July 26, 2014

The Tax Cut Deal: Risks and Opportunities

On Tuesday, Dec. 7, President Obama announced that he had reached agreement with congressional Republican leaders on a major package of tax cuts and emergency unemployment benefits. Some of the tax cuts are new, but most would temporarily extend provisions that would otherwise expire at the end of the month. By preliminary estimates, the revenue loss and higher spending contained in the agreement would amount to roughly $850 billion. None of the cost is offset by spending cuts or tax increases elsewhere in the budget, meaning that the entire amount would add to projected deficits.

Policymakers considering this agreement face two distinct challenges: a sluggish economy and a projected structural deficit that will remain at an unsustainable level even after the economy has fully recovered. Both of these challenges must be addressed promptly and seriously.

Failure to support the economy at this critical time would risk a prolonged period of slow growth, high unemployment and continued large deficits. However, an exclusive focus on stimulating the short-term recovery would leave projected deficits on an even more threatening path and increase economic uncertainty for the future.

Within that context, The Concord Coalition has reviewed the potential benefits and downsides of each major provision of the agreement. We conclude that, in total, the high cost of the agreement can only be justified if it is promptly followed by enactment of a substantial deficit-reduction plan that would take effect as the economy recovers.

It is unclear what can be achieved in the short time Congress has remaining in the lame duck session. Because the President’s National Commission on Fiscal Responsibility and Reform did not produce a sufficiently large majority vote to send a formal recommendation to Congress, there is no immediate prospect of a vote on a comprehensive deficit-reduction package.

With the impending expiration of tax cuts and emergency unemployment benefits having already run out, action must be taken on those items more swiftly than would be ideal, to prevent damage to the fragile economic recovery. However, there can still be conditions or commitments set along with this agreement that would pave the way for a fiscally prudent set of reforms. The existence and credibility of any such initiatives will be crucial in making a final judgment on the agreement.

Here are the main items included in the agreement between the President and Congressional Republicans:

The 2001/2003 Tax Cuts (2-year extension) -- $363.5 billion

 The main circumstance forcing action on this tax package is the pending expiration of the tax cuts enacted in 2001 and 2003. The agreement would extend all of these tax cuts for two years, including the rate reductions for upper-income earners (defined by the Obama administration as households making more that $250,000 annually). The top two rates would remain 35 percent and 33 percent rather than revert to 39.6 percent and 36 percent. The rate on capital gains and dividends would remain at 15 percent for two years rather than revert to 20 percent for capital gains and to the taxpayer's ordinary income tax rate for dividends. The agreement would extend for two years the child tax credit, marriage penalty relief and a number of targeted tax deductions, exclusions and credits.

A positive aspect of this agreement is that none of the tax cuts would be made permanent. According the Congressional Budget Office (CBO), permanently extending all of the tax cuts would reduce revenues by roughly $4 trillion over the next 10 years.This includes the cost of AMT relief, but not the additional debt service costs.  In the absence of comparable spending reductions or revenue increases from other sources (none of which have been proposed in this agreement) all of that $4 trillion would add to federal deficits and accumulated debt.

Keeping the tax cut extensions temporary preserves the option of letting them expire in the future, particularly if no plan is enacted to substantially reduce projected deficits. The risk of this approach is that policymakers may do nothing to reform the tax code or reduce spending until the next expiration date, in which case there will be strong political pressure in a presidential election year to enact another deficit-financed extension.

Despite the battle now raging, the economic difference between extending the tax cuts or letting them expire, in terms of effects on marginal tax rates and the breadth and efficiency of the tax base, is very small. However, even any small economic benefits from keeping lower tax rates would soon be overwhelmed by the negative effect of the growing debt burden. In fact, the Congressional Budget Office (CBO) has suggested that the largest economic effect of the tax cuts is their negative effect on national saving because they have been deficit-financed.

Because the tax cuts would be extended temporarily, the evaluation shifts from the impact on long-term deficits and economic growth to the trade-off between increased short-term deficits and short-term economic impacts. The primary argument for a temporary extension of the tax cuts is that raising taxes while unemployment is still high and economic growth remains sluggish has the potential to further depress economic activity. Therefore the main impact of extension is not that it will dramatically increase economic activity but that it will prevent economic activity from contracting.

On a "bang-per-buck" basis, there are certainly policies with similar costs in terms of the deficit that would have a much more stimulative effect on economic activity because they would direct more of their benefits to lower-to-middle income households who spend larger fractions of any additions to income. Swapping more effective policies for the less-effective 2001 and 2003 tax cuts (or at least for the least effective portions of them) would be the more fiscally responsible policy route.

