Wednesday, November 14, 2012

A new conservative or Republican tax orthodoxy?

In the aftermath of the election, increasingly people who are conservatives and/or Republicans are taking a new line on tax policy in response to the fiscal cliff (a.k.a. austerity crisis) and/or the longer-term fiscal picture.  They are saying that reducing special tax preferences, such as the home mortgage interest deduction and/or the exclusion for employer-provided health insurance, should be on the table as devices for increasing both income tax revenues and (by targeting the tax preference cutback at higher-income individuals) overall tax progressivity.

As I noted in a recent blog post, Speaker Boehner at least arguably suggested this  Since that time, Glenn Hubbard has said something favorable about it, and most recently Andrew Biggs, at the American Enterprise Institute, posted this item, entitled "All tax increases are not created equal."  And of course the Romney campaign dipped a toe in these waters, so long as one disregards its associated call for reducing tax rates.

Biggs expressly rejects the Grover Norquist line against allowing tax preference repeal to increase income tax revenues, on the ground that the items he would target are best viewed as spending, in line with tax expenditure analysis.  Indeed, he argues that, for this reason, Democrats rather than Republicans (once freed from the Norquist pledge) are the ones likely to be opposed to increasing revenues by these means.

While both endorsing and welcoming most of what Biggs says, let me offer a couple of quibbles regarding the following passage, in which he distinguishes deduction cutbacks from marginal rate increases.  After noting that tax rate increases induce substitution away from earning taxable income, he argues that deduction cutbacks instead have "what economists call an 'income effect' — people would have less after-tax income, and on average people would work more in order to make up the loss. But the amount they pay on each additional dollar of earnings — their marginal tax rate — stays the same, meaning that the tax change hasn't created any disincentive for them to decrease their work effort. While raising marginal rates would likely hurt economic growth, reducing tax deductions would likely increase it, at least by a modest amount."

(Small side comment: This is not the right time to try to induce people to work harder via the income effect, if we have ongoing high unemployment due to inadequate demand.  But this goes to the point that austerity by any means ought to wait a couple for years, or for the definite arrival of improved conditions, before being implemented.)

Returning to Biggs' argument above, I think he over-draws the distinction between raising rates and thus getting substitution effects, and reducing tax preferences and thus ostensibly getting just income effects.  Suppose I am considering working more AND using some of the extra income to buy a bigger house.  Then, under present law, I may anticipate home mortgage interest deductions that lower the marginal rate at the boundary I am actually considering.  So base-broadening actually can have substitution effects away from earning income, in addition to those (which we may want) away from choosing tax-favored assets or consumption.

In addition, if (although he does not propose this) there is any sort of income-related phase-in for tax preference disallowance, that could in effect be a shadow higher marginal rate.

The Romney deduction ceiling approach does not have the latter of these two adverse substitution effects if the dollar ceiling is the same for everyone.  But it could have the former, if increasing my income would make me more likely run into the ceiling.  So things are a bit more mixed and complicated, but that is not to dispute Biggs' basic point.

One last point I'd add is the following.  Suppose we agree with Biggs, me, and the Democrats who take a pro-tax expenditure view that the changes he advocates are actually spending cuts, rather than tax increases, even though they formally show up in budgetary computations as increasing income tax revenues.  Then a "balanced" approach in which both tax increases and spending cuts are being used to address the long-term fiscal situation should count this on the spending side, not the revenue side.  So base-broadening, by Biggs' own logic, does not mean that the "tax" side has been adequately addressed and thus that tax rates shouldn't or needn't go up.

Note also that, as an economic matter, higher rates and a broader base are complements, not substitutes.  The overall efficiency cost of raising the tax rate may decline when the tax is less avoidable because the base has been broadened.


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Olga Chursina said...

McCain dropped essentially every position contrary to Republican orthodoxy he had ever taken in 2009. Immigration, climate, taxes, deficits, campaign finance, DADT, torture, by 2009 he had dropped his opposition to standard Republican dogma on every one of them.

He was facing a stiff primary challenge from his right. Plus, he had to drop many of them in 2008 to win the National Republican nomination for President.

It's like Stephen Colbert once said of Joe Lieberman. "He sticks to his principals. Maybe some day he'll tell us what they are."
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