Thursday, November 22, 2012

What Real Tax and Spending Solutions Would Look Like, How Liberal Or Conservative Were Our Presidents?, Giving Thanks

The Real Reform We Won't Get
As fiscal cliff negotiations continue, it has become obvious to me that the field on which the game is being played is a small one.  We are arguing over a 3.6% difference in top marginal tax rates (between 36% and 39.6% for those making over $250K) and over "draconian" spending cuts which amount to $120 billion per year, split evenly across defense and domestic spending.

While it is good that we are having a serious conversation about how to reduce the deficit, it strikes me that the plans are not nearly bold enough.

Republicans are right to call for more fundamental tax reform - our labyrinth of deductions (home mortgage, child tax credits, earned income tax credits, charity, energy efficiency, state and local taxes, passive activity investing depreciation and on and on), exemptions and special rates for differing kinds of income (e.g. carried interest, which is essentially the salary of hedge fund managers as well as dividends and capital gains) produce a system where, on paper, the rates appear to be a smooth escalation from 10% at the low end to 36% at the high end, but in practice, 47% of Americans pay no income tax and Mitt Romney pays but 14% or so (not a criticism of Romney or the 47%, a criticism of our tax code.)

Our other taxes are a patchwork as well - Social Security taxes are actually regressive, hitting the first $110K of income only - so someone who makes $50K pays twice the rate that someone that makes $220K and 10 times the rate of someone who makes $1.1 million.

Corporate taxes are similarly a mess - high marginal rates (35%) but huge companies which can declare profitability to shareholders using one set of accounting methods, can take advantage of the patchwork of accelerated depreciation, favorable inventory accounting and a maze of credits to not be profitable on paper and pay no taxes (see General Electric for an example.)

Both parties are squarely to blame for this mess.  Carve outs, exemptions and deductions are among the most popular ways to give back to your constituents and everybody from Ronald Reagan to Bill Clinton to George W. Bush has expanded that patchwork in some form or fashion.

Fundamental tax reform would start with a few basic principles:
(1) The tax rates that you pay should be simple, transparent and consistent
(2) We should not attempt to tax people into poverty, but everyone else should pay a share of the tax burden that they can reasonably afford
(3) Taxes should be about generating revenue, not about encouraging or discouraging behavior

Simpson-Bowles provided the framework, which both Mitt Romney this Presidential cycle and now House Republicans have embraced - "broaden the base" by lowering deductions and exemptions and therefore be able to lower marginal rates and still increase revenues.  The issue with what the GOP is proposing is that they don't seek to do away with the deductions that really cost money - such as home mortgage interest and charity.  And they don't want to address the disparity in rates charged between "regular" (i.e. earned) income and capital gains and dividends.

On taxes, here is my simple proposal:
* Every individuals tax treatment is the same - this will avoid marriage bonuses, marriage penalties, etc.  Right now, if you are a working class family with one income, marriage is a huge tax boon.  If you are upper-middle class and have both spouses working, it's a huge penalty.  Let everyone pay taxes on their income.
* Treat all income equally - whether it is capital gains, carried interest, earned income, dividends, bond interest, whatever.  Add up everything you made last year.
* Exempt the first $35,000 per year in income and index that amount for inflation.  That is approximately the poverty level income for a family of four - a generous exemption that would ensure that no one is taxed into poverty.
* Apply a simple 20% tax rate to all income above the $35,000 level, regardless of source.

You could do your taxes on a post-card.  No more complex forms to fill out.

The revenue effect would be as follows.  There are approximately 155 million people in the workforce and assuming that most of them meet the $35,000 threshold, there would be about $5.4 trillion in income exempted from taxation.  But there is about $13.4 trillion in total income available, leaving $8 trillion subject to the 20% tax or, in other words, generated revenue of $1.6 trillion.
That's a big increase from the $1.2 trillion that is currently collected each year in income taxes.

But wouldn't this system be less progressive?

Actually no.  The $35,000 exemption provides a high degree of progressiveness while avoiding the trap of loopholes for higher incomes.

