April 23, 2014

Old Habits Could Jeopardize Budget Deal

With the latest exchange of offers, President Obama and House Speaker Boehner have moved closer to a deal that would reduce the deficit by about $2 trillion over the next decade.  On the surface, the split between spending cuts and tax increases seems relatively even and this is likely to be a point of resistance for those who argue for greater spending cuts.  Lost in the rhetoric, however, is that some policies traditionally defined as “tax increases” are really “spending cuts.”

If that fact could be acknowledged by both sides, they might find that bridging the gap is an easier task.

The current tax code is riddled with "tax expenditures" -- exemptions, deductions, credits, exclusions and preferential rates that function much like entitlement spending.

At a recent public forum convened by Strengthening of America – Our Children’s Future, former Treasury Secretary Larry Summers explained, "There are long-standing privileges in the tax code that perhaps should be thought of as misguided entitlements and...reform of entitlements should also extend to the tax entitlements that benefit many of those who are best off. If we take that approach and we recognize that the idea of expenditure, like the idea of entitlement, is a notion that applies both to what has traditionally been the spending side of the budget and to what has traditionally been the tax side of the budget, I believe we can move forward to make the necessary difficult choices."

At the same forum, Martin Feldstein, who headed the Council of Economic Advisors in the Reagan administration, said that, "much of the spending done by the federal government is done through the tax code, not by writing checks to individuals and companies, but by allowing deductions or credits or exclusions. ... So it ought to be possible for Republicans and Democrats, once we get past the election and the rhetorical barriers that an election imposes … to raise revenue by reducing government spending in the form of tax expenditures."

Feldstein’s prediction is proving optimistic, but the substantive case for eliminating or scaling back tax expenditures is strong. They complicate the tax code, distort economic choices and drain needed revenues. Moreover, because tax expenditures tend to benefit upper-income households more than middle- or lower-income households, reforms can result in a more progressive system, or at least one that is as progressive as the current system.

As Concord’s Chief Economist Diane Lim, has observed, "reducing these kinds of tax expenditures actually reduces the size and scope of government in our economy. Thus, it's a base-broadening, revenue-raising, deficit-reducing, yet government-shrinking proposal. It's therefore consistent with the fiscal policy goals of both Democrats and Republicans."

The extent to which large gains can be made by tax expenditure reform is essentially a matter of political will. The largest tax expenditures are not mere “loopholes,” as the public may understand that term.

The largest tax expenditures include the exclusion from income of employer-provided health insurance ($164 billion a year), the home mortgage interest deduction ($100 billion), the Earned Income Tax Credit ($58 billion), charitable contribution deductions ($52 billion) and the Child Credit ($52 billion).

Policymakers must be honest about which tax benefits would be lost and what the pay-offs would be (i.e., simplified, fairer and more pro-growth tax system with lower rates and higher revenues).

To be clear, changing the definition of what constitutes a spending cut versus a tax increase would not bridge all the policy differences or produce all of the deficit reduction needed to put the budget on a sustainable path. Traditional tax increases, such as rate increases for the wealthy, would still have to be on the table, as would traditional spending cuts such as reductions in projected entitlement costs.

Changing that definition would, however, be a more useful way of assessing the true impact of various policies. As Feldstein told the Strengthening of America panel, "The result shows up on the revenue side of the government’s accounts, but that’s just an accounting fact. The basic economic reality is that changing tax expenditures is a reduction in government spending."

Suppose, for example that the two sides agreed to find $600 billion of tax expenditure cuts. The economic effect would actually be the same as a spending cut, not a tax increase, and should be treated accordingly in assessing the balance of any budget deal. It would also mean that the two parties are not as far apart as a traditional view of "scoring" makes them appear.

So when we talk about spending cuts versus tax increases, let's jettison old habits and begin to think anew about how we define such things. It may just be the key to unlocking a budget deal that both sides can live with.