Sunday, April 20, 2014
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Inside America’s Tax Battle

BERKELEY – America’s recent presidential election answered the question of whether an increase in revenues will be part of the country’s long-run deficit-reduction plan. The answer is yes: there is now bipartisan agreement on the need for a “balanced” approach that includes revenue increases and spending cuts.

But there are still deep political and ideological divisions about how additional revenues should be raised and who should pay higher taxes. If a preliminary agreement on these questions is not reached by the end of the year, the economy faces a “fiscal cliff” of $600 billion in automatic tax increases and spending cuts that will shave about 4% from GDP and trigger a recession.

The majority of citizens agree with President Barack Obama that tax increases for deficit reduction should fall on the top 2-3% of taxpayers, who have enjoyed the largest gains in income and wealth over the last 30 years. That is why he is proposing that the 2001 and 2003 rate cuts for these taxpayers be allowed to expire at the end of the year, while the rate cuts for other taxpayers are extended.

So far, Obama’s Republican opponents are adamant that the cuts be extended for all taxpayers, arguing that increases in top rates would discourage job creation. This claim is not supported by the evidence. Recent research finds no link between tax cuts for top taxpayers and job creation. In contrast, tax cuts for the bottom 95% have a positive and significant effect on job growth.

During the past three decades, income inequality in the United States has increased significantly; indeed, the US now has the fourth-highest level of income inequality in the OECD, behind Chile, Mexico, and Turkey. At the same time, as the largest tax cuts have gone to high-income taxpayers, the US tax system has become considerably less progressive. The US needs fiscal measures that both curb the deficit and contain rising income inequality – and the inequality of opportunity that it begets.

But how should additional revenues be raised from top taxpayers to achieve these two goals? Most economists believe that increasing revenues by reforming the tax code and broadening the tax base is “probably” better for the economy’s long-term growth than raising income-tax rates. The analytical case for this belief is strong, but the empirical evidence is weak.

In theory, higher marginal tax rates have well known negative effects – they reduce private incentives to work, save, and invest. Yet most empirical studies conclude that, at least within the range of income-tax rates in the US during the last several decades, these effects are negligible.

A recent Congressional Research Service report, withdrawn under pressure from Congressional Republicans, found that changes in the top income-tax rate and the rate on capital gains had no discernible effect on economic growth during the last half-century. A recent review of the economic literature by three distinguished academics found no convincing evidence that real economic activity responds materially to tax-rate changes on top income earners, although such changes do affect their tax-avoidance behavior. So Obama has evidence on his side when he says that allowing the tax cuts for high-income taxpayers to expire at the end of the year will not affect economic growth.

Republicans have proposed tax reforms in lieu of rate hikes on high-income taxpayers to raise revenues for deficit reduction. Obama has signaled that he is willing to consider this approach, provided it increases tax revenues from the top 2-3% by at least the same amount as higher rates while protecting other taxpayers.

The federal tax system is certainly in need of reform. Tax expenditures – which include all deductions, credits, and loopholes – account for about 8% of GDP. Indeed, the US tax code is riddled with special preferences and contains large differences in effective tax rates across individuals and economic activities. These differences distort decisions about investment allocation and financing. Reforms that made the tax system simpler, fairer, and less distortionary would have a beneficial effect on economic growth, although economists concede that the size of this effect is uncertain and impossible to quantify.

Because tax expenditures are so large, limiting them could raise a significant amount of additional revenue that could be used both for deficit reduction and to finance across-the-board cuts in income-tax rates. Analysis of the Simpson-Bowles and Domenici-Rivlin deficit-reduction plans by the nonpartisan Tax Policy Center confirms that this approach is arithmetically feasible. Reducing large regressive tax expenditures like preferential tax rates for capital gains and dividends and deductions for state and local taxes, and replacing deductions with progressive tax credits, could generate enough revenue to finance rate cuts for all taxpayers, increase the tax code’s overall progressivity, and contribute meaningfully to deficit reduction.

But the odds of such an outcome are very low: what is arithmetically feasible is unlikely to be politically possible. Efforts to cap popular tax expenditures will encounter strong opposition from Republicans and Democrats alike. Nonetheless, some tax reforms are likely to be a key component of a bipartisan deficit-reduction deal, because they provide Republicans who oppose increases in tax rates for high-income taxpayers with an ideologically preferable way to increase revenue from them.

Unfortunately, it will take time to negotiate tax reforms – more time than remains until the end of the year, when the 2001 and 2003 tax cuts are scheduled to expire for all taxpayers. But there is still time to negotiate an agreement that extends these cuts for the bottom 98%, and that contains temporary measures to cap deductions and credits for high-income taxpayers in 2013. Such an agreement could help to break the political impasse over whether and how much these taxpayers’ rates should rise next year, thereby preventing the US from falling over the fiscal cliff and back into recession.

