The Costs of Tax Policy Uncertainty And the Need for Tax Reform

February 26, 2013

I. Introduction

The American Taxpayer Relief Act of 2012 (ATRA, P.L. 112-240) may be more significant for what it does not do than for what it does. Hopes for a ‘‘grand bargain’’ were not realized. In fact, ATRA does (almost) nothing to address the major fiscal problems that the United States continues to face.

No one seems pleased with ATRA. Noticeably absent were the self-congratulations among members of Congress that usually accompany the passage of significant legislation[1] — and for good reason. Even the bill’s title leaves something to be desired. The ‘‘Act of 2012’’ was not passed by Congress until 2013.

The primary focus here is not on the broader merits or demerits of ATRA, but rather on the issue of tax policy uncertainty. The fiscal cliff represented an extreme case of (manufactured) policy uncertainty. A growing body of research suggests that policy uncertainty imposes substantial economic costs in and of itself. ATRA substantially lessened U.S. tax policy uncertainty over the very short term by, for the most part, making permanent the Bush tax cuts.

However, all is not well. Policy uncertainty re- mains high. Under ATRA, added revenue will come from taxpayers at the top of the income distribution, but that will barely make a dent in the deficits that the United States has been running. Based on projections from the Congressional Budget Office, the Joint Committee on Taxation and the Office of Management and Budget, Veronique de Rugy shows that (over the next 10 years) ATRA is expected to add $332 billion in spending and $620 billion in added revenues. By contrast, projected deficit spending over the same 10 years is order of magnitudes larger than the projected deficit reductions from ATRA.[2] A strong recovery from the Great Recession would be a big help, but major structural problems would still remain.

Post ATRA, the problem of sequestration remains front and center. ATRA extended the start date for sequestration called for in the Budget Control Act of 2011 from January 1 to March 1. Even those wanting to cut the budget do not want to do so in the Procrustean manner laid out in current law. Thus, those cuts are unlikely to materialize, but what will take their place is anyone’s guess.

The Affordable Care Act (ACA) also remains a source of some tax policy uncertainty. As enacted, the individual mandate is set to start at the beginning of 2014. However, the tax is so low that it will be advantageous for many uninsured individuals to pay the tax and forgo insurance until they need it.[3] For the health insurance exchanges to function well and keep costs down, it will likely be necessary to substantially raise taxes from the individual man- date.[4] The only thing that is certain is that any debate over the tax issue will be contentious and heated.

Over the longer term, uncertainty looms. In the coming decades, the U.S. federal tax system is expected to bring in far less revenue than Congress is projected to spend. Major changes are needed to rein in programs such as Medicare, Medicaid, and Social Security, or major tax increases are needed — or a combination of the two approaches. Longtime budget expert Robert Reischauer (who served as director of the CBO and president of the Urban Institute) has said, ‘‘The path we’re on can’t go on for fifteen years. Whether it can go on for two, three, or four years, I have no idea.’’[5]

That near- and longer-term uncertainty is not good for the economy. Research is finding that uncertainty in and of itself has negative implications for the economy, slowing economic growth and possibly prolonging a weak recovery. Policy uncertainty has been shown to reduce investment and to cause companies and individuals to misallocate resources. All those things impose costs on society.[6]

A recent paper found that policy uncertainty could explain the United States’ poor economic performance in recent years.[7] The authors predict that policy uncertainty similar to what their measures show the United States has faced in recent years will result in a reduction in real GDP by 2.2 percent and a loss of 2.5 million jobs. The costs of uncertainty should be distinguished from the fact that uncertainty may arise from increased prospects for harmful policies. In recent years, those two factors (that is, uncertainty itself and the increased likelihood of inferior economic policy) have often been positively correlated. While policy uncertainty imposes economic costs, so too does a shift toward a bad policy environment.[8]

Continue Reading

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


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.