Transcript: 412 Deficit reduction, taxes, and how not to crash the economy

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The question of fully funding government has come back to the top of the legislative agenda on Capitol Hill. Up until this week, the question was connected to the extension of the Bush tax cuts for the rich. Now, Alan Simpson and Erskine B. Bowles, co-chairmen of President Obama’s panel on reducing the national debt, released a report that surprised many people. They outlined what the New York Times called "a politically provocative and economically ambitious package of spending cuts and tax increases" and ignited a debate that is likely to grip the country for years, or for the next couple of weeks anyway.

The plan calls for deep cuts in domestic and military spending, a gradual 15-cents-a-gallon increase in the federal gasoline tax, limiting or eliminating popular tax breaks in return for lower rates, and benefit cuts and an increased retirement age for Social Security.

Today's podcast begins with extended excerpts from Donald Marron, director of the Tax Policy Center, exerpted from a recent presentation to the National Economists Club. These few comments from Mr. Marron are worth the entire report from the Bowles-Simpson panel.

MARRON

Donald Marron. We improved the audio as much as we could. You can get the whole presentation with bad audio and Q&A off the National Economists Club feed. We fully support Mr. Marron's analysis of the tax expenditures. The controversy over rolling back the mortgage interest deduction could be addressed by cutting the overall tax rate for the middle class.

So. How to generate taxes in a productive manner? You have heard our advocacy for a Tobin tax on financial transactions and a driect tax on gasoline or the cap-and-dividend plan of Maria Cantwell and Susan Collins. That is taxing the bads of speculation and greenhouse gases.

As a bit of an aside, another way of eliminating the distortion for the mortgage interest deduction was proposed in 1992 by then candidate for the Democratic nomination for president and now once and future governor of California Jerry Brown. Brown proposed as part of a reconstruction of the tax code, allowing everybody, renters and owners, a housing allowance deduction. It replaced other forms of deduction and exemption. Brown's two tax program is still the standard for simplification with fairness. Maybe we'll remember that in an upcoming podcast in more detail.

In any event, up until Bowles and Simpson made their splash, the tax question was revolving around the extension of the Bush tax cuts for the rich.

Republicans in the person of new House majority leader John Boehner say, "Yes. Now is not the time to raise taxes on anybody. Instead it is time to cut services and roll back infrastructure, health care and education."

On the Democratic side, the position is more equivocal. The president is clearly in the pocket of Wall Street, even as it comes clear that hedge funds and other Wall Street financiers were behind the Carl Rove attack ad gangs. Yet it is the president who is most forcefully talking up letting the rich take a hit on taxes. Everyone is for extending the cuts for the middle class, and maybe include an extension of the larger middle class Obama tax cuts from the stimulus package. But Democrats begin to mumble when the issue gets to the top of the income scale. Either "No, we cannot afford to extend those cuts," or "No, but raise the definition of who is rich to beyond Suleiman." Or "Yes, extend them, but only for a year or so." Or, "Let's go along with the Republicans in the name of bi-partisanship and besides we're rich too."

The economic impact of tax cuts is not rocket science. Clearing away the political smoke may be beyond current technology, but there is a clear number, an index number, if you like, that displays the economic efficiency of tax cuts. Above 1.0, the tax cuts stimuate the economy. Below 1.0, no stimulation, higher cost than benefit. This index number is the multiplier. We can also use it to gauge the relative effectiveness of tax cuts vs. government spending as economic medicine. And we will. With Wall Street in control in DC, abetted by the corporate insiders of the National Chamber and the pseudo-populist tea partiers, we have to acknowledge that the political air has little chance of clearing, but we insist there is no doubt about the economics.

A special report to Congress from the Congressional Research Service, authored by Thomas L. Hungerford, issued on October 27, gives us some early information on the effect of the Bush tax cuts. First of all, it is entirely appropriate to call them the Bush Tax Cuts for the Rich.

Reduced capital gains, reduced dividends taxes, a repeal of what is called PEP/Pease, basically affect only the rich. The reduction of the top rate from 39.5 percent to 35 percent and the 36 percent rate to 33 also affect predominantly the rich. In the end, the richest one percent those with incomes averaging $1,071,100, saw their incomes boosted 5.3%. Those in the middle, not so much, 2.2%. So it is obvious that the tax cuts were massively regressive. This is borne out by their Suits index numbers. The Suits index is a straightforward gauge of regressivity. With zero as perfectly proportional, neither regressive nor progressive, and minus 1.0 as perfectly regressive, the four major boons to the rich earned minus .80, minus .73, minus .58, and minus .66.

But these are not our index numbers for economic stimulus value. Those are the multiplier. Still, it is instructive to note that the more progressive a tax, the higher the value of its multiplier. And again, the multiplier is the measure of the economic bang for the buck.

