BackInTheBlackBlog is on vacation this week, but let me offer just some brief reactions to two pieces of news of last week.
You may have seen repeated stories about Federal Reserve Governors and regional bank presidents doing the rounds to speak about monetary policy. I attended a speech by Jerome Powell, one of the most recently appointed Governors. I worked with Jay on his efforts to explain the dangers of playing a game of chicken over the statutory debt limit, and can testify that he is knowledgeable, skilled and impartial. He will be an excellent Governor for these trying times. But his remarks this week illustrate just how difficult the Fed’s job will be.
The speaking rush by the Fed comes because of what Jay described as an out-of-scale market reaction to Chairman Bernanke’s press conference after the most recent Federal Open Market Committee (FOMC) meeting. At that meeting, the members downgraded their individual near-term economic forecasts, but upgraded their forecasts for a few quarters down the road – citing evidence that the economic recovery has grown firmer roots. On the basis of those stronger expectations, Chairman Bernanke spoke in his press conference of his anticipation that the Fed would begin to taper off its current monthly purchases of longer-term securities in the open market as of September of this year, and would reach zero purchases by the middle of next year.
Reacting to this discussion, the financial markets went bonkers, with large one-week increases in long-term Treasury and mortgage interest rates. This raised the prospect of an adverse near-instantaneous feedback loop from housing-is-recovering to OMG-the-Fed-is-going-to-tighten to sell-bonds to higher-mortgage-rates to housing-plunges. It was a fear of such a market reaction that sent Fed Governors and Bank Presidents rushing to the microphones and television cameras.
Jay’s message – beyond characterizing the market reaction as out-of-scale to Chairman Bernanke’s signal – was to emphasize the magic words, “data-driven.” Jay made clear that Chairman Bernanke intended to describe a scenario that would play out if the central tendency of the Governors’ forecasts materialized; if the economy turned out softer, the Fed would delay its tapering off of the asset purchases.
That is of course the right policy process. But here is the rub: We are in a truly unprecedented situation; and there is a very fine line between being “data-driven” and “driving in the rear-view mirror.” Chairman Bernanke and the FOMC decided to send their initial signal on the basis of a forecast. Because the data lag actual events, even the FOMC’s final decision necessarily will be made substantially on the basis of a forecast of the future – else it could be too late. And because the situation is unprecedented – with the Fed sending pressure through previously unexplored channels to stimulate economic activity – the reactions of the market to further unprecedented steps, like withdrawing quantitative easing, are unpredictable and could easily be just as excessive as were the reactions to Chairman Bernanke’s press conference. So to avoid acting too late, and therefore quite possibly causing or exaggerating bubbles in the economy or setting off an accelerating inflation, the FOMC will have to act on a forecast – just as they spoke on a forecast through Chairman Bernanke after their recent meeting.
The FOMC clearly has thought this unprecedented situation through about as well as can be done. But there should be no doubt that they face a daunting task. Their decisions necessarily will depend on judgment calls about an unknowable future.
Another announcement came from Chairman Max Baucus (D-MT) of the Senate Finance Committee. Chairman Baucus said that his Committee will attempt to formulate a plan for tax reform by starting with the presumption that all tax preferences – often called “tax expenditures” – will be repealed. The burden of proof will be on those who want to restore any individual preferences, and restoring each preference will carry a price tag in the form of higher tax rates. Thus, each tax preference will have to undergo an implicit cost-benefit test before the Committee. No Member who advocates a particular tax preference will have any advantage over any other Member who advocates another, on the basis that one is presumed to be retained and the other to be repealed.
Looking from 35,000 feet, the biggest winner from a major tax reform (like that which was enacted in 1986) is the interest whose tax preference is not repealed. That interest gets all of the tax relief from the rate reduction financed by the repeal of everyone else’s tax preferences, but gets to keep its own. Proceeding under Chairman Baucus’s “zero plan” – as it was called by Erskine Bowles and Alan Simpson when they recommended it in their National Commission on Fiscal Responsibility and Reform – would ensure that no interest would win that jackpot simply by being forgotten in the rush, and instead would have to state its case and win majority approval.
