Thus, while states may benefit in the short-run from attracting a few relatively young, healthy, and wealthy pensioners, they may end up paying a substantial price when middle-income seniors become frail, go broke, and require Medicaid long-term care services.

When that happens, states such as Georgia may regret giving up revenue to subsidize seniors. Of course, the price for that mistake will be paid by some future governor who has the misfortune of serving years from now.       

Is a 102 percent tax rate possible? Not exactly. (Mary Knox Merill/The Christian Science Monitor/File)

102 percent tax rate? Really?

By Roberton Williams, Guest blogger / 02.09.12

Investment manager James Ross last week told New York Times columnist James Stewart that his combined federal, state, and local tax rate was 102 percent.  No doubt, Ross did pay a lot of tax to the feds and the two New Yorks, city and state. But did he really pay more than all of his income in tax?

No, he did not.

As Stewart made clear past the wildly misleading headline (“At 102%, His Tax Rate Takes the Cake”), Ross’s tax bills totaled 102 percent of his taxable income, a measure that omits all exclusions, exemptions, and deductions. Using that reduced measure of income inflates Ross’s effective tax rate far above the share of his total income he paid in taxes.

Deeper into his column, Stewart explains that Ross’s tax bill was just 20 percent of his adjusted gross income (AGI), a more inclusive measure that does not subtract out exemptions and deductions. Because he took advantage of many preferences, Ross’s taxable income was only a fifth of his AGI, resulting in that inflated 102 percent tax rate. But even AGI doesn’t include all income. Among other things, it leaves out tax-exempt interest on municipal bonds, contributions to retirement accounts, and the earnings of those accounts. Ross almost surely paid less than 20 percent of his total income in taxes

Stewart’s article demonstrates the common confusion about effective tax rates, or ETRs. There are many ETRs, depending on which taxes you count and against what income you measure them. Including more taxes drives up ETRs. Using a broader measure of income drives them down. And interpreting what a specific ETR means requires a clear understanding of both the tax and income measures used.

The Tax Policy Center has just released new tables that demonstrate what happens to ETRs when you include more taxes and or use alternative income measures. In 2011, for example, the federal individual income tax averaged 11.5 percent of AGI but just 9.3 percent of total cash income, the much broader measure of income that TPC generally uses for its analyses. Adding payroll taxes boosted those ETRs to 20.4 percent of AGI but just 16.5 percent of cash income.

The highest income 20 percent of households paid an average of 17.3 percent of AGI in individual income taxes in 2011. That’s the measure the media used recently when they reported the tax rates paid by Mitt Romney (13.7 percent), Newt Gingrich (31.5 percent), and Barack Obama (24.1 percent). Measured as a share of the broader cash income measure, ETRs for the top 20 percent are lower—just 14.9 percent. We don’t know total cash income for Romney, Gingrich, or Obama so we can’t compare their ETRs under this measure.

Add in payroll taxes—both employer and employee shares—and the highest income households paid 20.9 percent of their cash income in taxes. And if you tack on their shares of the corporate income tax and the estate tax, their effective tax rate hit 24.5 percent.

Now look at middle-income households. In 2011, they paid 4.1 percent of their AGI in income taxes but just 3.2 percent of their cash income—nearly 12 percentage points less than the rich. The income tax is quite progressive. Include regressive payroll taxes and their ETR jumps to 12.1 percent, about 9 percentage points less than the highest income households.  Add their (relatively modest) share of corporate income and estate taxes, and their ETR is only slightly higher—12.6 percent, or about half that for the top 20 percent.

The bottom line is you can use these numbers to tell many different stories, some more valid than others, depending on the taxes you include and the income measure you use. The broadest measure of income provides the most meaningful gauge of the relative impact of taxes on households. Narrower measures can yield absurd results—James Ross didn’t pay 102 percent of his income in taxes—and ignore important differences in households’ ability to pay.

It’s fine to tell those different stories but essential that any analysis compares equivalent ETRs, calculated for the same taxes using the same income measure. Combining apples and oranges may make a good fruit salad but it yields poor analysis.

Darkness sets in over the U.S. Capitol building hours before in this file photo. Gleckman argues that sweeping tax reform would affect individual states differently. (Jonathan Ernst/Reuters/File)

What tax reform would mean at the state level

By Howard Gleckman, Guest blogger / 02.08.12

What would fundamental changes in the federal tax code mean for state and local governments? Would it limit their ability to raise or borrow money? Would it make their revenue systems more or less progressive or even work more smoothly?

