The Center's work on 'Alternative Minimum Tax' Issues

Lee Tax Reform Plan’s Disappointing Details

March 20, 2014 at 10:11 am

In high-profile speeches on tax reform, Senator Mike Lee (R-UT) has called forcefully for expanding opportunity and helping parents raising children.  Unfortunately, the tax reform plan he recently detailed — which sets two income-tax rates of 15 and 35 percent, eliminates the Alternative Minimum Tax, repeals or reforms some major deductions, and, centrally, creates an additional Child Tax Credit — falls far short of his stated goals.

The plan gives its biggest benefits to the wealthiest one-tenth of 1 percent of tax filers and costs more than $2 trillion in lost federal revenue over ten years, according to a new analysis by the Urban-Brookings Tax Policy Center (TPC).  Also, its Child Tax Credit proposal excludes many working-poor families struggling to raise their children.  Worst of all, many of these families would lose significant amounts of child tax credits and marriage penalty relief they receive today.

In October, Senator Lee told a Heritage Foundation audience that “[T]he great challenge of our generation is America’s growing crisis of stagnation and sclerosis — a crisis that comes down to a shortage of opportunities,” adding:

“This opportunity crisis presents itself in three principal ways:

  • immobility among the poor, trapped in poverty;
  • insecurity in the middle class, where families just can’t seem to get ahead;
  • and cronyist privilege at the top, where political and economic elites unfairly profit at everyone else’s expense.”

He also stressed the importance of helping parents address “the enormous costs of raising their children.”

Yet a central piece of Senator Lee’s plan — a new Child Tax Credit to complement the existing credit — would do little or nothing for many working-poor families because it would be only partly refundable.  (Specifically, families could only receive the credit to the extent that their combined income and payroll taxes exceeded their Earned Income Tax Credit.)

This design ignores research showing that income boosts from sources like refundable tax credits have both short- and long-term benefits for low-income families, such as improving children’s school performance and likely work effort as adults (which, in turn, increases future federal tax revenues).

Moreover, Senator Lee would limit eligibility for his new credit for those at the bottom of the income scale but not those at the top.  This means that every child of a high-income banker or corporate executive would qualify, but many children of cashiers, house cleaners, and health aides wouldn’t.

Moreover, the Lee plan lets key improvements from 2009 in the current Child Tax Credit and marriage penalty relief in the Earned Income Tax Credit (EITC) — which policymakers on a bipartisan basis have extended through 2017 — expire at the start of 2018.

Picture a health aide with two kids working full time at the minimum wage (earning $14,500) in a nursing home in an affluent town.  Under the Lee plan, she would lose about $1,725 in 2018:  she would no longer qualify for the existing Child Tax Credit, and she earns too little to qualify for Lee’s proposed new Child Tax Credit.  Meanwhile, the higher-income people with parents that the health aide cares for would qualify for the new Child Tax Credit if they have children.

In another example, a married couple making $25,000 with two children would lose about $1,670 from the Lee plan because the plan lets the 2009 EITC and Child Tax Credit improvements expire.

Given Senator Lee’s inclusive rhetoric and his stated desire to expand opportunity for working-poor families, let’s hope that TPC’s findings surprise him enough that his future plans, unlike his current plan, will help these families raise their children and move up the economic ladder.

CBO Immigration Cost Estimate Doesn’t Support Use of “Dynamic Scoring” for Tax Reform

July 24, 2013 at 2:06 pm

Some members of Congress are claiming that the Congressional Budget Office (CBO) and Joint Committee on Taxation (JCT) used “dynamic scoring” to estimate the budgetary effects of the Senate immigration bill and should do the same for tax bills, starting with tax reform.  But they’re off base on the immigration bill, and their call for dynamic scoring for tax reform is an invitation for fiscal irresponsibility.