The Estate Tax (new 2-year parameters) -- $68.2 billion

 Another element of the 2001 and 2003 tax cuts was elimination of the estate tax. In 2009, the estate tax applied to any estate wealth that exceeded $3.5 million for individuals and $7 million for couples. The tax rate was 45 percent. In 2010, there was no estate tax. In 2011, the estate tax is scheduled to revert to the parameters from 2001 -- when estate wealth above $675,00 per individual and $1 million per couple was taxed at 55 percent.

President Obama has previously proposed a return to 2009 levels. The current tax package compromise would set the exemption amount at $5 million per individual and $10 million per couple for 2011 and tax additional wealth at 35 percent.

There is no stimulative effect from this provision, nor would there have been a contractionary effect on the economy from re-instituting the estate tax at 2009 levels. In an era where we need to be discerning about any policy that increases deficits, low estate tax levels for the wealthiest estates in the nation makes little sense. It would add to the deficit, do nothing for the economy, and can hardly be called an “emergency.”

Patch the Alternative Minimum Tax (AMT) -- $136.7 billion

The AMT was originally enacted to prevent high-income taxpayers from escaping income taxes through extensive use of tax preferences. However, it is capturing more and more taxpayers who don’t fall into this category. Two factors are responsible for the increase. First, the threshold levels at which the AMT applies are not indexed to inflation. This results in more taxpayers exceeding the threshold every year as incomes grow.

Second, the cuts in regular income tax rates enacted since 2001 subjected more taxpayers to the AMT because taxpayers above the threshold pay the higher of their liability under the regular rate or the AMT. Indeed, the 2001 and 2003 tax cuts more than doubled the projected share of taxpayers who will face the AMT in 2010.

Over the last several years, Congress and the President have prevented a substantial increase in the number of taxpayers subject to the AMT by enacting a series of temporary patches that increased the threshold levels. This tax deal would continue that practice for the tax years 2010 and 2011.

As with our evaluation of the 2001 and 2003 tax cuts, the story here is the prevention of contractionary tax policy, not any new effects on economic growth. Furthermore, the bang-per-buck in terms of stimulating economic activity is even lower than the "middle class" income tax cuts because households subject to the AMT tend to be higher-income (although not the highest-income) households. Additionally, permanent and paid-for reform of the AMT needs to be near the top of any tax reform agenda because the constant need for temporary patches has consistently become a last-minute "freight train" for additional deficit-financed tax cuts.

Social Security Payroll Tax Cut (one year) -- $111.7 billion

The single most costly new policy in the tax package is a one-year, two percent cut in the payroll tax paid by over 155 million wage-earners. This replaces the Obama Administration's targeted "Make Work Pay" tax credit, enacted in the 2009 stimulus bill, with a larger and broader tax cut.

This policy is designed to stimulate demand in the economy and increase economic activity. Most tax experts believe it is a more stimulative tax policy than extension of the 2001 and 2003 rate cuts.

Thus, while it increases deficits, it also has a greater bang-for-the-buck than the tax cut extensions in terms of how it helps the economy. This tradeoff is one recommended in the final deficit reduction reports from the President's bi-partisan fiscal commission and the Rivlin-Domenici Bipartisan Policy Center Debt Reduction Task Force.

The primary concern with this policy is that it adds another large temporary item to the tax code. Because unemployment will still be high in 2012, there will be a lot of pressure on politicians to extend it, especially considering that 2012 is an election year. Having this "tax holiday" remain a holiday and not the beginning of a permanent vacation, is crucial in our evaluation of it as a reasonable trade-off. And of course, if it is designed to be a more stimulative tax cut than the other tax cuts, it should have been traded off for those other less effective tax cuts, not just piled on as yet another opportunity for seemingly pain-free increase in deficits.

Unemployment Insurance (13 month extension) -- $56.5 billion

In addition to the payroll tax cut, the other item in the agreement that will likely do the most to stimulate economic activity is an extension of unemployment benefits at their current level for 13 months, through the end of 2011. Historically, unemployment extensions have been considered "emergency spending" and as such have been deficit-financed. Because this policy is explicitly related to the current high unemployment rate, there is little danger that it will be extended far beyond the time at which it may become harmful to economic growth. Thus, it responds to a legitimate need and does not add to the long-term structural deficit.

Immediate Business Expensing -- $21.8 billion

The bill temporarily allows businesses to expense all of their investments in 2011. Allowing businesses to take advantage of the tax benefits of depreciation deductions more quickly could provide some stimulus to the economy by providing businesses with greater incentives to make investments during the current year. The Obama administration projects that this could generate more than $50 billion in additional investment in the U.S. in 2011. Analysis by the Congressional Budget Office also sugests that such a proposal could provide a quick and effective stimulus over the short-term.

