On the President’s Recommendations to the Joint Select Committee

William G. Gale
William G. Gale The Arjay and Frances Fearing Miller Chair in Federal Economic Policy, Senior Fellow - Economic Studies, Co-Director - Urban-Brookings Tax Policy Center

September 19, 2011

Today, President Obama outlined proposals to reduce the medium-term federal budget deficit. His proposal would pay for the $447 billion stimulus package he proposed last week and reduce the 10-year federal budget deficit by an additional $3.2 trillion, according to Office of Management and Budget (OMB) estimates.

The $3.7 trillion ($3.2 trillion + $447 billion) in budget savings is categorized as follows:

  • $257 billion in mandatory spending
  • $320 billion in health care spending
  • $1,084 billion in defense spending (overseas contingency operations)
  • $1,573 billion in tax revenues
  • $436 billion in net interest savings

The proposals would bring the deficit down to about 2.7 percent of GDP by 2014, where it would hover and then eventually fall to about 2.3 percent of GDP by 2021. The debt/GDP ratio would peak at just under 77 percent of GDP in 2013 and would fall to 73 percent by 2021. The budget would be in primary surplus by 2017 and reach a primary surplus of 0.9 percent of GDP by 2021 (all data according to OMB). 

Some initial reactions:

I. Going Big

The debt-limit deal signed in August had two parts. OMB estimates that the first part will reduce spending by $1.2 trillion (this may seem confusing, because the commonly-used figure for this part was $900 billion originally).

In combination with the debt-limit deal, then, the new proposals would (a) pay for the stimulus package the President proposed and (b) still reduce 10-year deficits by $4.4 trillion. Changes of this size constitute “going big” in current budget parlance and should be applauded.

In contrast, the Joint Select Committee needs to come up with “just” $1.5 trillion in deficit reduction to avoid the automatic second-round cuts. The president is asking Congress to go well beyond that and make a much more significant dent in the fiscal problem now.

II. Compared to What?

The baseline that OMB uses is a measure of “current policy”: it assumes the extension of all of the 2001 and 2003 tax cuts, the indexation of the AMT for inflation, the non-reduction of Medicare provider payments, and the continuation of military operations at full throttle in Iraq and Afghanistan (it does not appear to assume that the run-of-the-mill temporary tax policies, the so-called “extenders,” are extended).

I have argued elsewhere that, in many ways, it makes more sense to use current law as the baseline. Ultimately, the most important thing is where the proposal ends up in terms of deficits, debt, taxes, and spending. The President’s proposal would put the country on a more sustainable fiscal path and buy significant time to deal with long-term problems.

III. Timing

The combination of the president’s stimulus proposal and the medium-term deficit reduction measures would raise the deficit by $300 billion in 2012, and then would reduce the deficit (all, relative to baseline) by $23 billion in 2013, by almost $300 billion in 2014, and by increasing amounts thereafter. If the economy has fully recovered by 2013, it will be able to bear the burden of changes in the direction and magnitude of the deficit. But if the economy is still weak, the increase in fiscal drag in 2013 and 2014 may cause significant problems.

IV. The Role of Taxes

The president is right to call for tax increases as part of medium-term deficit reduction. As I described last month, any credible proposal to solve our fiscal problem will include an increase in government revenue.

  • All major durable deficit reduction packages enacted in the last thirty years, including the 1983 Social Security reforms and the 1990 and 1993 budget agreements, included both tax increases and spending cuts.
  • The only way to provide shared sacrifice is by including tax increases in the package. Spending cuts do not require any significant sacrifice from very high-income households.
  • The notion that government can be reduced in size by holding taxes low has not fared well over the last 30 years. The “starve the beast” approach was tried by Presidents Reagan and George W. Bush, who cut taxes, but ended up raising spending. In contrast, when President Clinton raised taxes, government also reduced spending, resulting in better fiscal discipline on both sides of the budget.
  • Tax increases will be needed, too, because historical revenue levels will not be sufficient to pay for the costs of an aging population with rapidly rising medical costs. Even with significant reforms of Medicare and Medicaid, health costs will place a significant burden on the federal budget.
  • Because the debt-limit deal focuses only on spending cuts, adding tax increases as one part of the new package will help, in all of the ways described above. The overall package looks to have about a 2:1 ratio of spending cuts to tax increases.
  • A combination of tax increases and spending cuts is in accord with the wishes of the American public, who vastly prefer a combination of the two types of budget solutions to a solution that involves spending cuts alone.

V. Taxes on high-income households

It is appropriate to include tax increases on high-income households as part of the fiscal package.