Read more from our "Fiscal Cliff Notes" Focal Point.

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  1. Commentedsande cohen

    The sophisms do not stop. You write: But there is still time to negotiate an agreement that extends these cuts for the bottom 98%, and that contains temporary measures to cap deductions and credits for high-income taxpayers in 2013." The NYTimes has a piece today that says the 250k is after deductions, not before. The 98% you refer to includes then those making up to 330k (before deductions reduce that to 250k) and those making 10cents a year. As the average family income in the U.S. is now 49,500k per year, exactly where did the number 250k come from....?

  2. CommentedMark Pitts

    Mr. Buffet’s duplicity is obvious to all who understand his businesses.

    He has consistently advocated higher taxes on dividends – yet his own company (Berkshire Hathaway) has never paid a dividend.

    He advocates higher capital gains taxes for individuals, yet has always practiced a buy and hold strategy that creates few capital gains.

    Despite his obvious great value as CEO, he pays himself only $100k per year salary – not surprising since salary is taxed at a much higher rate than investment returns.

    He has structured many Berkshire Hathaway holdings within an insurance company where tax treatment for investment returns is much more favorable.

    In short, he has structured his whole business life to avoid taxes.

    1. CommentedJohn Brian Shannon

      Just like anyone else does, Mark Pitts.

      I see nothing wrong with taking every legal tax advantage, certainly everyone else does the same sort of thing at tax time.

      By the way, I enjoy reading your many comments here at PS -- but I disagree with this one.

      Regards, JBS

  3. CommentedG. A. Pakela

    Mr. Sokoll,

    Thanks for your comments. Let me make a couple of points. The most fundamental concept in economics is how value is established by supply and demand. The law of supply and demand applies to the factors of production as well as goods and services for final sale. Increase the after-tax cost of capital will cause fewer investment projects to be undertaken. My gripe is that many economists ignore that axiom in their quest to justify equity-based tax proposals. And yes, I don't believe in the utility of empirical studies such as the ones cited in the article to direct policy that is at odds with fundamental economic theory. To be sure, you can point to the tremendous benefit for certain business of being located in Silicon Valley or lower Manhattan in spite of being subject to high marginal tax rates, but the business owner contemplating the risks and rewards of a new investment is going to take into account the after tax return in spite of what Mr. Buffett thinks.

  4. CommentedG. A. Pakela

    I guess the laws of supply and demand do not apply to investment decisions. That is, the after-tax return on investment doesn't really make a difference in whether that investment is undertaken.

    The problem with the so-called empirical studies is that they do not capture what would have happened in the absence of the policy in question. You can compare economic performance in the 1950s and 1960s to the post-Reagan era, including the Clinton years, but the world was fundamentally different in the earlier era, and the U.S. faced little competition in comparison. Moreover, the level of economic growth is largely driven by population growth, labor force participation rates and productivity increases.

    Inequality is not as big a problem as lack of opportunity. If you confiscate capital income you are going to reduce opportunity at the margin, right economist?

    1. CommentedMark Pitts

      Mr. Pakela is right. There have been very few distinct "regimes," so the data that goes into the statistical studies are either few in number, or highly overlapping and correlated.

    2. CommentedJohn Sokoll

      Mr. Pakela,

      I don't like the way you say, "right economist?", as if SHE'S the one doing it wrong. Economists base their arguments on data and research, like those she cited, and think in terms of correlations. Mrs. Tyson is fully aware of the limitations of "historical experiments". Are you aware of their utility?

  5. Commentedatul baride

    This is restoration of the tax structure defunct cause of 9/11 and it's economical impact. The Wound is Gone, so should medicine. allthough Scar remains but as a evidence of an event.

  6. CommentedMark Pitts

    The current tax proposals are just political gimmicks.
    Why else would the president spend 95% of his time and effort on raising taxes on the rich, when those tax increases would only cover 5% of the problem (i.e. 5% of the deficit)?

  7. CommentedProcyon Mukherjee

    Those of us who thought the battle is won have already concluded that it has not even begun; the divide on 'how' to 'who' would take the bulk of the space on the economic debate in the next months, (could be even years) before we see a cogent plan that is not just an academic discourse or a prescription that would cure the patient by killing it.

    On the other hand there is sufficient research already in place on the federal spending on infrastructure and the multipliers related to it that could change things in the real space.

    The stage is set, but it takes unusually long time to make things happen on the ground, while the slightest of hint makes market move this way or that. It is stale reminder of the usefulness of a maddening penchant for speculation; so be it.

    Procyon Mukherjee

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