Ev Ehrlich's Everyday Economics

One For You, Nineteen For Me (I)

The health care debate was a walk in the park.

Don’t believe it?  The Bush tax cuts of 2001 expire at the end of this year, and if the accusations of death panels and socialism seemed excessive, as Al Jolson would have said, “You ain’t heard nothin’ yet.” 

Because taxes go even deeper into the woods of ideology and doctrine than health care did. 

The Bush tax cuts were passed in 2001 with a “sunset” provision that makes them expire at the end of this year; this was done to avoid accounting for them in long-term deficit calculations, while sardonically betting that no one would have the nerve to take them back.  Given the calamitous path of deficits since, this gaming was conspicuously wrong-headed. 

So now the issue of whether and in what form to extend these cuts must be joined amid the nation’s worst fiscal crisis in our lifetimes.

Even if we weren’t presented with the expiration of the Bush tax cuts, the time would still be ripe for a rewrite of the tax code.  By next year, the expansion will be well underway and employment will be in an extended climb back to something like normalcy.  The economic debate will have shifted from stimulating the economy and making credit effortless to secure to finding an “exit strategy” that avoids the widely-feared outcomes of goods and services inflation (overrated), hyperliquidity-driven asset bubbles (not so overrated), currency stampedes (oversold, at least for some while), and undue risk taking and profound moral hazard (a genuine concern so long as financial regulation goes unaddressed), and a return to greater systemic risk (ditto). 

Moreover, we should remember what Peter Peterson and other budget scolds have repeatedly warned – that we had a long-term fiscal crisis before the 2008-09 economic collapse.  The government’s contingent liabilities, when estimated before the current deficit projections, were already as large as all of American private wealth – they were already the equivalent of financial anti-matter capable of destroying any and all matter with which they came into contact – in this case, all the wealth our society has produced to this moment in history.  From that perspective, all the 2008-09 crisis and the response to it did was move this moment of financial conflagration up in time.

But as the tax debate gains traction, we will inevitably confront the reality that the tax system is broken beyond repair.  By “broken,” many mean “unpopular,” or “impenetrable,” but the situation is actually worse than that.  That is, our tax system is increasingly incapable of generating revenue, either effectively, or at all.

That is because the tax system is so shot through with holes as to be porous.  Irate critics from all political perspectives speak of “loopholes” for “special interests” and, however egregious these may sometimes be, the great bulk of the holes in the system were put there, and are kept there, with broad, bipartisan, and usually enthusiastic support.  Among them are:

• The home mortgage interest deduction, an unindicted co-conspirator in the 2000s boom and bust of the mortgage market, but which has nonetheless left the rate of American home ownership not appreciably different from other advanced nations that lack such a feature;
• The tax-deductibility of employer-provided health benefits (admirably put on the table in 2008 by candidate John McCain), which helps blind users to the cost of their care and surely pushes up insurance prices while counter-productively tying workers to particular employers and employments;
• The myriad of tax-privileged savings accounts – IRAs, Roth IRAs, 529 and 527 college plans, health savings accounts, education and training accounts, and others.  None deliver benefits as efficiently or as fairly as would be hoped; consider the audacity of telling a worker making $30,000 or $40,000 a year that a college or health savings account is the answer to the problem of limited access and affordability;
• The differential capital gains tax rate, which leads to a multi-billion dollar struggle by lawyers and accountants to redefine more highly-taxed “conventional” income as more lightly-taxed capital gains, much as early missionaries discovered that their native converts had  baptized their meat as “fish” and ate it on Friday.  Special capital gains treatment makes the tax code complicated if not bewildering, reduces its progressivity, and does much to change the form economic activity takes but little to change (positively) its absolute level.

The base of the current system, therefore, is so limited that it is incapable of delivering adequate quantities of revenue.  In fact, under the current arrangement, increasing tax rates to bring in more revenue would increase the desirability and importance of these features, as well as bolstering the political will to preserve and expand these features, making the system even worse. 

In short, the tax system is an old grey mare that ain’t what she used to be.  Its weakness begins at the ends and is spreading to the center.   Capital income is disappearing through capital gains treatment or is sheltered in special accounts.  Meanwhile, the zero-bracket, the Earned Income Tax Credit, and remaining progressivity all provide some (justifiable) relief to the working poor and the lowest strata of the middle class.  Thus, our tax code is rapidly devolving into a tax on the wages and salaries of the upper reaches on the middle class. 

And if the middle-class had any thoughts of escaping this burden, it finds its avenues of egress blocked by the Alternative Minimum Tax.  As many taxpayers learn each April, the AMT claws back a rising share of the total value of itemized deductions – principally the aforementioned mortgage interest deduction and the value of state and local income taxes paid.  It, therefore, falls primarily on families with big mortgages in high-tax states and localities – Good Morning, New York! – and thereby ensures that the burden of taxes falls not necessarily on those with the greatest income or wealth, but on this group.  What is even more galling is that, decades ago, when this feature first entered the code, the deductions it reined in were capital gains and the like, the beneficiaries of which were those who had a greater normative obligation to pay something.  But like the rest of the tax code, the AMT has been turned to train its guns on the middle class. 