The effective tax rates paid at various income levels would be as follows:
At $35,000 you would pay an effective tax rate of 0%
At $50,000 you would pay an effective tax rate of 6%
At $75,000 you would pay an effective tax rate of 10.7%
At $100,000 you would pay an effective tax rate of 13%
At $200,000 you would pay an effective tax rate of 16.5%
At $500,000 you would pay an effective tax rate of 18.6%
At $1 million you would pay an effective tax rate of 19.3%
At $10 million you would pay an effective tax rate of 19.9%

So it is actually a very progressive and simple system that generates a ton of income.

So who pays more?
(1) People who currently take big advantage of deductions - generally upper-middle class people who have large homes and therefore large mortgages and live in high tax states.  I think we'd all agree these folks can pay a little more.
(2) High income earners who have a high percentage of their income in the form of dividends and capital gains versus ordinary income.  I think most would agree that the Mitt Romneys of the world can afford to pay 19.9% instead of 14%, right?
(3) Middle-class homes with lots of kids.  Right now, if you make $50,000 and have lots of kids, there is a good chance that you don't pay any income taxes.  Under this plan, you'd owe $3,000 per year.  This is probably the toughest sell in this plan, but don't we want everyone who can afford it to contribute a little?

By adopting this fair, simple, plan, we cut the deficit by $400 billion per year, about the same amount as if we simply let the current tax rates revert as will happen if nothing is passed, but this is a far more fair system that encourages economic activity by having a low marginal rate and eliminates a lot of the inherent unfairness in our system.

On the spending front, we'll deal with 3 basic categories - defense, entitlements and everything else:
On defense, we currently spend about $716 billion per year.  This includes about $298 billion spent on personnel, supplies and military housing with the balance being spent on equipment, R&D and construction.

I would not touch the money spent on personnel - we need troops and we have an obligation to pay them a reasonable rate and feed and clothe them.  But there is over $400 billion spent on equipment that could be cut dramatically.

Adjusting for inflation, spending on personnel, supplies and housing has risen by 25% since 1993.  All other military spending (equipment and R&D) has risen a whopping 84%.  Returning this spend to inflation-adjusted 1993 levels by cancelling programs such as new fighter jets we don't need (it's been over 60 years since a fighter jet was used in combat), nuclear subs (which have never been used in combat) and the like would yield a savings of $190 billion per year.

On entitlements, there are no quick fixes, as we have current obligations to current retirees that no one wants to touch.  Presently, we spend about $1.6 trillion per year on Medicare and Social Security and take in about $900 billion per year in the taxes that fund them.  This is a little deceptive in that this year includes the 2% payroll "tax holiday" that takes about 15% of the tax revenue away from the system, but we clearly still have a problem and it is getting worse with rising health care costs and increased life expectancy.

My proposals are fairly straightforward:
(1) Allow the tax holiday to end as planned
(2) Raise the Medicare retirement age from 65 to 67 for those presently 50 and under
(3) Adjust the Social Security increase from the CPI-U to the Chained CPI-U
This essentially adjusts the cost-of-living increases for social security to more accurately reflect the underlying economics - CPI-U assumes that people keep buying the same things regardless of their cost, Chained CPI-U assumes people modify their buying behavior to prices - for instance, people might buy chicken instead of pork if pork prices rise more than chicken.  The effect of this would be a gradual slowing of the increasing rate of payout in social security payments.
(4) Cap Medicare expenditures at current rates per person, adjusted for inflation
This cap would have the effect of requiring trade-off decisions if medical inflation continues to outpace general inflation.  Yes, this is a form of rationing - it would likely mean that you couldn't get every available treatment at will.  But there is no way to give everyone every treatment at will and contain costs.  It would put pressure on the system to get more efficient.
(5) Eliminate the payroll tax cap on Social Security
Tax all income, not just the first $110K.  Someone making $250K can afford to pay the same rate as someone making $110K.

These changes would not have a dramatic immediate effect on the deficit, since most manage the future rate of increase of spending, not cut current spending.  These actions would reduce the current deficit by about $365B, but would reduce future deficits but far more than that over time and make the system more solvent.

