The Fiscal Cliff, Policy Uncertainty and Tax Reform

Saturday, December 1, 2012

The founding fathers purposefully designed a political system that perpetuates gridlock. Frictions in political decision-making should foster stable policies. However, in recent years, this has been turned on its head.

In recent decades, Congress has passed a series of budget control acts intended to impose discipline on the budget process. These acts, by encouraging policy phase-ins, phase-outs and expiration dates, have had the unintended consequence of policy uncertainty. 

A growing literature is finding that policy uncertainty imposes substantial economic costs. Policy uncertainty leads individuals to misallocate resources or to incur added costs from planning for possible scenarios. Policy uncertainty, it is argued, leads investors to sit on the sidelines, rather than bet on whether or how Congress will act.

In a newly released study by the Mercatus Center, we find that investors may do worse than sit on the sidelines. We argue that policy uncertainty may decrease productive business activities, like research and hiring, while increasing resources spent on unproductive investments, like lobbying government.

We argue that policy uncertainty is a signal that government is open for business. With little policy uncertainty, higher returns may be sought from investing in productive activities. However, when government is receptive to policy changes, the returns from lobbying, political action committees, etc. may be more remunerative. We believe that this may be yet another important cost of policy uncertainty.

Our hypothesis builds on the work of William Baumol, who argued that entrepreneurship can be divided into productive, unproductive, and destructive activities. Baumol chronicles great innovations made over wide swaths of history, but notes that, in many cases, little effort was made to disseminate these inventions to the masses or to use the inventions to increase productivity. Baumol argues that political and cultural institutions play a key role in whether or not innovations are geared toward improved productivity and economic growth. In many preindustrial societies, the path to wealth was through rulers, and not the marketplace. 

The fiscal cliff and chronic policy uncertainty in recent years underscore the need for fundamental tax (and spending) reform. The Tax Reform Act of 1986 was America’s most recent fundamental tax reform. This reform closed loopholes, broadened the tax base, and lowered rates. On the downside, it was susceptible to constant tinkering. In fact, the report of the 2005 President’s Advisory Panel on Federal Tax Reform noted that Congress had subsequently amended the tax code approximately 15,000 times!

In their detailed review of the effects of the Tax Reform Act for the Journal of Economic Literature, Alan Auerbach of the University of California and Joel Slemrod of the University of Michigan concluded that “Even the simplification potential of radical tax reform depends on how enduring a simple, broad-based tax can be, in the face of constant political pressure to reintroduce special ‘encouragements’ or to redistribute the tax burden.” We argue that stability and resistance to constant tinkering should be a first order considerations in any tax reform, and a major lesson from the 1986 reform.

The Economic Costs of Tax Policy Uncertainty: Implications for Fundamental Tax Reform

November 27, 2012

Summary:

For myriad institutional and political reasons, the U.S. faces tremendous tax-policy uncertainty in both the near and long term. While good tax policy is always preferred to bad, economic literature increasingly finds that policy uncertainty itself has negative implications for the economy, reducing investment, consumption, employment and growth, and possibly prolonging a weak recovery. 

A new Mercatus study suggests an additional, largely unexamined cost of the United States’ tax-policy uncertainty: “unproductive” or “destructive” entrepreneurship—the diversion of resources away from economically productive activities to the unproductive activity of lobbying for preferential tax-policy treatment. 

The Economic Costs of Tax Policy Uncertainty reviews existing academic research on the causes and economic effects of tax-policy uncertainty, examines the relationship between tax-policy uncertainty and increased rent-seeking (such as lobbying and political action committee spending) and considers what these findings imply for fundamental tax reform.  

To read the study in its entirety and learn more about its authors, please click here

Key Points:

Economic Implications of Temporary Tax Policy

Tax-policy uncertainty has been shown to negatively impact a variety of factors relating to economic growth, including investment, consumption, and employment. 

The study’s findings suggest tax-policy uncertainty also leads to an increase in rent-seeking. 