Advocates of “dynamic scoring” want to see “macroeconomic feedback” effects incorporated into estimates of the budgetary effects of legislation.  That means trying to estimate (1) how the legislation might change households’ work and saving decisions and businesses’ investment decisions, (2) how those decisions would affect broad macroeconomic variables like gross domestic product (GDP) and employment, and (3) how those changes in the economy would induce changes in revenues and spending.

CBO and JCT do not do this in their cost estimates, and with good reason.  Economists do not agree on the size — sometimes even the direction — of macroeconomic feedback from cutting marginal tax rates or making other changes to taxes or spending.

Such dynamic scoring would also impair the credibility of the budget process.  Because the estimates of macroeconomic feedbacks are very uncertain, including them in budget estimates would be highly controversial and inevitably viewed as biased and politically motivated.

In its official cost estimate of the immigration bill, CBO made an exception to its longstanding policy of assuming that the legislation under consideration does not affect the overall size of the economy.  It did not, however, embrace dynamic scoring.

CBO and JCT confront a unique challenge with immigration bills, which — unlike virtually all other legislation — would substantially expand the U.S. population and labor force and therefore affect the budget independently of any impacts resulting from changes in households’ and businesses’ behavior.  As our analysis of the Senate bill explains, CBO’s cost estimate accounted for the direct effects of these population and labor force increases on the size of the economy, revenues, and federal benefit spending.  CBO employed a similar procedure in its cost estimate for the 2006 immigration bill.

Other than that, CBO sought (in its words) “to remain as consistent as possible with the rules CBO and JCT follow for almost all other legislation” and did not “incorporate the budgetary impact of every economic consequence of the bill.”  CBO did not, for instance, include more speculative and uncertain effects on GDP, such as changes to business investment and productivity.  In short, CBO’s cost estimate of the immigration bill does not include the type of “dynamic scoring” that some members of Congress are calling for with respect to tax legislation.

As it sometimes does with major legislation, CBO provided a separate analysis of additional economic effects not in its official cost estimate of the immigration bill, as well as their potential impact on the budget. Reflecting the high degree of uncertainty surrounding these effects, CBO provided a range of estimates rather than the precise estimates required in an official cost estimate.

This is the appropriate approach for any legislation with such potential economic effects, including tax-reform legislation.  But by claiming that CBO employed dynamic scoring in its cost estimate for the immigration bill, advocates of using dynamic scoring for tax bills are seriously misrepresenting CBO’s approach to the unique situation that it faces with immigration bills.  Policymakers should not fall for this mistaken claim when they consider tax reform.

The fact remains, as we explained a year ago, that budget plans — whether on the tax side or on the spending (“investment”) side of the ledger — should not rely on dynamic scoring.

“Blank Slate” Approach to Tax Reform Leaves Biggest Question Unanswered

June 28, 2013 at 11:54 am

Yesterday’s call from Senate Finance Committee Chairman Max Baucus and ranking Republican Orrin Hatch to initiate tax reform with a “blank slate” that doesn’t include any of the deductions, credits, exclusions, and other tax breaks collectively known as “tax expenditures” leaves a critical question unresolved:  what will policymakers do with the proceeds from narrowing or eliminating tax expenditures?

Will they use a substantial share of the savings to help put together an alternative to sequestration or otherwise devote such savings (presumably in conjunction with spending reductions) to the long-term deficit reduction that the nation needs?  Or will the savings go entirely to cutting tax rates?

Using some of the savings as part of a responsible, balanced alternative to sequestration —thereby averting harsh cuts in areas ranging from national security to education, medical research, and Head Start — and to help put the nation on a firmer long-term fiscal footing ought to be a higher priority than the pursuit of ever-lower tax rates.

Tax reform that curbs unproductive tax expenditures surely has merit.  Yet revenue-neutral tax reform would be highly problematic, as it would likely take revenues off the table for deficit reduction for years to come by using up virtually all politically achievable reductions in tax expenditures.  That, in turn, would likely take mandatory programs off the table for deficit reduction as well, because many policymakers would justifiably reject large mandatory cuts in the absence of new revenues.