On all other spending,
The choices are tough.  I definitely do not want to cut funding for infrastructure spending, which is one of the highest dollar returns that a government can invest in and is sorely needed.  And I certainly don't want to cut things like the Veterans Administration - our budget situation can't let us not fulfill our obligation to our veterans.  I'd propose the following:
(1) Eliminate Farm Stabilization (a.k.a. farm subsidies)
I've never understood why we subsidize large factory farms out of the federal budget.  The broad availability of crop insurance and the large capital that companies like Monsanto and ADM have at their disposal make this utterly unnecessary.  Eliminate it entirely and you save $13B.
(2) End Extended Unemployment Benefits
Under normal circumstances, you can collect unemployment for 6 months.  Under current law, we have extended it to almost 2 years.  This makes sense at the front-end of an economic shock.  But at this point, if you haven't found work in your field, it's time to accept work in another field.  Reverting to normal unemployment payouts would save approximately $40B per year.
(3) Reform Federal Pensions
Federal pensions are among the most generous out there - far more generous than in private industry - and are costing $127 billion per year and growing.  Make a 401K contribution match, similar to private industry, but end the practice of guaranteed lifetime income for federal workers - no one in the private world gets such benefits anymore.  Assuming that you could cut 25% of the cost (a very conservative assumption), you would save $32B per year.
(4) Manage FDIC Rates
We have the unusual situation right now where the FDIC is running a deficit because of the large number of bank failures - historically it has turned a profit - the FDIC should adjust it's insurance rates to make up for the increased risk it has experienced, as any insurance company would do.  This would save $28B per year from the current deficit.

All told, I'd cut $113B out of discretionary spending without touching, infrastructure, VA benefits, food stamps or education.

So if you add up all these numbers:
$400 billion from tax reform + $365 billion from entitlement reform + $113 billion from discretionary spending reductions = $878 billion in deficit reduction.

Against a $1.1 trillion deficit, that's a pretty awesome year one down payment.  And if we also capped other programs at the rate of inflation, you could take care of the rest as the economy naturally grows (eventually!) and costs on other programs come down as more people find work.

Of course, all of this won't happen, but I wanted to dream for a moment about what would be possible if we didn't view the world so myopically.

Liberals vs. Conservatives
What defines a liberal versus a conservative?

In social terms, it is complex, but in economic terms, I think there is relative consensus - a conservative wants smaller government and lower taxes and a liberal wants larger government and therefore higher taxes.

The conventional wisdom is that Republicans generally pursue more conservative policies, Democrats more liberal policies.  Reality, as always, is a little more complex than that.

I've looked at US Presidents since World War 2 and analyzed what happened during their administrations on taxes and spending.  I've looked at the net CHANGE in taxes and spending as a percentage of GDP during their administrations versus the absolute levels since every President has to deal with a baseline budget coming in.

The obvious limitation of this methodology is the composition of Congress.  For instance, a liberal President might want to spend more, but a hostile congress could have blocked the spending or vice-versa with a conservative congress.  So, we'll discuss that impact with the numbers.

Looking at the four quadrants that are possible, I've assigned the four descriptions:
(1) Deficit Hawks
These Presidents have the attribute of HIGHER taxes and LOWER spending.  In other words, they shrunk government but also paid the bills.
(2) Deficit Spenders
These Presidents have the attribute of LOWER taxes but HIGHER spending.  They effectively grew the size of government, but didn't pay for it.
(3) Liberals
These Presidents pursued a larger government policy - higher taxes and spending.
(4) Conservatives
These Presidents pursed a smaller government policy - lower taxes and spending.

Deficit Hawks: Clinton, Obama
Deficit Spenders: W. Bush, H.W. Bush, Ford
Liberals: Carter, Johnson, Kennedy
Conservatives: Reagan, Nixon, Eisenhower

The chart is actually quite stunning in showing how much of an outlier the W. Bush administration was.  Government spending increased by 7% of GDP from 2001 to 2009 going from 18.2% of GDP to 25.2% of GDP.  Meanwhile, taxes fell from 19.5% of GDP to 15.1% of GDP.  The net result is that in that 8 years, a budget surplus of 1.3% of GDP turned into a massive deficit of 10.1% of GDP.