Last Friday, I participated in a joint Tax Policy Center and UCLA Law School conference sponsored by the MacArthur Foundation  on what federal reform would mean to governments beyond the Beltway.  And the short answer is: A lot.

Some change might be good, while other reforms might be quite disruptive. The bottom line seems to be that Congress could go a long way towards fixing the federal system without destroying state revenue codes—but only if reform is done carefully.

Take, for example, the federal deduction for state and local taxes, which reduces federal revenues by more than $70 billion annually. Policymakers have been talking about repealing it at least since the Reagan Administration.

Since most low- and moderate-income taxpayers don’t itemize, the deduction does them no good at all. Even many middle- and upper-middle class households who do itemize lose the benefit of the deduction if they fall into the dreaded Alternative Minimum Tax.

Still, the system encourages states to rely on deductible levies such as income and sales taxes. The good news is that state income taxes can be progressive (though many are not). The bad news is income and sales tax revenues are sensitive to changes in the economy and their decline is one reason states are in deep fiscal trouble today.    

What would happen if Congress got rid of the deduction?  To start, while upper-income households would owe more, it wouldn’t matter to the 70 percent of households that don’t benefit now. According to UCLA law vice-dean Kirk Stark and my TPC colleague Kim Rueben, while taxpayers in all states benefit from the deduction, the effects of repeal would be concentrated in a few, high-income, high tax states such as New York and California. Other alternatives, such as turning the deduction into a credit, could benefit lower-income households by reducing their federal tax.

Another item on many tax reform lists is the mortgage interest deduction. Completely eliminating the deduction would drive down home values, at least in the short-run, and hammer state and local property tax revenues. But more modest reforms, such as turning the deduction into a credit, would have relatively modest effects on state and local revenues overall, according to Andrew Hanson of Georgia State University and David Albouy of the University of Michigan.

What about a very broad federal reform, such as creating a national consumption tax? That could turn state tax systems upside down, but the two structures may still be able to live well together. Canada has a national Value-Added Tax, while its provinces operate their own sales levies or piggyback off of the federal tax.  

Could the U.S. pull this off? Michael Smart of the University of Toronto felt such a transformation is doable, though not easy. But Stanford University’s Charles McClure, a veteran of Washington’s tax reform battles, was far less confident.  

Canada, Charlie noted, was a “best case.” The Canadians replaced a bad tax with a good one and did not have to worry about raising new revenues, yet political opposition to reform was still strong. By contrast, it would be much tougher in the U.S., which suffers from a more toxic political environment, probably would be adding a consumption tax to an income tax, and would likely have to use reform to raise revenue.

While there was lots of healthy debate in LA last week, the participants did agree on one thing: When Congress does get around to federal tax reform, it better not forget what these changes will mean to the states.

U.S. President Barack Obama delivers the State of the Union address to a joint session of Congress on Capitol Hill in Washington. Congress has repeatedly extended temporary tax cuts, a habit Altshuler blames for creating tax code instability. (Kevin Lamarque/Reuters)

The tax system needs a bulldozer

By Rosanne Altshuler, Guest blogger / 02.03.12

On Tuesday, I testified before the Senate Finance Committee at a hearing titled “Extenders and Tax Reform: Seeking Long-Term Solutions.” I was already depressed about the state of our tax system before I started preparing. As I drafted my testimony, I became distraught.

Our tax system is a mess and unless we send a clear signal to Congress to do something about it, it’s just going to get messier and messier. As Bruce Bartlett writes in his book, The Benefit and The Burden, the tax system is like a garden. It gets overgrown and chaotic unless you regularly clean it. Well, we’ve got an eyesore now and need to bring in a bulldozer.

Here’s what leaves me distraught.

Sixty temporary tax provisions expired at the end of 2011. Congress enacted each with an expiration date and has subsequently extended almost every one. Most of these “temporary” provisions—nicknamed “extenders”—have been repeatedly extended.

Congress created the vast majority of extenders to provide special treatment for a particular activity or investment. They vary widely from special depreciation rules for NASCAR race tracks to subsidies for commuting. Unlike other tax provisions that provide targeted tax benefits, however, extenders have a limited shelf life. Much like the dairy section of the grocery store, our tax code is now littered with expiration dates. 

For many taxpayers whom these extenders affect, the recurring ritual of enduring a tax code death watch only to be saved by last minute clemency — or, in cases like this year, resurrection — creates tremendous volatility and uncertainty. It creates a perception that our tax code is unfair and reinforces the view that the current legislative process is dysfunctional and our elected representatives are unwilling or unable to choose among competing priorities.

