Tax expenditures conference in Loyola (LA)

Yesterday’s conference was reasonably lively. Four panels over 7-1/2 hours went pretty fast. There was widespread consensus among the attendees concerning:

(1) The basic validity or at least value of the tax expenditure concept, so long as one is not overly reductive and broad-brush about it. Ed Kleinbard noted that this is a significant change from where the debate stood 10 or 15 years ago.

(2) The point that, for many though not all of the items commonly classified as tax expenditures, the term “spending through the tax code” is a reasonably descriptive shorthand. I would quibble a bit, saying that the better distinction to draw is between (a) allocative policy aimed at resource allocation and (b) distributional policy aimed who has what. But “spending” is an acceptable lay shorthand for “allocative policy” (such as favoring the coal industry) – although this helps make the point that it is silly to apply the “spending” label to, say, child tax credits, which is a distributional adjustment for family size or the earned income tax credit.

(3) The need to use the budgetary gains from reducing or eliminating bad tax expenditures in the process of addressing the long-term U.S. fiscal gap and avoiding a catastrophic actual or implicit default or collapse in U.S. credit-worthiness.

On (2), a paper-to-be (for now, just PPT slides) by Len Burman and Marvin Phaup proposed that, as a matter of budgetary accounting and for purposes of various budget rules of the present or future, tax expenditures be treated as a tax payment plus an outlay.

To illustrate, consider what has long been my favorite canonical example, David Bradford’s fictional “weapons supplier tax credit” or WSTC. In my version of the example, the government decides to reduce both taxes and spending by $10 billion by (a) eliminating a $50 billion weapons program even though we still want the weapons, and (b) offering the supplier, Acme Industries, $10 billion in WSTCs if it continues furnishing the weapons. Acme uses these to eliminate the taxes it would otherwise have owed. The WSTC is tradable, so it can sell any that it exceed its tax liability to someone else who gets to claim them instead. But for simplicity, let’s assume that Acme would otherwise have owed $11 billion, so it can use the WSTCs itself and lower its federal income tax liability to $1 billion.

When the dust has settled, absolutely nothing has changed. Everyone has the same amount of money as before, and the government has the same weapons as before. But official accounting measures treat both spending and taxes as $10 billion lower than previously.

Under the Burman-Phaup proposal, accounting wouldn’t change either. Acme is treated as having paid $11 billion of tax and received a $10 billion payment from the federal government, even though the WSTC permitted it to net these two transactions without any need for the matching tax flows.

Same proposed treatment for, say, the income exclusion for employer-provided health insurance. Suppose my marginal rate is 35 percent, and that I get to exclude a $10,000 employer-paid health insurance premium from my taxable income. When the federal government computes for official accounting purposes (and any applicable budget rules in the Congress) the amount of overall taxes and spending, my little transaction figures in as a $3,500 tax collection plus a $3,500 federal outlay (i.e., a payment to me offsetting the tax I notionally paid).

Same accounting treatment, presumably, for my excluding the value of the premium for payroll tax purposes, though for the Social Security tax the exclusion won’t affect my liability if I am over the annual ceiling.

The idea is to prevent the use of tax expenditures instead of direct spending from causing the budget picture (or rules) to apply differently when they only differ in form (if the frame viewing this as disguised spending fully applies).

I think this is likely to improve both the informational content of budgetary reporting and the capacity of budget rules to constrain legislation as intended. An obvious application is to the House of Representatives’ new “CUTGO” rule, under which the differential treatment of “tax cuts” on the one hand and “spending” on the other invites legislators simply to repackage the types of “spending” proposals that the Republicans supposedly want to discourage, without changing their substance whatsoever, and thereby evade the rule. Indeed, to make the point clear, the hated “earmarks” that we often hear so much about should presumably get the same opprobrium even if they are cleverly restructured to operate via the tax system with no change in substance.

