Tag Archives: Tax Reform

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.

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Just about every tennis player of a certain age – and every serious tennis buff – knows of Ken Rosewall.  Despite losing some of his best years to a period when professionals were barred from the major tournaments, Rosewall, an Australian born in 1934, compiled an incredible record.  He won eight “grand slam” singles tournaments, and in his prime and on his day was widely considered almost impossible to beat.

Ray Ruffels (2)

In contrast, only the true tennis buff – of a certain age – has heard of Ray Ruffels.  Ruffels, another Australian, born in 1946, evolved into a doubles specialist, notably mixed doubles.  In 1978, when Billie Jean King had just about reached the zenith of her remarkable career and sought a 20th Wimbledon championship to surpass the lifetime record of 19 long held by Elizabeth Ryan, she chose Ray Ruffels as her mixed-doubles partner to do it.

Ironically in the nascent Australian tennis madness of the late 1950s and early 1960s, there were few quality public courts.  Serious players had to build their own behind their homes.  Rosewall and Ruffels were good friends, and often would visit each other’s homes to practice and play.  The story goes that in these private matches, Ken Rosewall never beat Ray Ruffels.  But in major tournament play, and despite being 12 years younger, Ray Ruffels very rarely beat Ken Rosewall.  Somehow, when the cameras were focused and the money was on the table, Ken Rosewall always could find the steel in his spine to withstand the pressure.  Ray Ruffels couldn’t.

Graceful transition to tax policy:  As they declared in their April 8 opinion column in the Wall Street Journal, House Ways & Means Committee Chairman Dave Camp (R-MI) and Senate Finance Committee Chairman Max Baucus (D-MT) have begun to collaborate on a tax reform bill.  As required by the Constitution, this bill, if it in fact proceeds into the legislative process, must originate in the House.

And therein lies a cautionary tale.

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As you may know, an early but active debate on tax reform is underway.  My 1987 article, HOW TAX REFORM CAME ABOUT, provides a useful perspective from the time of the last successful attempt at tax reform. The situation in 1986 was different from today in many important respects – in particular, the overall budget situation was bad, but better than it is now. Still, the “1986 model” remains relevant, because many key tradeoffs – between total revenues and tax rates, among groups that enjoy tax preferences, among income groups – are inherent in any quantum change in tax policy.

Perhaps most important is the political dynamic.  Tax reform in 1986 required the cooperation of the Congress with a President whose party controlled the Senate, but did not control the House.  Still, leaders of the two parties communicated with each other, and found common ground. Policymakers came to realize that the serious faults in the then-current system gave them the potential to achieve important steps forward for many taxpayers and for the economy.

And as policymakers studied the issues, they learned that there were important advantages to a tax system with a broader, more-neutral base and lower tax rates.

The article is made available with the permission of Tax Notes, which is the original publisher.

  • There is considerable debate – but arguably somewhat less understanding – about what constitutes a “fair” tax system.
  • There is no simple numerical rule that defines fairness.  It is, instead, a collective political judgment.
  • There are arguably reasonable conditions for making a sound collective judgment – but they are not met in the real world.
  • If the nation can agree on opportunity as an objective, we are left with a choice:  Will we direct our resources to reward the few spectacular successes, as an incentive to others; or will we instead use those resources to limit the tax burden on many ongoing businesses, to facilitate effort?  This blog argues for the latter, on both economic and fairness grounds.

With recent changes in tax rates as part of the year-end “fiscal cliff” deal have come renewed discussion of the most fundamental question of tax policy:  What is “fair?”

A frequent form of this question is a lament that “the 1 percent of taxpayers with the highest incomes pay 22.3 percent of the taxes” (typically using the figures published for some time now by the Congressional Budget Office (CBO); the number I quote here is from their latest estimate, using 2009 data, available here).  A possible subtext, never articulated, is that because 22.3 percent is greater than 1 percent the tax system is excessively progressive.  To interpret that subtext we need a conceptual marker.  If the top 1 percent of taxpayers paid 1 percent of the taxes (and the same for every other 1 percent ranked by income), then we would have the numerical equivalent of a head tax – both Warren Buffett and the proverbial elderly widow in the walk-up cold-water flat would write a check (if the widow had a checking account) to the Treasury for the same number of dollars.  That probably would not strike too many people as a “fair” tax system.

Sometimes the lament is a bit more sophisticated.  With a one-layer-deeper dive into the data, it can be worded as “the 1 percent of taxpayers with the highest incomes earn 13.4 percent of the income, but pay 22.3 percent of the taxes.”  Again, the unstated subtext can be read that 22.3 percent of the taxes, being greater than 13.4 percent of the income, is too high.  But the implied standard that those with 13.4 percent of the income should pay 13.4 percent of the taxes is the numerical equivalent of a single-rate income tax with no exemption or deduction.  Both Warren Buffett and the proverbial elderly widow would pay the same 13.4 percent of their income in taxes – and not the marginal rate (on their last dollar of income), but the average rate (the percentage of all of their income that they actually paid).  Most Americans probably would question whether that was a fair outcome, either.

(Footnote:  The numbers quoted above are for total federal taxes paid – income taxes, payroll taxes, excise taxes, and everything else.  This yields a different perspective than looking at income taxes alone.  The differences between the two are debated with an almost religious fervor, and are a topic for another, very long, day.  Also note that the sum of those different taxes is more a patchwork quilt than a “system.”  But we must persevere, because that is the tax “system” with which we must live.)

So if the 1 percent of Americans with the highest incomes earn 13.4 percent of the total income in the country, how much of the taxes should they pay?  Probably more than 13.4 percent; but how much more?  In truth, there is no simple numerical answer – as the very basic review of the tag lines above suggested.  This question can be answered only by the American people themselves, through the political process.

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Both sides in this year’s presidential election campaign have a fair way to go to get real on the budget problem.  Democrats are making hay by attacking the only viable tool to bend the Medicare (and health care generally) cost curve.  And Republicans are promising very specific steps that would cut income taxes, while keeping their counsel on what they would do to offset the cost (not to mention actually increasing net revenues to reduce the deficit).

The tax issue came up again in the campaign debate this week.  President Obama challenged Governor Romney to specify how he would offset the cost of the tax rate cuts that he has proposed.  Governor Romney returned to a notion that he had floated earlier: a cap on the amount of itemized deductions that each taxpayer could claim.

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Hitherto, the standard position on both sides of the aisle with respect to taxes as a part of deficit reduction has leaned strongly toward tax “reform.”  The word “reform” can mean anything that anyone wants it to mean, of course.  But if the word has borne any content at all with respect to taxation, it has meant “broaden the base, and lower the rates” — in other words, close or narrow selective tax preferences, and use the resulting additional revenue to reduce tax rates for everyone.

Tax reform for deficit reduction, however, could reduce tax rates to give back only some, not all, of the revenue gained by cutting back tax preferences.  The rest of the revenue gained would be kept by the federal government to reduce the deficit.  (Some would assert that the rate reductions could return all of the revenue gain using static scoring, but that taxpayers would work harder and invest more, which would result in more revenue being collected at the end of the day — the classic argument for dynamic scoring.  Large deficits in the 1980s and in the decade of the 2000s make that proposition suspect.)

But earlier this week, Senator Charles Schumer (D-NY), who has become involved in the “Gang of Six (or Eight, depending on who is counting)” budget discussions in the Congress, made a contrary speech. Senator Schumer says that Congress should give up on reducing tax rates, and instead use any tax-preference cutbacks purely to raise more revenue.  He concludes that this path will be more likely to reduce the deficit, and will be better for the middle class.

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