  • High-income households have seen enormous income growth over the past 30 years, which has not been reflected fully in the tax revenue statistics. The share of total income going to the top 1 percent has more than doubled, rising from 9.3 percent of pre-tax income in 1979 to 19.4 percent in 2007. In a progressive tax system, where average tax rates rise with income, one would expect that such a massive increase in income would be coupled—in the absence of any change in tax law—with significantly higher average tax rates (since more income is taxed at the highest rate as income skyrockets). Instead, the average federal tax rate on the top 1 percent of households fell over the time period from 37 percent in 1979 to 29.5 percent in 2007. (As a result, the share of federal taxes paid by the top 1 percent went up by less than double (even though the income share more than doubled) to 28.1 percent in 2007, up from 15.4 percent in 1979.)
  • In contrast, the middle and lower ends of the income distribution have shown very small gains over the past 30 years. According to the Census, median family income after adjusting for inflation only increased 7.3 percent since 1979. More recently, median real family income has declined over the past decade, with median income in 2010 7.1 percent below its 1999 peak.
  • The president’s proposal would return tax rates for high-income households to their late-1990s levels, a period of strong economic growth. Even though the tax rates of the 1990s did not cause the strong economic growth, it is clear that they did not get in the way of the strongest growth period the nation has had in several decades.
  • Proposed taxes on high-income households seem to always generate two responses – it will hurt small business and it constitutes class warfare—which are discussed below.

VI. Small business

There will be concerns voiced that raising taxes on high-income households will hurt small businesses. However, the case can be vastly overstated.

  • First, the proposed tax rates will not affect the vast majority of small businesses. According to the IRS’ 2009 Statistics of Income, only 9.9 percent of tax returns reporting business income were filed by taxpayers with an adjusted gross income greater than $250,000. Second, businesses in the upper income brackets are naturally larger than those in the lower brackets, and account for almost half of the aggregate income of so-called “small business,” but it is unclear that many of these businesses are indeed small. (For example, when Goldman Sachs was a partnership, the income of its managers would show up as “small business” income.) Moreover, most of the income in those income groups is not business income.
  • Those statistics aside, the effective tax rate on small business income is likely to be zero or negative, regardless of small changes in the marginal tax rates. This is for three reasons. First, small businesses can expense (immediately deduct in full) the cost of investment. This alone brings the effective tax rate on new investment to zero, regardless of the statutory rate. Second, if they can finance the investment with debt, the interest payments would be tax deductible, making the effective tax rate negative. Third, they can deduct wage payments in full, so the marginal tax rate should have minimal impact on hiring.

VII. Class Warfare

Proposals to raise taxes on high-income households inevitably generate claims of “class warfare.”

  • But it seems reasonable to ask for some fiscal sacrifice from a group that (a) is very well off, (b) has seen meteoric income gains relative to the rest of the population over the past 30 years, and (c) has nevertheless seen their average tax burden fall, not rise, during that period. It does not seem fair to let the wealthiest escape from sharing the burden of closing the fiscal gap; nor is there a way to impose that burden without tax increases.
  • Ironically, proposals like Rep. Ryan’s recent plan to address long-term fiscal issues would impose more than the full burden of closing the fiscal gap on low- and middle-income households and, at the same time, give high-income households a tax cut. That seems much less justified on fairness grounds than asking high-income households to share in the burden of closing the fiscal gap.

VIII. The Buffett rule

As a guideline for future tax reform (but not as a specific proposal now), the president described “the Buffett rule,” (named with reference to Warren Buffett, who has commented that he faces a lower average tax rate than many of his employees) as implying that no one with income over $1 million should pay a smaller share of his income in taxes than middle class families pay.

  • The notion that people with income above $1 million should pay higher average tax rates than those in the middle class should not be a controversial proposition in principle. It is simply an extremely mild form of progressive taxation.
  • However, the guidelines say “no household” with income above $1 million, which might create issues.
  • The mild form of progressivity may not hold in the current system because different income types have different tax rates. These income types are concentrated in certain income groups more than others. For example, wages and salaries, which are a big share of low- and middle-income households’ income but not of high-income households’ income, are taxed at a flat payroll tax rate (up to a maximum) and graduated income tax rates. Capital gains and dividends are taxed at very low rates (15 percent maximum) under the individual income tax; these constitute less than 1 percent of the income of the bottom 80 percent of the income distribution, but more than 30 percent of the top 1 percent of households (in 2007, the figure will vary from year to year). According to Tax Policy Center estimates, the top one-tenth of one percent of households receive almost half of the benefits from preferential rates on capital gains and dividends. Low- and middle-income households cannot benefit from these tax breaks like millionaires, nor can they exploit other tax loopholes and deductions like high-income households.
  • The Buffett Rule could be implemented in different ways: via a surtax on those whose income exceeds $1 million; via a reformed Alternative Minimum Tax (which would ensure that high-income, not middle-income, households are primarily affected); or via elimination or reduction of preferential rates for dividends and capital gains. The goal of a progressive tax system is laudable and should be pursued, especially as the greatest income gains have benefitted the top while median incomes have stagnated.