How to Reduce Deficits and Improve the Tax System Without Hurting Most Families

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Even though unemployment remains well above 9 percent, and the federal government could be doing much more to strengthen the economy, attention in Washington has turned to how best to reduce long-term federal deficits. In this issue brief from The Century Foundation, economist and senior fellow Bernard Wasow weighs in with a solution to a significant part of the long-term deficit challenge that would be relatively pain free for low- and middle-income citizens: reform the income tax system to fix the problems with tax breaks.
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     The Century Foundation conducts public policy research and analyses of economic, social, and foreign policy issues, including inequality, retirement security,election reform, media studies, homeland security, and international affairs. The foundation produces books, reports, and other publications, convenes task forces and working groups, and operates eight informational Web sites. With offices in New York City and Washington, D.C., The Century Foundation isnonprofit and nonpartisan and was founded in 1919 by Edward A. Filene. H EADQUARTERS :   41   E AST 70 TH S TREET –   N EW Y ORK ,   NY   10021   –   212.535.4441   –   212.535.7534   ( FAX )   – INFO @ TCF . ORG – WWW . TCF . ORG   D.C. OFFICE :   1333   H   S TREET ,   NW   –   10 TH   F LOOR –   W ASHINGTON ,   D.C.   20005   –   202.387.0400   –   202.483.9430   ( FAX )   – INFO @ TCF . ORG – WWW . TCF . ORG   H OW TO R EDUCE D EFICITS AND I MPROVE THE T AX S YSTEM W ITHOUT H URTING M OST F AMILIES B Y B ERNARD W ASOW   I NTRODUCTION    The economic crisis that began in 2007 has caused current federal deficits to soar while worsening thealready poor long-term budgetary outlook. Declining incomes and corporate profits have greatly reducedtax revenues, while the federal stimulus legislation and the “automatic stabilizers” of safety net programshave increased domestic spending, leading the deficit to catapult from $248 billion in 2006 to $1.4 trillionin 2009.Under the latest projections of the Congressional Budget Office (CBO), deficits are expected to declineafter the economy recovers but then are expected to increase unsustainably beginning in the decade of the2020s. Those forecasts show that, without corrective action, federal debt will exceed 113 percent of GDPin 2026—surpassing the previous record set during World War II—and then will rise ever upward in theyears beyond. Virtually everyone agrees: the long-term budget outlook is serious enough that after jobgrowth resumes, restoring fiscal health will require some combination of sizeable tax increases andspending cuts. But there is no consensus at all about the details of how to achieve that goal.President Obama created a National Commission on Fiscal Responsibility and Reform, co-chaired by Democrat Erskine Bowles and Republican Alan Simpson, to develop recommendations for significantly reducing long-term deficits. If fourteen of the commission’s eighteen members can agree upon a plan, which is due by December 1, 2010, it will be presented to Congress. Although the co-chairmen of the commission have insisted that “everything is on the table,” many of theRepublican members in the past have adamantly opposed tax increases. So it is highly uncertain whetherthe commission will be able to reach a consensus, and if it does, whether Congress will approve itsrecommendations. As these deliberations unfold, one common refrain will be that there is no painless way to reduce deficits.Many will argue that cuts to important and popular social insurance programs such as Social Security,Medicare, and Medicaid are the only path to fiscal responsibility. But the debate over the past year thatrecently concluded with enactment of health care reform is instructive. Rapidly rising medical costs are farand away the single biggest factor underlying the projected long-term increase in federal deficits.Many provisions in the health care bill, particularly those affecting Medicare and Medicaid, are intended tohelp make the nation’s highly inefficient health care system less wasteful. Because we do not know yet how successful those experiments will be, government forecasts of rapidly rising costs have not changed much   2  www.tcf.org    in the wake of the legislation’s passage. But many experts are optimistic that some of those reforms mighthelp to “bend the cost curve,” which would ease at least some of the long-term budgetary pressures on thefederal government. If so, that would demonstrate that reforms could help to reduce deficits withoutinflicting pain on average Americans. In fact, if they work, they would save money while improving andexpanding medical coverage.One other possible source of savings that would not only be painless for the vast majority of Americansbut also salutary is reform of the loophole-ridded federal tax code, which is filled with inefficiencies,unnecessary complexity, and inequities. The CBO tabulates 165 major deviations from a straightforward,simple income tax. In spite of the fact that these tax breaks—more formally known as “taxexpenditures”—are expected to cost more than $5 trillion in foregone revenue over the next five years,they remain deeply embedded in the system without any of the congressional oversight or review thatspending programs receive as a matter of course. No process exists for evaluating the extent to which taxbreaks are accomplishing their desired goals or otherwise justifying their cost. In fact, the vast majority of tax breaks have not been shown to change behavior in ways that Congress intended when first enacting them into law.Legislators use tax breaks to encourage certain behaviors and at times simply to reward privateconstituents as well as businesses. In the name of promoting saving, investment, and home ownership, forexample, the income tax code has been endowed with special provisions that deliver very little to low-income households, significant benefits to the middle class, and huge tax breaks to high-incomehouseholds. Imagine a direct spending program that delivered benefits worth 5 percent of income to topearners, 2 percent of income to the upper-middle class, and less than 1 percent to those earning less than$30,000 per year. Such a spending program rightly would be looked upon as unfair. But in the guise of “taxexpenditures” such unfair “spending” is widespread.Many political analysts and pundits argue that it is hopeless to try to scrub the tax code of wastefulprovisions because well-financed interest groups have a huge