It’s time to take a stand on extenders and on tax reform. I recommended at the hearing that the extenders be considered within the context of fundamental tax reform.

We seem to have forgotten that the fundamental purpose of our tax system is to raise revenue to fund government. The current system is riddled with tax provisions that favor one activity over another or provide targeted tax benefits to a limited number of taxpayers. Whether permanent or temporary, these provisions create complexity, impose enormous compliance costs, breed perceptions of unfairness, create opportunities to manipulate rules to avoid tax, and lead to an inefficient use of our economic resources. The tax code has become less stable, increasingly unpredictable, and more and more difficult for taxpayers to understand.

A reform that broadens the base would not only raise revenue but would also simplify the system, increase transparency, make it less distortive by reducing tax-induced biases towards certain activity, and improve the fairness of the system. Broadening the base requires deciding which special tax provisions to keep in the code and how best to design them.

Our current fiscal situation demands that we refrain from our habit of kicking the can down the road on tax reform and face the challenges ahead. It’s time to bring in that bulldozer.

The U.S. Capitol building. Burman proposes that after a tax provision has been extended three times, it should either be made permanent or it should be erased from the books. (Jim Bourg/AP)

Why expiring tax cuts should actually expire

By Len Burman, Guest blogger / 02.02.12

On Tuesday, the Senate Finance Committee held a hearing on “Extenders and Tax Reform: Seeking Long-Term Solutions.”  It’s about time!  The charade of annual or biennial debate about perpetually “expiring” tax provisions is terrible tax policy and a symbol of our failure to come to terms with budget reality.

If you need help sleeping, download the Joint Committee on Taxation’s (JCT’s) annual list of expiring tax provisions—tax laws that have built in sunset dates. The latest list is here. More than 70 provisions expired in 2011. Based on past experience, almost all will be extended after some debate about how or whether to pay for their budgetary cost.  They include very popular provisions like the research and experimentation (R&E) tax credit and the so-called “patch” that prevents tens of millions of middle-class taxpayers from falling prey to the AMT. There is a host of tax credits for energy efficiency and alternative fuels. There’s the tax deduction for state and local sales taxes. And the list includes the ethanol tax credit that provides a windfall to Midwestern farmers while contributing to higher food prices here and starvation in the rest of the world.

Given that the merits of some of these provisions are debatable (to put it nicely), subjecting them to periodic review would seem to be the epitome of frugal budgeteering. But pretending that the provisions will only be in place for a year or two makes them appear to be much more affordable than they will turn out to be.  The AMT patch and the Bush tax cuts have been extended without offsetting tax increases or spending cuts, in part justified by the relatively modest budgetary cost of a short-term extension.

University of Virginia law professor (and former JCT director) George Yin has argued that all tax breaks should be subject to annual review, as discretionary programs are, so that Congress will have to take an up or down vote on the provisions to continue them. George argues that temporary provisions are the only tax laws where the costs are fully accounted for because permanent tax cuts can cost much more outside the budget window than in the five- or ten-year period considered when the legislation is debated.  Temporary measures, in contrast, typically incur all of their cost within a few years.

Even if you buy George’s analysis of the budgetary effects (Howard Gleckman does not), there are other issues. One is that the provisions are continually extended and become a vehicle for more dumb tax laws. When I worked at the Treasury Department, we deliberately aligned temporary measures so that they would come up for renewal at the same time as the R&E credit, because we knew there would be a vote on extending that popular measure. The AMT patch has become another must-pass extender. It seems likely that the less popular measures would have a hard time surviving if they had to be voted on separately. And without the vehicle for mischief, some dubious new measures might never become law.

Furthermore, Congress’s chronic procrastination means that many temporary provisions are not extended until after they have expired. Astute calendar watchers will no doubt have noticed that 2011 came and went while the 70+ expiring provisions waited in vain for action.  There will be an extenders bill this year, but the uncertainty means that taxpayers might rationally discount the actual tax breaks and that raises the odds that they will simply provide windfalls rather than affecting behavior. Research expenditures, for example, have a very long lead time. Investors might guess that the R&E credit will be in place when the research occurs, but they can’t be sure that the provision will not change. There’s some evidence that research is relatively unresponsive to the credit, and its ephemeral nature might be part of the explanation. Similarly, taxpayers don’t know for certain whether they can take tax credits against the AMT. (The provision allowing the use of personal credits is up for renewal.) And, of course, all of those green tax incentives are doubly uncertain—they may or may not be extended and if they are, their value will depend on the size of the AMT patch (since business credits are not allowed against the AMT).