In addition, policymakers face an immediate need to replace the harmful sequestration budget cuts, which are affecting defense and non-defense programs alike, with a mix of savings from tax expenditures and mandatory programs.  But revenue-neutral tax reform could foreclose that option by using up all of the politically achievable tax expenditure savings to pay for tax-rate reductions.

An essential ingredient of tax reform — and the one target for policymakers to specify in advance — is therefore a revenue target: one that contributes to a balanced deficit-reduction package that includes replacing sequestration.  Revenues raised through tax reform — including through a “blank slate” approach — should go to lower rates only after this target has been met, as most budget agreements under discussion over the past few years would have done.

This means that while policymakers may have useful exploratory discussions on tax reform now, they should defer actual legislative action until there is a larger fiscal policy agreement that includes a revenue target under which tax reform will contribute meaningfully to deficit reduction.

Tax Day Roundup

April 15, 2013 at 10:40 am

Top 10 Federal Tax Charts

April 15, 2013 at 5:00 am

In recognition of Tax Day, we’ve collected our top ten charts related to federal taxes.  Together, they provide useful context for ongoing debates about how to reduce deficits and reform the tax code.

Our first chart, below, reminds us what taxes pay for.  National defense, Social Security, and major health programs like Medicare and Medicaid account for roughly three-fifths of federal spending.  Safety net programs and interest on the debt account for 12 percent and 6 percent of federal spending, respectively, while the remaining 20 percent goes to other areas such as roads, education, and health and science research.

Our second chart, below, shows where federal revenues come from.  Individual income taxes make up a little under half of all federal revenues — and have for more than half a century.

Payroll taxes make up a much larger share of federal revenues than in earlier decades, while corporate income taxes make up a much smaller share.  In fact, corporate tax revenues are near record lows when measured as a share of the economy, even though corporate profits are at historic highs.

Many business leaders have called for cutting the top U.S. statutory corporate tax rate of 35 percent, which is high by international standards.  But the average tax rate — that is, the share of their profits that companies actually pay in U.S. taxes — is much lower because of the many deductions, credits, and other write-offs that corporations can take.  Many corporations pay very little tax.

As for taxes on individuals, the country’s overall tax system — counting state and local taxes as well as federal taxes — is modestly progressive, as our third chart, below, shows.  Low-and moderate-income Americans pay significant shares of their income in taxes.

Policymakers considering changes in tax policy must keep in mind the economic context, including the dramatic increase in inequality in recent decades.  Congressional Budget Office data show that incomes grew at much faster rates for high-income people than for everyone else between 1979 and 2009 (the most recent year available).

One way to look at the impact of this unequal growth is to compare the average 2009 income for households in different income groups to what it would have been if the income of every group had grown at the same rate since 1979.

Our fourth chart, below, and the accompanying table give the results.  They show, for example, that the average middle-income family had $8,700 less after-tax income in 2009, and an average household in the top 1 percent had $349,000 more, than if incomes of all groups had grown at the same rate since 1979.

The sharp growth in income inequality suggests that higher-income taxpayers can and should contribute more in taxes to help reduce deficits.

The fifth chart, below, shows that both parties have recognized the need to raise more revenue to help reduce deficits.  During the December 2012 budget negotiations between President Obama and House Speaker John Boehner, both sides called for much larger tax increases than those in the January 2013 “fiscal cliff” deal, the American Taxpayer Relief Act (ATRA), as the fifth chart, below, shows.

Moreover, the bulk of the deficit savings enacted to date — including ATRA and earlier legislation, most notably the 2011 Budget Control Act (BCA) — have come from spending cuts rather than revenues.

An obvious place to turn for more revenue is reforming tax expenditures.  As a group, they cost more than Social Security or Medicare and Medicaid combined, as our sixth chart, below, shows.