stake in sustaining and adding to thosebreaks. But the experience in 1986, when President Reagan and Congress enacted a sweeping set of reforms that reduced or eliminated, at least for a while, many tax breaks, demonstrates that it is possible inthe United States to gain broad political support for major tax simplification. Although the revenue gainedfrom eliminating sundry tax breaks was offset entirely by tax rate reductions and other changes in 1986— producing a “revenue neutral” bill—one goal of new legislation would be to help reduce the long-termgrowth in federal debt that everyone acknowledges must be addressed. Moreover, the tax increases of 1993under President Clinton demonstrated, contrary to the dire predictions at the time, that increasing revenues can help lead to economic prosperity and a vastly improved budget outlook. The good news is that many of the inefficiencies in the tax code could be curtailed without imposing asignificant hit on the finances of Americans who can bear it the least. Because most of the existing taxbreaks benefit specific industries, and the most costly breaks disproportionately benefit upper-income households, tax reform could be implemented in ways that would raise needed revenues; make thetax system simpler, fairer, and economically efficient; and impose costs primarily on those who can mostafford them. Because the economy still is struggling mightily, with unemployment over 9 percent, it wouldbe premature and counterproductive to try to reduce tax breaks today. But since the debate over deficitreduction is sure to focus on cuts to programs that mainly help middle-class and poor Americans, it isimportant for the public to understand that there are other alternatives that would be less painful and morebeneficial to the country as a whole.  T HE S IZE OF THE D EFICIT P ROBLEM   Budget deficits in and of themselves are not inherently harmful to a country, and actually are the mostprudent policy during economic downturns, when government spending is essential to alleviating hardship   3  www.tcf.org    and revitalizing economic activity. But large and growing deficits during periods of prosperity can becomea significant problem for several reasons. One is that if federal debt—deficits accumulated over theyears—grows faster than revenues, the interest payments required to service that debt take over fromother spending, crowding out a more productive use of funds. When the economy is near fullemployment, public borrowing also can drive up interest rates, crowding out private investment. There is no level of debt to annual income (debt/GDP) at which a crisis is certain. The EuropeanCommunity worries about its members’ high debt burdens and accordingly has set the target that every country should aim for at a debt/GDP ratio no greater than 60 percent. This is an arbitrary rule of thumb—just as the target that housing costs should not exceed one-third of income is arbitrary for afamily—but it is the product of prolonged deliberation among European economic experts. Currently,federal debt held by the public amounts to about 60 percent but is expected to climb to 90 percent by 2020. Another commonly discussed target is to limit annual deficits during periods of economic expansion tolevels that would cause over debt levels to stop growing and begin to decline as a share of the economy. That works out to deficit-to-GDP levels between 2.5 percent and 3 percent, which is about half of thecurrently projected 6 percent. R  EMOVING THE  T  AX B REAK  L OG  J  AM   Curtailing tax breaks could go a long way toward bridging the gap between current deficits and either the60 percent debt/GDP target or the 3 percent deficit/GDP goal, but few policy makers are talking about it. Tax breaks today cost about 6.7 percent of GDP in foregone revenue, climbing to an expected 7.4 percentby 2014. 1 The 165 specific breaks identified by the Office of Management and Budget (OMB) togetherreduce revenue over the 2010 to 2014 period by about $5.2 trillion. 2 A moderate reform of tax breakscould be expected to reduce the deficit as a percentage of GDP by perhaps a quarter to a half of the fiscalcorrection needed to meet the target at the end of the next decade.One lesson of the 1986 tax legislation is that, in order to surmount political obstacles, reform must begenerally perceived as making the system fairer for the vast majority of taxpayers. The entire set of taxbreaks must be reviewed as a package, with sacrifice widely shared and a resulting revised system that iseasily understood to be more fair and simple than what we have today. For that, we turn to a more detailedanalysis of the tax data.Many tax breaks apply to specific commercial interests, such as extractive industries—oil and gas, mining,and timber. Others apply to industries or activities, such as insurance or exporting. But the biggest taxbreaks, in terms of foregone revenue, apply to the personal income tax. Over the next five years, the OMBprojects that more than 90 percent of revenues foregone to tax breaks will arise from provisions affecting households, through exclusions and deductions that go beyond the standard deduction. 3     4  www.tcf.org      Figure 1. Tax Breaks on Business and Personal Income and Expenses Grouped by Purpose 2010-2014(165 breaks totaling $5.2 trillion) Business income tax breaks:$475 billion - 9% Health insurance/care paid byemployers18%Interest paid on a homemortgage12%Retirement saving10%Charitable contributions 6%Capital gains 6%(excluding home sales)Fringe job benefits 5%(excluding health)Property tax and otherhome/rental expenses 5%State and local taxes 5%(excluding property tax)Capital gains on home sales 5%Interest earned on bonds 3%Retirement benefits 3%Other purposes13%  Personal income tax breaks:$4.7 trillion   Source:  Office of Management and Budget, Budget of the United States Government Fiscal Year 2010, Analytical Perspectives, Table 19-1,http://www.gpoaccess.gov/usbudget/fy10/pdf/spec.pdf.   Exclusions are income tax by their purpose. 4 (See Figure 1.) For example, tax breaks for 401(k) plans,Keogh accounts, the Savers Credit, and Individual Retirement Accounts are combined in the slice of thestacked bar labeled “retirement saving.” The multitude of slices—there are eleven, plus a catch-all “other”category—conveys the wide variety of functions that tax breaks are supposed to serve while suggesting thebroad array of special interests that could be expected to resist efforts to reform the tax code. 5   The fourteen largest single tax breaks together cost about $3.9 trillion, three-quarters of the total cost. 6  
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