  • Because policy uncertainty means the government is open to policy change, it encourages interested parties to spend more money on government lobbying efforts to secure preferential policy treatment. 
  • This diverts resources away from economically productive activities and toward the non-economically productive activity of rent-seeking, thus harming economic growth.
  • This cycle works both ways: tax-policy uncertainty increases rent-seeking; rent-seeking drives constant changes to the tax code, fueling uncertainty.
    • Tax-policy uncertainty—and the rent-seeking and tax loopholes it spurs—shrinks the tax base and reduces revenues. This increases borrowing and debt, which threatens higher tax rates that would further hamper economic growth.

Causes of Tax-Policy Uncertainty

The Budget Process. In recent decades, Congress has passed a series of budget control acts intended to impose discipline on the budget process. These acts have had the unintended consequence of encouraging policy phase-ins, phase-outs, and expiration dates. This gaming of budget rules results in official estimates of budgetary impact that are unrealistically favorable, in addition to an unstable and uncertain policy environment. Over the short term, this uncertainty is reflected by the “fiscal cliff.” Over the long term, uncertainty stems from a tax system that is expected to bring in far less revenue than Congress has committed to spend. 

  • The Congressional Budget Office’s (CBO) process for assessing the budget implications of proposed legislation—as set by the 1974 Congressional Budget Act and subsequent amendments—is regularly gamed by legislators who produce bills designed to receive unrealistically favorable analysis (or a smaller effect on the deficit than is likely to actually materialize).

No Lobby for Economic Efficiency. A key challenge to establishing and maintaining a predictable tax code (one with few special-interest loopholes) stems partly from the fact that economic efficiency does not have a well-organized or focused interest group to represent it. This is because while economic efficiency produces great benefits, these benefits are widely dispersed, making organized lobbying more difficult. 

  • In contrast, carve-outs that make the tax system more inefficient, complex, and inequitable often confer concentrated benefits on a relatively small group. While the costs of such measures generally far outweigh the benefits, the beneficiaries are more concentrated and the benefit-per-beneficiary is often much larger. These measures lend themselves to increased special-interest lobbying.

Lessons from History: TRA 86

The federal government’s most recent fundamental tax reform effort—the Tax Reform Act of 1986—closed loopholes, broadened the tax base, and lowered rates. Studies have shown that it greatly reduced economic inefficiencies, and some argue it laid the foundation for the United States’ strong economy during the remainder of the 1980s and in the 1990s. 

  • But in the 20 years following TRA 86, Congress amended the tax code approximately 15,000 times—that’s more than twice a day, including weekends!
  • A major shortcoming of TRA 86 was that the new tax system remained malleable, leaving open some of the largest and most politically sensitive tax loopholes—such as the mortgage interest deduction and the exclusion of employer-provided health insurance. As soon as many of the other loopholes were closed, lobbyists and Congress were hard at work to reopen them. 
  • Economists Alan Auerbach (Berkeley) and Joel Slemrod (Michigan) concluded in their review of TRA 86: 

“Even the simplification potential of radical tax reform depends on how enduring a simple, broad-based tax can be, in the face of constant political pressure to reintroduce special ‘ encouragements’ or to redistribute the tax burden.” 

Enduring Fundamental Tax Reform 

Create a code that is simple, equitable, efficient—and predictable—requires diminishing the opportunities for rent-seeking. 

  • Budget Process Reform. Reforms could include requiring CBO and JCT to score proposed legislation over the next decade both as written and as fully phased-in; the score that is less favorable would be operative. 
  • Restricted Deductions. 
    • A no- or low-loophole tax code could take the form of a flat tax with limited exclusions enforced by a constitutional amendment (as suggested by Milton Friedman), possibly requiring supermajorities to pass laws pertaining to tax expenditures.
    • Other studied reform options include setting a fixed and enforceable limit for tax deductions. 

Eliminate the Marriage Tax Penalty

Tuesday, September 18, 2012
Authors: 
Jason J. Fichtner

Some sociologists claim that marriage improves the lives of couples and their children, yet the number of married adults in the United States has declined by more than 20 percentage points since 1960. While the reasons for this decline vary, for many, the U.S. tax code discourages marriage. Even among households with equal earnings, the tax code penalizes some marriages while others receive a bonus. Bonuses predominantly occur among married single-earner households while marriage penalties mostly occur among two-earner couples. However, marriage penalties are growing as more women are employed. These penalties could be eliminated by allowing people to choose between filing taxes jointly with their spouses or as single-earners. The existence of marriage penalties and bonuses create three socially undesirable consequences.