So how did this happen?
The spending increase basically comprised three things - the spending on the wars associated with Iraq and Afghanistan and the creation of the Department of Homeland Security, a large increase in Medicare spending associated with the prescription drug program and massive spending at the end of his term dealing with the financial crisis - including TARP and higher cost for programs like Food Stamps and Unemployment as the economy tanked.

The tax receipt reduction was principally the byproduct of the 2003 tax cuts that Bush pushed through that slashed rates across the board.

So how influential was congress in this mess?
From 2001-2003, Republicans controlled congress.  From 2003-2007, Republicans controlled the House and Democrats the Senate.  From 2007-2009 Democrats controlled both chambers.

So, breaking it down by era, we can look at the changes that happened during each stage:
From 2001 to 2003 - taxes fell 3.2% of GDP and spending increased 1.5% of GDP
From 2003 to 2007 - taxes increased 2.5% of GDP and spending was flat
From 2007 to 2009 - taxes fell 3.4% of GDP and spending increased 5.5% of GDP

The big hits to taxes came at first with the Bush tax cuts and then with his early attempts at tax stimulus in 2007 as the economy headed south (along with the decrease in taxation caused by reduced profits at large corporations.)

The biggest spending hit was clearly TARP and the fallout from the recession, but the prescription drug program and expansions in discretionary spending which happened under an all GOP watch also contributed.

So, in the case of Bush, the blame is somewhat shared and the numbers are exaggerated by an economic crisis, but we were clearly on an irresponsible path far before then.

The biggest deficit Hawk on our list is Bill Clinton.  Clinton faced a Democratic congress from 1993-1995 and a Republican Congress from 1995-2001.

1993-1995 saw a 0.8% of GDP reduction in spending and a 0.9% of GDP increase in taxes
1995-2001 saw a 2.4% of GDP reduction in spending and a 1.1% of GDP increase in taxes

Interestingly, the 6 years of GOP-control looked a lot like the 2 years of Democratic control in terms of trend.  The Democratic congress set tax hikes in motion and reduced military spending - the GOP congress reined in domestic discretionary spending.  So there is some shared credit, but also a clear trend with Clinton.

The other President whose numbers may appear surprising is Obama.  The conventional wisdom is that deficits have exploded under Obama thanks to prolific stimulus spending.  In fact, spending has fallen modestly and tax receipts are up modestly.  This is partly deceptive, since Obama's "base" includes emergency TARP spending that has lapsed.  But it also speaks to the mess that Obama inherited in the budget, with 10%+ deficits in the baseline.

What parties say and what Presidents do often diverge.  Leadership is about more than party membership.

Giving Thanks
Today is Thanksgiving and as I have traditionally done, I wanted to give thanks for some things that are great about our nation.
* Thank you to the soldiers who go to far-flung dangerous lands to guard our freedom.  And thanks to Congress and the President for giving brave gay soldiers equal standing.
* Thank you to the voters of Oregon and Colorado for forcing politicians of both parties who don't want to talk about the failed "War on Drugs" to deal with the issue.
* Thank you to the poll workers who worked long hours to protect the most sacred rite of our republic - the integrity of the vote.  Here's to hoping politicians finally make common, secure voting technology a priority in the coming year.
* Thank you to FEMA and all of the volunteers and emergency workers that made an awful storm on the east coast a little less awful.
* Thank you to everyone who ran for public office this past election - win or lose - for putting themselves out there and giving us choices
* Thank you to everyone who works Thanksgiving day so that we can enjoy it with our families - cops, fire fighters, grocery store workers - thank you to all of them.

I hope that you are enjoying turkey and football with your family today - or whatever your personal Thanksgiving tradition is.  And if you are working today, thank you again, and I hope that you get some time with your family.

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