But is this the best way to move forward? It isn’t clear. Only time will tell.
Certainly, the burden of proof should be on the decision to retain a tax preference, not to eliminate it. And implicitly, someone who knows what he or she is doing about tax policy, if given the opportunity to formulate a total tax overhaul, will start in this fashion.
But he or she will move a very long way in the first five seconds. We all know that there will be a tax preference for homeownership, almost certainly in the form of a deduction (or credit) for mortgage interest. We know that there will be a tax preference for charitable giving. We know that pension saving, up to some limits, will be tax-preferred, probably through a deferral. There is not much sense going through time-consuming theatrics to make those decisions. (And the record shows that some of the most productive sessions in the 1986 drama took place in private, where such theatrics could be dispensed with.)
So the experienced tax reformer will start with a good sense of what the list of surviving tax preferences will be – at least the big ones, which largely determine what the other major decisions will be, if not which way they will be decided. And there follow many other decisions besides what tax preferences to retain, and which to repeal. The distribution of the tax burden matters, and will be extraordinarily contentious. And then there is the minor detail of how much tax revenue to collect. In 1986, that question was settled on day one, in that President Ronald Reagan made clear that he would not sign a bill that increased the total tax take by a dime. Today, the revenue yield is an open question – at least to one chamber of the Congress and to the President. (Some will argue over whether to measure revenues according to traditional “static” scoring, or with some dynamic methodology – and if that latter, just what that methodology might be.) But if the process does not begin with a target of what amount of revenue to collect, then the motion to reinstate a tax preference does not carry an automatic cost in the form of higher tax rates; it might just reduce revenue a little.
And there are relatively large structural questions beyond repealing or retaining any given preference. There are potential changes in the configuration of the personal exemptions and standard deductions in the tax law. (See the Bipartisan Policy Center’s Domenici-Rivlin Debt Reduction Task Force proposal for some creative ideas – I was involved in the process, but credit (pardon the pun) for those ideas goes to my colleague Len Burman of the Urban Institute-Brookings Institution Tax Policy Center.) There are some who would argue strongly that the United States should not have an income tax at all, but instead should replace it with some form of tax on consumption. We won’t choose to go down that route, but perhaps the debate should be had.
One reality that the “zero plan” does not explicitly capture is that all of the relevant decisions are not serial, but rather simultaneous. Because group decision processes always proceed one decision at a time, this will cause problems. The process will be irrational for sure, but those who must defend their tax preferences first might be at a systematic disadvantage. Start from a zero base, and then argue to retain your tax preference. In the context of very low tax rates, the group might decide that your interest might get along acceptably without a preference. Further on in the process when some tax preferences have been accepted and tax rates are higher, a potentially successful line of defense by another interest might be that the tax rates are so high that they cannot get along without their tax preference – and that argument might be persuasive. If several arguments along those lines are successful, of course, the entire process could explode.
This argument had historical embodiment in then-Finance Chairman Bob Packwood (R-OR), who in a Committee hearing confronted several captains of industry with the tradeoff between the top-bracket ordinary-income tax rate, on the one hand, and a tax preference for capital gains, on the other. How low would the top-bracket rate have to be, he asked, for you to give up the capital-gains break? With that question, Chairman Packwood laid the foundation for the deal that he eventually cut to get tax reform through the Senate, and then through the Congress and on to President Reagan’s desk.
Of course, to be able to play that card, Chairman Packwood needed to have a final plan in his pocket. He needed to know where the tax rates would wind up – not where they would be under a no-hoper zero base. Debating over a zero base that will not happen may have some philosophical benefit, but it is of little practical utility. That is why the 1986 tax-reform process – and to the best of my understanding, the 1969 process, which is the closest historical analog – began with some kind of “chairman’s mark” to debate in a relatively specific way. This is not to say that Chairman Baucus’s “zero plan” cannot succeed, but it will yield an exceedingly long conversation – unless it gets very specific, very quickly, with somebody’s idea of what a sound final package would be.