Friday, November 12, 2010

Paul Krugman on the Entitlement Commission’s tax reform plans

In his NYT column today, “The Hijacked Commission,” Paul Krugman harshly criticizes the Entitlement Commission’s tax reform proposals. Krugman is a lightning rod, of course, but in my view he’s been right about a lot of things. Here, however, he is in part taking on views widely accepted in the tax policy community, from at least moderate left to right. So herewith I quote the relevant paragraphs from his column, then offer some thoughts in response.

KRUGMAN: “We’ve known for a long time, then, that nothing good would come from the commission. But on Wednesday, when the co-chairmen released a PowerPoint outlining their proposal, it was even worse than the cynics expected.

“Start with the declaration of “Our Guiding Principles and Values.” Among them is, “Cap revenue at or below 21% of G.D.P.” This is a guiding principle? And why is a commission charged with finding every possible route to a balanced budget setting an upper (but not lower) limit on revenue?”

RESPONSE: Agreed as a matter of policy. The right level depends on social value for money or the costs versus benefits of greater government expenditure. The only good explanation for a revenue cap, but it is potentially plausible, would be that there is a political problem of undesirable “program creep” that can be addressed on the revenue side. Unfortunately, addressing program creep through a revenue cap is a “starve the beast” strategy which, as other critics of the plan have noted, does not appear to work. If you want to address the program creep problem, it really needs to be done on the outlay side, given the political ease of using debt financing.

There is, however, one other argument for a revenue cap. It is simply that one needs some such thing for the right to be willing to play ball on deficit reduction. Even if Krugman is 100 percent right on all policy matters, a feasible deal to prevent a U.S. fiscal crisis will need to involve compromise with others who have different views. So here one could see him as making a tactical argument that it’s too soon to concede this when the right isn’t yet really willing to play ball – or alternatively as demanding total victory. (Impossible to distinguish between these two variants until one has an actual, politically feasible take-it-or-leave it deal on the table.)

KRUGMAN: “Matters become clearer once you reach the section on tax reform. The goals of reform, as Mr. Bowles and Mr. Simpson see them, are presented in the form of seven bullet points. ‘Lower Rates’ is the first point; ‘Reduce the Deficit is the seventh.

"So how, exactly, did a deficit-cutting commission become a commission whose first priority is cutting tax rates, with deficit reduction literally at the bottom of the list?”

RESPONSE: Touché, at least to a degree. But this doesn’t mean it’s a right-wing plot. The panel appears to have relied on tax reform types (hardly a word of opprobrium, coming from me) who offered the standard prescription of broadening the base and lowering the rate. Why do this here? Two reasons. First, if revenues are going up relative to current law, it’s all the more important to increase the efficiency of the tax system, since distortions have more impact as it grows. Second, if lots of unpopular stuff is being done anyway to reduce the fiscal gap, why not throw in other unpopular but good-policy type stuff.

KRUGMAN: “Actually, though, what the co-chairmen are proposing is a mixture of tax cuts and tax increases — tax cuts for the wealthy, tax increases for the middle class. They suggest eliminating tax breaks that, whatever you think of them, matter a lot to middle-class Americans — the deductibility of health benefits and mortgage interest — and using much of the revenue gained thereby, not to reduce the deficit, but to allow sharp reductions in both the top marginal tax rate and in the corporate tax rate.

“It will take time to crunch the numbers here, but this proposal clearly represents a major transfer of income upward, from the middle class to a small minority of wealthy Americans. And what does any of this have to do with deficit reduction?”

RESPONSE: Krugman must have really hated the 1986 tax reform, which used ALL of the revenue from base-broadening to pay for lower rates. Here, the commission sets aside $80 billion (in the initial year) for deficit reduction, while using the rest to pay for lower rates.

And yes, the numbers do have to be crunched before we draw conclusions here. Note that the 1986 Act, at least as estimated, was distribution-neutral. And indeed it was probably progressive on balance if, at the time, the corporate tax (which went up despite corporate rate reduction) was mainly borne by shareholders in the transition and savers in the 1980s version of the “long run” (i.e., before global capital mobility, which tends to shift the incidence of the corporate tax to workers, had quite reached current levels).

Krugman does not mention a big chart the commission included, called “Who Benefits from Tax Expenditures,” showing that their effect on after-tax income is greatest for the top 1%. He notes that the deductibility of health benefits and mortgage interest, “whatever you think of them, matter a lot to middle class Americans.” But these benefits are uncapped, apart from the $1.1 million ceiling on home mortgage loan principal that generates deductible interest, and the fact that they “matter” to middle class Americans at lower dollar levels is not really the point. And the middle class does benefit from rate reduction. For example, the Commission’s “Option 1” plan, the one he appears to be addressing here, creates a 3-tier rate structure of 9%, 15%, and 24% (I’m using the variant that keeps the child tax credit and EITC, which, as I have explained elsewhere, are better viewed as rate structure features than as tax expenditures). This does significantly cut rates for everyone, not just at the top, thus creating an offset.

If I had to guess before someone crunches the numbers, the top 1% doesn’t necessarily win under the plan, though the uppermost portion of that percentile may well win big. (This reflects that tax expenditures at very high levels may stop growing significantly with income - e.g., how much bigger is your primary residence likely to be if you earn $50 million, rather than $40 million?) This was probably true in 1986 as well. In analyzing this, the efficiency aspects of lower rates are relevant. Krugman often expresses skepticism about them, usually by correctly debunking exaggerated claims about how higher rates shut down the economy (which we have certainly seen they don’t). But plausible economic models, and not just those done by more conservative economists who assume relatively high taxpayer responsiveness, do show some positive impact of lower rates on productive economic activity.

Important to keep in mind here that this is still an income tax, creating lots of distortions (even if savings behavior as such is relatively inelastic) because the asset valuation piece of income is so hard to measure and thus we are forced to use realization rules. If we’re talking tax reform fantasies here, I would switch to a progressive consumption tax and would certainly expect to end up proposing higher top bracket rates (such as on the order of 35%) than the Commission does under an income tax.

Note also that the Commission proposes lowering the corporate rate – under the option I’m considering, from 35% to 26%. Given current models and empirical work looking at corporate tax incidence in a global economy, this shift probably has a relatively progressive long-term impact, from its attracting more capital to the U.S. through the lower rate (though for this purpose one has to consider the effective rate, increased by base-broadening, not just the marginal rate). But the transition gain from cutting the rates, before investment levels adjust, may go to current shareholders.

By the way, a very non-Krugman problem with the Commission’s Option 1 is that (in the variant I consider) the corporate rate exceeds the top individual rate, and in addition dividends and capital gain are taxed as ordinary income, making the system’s bias against corporate equity (and in favor of debt financing or non-corporate entities) significantly greater than under present law.

An underlying philosophical question here is what should proponents of progressivity really be most concerned with – raising the bottom or lowering the top? I am more of a raise-the-bottom person, although I do see the rising concentration of wealth in the U.S. at the very top as potentially having dangerous social, political, and economic implications. But estate or inheritance taxation may be a better instrument than the annual income tax for addressing this. And I would especially like to focus policy at the top on fortunes that are being made through unproductive activity (e.g., Blackwater-style crony capitalism, horrendously maldesigned executive compensation, and the undue growth of the financial sector), as opposed to winner-takes-all yet to a degree productive development of new consumer products (e.g., Microsoft or Facebook). But this presumably involves political economy and regulatory responses, as opposed to using the tax system.

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