The Budget Deal: An Opportunity Lost . . .

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

August 1, 1997

A balanced budget. Tax cuts for families with children, family farmers, small business owners and investors. What’s not to like?

A lot. Think back just to last year. A consensus had developed that taxes needed to be simpler, fairer and more friendly to economic growth.

Now the silence is deafening on those same issues. Congress and the administration have managed to fashion a tax cut that makes taxes more complex, less fair and at best leaves economic growth unchanged. That’s actually hard to do, and in the end, it will hurt everyone.

The agreement would make taxes even more complicated than they already are, particularly for typical families. The education and child credits will require separate calculations and involve complex phase-outs. Capital gains tax cuts and confusing IRA choices will create more complexity and significant opportunities to shelter income. Families in ordinary economic circumstances but who have several kids may find themselves placed on the intricate alternative minimum tax.

Although views about fairness will always be “in the eyes of the beholder,” the agreement creates problems here as well. The notion that families with equal incomes should pay equal taxes takes a beating. A family’s tax burden will now depend even more on how it earns or allocates its income and how it spends money. The tax cuts for the wealthy—capital gains and estate taxes in particular—will have their largest effects outside of the 5-year budget window and hence out of public view.

Americans might not be so keen on the package if they understood the long-run distributional effects. And the deal provides very little for the poorest families. For the richest economy in the history of the world having one of its best years ever, that is unconscionable.

These problems might be acceptable if they produced a big spurt in economic growth, but they won’t. It is at best controversial whether capital gains tax cuts and IRAs stimulate saving and investment, but even if they do, the scale of the effect is too small to noticeably affect growth. And the agreement will make the economy less efficient by introducing new loopholes, which divert investment from their best economic use toward their best tax-motivated use. The deal increases the effective tax rate on wage income in various ranges due to the phase-outs of education and child credits. Even Newt Gingrich has acknowledged that the credits will reduce—not increase—labor supply.

Essentially, this is a lost opportunity. Fortuitous events, sound monetary policy and responsible fiscal actions in 1993 have produced a large tax windfall for the government. But suppose you were given an extra $250 billion (the 10-year cost of the tax cut) and could use it only to help solve the nation’s social and economic problems. How would you spend the money? For the administration, the most urgent use of the funds was to subsidize middle-class kids to attend college even though most of them already do anyway.

For Republicans, the most urgent use was to cut by more than a quarter the taxes on investors whose assets have received gigantic gains, doubling in value in three years and rising almost 400 percent in real terms over the past 15 years. Both sides wanted the child tax credit, but there is no guarantee that parents will actually spend much of the tax cut on or for kids. And up to one-third of all kids live in families with income too low to get any child credit benefits.

The deal is more than just a lost opportunity, though. It creates more targeted tax breaks and encourages the idea that taxes should be used to “pick winners” or to favor particular groups. It tells lobbyists that if they did not get their favorite tax cut this time, come back and try again next time—the market for subsidies is open.

This approach is ultimately flawed—in the long run, subsidizing everyone is the equivalent of subsidizing no one. It will also make sensible reforms that eliminate loopholes, simplify taxes and reduce rates much more difficult to pass. And by creating fiscal time bombs—tax cuts that kick in with the most force in later years—the deal makes long-term financing issues relating to Social Security and Medicare even more difficult to handle.

In 1986 a bipartisan agreement with presidential leadership led to fundamental restructuring of the tax code. The resulting reform reduced rates, eliminated loopholes and made taxes fairer. In 1997 a bipartisan tax bill will throw away most of these gains. If this is how the new bipartisanship works, let’s hear it for old-fashioned gridlock.