February 26, 2013

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

  • Jacob Feldman

  • Seth H. Giertz

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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]

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