First, marriage penalties are regressive, leading to cohabitation among the poorest of society instead of encouraging marriage and family stability. In particular, marriage penalties are assessed against low-income families receiving the Earned Income Tax Credit, or EITC. The EITC provides tax breaks to working lower-income taxpayers based on the number of qualified children and is phased-out as household income rises. Two non-married workers receiving the EITC could actually see their after-tax income decrease if they married. For example, the phase-out of the EITC for two non-married workers with two children potentially begins at $34,180 while the EITC for the married couple begins decreasing at $22,300. Although the decision to marry shouldn't be based on money, the reality and stress of making ends meet may drive low-income workers to not marry and even drive some marriages into divorce. Whether tax policy should encourage marriage or not is open to debate. But, at the very least, the tax code should not penalize marriage. 

Continue Reading

Taxing Marriage: Microeconomic Behavioral Responses to the Marriage Penalty and Reforms for the 21st Century

September 17, 2012

Key Issues Covered:

  • Taxes: Extenders, Fairness, Skewed Incentives, Need for Fundamental Reform
  • Jobs, Economic Competitiveness and Diversity
  • Social Consequences: Dis-incentivizing Marriage, Incentivizing Cohabitation, Divorce—particularly among low-income

Summary:

Academic research suggests that a successful revenue system should be simple, equitable, efficient, and predictable. But as the coming “taxmageddon”—or the expiration of a host of long-standing ‘temporary’ tax laws—underscores, the current tax code fails on all counts. By severely distorting market decisions and the allocation of resources, it also impedes both potential economic growth and potential tax revenue.

Among the tax laws set to expire at the end of the year is the ‘fix’ (or the “marriage tax credit”) applied in 2003 to the tax provisions related to marriage. This working paper examines the effects of the joint-income filing requirement (and the “marriage tax penalty” it imposes), and weighs potential long-term solutions.

Key Points:

The joint-income filing requirement imposes significant financial penalties on two-earner married couples, discouraging both marriage and work.

Severely Outdated

  • The current marriage tax laws are holdovers from when men worked and women stayed home. They reflect the consequences of Congress’ long-standing failure to reform the tax code.
  • The percentage of households with two earners has increased from 34 percent to 77 percent over the past 40 years.
  • The code penalizes stay-at-home spouses from entering the workforce or returning to work.
  • While a single person entering the workforce would pay a 10-percent tax rate on their first dollar earned, a married person entering the workforce would face a 25-percent tax rate if their spouse has $60,000 of taxable income.
  • The code actually incentivizes non-working spouses to stay home and not work because of the “marriage bonus.”
  • Women are most often impacted—marriage tax penalties discourage working women from getting married; marriage tax penalties and bonuses discourage married women from working.
  • Although married individuals have the option of filing separate tax returns, filing under the tax status “married filing separately” imposes limits on tax deductions, narrower tax brackets and higher marginal tax rates.
  • The system forces many two-worker couples to choose between getting or staying married and having lower household income, or cohabitating or divorcing and having more take-home pay.
  • Marriage penalties are regressive, with the effect of joint-filing tax penalties highest on those with the low to middle incomes for which spouses incomes are roughly equal.
  •  Low-income families receiving the Earned Income Tax Credit are hardest hit. The EITC provides tax breaks to working lower-income taxpayers based on the number of qualified children, and is phased-out as household income rises.
  • Two non-married workers receiving the EITC could actually see their after-tax income decrease if they married.

Horizontal Inequity

The marriage penalty creates unfairness among households with the same income.

  •  For many middle-class families, the tax brackets for married couples filing jointly for any given tax rate is roughly twice the amount as a non-married worker.
  •  A single-earner household with an annual income of $60,000 could receive a $3,465 marriage bonus using the standard deduction, while a two-earner household with annual incomes of $30,000 each could receive a marriage penalty of $1,083.