But now let’s think a bit more broadly about how the proposal invites us to restructure our thinking about tax reform proposals. Suppose we think of the 1986 Act as a budget-neutral, “revenue-neutral,” and distribution-neutral trade of tax expenditure repeal for lower rates. Using the improved frame has no effect on whether the 1986 Act was budget-neutral or distribution-neutral. But it tells us that viewing it as “revenue-neutral” was an illusion based on mistaking form for substance with respect to the repealed tax expenditures that one has agreed were “disguised spending through the tax code” (as the Bowles-Simpson Fiscal Commission Report tells us). Rather, the 1986 Act was a budget-neutral and distribution-neutral cut in both taxes and spending, as reformulated to take into account the point that tax expenditure analysis makes.

Same point for the Fiscal Commission’s proposal to repeal a lot of tax expenditures, but to give back almost all of the budgetary improvement achieved thereby by cutting tax rates (with the top individual rate perhaps declining to as little as 23%). In the cause of narrowing the fiscal gap, and in terms of their own description of tax expenditures, they are greatly reducing taxes – even if not “tax revenues” – with no budgetary motivation whatsoever. The only rationale for cutting the tax rates in this context is that (a) they would otherwise have overshot the target of fiscal balance, and (b) as a policy matter, they happen to like using some of the budgetary surplus thereby created in this particular way. No word on why this is better than some other way of using this surplus, other than that they happen to like lower taxes (a course that has clear efficiency advantages, but is merely one of many possible policy choices).

Based on this line of reasoning, the slides for my commentary at the conference included the following relatively strongly-worded statement:

“For Bowles-Simpson proponents to ponder budget-neutral tax reform is merely insane; for them to ponder revenue-neutral repeal of TEs is also incoherent.”

Insane because one should deploy the budgetary gain from tax expenditure repeal to reduce the fiscal gap, not to fund rate cuts in the face of a huge gap. Incoherent because they are forgetting their own point about tax expenditures if they focus on revenue-neutrality as formally defined.

And I argued that the same point applies to their idea of capping “revenue” as a percentage (such as 21%) of GDP. That feature of their plan also attracted well-deserved flak from other speakers at the conference, who viewed it as overly constraining when we need to be able to respond flexibly to our growing budgetary problems and the general political difficulties in addressing them.

During the question period after my panel, an offsite on-line participant submitted a question to me, based on noting that the above-quoted statement about Bowles-Simpson sounded a bit harsh. Was I saying that adopting it would be worse than where we stand otherwise?

In answering, I felt the questioner had a point, so far as the tone of the bullet point was concerned, because I don’t think Bowles-Simpson as a whole was as bad as I feel they were at that dimension. Yes, for all its limitations (such as underspecified ways of cutting spending growth) it is among the approaches one could reasonably consider deploying in any attempted march away from the cliff of catastrophic fiscal collapse. As it happens, among such plans it’s surprisingly to the right of center for a plan that comes out of a Democratic Administration. If the most liberal plan that could be within plausible responses stands all the way to the left at point 0, and the most conservative such plan stands all the way to the right at point 10, I would say Bowles-Simpson is at about point 8.

Fine, I’d prefer a lower number myself, but having plans at different points along the spectrum is generally constructive, albeit that one might have expected a Democratic Administration (especially one routinely attacked as left-wing) to generate something no higher than point 5. But that doesn’t make the Bowles-Simpson plan insane or incoherent, so from that perspective my comment (if generalized to an assessment of the plan as a whole) was too harsh.

But the error in the Commission’s thinking about and presentation of tax policy issues needs to be made forcefully and clearly if it is to be noticed – and all the more so because this wasn’t just the Commission’s distinctive error, which will cease to matter as such if (as seems likely) its report is swiftly forgotten. The idea that tax reform means a 1986-style trade of base-broadening for lower rates, even in the face of an approaching fiscal crisis that makes budget neutrality entirely the wrong approach, needs to be discredited before the next budget commission (and there will no doubt be many) gets to work.