If Congress is going to spend the money to provide incentives, it shouldn’t undermine them by making them uncertain.

It might, however, make sense to make new provisions temporary. Congress might even go a step further and mandate data collection so that Treasury or other agencies could study their effectiveness. But temporary provisions should not be extended endlessly.

I propose a “three strikes and you’re out” rule.  After a provision has been extended three times, it should either be made permanent (and its cost fully offset) or it should be erased from the books.

A better solution still would be fundamental reform, which is at least hinted at by the hearing title and Chairman Baucus’s statement at the hearing.  Many of the expiring provisions would not survive a rational reworking the tax code.  RIP.

Dusk sets in over the US Capitol building. A "value-added tax" would simplify the tax code, but Gleckman doubts that Congress would ever pass such a levy in anything like its ideal form. (Jonathan Ernst/Reuters/File)

What is a 'value-added tax' and what can it mean for the economy?

By Howard Gleckman, Guest blogger / 02.01.12

A well-designed Value-Added Tax could simplify the tax code for most households and finance significant reductions in corporate and individual income tax rates without adding to the budget deficit. And it could be a key piece of a revenue system that is both progressive and less intrusive in economic decisions than today’s law.

That’s the conclusion of a new study by my Tax Policy Center colleagues Eric Toder, Jim Nunns, and Joe Rosenberg.

The VAT, a national consumption levy that would tax household purchases of all goods and services, is hardly perfect—no tax is. But properly structured, it could be a vast improvement over what we have.

In a project funded by the Pew Charitable Trusts, TPC modeled a sweeping reform of the federal tax system that includes a VAT. The plan was authored by Columbia Law School professor Michael Graetz . While there are many forms of consumption taxes (Herman Cain’s 9-9-9 tax included several), Graetz’s is similar in structure to the one used by most other countries. In effect, every business pays tax on its sales and gets a credit for any tax that is included in the price of what it buys from other firms.

Graetz does not eliminate the existing income or payroll tax. This no doubt disappoints some reformers, but helps fix a problem that is common to many consumption taxes—they hit poor people (who spend nearly all of their income) more than rich people (who don’t).

Mike’s solution is two-fold: First, he creates a family allowance of $100,000 ($50,000 for single filers), which wipes out all income tax liability for 8 out of 10 households. To ease the burden of the VAT on low-income families, he also creates a rebate tied to wage and self-employment income. But he does not exempt items such as food or housing from the tax.

Graetz sets two income tax rates–16 percent and 25.5 percent—that apply to all income, including capital gains and dividends. He’d repeal the Alternative Minimum Tax. He’d also eliminate the standard deduction and all family-based provisions, such as personal exemptions and the child credit and earned income credit, which he’d replace with the rebates.

He’d allow deductions for charitable gifts and mortgage interest only if they exceed 2 percent of adjusted gross income. Of course, these wouldn’t matter for those making $100,000 or less, since they’d owe no income tax anyway.

Finally, Graetz would cut the corporate rate to 15 percent, eliminate all business credits except the foreign tax credit, and end many deductions and exemptions.

Eric, Jim, and Joe figure Graetz could do all this with a relatively low VAT rate of 12.3 percent. That would raise the same amount of money as the 2011 tax law and be just about as progressive. People in various income groups might pay a bit more or less on average than they do today, but the changes would be surprisingly small.

Besides fairness, economists always look at how much any tax law distorts economic decisions. The current code is a swamp of subsidies aimed at encouraging or discouraging specific economic behavior. By contrast, a well-designed VAT mostly keeps government out of these decisions. It would reduce effective marginal taxes on labor, thus encouraging people to work. And it would reduce overall effective tax rates on capital.

The VAT does have issues. While it would reduce compliance costs for individuals, it would also create new administrative burdens for businesses that have to collect it.

But the biggest question is whether Congress would ever pass such a levy in anything like its ideal form. Any consumption tax must have a very broad base to succeed and this one does. It would apply to new home construction, health and education spending, and purchases and payrolls of non-profits and state and local governments. If Congress buckles under the inevitable pressure to exempt some or all of this consumption from tax, it would have to raise the rate.                                                                                                   

Still, at a time when the campaign trail is awash in tax “reform” plans that are more surreal than serious, it’s nice to see a proposal that has the potential to vastly improve the revenue code without adding trillions to the deficit or providing a windfall to those who need it least.