Conclusion

  •  Current tax policies related to marriage highlight the need for fundamental reform of the outdated, overly complex, inefficient, and inequitable tax code that hinders economic growth, diversity, and competitiveness.
  •  These policies also highlight the problems inherent in Washington’s attempts at social engineering through the tax code.
  • The Bush 2003 tax cuts lessened the penalty for marriage, but didn’t fully “fix” the problem—but these cuts are set to expire at the end of 2012.
  • An ideal tax code would be completely neutral with respect to marriage.
  •  At a minimum, married taxpayers should be given the choice to file as married or single; this would eliminate the marriage penalty and end the tension between financial wealth and marital status.

See table (p.7) comparing the effects of various proposals on tax liabilities of couples under current law, mandatory single filing (authors recommend this), and 50-50 income split. This table’s numbers are up-to-date using 2012 IRS tax rates.

Read the working paper as a PDF

When are Tax Expenditures Really Spending?

November 14, 2011

The 1986 Tax Reform Act (TRA86) sought to promote greater efficiency, equity, and simplicity in the tax code. However, TRA86 eliminated only the most politically vulnerable tax expenditures while retaining the tax expenditures with the most vehement political support and greatest economic cost: exclusion of employer-provided health insurance and pension benefits and the home mortgage-interest deduction.

Today, unchecked tax expenditures obscure honest public-policy conversations about the size of government. Even a tax system that allows for only a few substantial tax expenditures keeps the door open for high annual compliance costs as taxpayers continue to seek professional assistance to reduce tax liabilities.

Jacob Feldman Explains 'Cost of Government Day' on RT TV

Mercatus MA Fellow Jacob Feldman explains what the 'Cost of Government Day' means.

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Lessons from the 1986 Tax Reform Act

April 12, 2011

The 1986 Tax Reform Act (TRA86) was designed to improve three aspects of the tax code: efficiency, equity, and simplicity. TRA86 accomplished all three goals in some measure by reducing the standard rates, increasing the standard deduction, and ending various tax expenditures that distributed resources to less efficient production purposes that sometimes served as the proverbial “tax haven.” The debate leading up to passage of TRA86 was contentious and, like today, tax reform was seen as being politically impossible. However, TRA86 achieved significant bipartisan support with final passage in the Senate on a 97–3 vote.

At the time, TRA86‘s passage seemed like a great success for tax reform. However, looking at the 2011 tax code, taxpayers would be hard pressed to find the aspects of efficiency, equity, and simplicity that were improved with passage of TRA86. The principles embodied in the tax reform of 1986 did not last. Tax reform expert and current Yale University law professor Michael Graetz analyzed the tax code in 2007 and exclaimed the failure of TRA86, noting “The Tax Reform Act of 1986 has not proved a stable outcome: Congress has since narrowed the tax base and raised income tax rates.”1 Additionally, stability can be judged by the number of temporary provisions in the tax code. In contrast to the 25 expiring expenditures in the 1985 tax code, 2010 had over 141 provisions that would expire within the next two years.2 Many of these provisions were renewed again with the passing of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.

What happened over the past quarter of a century? How quickly did the reforms of TRA86 unravel and why? This paper examines the act‘s goals of efficiency, equity, and simplicity, to find the lasting successes and failures of TRA86. Now, 25 years later, the federal tax code is again in dire need of reform. The old saying that those who ignore history are doomed to repeat it also applies to tax reform. Those wishing to reform the tax system today would be wise to learn from the past.
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1 Michael J. Graetz, “Tax Reform Unraveling,” Journal of Economic Perspectives, Vol. 21, No. 1, Winter 2007, pp. 86, accessed through EconLit (11/8/10)
2 Randall D. Weiss, Managing Director of Economic research at The Conference Board in New York City, “How Did the 1986 Tax Reform Act Attract So Much Support?” text from the Senate Committee on Finance, September 23, 2010, pg.8-9, accessed at http://finance.senate.gov/imo/media/doc/92310RWTEST1.pdf (2/25/11)

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