A somewhat conservative, but widely accepted estimate of the value of various multipliers was released earlier in the year by Mark Zandi and Alan Blinder, mostly Zandi at Moody's. Dividend and capital gains tax cuts earned a .37 rating. But wait! The multiplier has a different neutral value than the Suits index. The neutral number is 1.0. That is, any value below 1.0 is less than a dollar of value for a dollar of cost. That above 1.0 creates more than a dollar in economic bang for the dollar cost. So the .37 rating means the benefit of a capital gains tax cut is 63 percent below its cost.

Largely as a feature of its canting to the upper income brackets, the multiplier for the income tax portion of the Bush tax cuts for the rich earned a multiplier of 0.32. That is, a benefit on a dollar's cost of 32 cents.

Backing up a bit, there are disputes as to the size of the multiplier, with some contending the multiplier is zero. This is the contention of noted knothead Robert Barro, who in spite of all evidence to the contrary, continues to promote the Ricardian equivalence theory that tax cuts or spending increase decisions by the government will be perfectly estimated by private actors who will reduce their spending by precisely the amount of those decisions.

I kid you not. Barro’s notion of a zero multiplier depends on perfect foresight by households and businesses and financial markets that are perfectly functioning. They not only know precisely what their future tax liability will be, but move immediately to save for that event.

Yes, even after the Wall Street debacle and the spectacle of millions of households under water.

On the other end, very few economists posit a multiplier greater than 2.0. This is a bit surprising to the newcomer, because algebraically, in an economy in which everyone spends what they don't save and the recipients of that spending do likewise in exactly the same proportion. That is, in which a savings rate for all actors is the same, say 5 percent, the multiplier would be twenty. Twenty is a lot different than two.

Oddly the advocates of the zero multiplier are closely allied with the free market extend all tax cuts group. But as we said, in order for the multiplier to be zero, we would have to either repeal the laws of arithmetic or imagine a one hundred percent savings rate. The multiplier is simply the mathematical acknowledgement that for any specific spending event, a number of purchases are generated, each of which is an income to somebody and the source of further purchases. The dollar given to the butcher produces a purchase from the baker, whose new revenue allows a buy from the miller and the farmer and a few truckers and maybe a barrista.

But if tax cuts for the rich are not only regressive, but economically inefficient, What about tax cuts for the middle class? It turns out they are modestly productive as stimulus. An across-the-board tax cut of any particular amount is estimated by Zandi to have a multiplier of 1.02. A payroll tax holiday, which would be progressive, since the payroll tax is regressive on account of its not applying to unearned income and being capped at roughly 100,000 -- a payroll tax holiday would have a multipllier of 1.24, according to Zandi. Unemployment benefits have a multiplier of 1.61. Food stamps increases 1.74.

Now we come to the phenomenon with regard to fiscal policy that nearly cost Dwight Eisenhower his place in the Republican Party. That is, government spending has a higher multiplier than tax cuts.

Yes, They have it exactly backward when Tea partiers say that we cannot afford to raise taxes and we need to cut spending to get government off the backs of the economy. The contadiction to this does not rely on the obvious distributional effects which in all rational economics allows that a dollar to a lower income person is more valuable than a dollar to an upper income person. Neither does it include the calculation of the undeniable benefits of public goods created with government spending. The superior economic impact of government spending versus tax cuts comes simply from the size of the multiplier. Public spending has more bang for the buck than tax cuts.

In Zandi's list, this is displayed in the size of the multipliers for general aid to state governments, for increased infrastructure spending, as well as for food stamps and unemployment. General aid to state governments has a multiplier estimated at 1.41. Infrastructure spending 1.57. Just as a function of the stream of payments. Before benefits received.

Why are the multipliers for spending higher than those for tax cuts? Because government spending begins at one point oh. Government hiring and procurement produces economic activity with the first cent. A tax cut will be divided between savings and spending. For every dollar of cuts, five cents may be saved, another ten cents go to debt service, maybe a quarter to rents, and so on. There will be some follow-on spending from rents and debt payments, but certainly not to the level of groceries or professional services. In fact, since a new tax cut is a marginal addition to a broad range of incomes, the stimulus benefit is limited.

Every cent of a marginal increase may be spent at the lowest income, but this is not where tax cuts are concentrated. Tax cuts by definition accrue to those who pay taxes, and the more taxes you pay, the more marginal income you get from a tax cut. The biggest beneficiaries will be those whose propensity to consume out of marginal income is the lowest.

The Bush tax cuts, for example, as we said, benefited a top income to the tune of fifty or sixty thousand. Those in the middle, two or three thousand. Those at the bottom make out in the low three figures. Leaving aside all arguments about fairness, in terms of the ecoomic impact of the multiplier, that kind of distribution is immasculating.

The argument we have been making is that marginal additions to incomes are in general not as stimulative and tax cuts are disproportionately weighted to those who have the least propensity to spend. A similar, but distinct argument says that the spending out of marginal income is likely to be lower than out of average income. Public spending tends to create jobs which create average spending profiles. Hiring a teacher produces new demand for goods and services across the spectrum at the level of middle income cohorts rather than the very wealthy. And all this is in addition to the services of teaching, a productive activity that is not really challenged in the private sector for its value.

