1. Reforming Taxes as Part of Budget Reform Testimony before the National Commission on Fiscal Responsibility and Reform June 23, 2010 C. Eugene Steuerle Institute Fellow & Richard B. Fisher Chair The Urban Institute

2. Outline Taxes & the Budget Principles of Public Finance More on Tax Subsidies & “Expenditures” Tax Gap & Tax Havens Thinking Comprehensively & Lessons from Past Tax Reform 2

3. Taxes & the Budget Reforming taxes involves dealing with: Entire revenue side of budget, including special taxes for: Social Security & Medicare & highways Complex measurement issues (e.g., cost of business) Incentives for work & saving (which affect future revenues) Tax rates About 1/4 to 1/3 of all “spending” or subsidies More housing subsidies (e.g., mortgage interest) than HUD A larger low-income subsidy (EITC) than welfare (TANF) Thousands of provisions Like expenditures, each provision a different rationale 3

4. Relationship Between Tax &Budget Reform Four ways to reduce deficits (1) Reduce direct spending (2) Raise tax rates (3) Spend less on tax subsidies (4) Work more (& save more) Example: Raise early retirement age Biggest budget effect: income tax revenues Actually increases Social Security benefits All except (1) related to taxes 4

5. Taxes & Spending per Household($2010) 5 Source: S. Rennane and C. E. Steuerle, the Urban Institute, 2010. CBO Alternative Baseline, with author adjustments for health reform.

6. Relationship Between Tax &Budget Reform A common problem: permanent built-in growth Many mandatory spending (entitlement) programs Most tax programs Throughout all U.S. history until today, the long-term budget under current law was in surplus E.g., huge 1980 surpluses under 1970 law E.g., huge 1954 surpluses under 1944 law Today, revenues spent before new Congress assembles 6

7. Steuerle-Roeper Index of Fiscal Democracy:-- % of Revenues Not Yet Committed toPermanent (Mandatory) Programs-- 7 Source: S. Rennane, T. Roeper and C. E. Steuerle, 2010. Data from OMB and CBO, with author adjustments for health reform. Excludes TARP.

8. Principles of Public Finance--Apply to Taxes & Expenditures-- Equal Justice (equal treatment of equals) Efficiency (competitiveness, growth, bang per buck, no special favors) Progressivity (e.g., don’t tax those who can’t pay; subsidize needs, not everyone) Simplicity (includes transparency, ability to administer) Individual Equity (entitled to rewards from own efforts) 8

9. Opportunities for Reform:Adhering to & Balancing Principles (1)Special candidates for reform: a principle violated without furthering other principles Preferences by industry, consumption, taxpayer (2)Check for balance How strong is policy rationale for intervention? How much can base broadening deter rate increases? What are the real marginal tax rates—direct & indirect? What are the error rates? Do we need multiple “programs” for education, capital gains rates, etc.? What is the evidence for effectiveness? Who really benefits? Does form (e.g., credit or deduction) matter? Are floors or caps reasonable? 9

10. Tax Expenditures Expenditure-like preferences in tax code Exclusions, deductions, credits, special rates, timing shifts Goals: social, economic, redistributive Usually targeted at specific groups or for specific activities Other Issues Accounting for them doesn’t make them good or bad per se Like expenditures, do affect behavior Often not “neutral” or efficient E.g., favor one form of energy production over another E.g., favor one form of saving over another Some controversy over which to count Most conflicts over capital income taxation For example, should base be income or consumption? 10

11. How Tax Expenditures Differ From Direct Spending Enactments show up as tax cuts, not spending increases Removals show up as tax increases, not spending cuts Administered by IRS, not spending agencies Other Considerations “Authorized” by tax-writing committees Most are permanent (“tax entitlements”) and many intended to be permanent (“tax extenders”) Use annual accounting period (e.g., EITC based on annual wages, welfare based on monthly income) Most (other than EITC and child credits) not “refundable” 11

12. Income & Corporate Tax Expenditures: Comparison to Income Tax and Total Revenues(2010, $ billions) *Percentages especially high in 2010 due to recession Source: Urban-Brookings Tax Policy Center, 2010. 12

13. Tax Expenditures: Largest in 2009(Billions, $2009) 13 Source: OMB Analytical Perspectives. Income Tax Expenditures only.