Such stimulative effects, however, depend on the provision being temporary. Otherwise, businesses would lose their incentive to quickly take advantage of the tax breaks by moving investments forward in time. Similarly, the provision's deficit effects would substantially worsen if extended.

2009 Stimulus Bill Tax Cuts (two years) -- $44 billion

Some targeted tax breaks originally included in the 2009 American Recovery and Reinvestment Act are also extended in this package. They include an enhancement of the child tax credit originally enacted with the 2001 and 2003 tax cuts, and an expansion of the Earned Income Tax Credit for low income families with three or more children.

Also extended is the American Opportunity Tax Credit which helps students and their families cover the cost of college tuition.

While these tax policies might be of some assistance to individuals and families during the current economic downturn, they are not necessarily designed as counter-cyclical policies. Thus the temptation will be to continuously press for their extension beyond the duration of this deal. In fact, that has already happened here, since this marks their first extension after being enacted "temporarily" in the 2009 stimulus bill.

Energy Tax Incentives (one year) -- $11.3 billion

In an attempt to attract support for the tax deal, the Senate has added to the original framework. One group of additions are temporary extensions of several energy-related tax provisions. Included are incentives for a wide range of priorities including, biodiesel and renewable diesel, refined coal production, alternative fuels, electric transmission property, oil and gas wells, ethanol, and energy efficient homes and appliances.

Extending these tax breaks for a short time obscures their true cost and avoids an honest debate over the merits of making the incentives a permanent part of the tax code. In many cases, the provisions use federal tax dollars to subsidize competing priorities -- for instance, fossil fuels, renewable energy, and energy efficiency receive preferences. While many of the individual provisions may have merit, together they result in inconsistent energy and tax policies. In addition to increasing the deficit, the provisions lose revenue in the most inefficient way by distorting markets. In the case of the ethanol tax incentives, both the Government Accountability Office (GAO) and CBO have recently raised questions about the necessity and effectiveness of tax incentives for an industry that has become more mature and already benefits from mandates included in recent energy legislation.

Other Extenders (one year) -- $44 billion

There are a number of other tax provisions extended in this proposal that get extended every year, in what is one of the more perverse rituals in Washington. Called the "extenders," these provisions run the gamut from a state-and-local sales tax deduction, available only to individuals who itemize their taxes and pay more in local sales taxes than income taxes, to the Research and Development tax credit, to even more narrowly targeted breaks like a $101 million provision targeted toward specific film and television productions and a $36 million provision for motor sports racing track facilities.

These "tax expenditures," should be paid for and justified with an analysis of their necessity and effectiveness. The fact that these benefits are distributed through the tax code allows them to escape even the limited scrutiny most narrow spending programs are put through in the appropriations process. Continuing such tax breaks with no analysis or debate is exactly the opposite of good, efficient tax policy.

Even if Congress can't muster up the courage for analysis, at the very least these provisions should not be included in tax bills at the last minute without being paid-for. This is a prime example of why fundamental tax reforms are needed. That would enable Congress to abandon the practice of including short-term extensions in end-of-the-year tax bills, and conduct a comprehensive review of each provision.

Conclusion

Two points are worth stressing.

First, there should be no professed "sticker shock" regarding the deficit impact of this agreement. Policymakers have always known, or should have known, that continuing current policies would substantially increase projected deficits. This would be true regardless of whether the tax cut extensions were limited to the "middle class" or applied more broadly. If fundamental tax reform is not undertaken soon, the $850 billion price tag of this agreement will be just a small sample of things to come.

Second, the extension of many narrow tax preferences in the Senate's legislative version of the agreement runs directly counter to the widely praised recommendations of the President's fiscal commission and the Rivlin-Domenici Task Force. Both groups made a strong case that scaling back or eliminating such "tax expenditures" could be used to build a more efficient system for revenue collection, lower rates and also raise needed revenue. Ignoring this advice, as the agreement clearly does, is a discouraging signal that business-as-usual in Washington has not yet been altered.

Whether this deal is fiscally responsible will ultimately be determined by what Congress does prior to the expiration dates of its main components. Ideally, these short-term policies will give Congress and the President time to consider fundamental tax reform along with the bi-partisan suggestions from the President's fiscal commission for long-term spending restraint.

The sooner we can break out of the box from our current patchwork of tax-cut sunsets and tax expenditures and replace these policies with a more efficient, more permanent, and more responsible tax policy, the easier it will be to break out of the short-termism affecting the rest of the nation's fiscal policy.

The outpouring of credible plans from partisans and policy wonks in response to the work of the President's commission has made clear that nearly everyone in Washington longs to fundamentally transform the tax code -- making it the most sensible area for the nation's leaders to immediately begin our long march towards responsible budget policy.

2010 Tax Cut Compromise