The Fiscal Delusion
By ROBERT E. RUBIN
Published: November 12, 2012
NOW that the election is over, Washington’s attention is consumed by the looming combination of automatic spending cuts and tax increases known as “the fiscal cliff.” That combination poses risks, including economic contraction and erosion of confidence in government. But it also offers a chance to address our unsustainable and dangerous fiscal trajectory.
Much of the current energy around establishing sound fiscal conditions is focused on plans that theoretically would both contribute revenue to deficit reduction and significantly reduce individual income tax rates. Though hugely appealing, that’s a tall order.
These plans rely on reducing or eliminating many tax deductions, exclusions and the like, known collectively as tax expenditures. Reducing tax expenditures to pay for both lower personal income tax rates and deficit reduction may seem like a politically attractive alternative to raising tax rates or cutting entitlements or other spending.
However, many of these tax expenditures are important and popular policy programs on which people now rely. They include the deductibility of mortgage interest, charitable contributions and the exclusion from income of employer-provided health insurance. Some tax expenditures should be cut back and reformed. But when the substantive effects and political realities of large-scale reductions are examined, it becomes clear that there would not be sufficient savings to reduce tax rates and also cut the deficit.
Not long ago, a former senior official involved in the federal budget process told me that various senators used to meet with him periodically and argue for reducing tax expenditures. He would say that was a good idea, and then go down the list of large tax expenditures. At each one, the senator would say, “Oh no, we can’t do that,” and at some point the senator would repeat his proposition and the conversation would end.
The nonpartisan Congressional Research Service examined the full range of existing tax expenditures and concluded that, “Given the barriers to eliminating or reducing most tax expenditures, it may prove difficult to gain more than $100 billion to $150 billion” a year. But most plans based on reducing tax deductions and other expenditures project revenues of three to four times that amount. And the 1986 Tax Reform Act, cited as an example of lowering rates through tax expenditure reductions (called base broadening), left all of the major individual tax expenditures largely unchanged.
The plans that reduce both tax rates and deficits, like the impressive work by the Simpson-Bowles commission, have served a great public service — raising awareness of our fiscal risks, bringing Democrats and Republicans together, providing a framework aimed at stabilizing debt at an acceptable level, and recognizing the need for substantial revenue increases and spending cuts.
However, these same plans also pose a serious risk to achieving the very objective they seek. If we invest too much time and effort pursuing plans that ultimately prove undesirable and unworkable, we may go down a road that leads nowhere. Then we would be forced to search for a new solution when it will almost surely be too late. In effect, we will have pursued the policy equivalent of a wild-goose chase only to discover that, to mix metaphors, the tax expenditure goose doesn’t have enough golden eggs.
Advocates of extensive tax expenditure reduction argue — correctly — that all deficit reduction choices involve substantive costs and are politically difficult. They then suggest that, when compared to other possibilities, substantially more cuts may be doable than the Congressional research numbers suggest.
Maybe, but I think that’s unlikely when compared to the alternative of restoring the topmost tax brackets to their Clinton-era level.
Raising tax rates for those with the highest incomes challenges the supply-side proposition that even moderately higher rates would hurt growth. President Bill Clinton’s 1993 deficit reduction plan increased income tax rates for roughly the top 1.2 percent of incomes. Opponents said this would lead to recession. Instead, we had enormous job creation and the longest economic expansion in our history.
A recent report by the Hamilton Project, an economic policy project on whose advisory council I serve, reviewed 23 studies of the impact of tax-rate changes on the propensity to work and found that most of them concluded there was no meaningful effect. Tax expenditure reductions, on the other hand, will not raise nearly the revenues needed for sufficient deficit reduction without increasing taxes on the middle class significantly and are likely to disrupt important social and economic goals, though many economists don’t acknowledge that.
When you compare raising the marginal rates for roughly 2 million Americans to phasing out health insurance exclusions that would affect 150 million Americans — even if some reform should be done — I don’t think it’s a close call substantively or politically.
We should let the Bush high-end tax cuts expire, with an achievable, progressive reduction in tax expenditures. And we should have spending cuts, including entitlement reforms, equally matched by revenue increases. The entire program — including budgetary room for public investment and a moderate upfront jobs package — could be enacted now and deferred for a limited time with a serious mechanism to guarantee implementation.
For plans that both reduce deficits and lower rates, some suggest that, instead of raising the top two brackets to Clinton-era levels, we can find the same revenues by limiting tax expenditures for those groups. That would have some meaningful negative policy impacts, unlike increasing the top rate. The bigger problem is that such a step would yield only a fraction of the necessary revenue, requiring higher taxes on the middle class.
The pressure of the fiscal cliff, the fact that doing nothing is not viable, and the distance to the next election all combine to make this a special opportunity to meet our fiscal imperative. We need an open, cleareyed debate so we don’t squander it.