14. Tax Expenditures: Some Comparisons to Spending by Function, 2009 ($, billions) 14 Source: Center for a Responsible Federal Budget. Tax Expenditure calculations do not include interaction effects.

15. Distribution of Major Tax Expenditures 15 Source: Burman, L., E. Toder and C. Geissler, 2008. Urban-Brookings Tax Policy Center.

16. Distribution of Tax Expenditures Throughout the Income Scale Benefits from high- to low-income taxpayers: Lower rates on capital gains and dividends Itemized deductions Exclusions for pension & health insurance Student loans & higher education subsidies Above-the-line deductions Child-care expenses & tuition credits Child Credit (partially refundable) Earned Income Credit (fully refundable) 16 Source: Burman, L., E. Toder and C. Geissler, 2008. Urban-Brookings Tax Policy Center.

17. Examples of Issues Throughout Income Distribution High income: zero taxes or multiple taxes? Much income accrued & never taxed or taxed at capital gains rates But also multiple taxation: individual, corporate, estate Middle income: are adjustments appropriate & by how much? Housing, pensions Adjustments for family size—too little or too much? Example: family of 4 & family of 2, each making $50,000 Low income: who should administer and how? Earned income tax credit Alternative to welfare But leaves out singles, particularly low-earning males 17

18. Sources of Tax Gap, 2001 ($ billions) 18 Source: Toder, E. 2007. “What is the Tax Gap?” Tax Analysts.

19. Tax Gap & Tax Havens: Opportunities Moderate saving relative to deficit, BUT… Tax Gap Simplification & lower rates = less tax gap More IRS enforcement/resources Direct effects: about $4 per $1 of spending Indirect effects: deterrence More information reporting + withholding Greater equity, but labor switched out of “productive” activities Tax Havens Both evasion (cheating) and legal avoidance (income shifting) Business income shifting perhaps costs $20 billion to $60 billion Includes large interest deductions where few assets Disputes over “transfer pricing” & location of intangibles Financial capital extremely mobile 19 Sources: E. Toder & R. Altshuler, Urban-Brookings Tax Policy Center; H.Grubert, Treasury; IRS; C. E. Steuerle

20. Thinking Comprehensively Inevitable controversy over cuts in spending & tax increases Headlines same for attacking 5 or 500 special interests Controversy already assured over renewal of Bush tax cuts Might as well claim some major achievement Lesson from 1984-86 tax reform effort Burden of proof under narrow reform: Special interest argue they have been “picked on” unfairly” Switch in burden of proof under broad reform: Special interests must argue why principles don’t apply to them Precedent very important Congress facing fiscal huge challenges for many years 20

21. Opportunities: Interactive Tax & Budget Issues Work longer: more revenues at any given tax rate Combined private pension & Social Security reform Recent British example Employee benefit reform: affect income taxes & Soc Sec solvency Financial reform: tax-induced leverage Corporate debt preferred to equity Individual borrowing for larger houses & second homes Interest deductions, yet excluding interest in 401 (k) plans Unprecedented opportunity to combine direct spending & tax subsidies (not possible even in 1986 tax reform) 21

22. Consider Broad Rules & Criteria for Action Limit automatic growth in all mandatory programs Remove special preferences for particular types of industry, consumption or taxpayer Trigger action for excessive growth or fiscal imbalance Goal is to encourage action Remove needless duplication (& combine programs) Education, capital gains, housing, urban, etc. 22

23. Real Budget Reform MeansLower Taxes & Better Spending Over long-run, taxes = spending Current spending = revenues collected today + revenues collected tomorrow Bills don’t go away because paid with credit Interest costs reduce funds for alternatives 23