Thus, even if we were to accept these the system as fair, it would be impossible to raise rates on this ever-shrinking base to levels remotely commensurate with the problems we confront.  As I recall Rudy Penner once casually but accurately saying in a CBO staff meeting coming on 25 years ago, “the more we ask the tax system to do, the less it will accomplish.”

And then, we would encounter the traditional sloganeering and shibboleths of both the left and right.  These merit review.

From the left, we start with the championship of tax-free accounts or special tax treatments regarding education, renewable energy, or what-have-you.  The goals are admirable, but the results are often not.  Expanded Pell Grants, for example, would give more money more transparently to needier students.  Direct spending on to support research, development, and demonstration in the use of renewable resources and carbon capture and sequestration -- and an effective cap-and-trade regime -- would provide a better and, ultimately, cheaper way for the renewable industry to gain scale, reduce costs, and make investments than substantial tax credits for homeowners for digging geothermal wells.  Forgiving taxes on employer health insurance drains away resources that could be used to create true universal coverage and health care security.  We have, in short, tried to morph unpopular spending increases into popular tax cuts, and it’s not working.

On the right, discourse about a “simpler” tax system is directly at odds with their advocacy of different treatment for different types of income, meaning capital income.  These differentials are the driving reason why the system is unduly complex and why its compliance costs are so large – because of the hordes of lawyers and accountants who area hired to explore, expand, and exploit these crevasses in the system.

The conservative analysis behind the different treatment of capital income deserves mention.  It holds that capital income, if taxed, would be subject to “double taxation.”  For example, consider a fellow who makes a dollar, saves a dime, and who earns a penny on that investment – taxing that penny, it is argued, would be “double taxation” because the source of that income – the dime saved – has already been taxed.

I don’t get it.  If the penny in this example results from saving rather than work, why should it escape the system?  Saving represents the foregoing of consumption, but work is the foregoing of leisure.  And if the goal is to let the fruit of saving go untaxed, how can we distinguish between saving and inheritance?  And what of the person who uses the dime to pay for a skill-building education and realizes more income as a result?  Why favor those who invest in one factor (capital) but not another (skill)? 

And despite claims that taxing the returns to saving deters saving itself, there is little convincing evidence that tax features affect the propensity to save the last dime of the income dollar; witness, for example, the strikingly low U.S. savings rate during the various (and significant) tax changes during the Clinton and George W. Bush years.

The greater concern is, and should be, the rate at which the dollar, not the penny, is taxed – the incentive we give people to work and earn, and to do what they want with what they get when they do.  And, again, not taxing the penny forces us to raise taxes on, and reduce the incentive to earn, the underlying dollar.

 Both the left and right, however, make some good points on tax system goals.  Let us all exhale deeply and attempt to acknowledge and concede these merits, whether promoted by our adversaries or not.

First, you cannot raise tax rates forever without interfering with the incentive to earn. The “Laffer Curve,” so fittingly first drawn on a cocktail napkin, has led to undue belittling of this reality.  But, there is truth in the premise that, as I once heard the late Jack Kemp say, “there is only so much blood you can squeeze from the turnip.”  But I don’t think this principle means that we should bribe the indolent rich to go back to work; it’s probably more important for second-earners in families, retired or semi-retired workers, people under the Social Security ceiling, and others for whom the rewards of additional work would be substantially taxed away.  Meaning it’s probably true to lower rates than higher ones.

Second, on the other side of the debate, we need a progressive income tax system.  The idea of one rate for all payers has a Steve Forbes-ian and Ayn Rand-ish sophistic virtue to it – it’s great if you think of it wholly out of context.  But it fails on all counts in the real world.  In fact, as basic as these institutions may be, the rich benefit disproportionately from the existence of a state that promotes security, the rule of law, and, most importantly, the protection of property using its monopoly franchise for sanctioned punishment.  And while interpersonal comparisons are odious, Engel’s Law and the principle of diminishing marginal utility tell economists that a tax of a given percentage disadvantages the rich much less than the poor.  So a “flat” tax can safely said to be, in reality, a regressive one – one that provides more benefit to the rich than the poor.

Third, “simplification” and a “reduced cost of compliance” can’t occur without purging the tax code of its special treatments.  It costs a great deal to administer the tax system not because taxpayers are compelled to pay preparers, but because some taxpayers choose to pay vast amounts to capitalize on the availability of these treatments, starting with the idea that one “kind” of income deserves a different status than does another.

Fourth, saving is a good thing.  In fact, it’s so good that its importance should be more than a pretext for favoring traditional savers (the rich and profit-earning entities), and most of our efforts to promote savings have disproportionately benefited these groups.  But saving is the vehicle through which we provide a higher standard of living to future generations, by putting away resources that finance investments that embody invention and innovation.  Moreover, if a society wishes to invest, it has to save – the alternative is to rely on foreign savers and to take on the debt-service obligations their lending entails, as well as to give the lender a voice in U.S. economic policy, as we have China.

I am as pessimistic as the next fellow about resolving all of this in anything remotely resembling a rational fashion.  But I am hopeful that we can have a discussion that lets a true center emerge in this debate, even if many lawmakers have little interest in coalescing around a center.  Unlike health care, there is a center in taxes, and it could be reached.

In my next entry, I’ll try to take these goals and criticisms and use them to construct a program that could allow both the Left and Right to see their handiwork in it.  Beware the pennies on your eyes!  Come back and let’s continue then.