One last point. Double the impact. Yes, when we trade government services for tax cuts as we do under the Mad Hatter plan, we employ the multiplier in a negative direction. The reduction in government spending operates downward with the same velocity as increases in spending go upward. So when we trade a 1.41 multiplier for a .32 multiplier, well, you can do the math. We are going in reverse.

So it is literally upside down to say small government and low taxes are good for the economy. Do I hear a groundswell of support for big government? No? Just gas? Ah well, welcome to the Great Stagnation.

Following is a summary of Donald Marron's remarks to the NEC:

Raising more revenue: The best methods
Summary of remarks by
Donald Marron,
Director
Tax Policy Center, Urban Institute
October 7, 2010

The shared vision of the long-term federal budget is scary, with debts and deficits poised to rise precipitously in the years and decades to come. In the short-term, whenever a nation recovers from recession, governments will spend more than they collect in taxes. In the long-term, the government will have to make changes both in spending and in revenue.

One challenge in forecasting is that there is disagreement about the baseline scenario, as it is uncertain whether Congress will extend the tax cuts that are supposed to expire at the end of the year. The Congressional Budget Office assumes the tax cuts will expire in their projections. But even if the tax cuts are extended, tax burdens will rise at a faster rate than the economy due to bracket creep.

Whatever the baseline, given our debt and deficits, it is unlikely we will have the same tax burdens in two decades that we have now. We have the lowest level of tax revenues relative to the economy in our lifetime, about 15 percent of GDP compared to a historical average of a bit more than 18 percent. As the economy recovers, revenues will naturally revert to 18 to 19 percent of GDP and are scheduled to go a bit higher with the introduction of additional Medicare taxes in 2013 and the so-called “Cadillac tax” on high-cost health insurance in 2018. At the same time, however, policymakers will confront increasing pressures to make some tax cuts, for example to patch the alternative minimum tax and to reduce corporate taxes.

Stronger economic growth is one way to increase tax revenue. CBO estimates that a one percent increase in economic growth would increase tax revenues by two and a half trillion dollars over the next ten years. Productive members of society need to be encouraged to work longer, and immigration of high skilled workers should be encouraged.

Reducing tax expenditures is another way to increase tax revenue. Tax expenditures are effectively spending programs operated through the tax system. Not all tax expenditures are created equal. A particularly egregious expenditure is the mortgage interest deduction, which studies have shown has no effect on homeownership rates. In addition, this deduction encourages more debt, bigger homes, and higher interest rates. Furthermore, it is skewed towards those who itemize and who probably can afford homes without help from the deduction. It costs the federal government $150 billion annually.

We could also generate more revenue if we taxed employer-sponsored health insurance. Not taxing health insurance plans leads to over-coverage.

In the spirit of using taxes to guide behavior, a carbon tax would also be an appropriate way to generate more revenue. Some argue we need more research and development before we impose such a tax. Marron disagrees: The carbon tax would drive R&D. It is the ideal Pigouvian tax.

If all of these taxes have not raised sufficient revenue to meet expenses, then the government needs to consider value added taxes. Bigger governments tend to have VATs; the tradeoff in simplicity is that it is less progressive than other taxes might be.

After Marron’s prepared remarks, he fielded questions.
Q: What about state and local tax receipts?
A: State and local governments have their own challenges, with balanced budget requirements and volatile revenues. Also these governments must deal with underfunded pensions.
Q: What about taxing (and making legal) certain currently illegal activities as a way of generating more revenue?
A: Senators Wyden and Gregg have a step in that direction – raising revenue from gambling – in their tax reform proposal.
Q: What role does the monumental defense budget have in the current fiscal crisis?
A: The defense budget should certainly be reconsidered.
Q: Other nations use the green technology that we create here. How do we make sure we capture the return on investment?
A: There is certainly this challenge with intellectual property.
Q: We are falling behind on infrastructure investments – how do we make this a priority?
A: We have to convince the decision makers that infrastructure and economic growth are related.
Q: What role does tax evasion play in our current fiscal situation?
A: An estimated $300 to $400b in owed taxes is not paid every year. Small businesses are particular scofflaws, and it is difficult to pursue them.
Q: What is the outlook for the fiscal commission?
A: The commission is doing good work, but faces significant political hurdles in reaching agreement. The Bipartisan Policy Center is also delivering a report about debt reduction.

Donald Marron is the Director of the Tax Policy Center at the Urban Institute. Marron previously served as a member of the President’s Council of Economic Advisers, as acting director of the Congressional Budget Office, and as executive director of Congress’s Joint Economic Committee. Before his government service, he taught economics and finance at the University of Chicago Graduate School of Business and served as chief financial officer of a health care software start-up. Marron is also a visiting professor at the Georgetown Public Policy Institute.