Both parties have recognized the need for tax expenditure reform.  For example, Speaker Boehner’s December 3 offer called for raising $800 billion in revenues entirely through tax expenditure reforms.  And Harvard economist Martin Feldstein, former chair of President Reagan’s Council of Economic Advisers, has said that “cutting tax expenditures is really the best way to reduce government spending.”

Tax expenditures are not only costly; many share a design flaw that makes them both economically inefficient and inequitable.  Because their value is based on a person’s tax rate, it rises as income rises, so the biggest subsidies go to higher-income people — even though they least need a subsidy to do what the subsidy is supposed to encourage, like buy a house or donate to charity.

The mortgage interest deduction is a good example, as our seventh chart shows.

The design of the mortgage interest deduction is “upside down.”  For example, an investment banker making $675,000 pays about 65 cents per dollar of mortgage interest, and the taxpayers pick up the remaining 35 cents.   By contrast, a schoolteacher making $45,000 pays 85 cents of every dollar of mortgage interest and taxpayers pick up 15 cents.  Thus the banker’s subsidy represents a greater share of the banker’s mortgage interest expenses than is the case for the schoolteacher.  In addition, the high-income banker is likely to have a more expensive house and thus a larger mortgage than the schoolteacher, further increasing the disparity in the subsidy each receives.

Because it could prove politically difficult to reform tax expenditures on a case-by-case basis, several recent proposals would impose an across-the-board limit on tax expenditures for high-income people.

The soundest of these proposals is President Obama’s proposal to cap the value of certain tax expenditures at 28 percent.  The eighth chart, below, shows that this proposal would raise more than half a trillion dollars over the coming decade.

At the same time, policymakers should close loopholes that allow wealthy people to avoid substantial tax.

One example is the tax break that allows investment fund managers to pay taxes on a large part of their income — their “carried interest,” or the right to a share of the fund’s profits — at the 20 percent capital gains tax rate rather than at normal income tax rates of up to 39.6 percent.

As a result of this tax break, a hedge fund manager earning $10 million or more can pay a smaller share of his income in federal income taxes than a middle-income schoolteacher or policeman.

The House-passed Ryan budget also calls for tax expenditure reforms.  But, whereas the President’s proposal would use the resulting savings to reduce the deficit, the Ryan budget would use them to pay for a new round of tax cuts.

The Ryan budget lays out tax-cut goals that would reduce revenues by $5.7 trillion over ten years, according to the Urban-Brookings Tax Policy Center.  It implies that these tax cuts would be fully offset by tax expenditure savings but doesn’t specify any actual changes in tax expenditures to accomplish this.  And, as our ninth chart, below, shows, the $5.7 trillion revenue hole that the budget’s tax-cut goals would create is even larger than the budget’s $5.2 trillion in program cuts.

In addition to being extremely costly, the Ryan budget’s tax-cut goals are heavily tilted towards people with the highest incomes, as our tenth chart, below, shows.

We estimate that the individual income tax cuts specified in the budget (assuming they met their goals, including a top rate of 25 percent) would raise after-tax incomes by 15.4 percent among households with annual incomes above $1 million but by just 1.8 percent for households with incomes between $50,000 and $75,000.

In dollar terms, the tax cuts would be worth an average of $330,000 apiece to those millionaire households, compared to $1,700 for the middle-class households.

The revenue levels in the Ryan budget imply that the cost of its tax-cut goals will be offset by scaling back tax expenditures.  But Tax Policy Center analyses indicate that if policymakers coupled the Ryan tax-cut goals with sweeping (and likely politically implausible) cuts in tax expenditures for households with incomes above $200,000, these households would still receive a large net tax cut.

As a result, to fully finance the net tax cuts for people with incomes over $200,000, taxes on people below $200,000 would very likely have to rise.  Alternatively, if those with incomes under $200,000 were protected from tax increases, then the Ryan tax changes would add mightily to the deficit.