James Pethokoukis

Politics and policy from inside Washington

Will 2011 be the year of the tax cut or tax hike?

Oct 29, 2010 14:53 UTC

There’s a brewing debate among conservatives over whether they should favor some tax increases to close the budget deficit. Some Republicans on Obama’s deficit panel are talking about cutting various tax breaks for individuals. Possible presidential candidate Governor Mitch Daniels of Indiana recently spoke favorably about a value-added tax and an energy tax.  And here is Kevin Williamson of the National Review Online’s Exchequer blog:

Here’s the problem: The deficit is, by my always-suspect English-major math, about 36.3 percent of federal spending ($1.29 trillion deficit out of $3.55 trillion spending). For comparison: Defense accounts for about 18 percent of federal spending. So you could cut out the entire national-security budget, and another Pentagon-sized chunk of non-military spending, and not quite close that deficit. You could cut the Pentagon to $0.00 and eliminate Social Security entirely and just barely get there.

Don’t get me wrong: In a perfect world, Exchequer would love to see the budget balanced and some tax cuts enabled through spending reductions alone.  … Not going to happen. So, our choices are this: 1. Hold out for the best-case scenario, in which a newly elected Speaker Boehner gives President Obama the complete works of Milton Friedman and everybody agrees to cutting federal spending by more than a third. 2. Keep running deficits and piling up debt. 3. Raise taxes. My preferences, in order, go: 1,  3, 2. And No. 2 is not really acceptable.

Like it or not, taxes are going up: If not today, then in the near future. Even once the deficit is under control, that debt is still going to have to be paid down, lest debt service alone overwhelm the federal budget, necessitating even more tax hikes.

What all this misses is that 2011 will more likely be the Year of the Tax Cut than Tax Hike. The Bush tax cuts will be extended, various business tax breaks passed, maybe even a payroll tax cut — all to do something about a slow growth, high unemployment economy. Here is how voters see things, according to Rasmussen:

When faced with a budget crisis, most Americans think “it’s always better to cut taxes than to increase government spending because taxpayers, not bureaucrats, are the best judges of how to spend their money.” A new Rasmussen Reports telephone survey finds that 59% of Americans agree with that statement, while 26% disagree. Fifteen percent (15%) are undecided. … That’s down just slightly from August 2009, when 62% agreed that taxpayers are better judges of how to spend money. However, in January of 2009, just 53% agreed with that statement.

Fifty percent (50%) of Adults now say a dollar of tax cuts is always better than a dollar of public spending, up nine points from January of last year. Twenty-nine percent (29%) disagree, and another 21% are not sure. Just 27% think public spending provides “more bang for the buck” than tax cuts when it comes to economic policy and creating jobs. Forty-nine percent (49%) disagree, a seven-point increase from the beginning of 2009. But 24% are not sure.

Obama deficit panel veers dangerously off track

Oct 26, 2010 16:39 UTC

Here’s the problem with President Barack Obama’s deficit reduction commission: Exploding debt caused by out-of-control healthcare spending is an Extinction Level Event for the U.S economy.  By 2050, according to the Congressional Budget Office, the national debt will likely be three times as big as the overall economy with Medicare and Medicaid gobbling up half the budget.

And that’s not even the worst news. Such a fiscal path would cause an economic implosion long before 2050. Financial Armageddon. Yet the Obama panel almost certainly won’t come to agreement on any fixes for healthcare entitlements. Probably not Social Security, either.

But the group is eyeing $1 trillion in annual tax breaks as a way of cutting the budget. These “tax expenditures” include a variety of credits and deductions for federally favored activities. Many economists on both sides – and a few brave politicians – agree, however, that such favoritism introduces harmful market distortions.

While low interest rates and lax regulation had star billing in the American housing bubble, the $89 billion mortgage deduction in 2008 also was a supporting player. It’s also true an aging society and advancing technology are prime drivers of rising healthcare costs. But so too is giving related benefits a $131 billion annual tax break.

Let’s say America axed mortgage-interest deductions, child tax credits and the ability of employees to pay their portion of their health-insurance tab with pretax dollars. All these are mentioned in a Wall Street Journal story on Monday. Analysis by Americans for Tax Reform finds the net effect would be a $2.4 trillion tax hike over the next five years. (Mortgage interest deduction: $638 billion; child tax credit: $60 billion; exclusion for employer-provided health insurance: $1.66 trillion, including higher FICA taxes.)

Such a fiscal drain would surely put America back into recession, unless marginal tax rates were also lowered to compensate.  Cutting the total amount of tax expenditures by half might allow the top income tax rate to be cut from 35 percent to 25 percent.  That is what you want in an ideal, pro-growth tax system: low rates applied to a broad base.

The politics are treacherous. That’s why major reform hasn’t happened in a generation. Back in 1986, Congress agreed to eliminate scores of tax loopholes for individuals. But lawmakers wisely sweetened the bitter medicine at the last minute by lowering the top marginal tax rate by nearly half, making those breaks less valuable. Many businesses were also willing to accept fewer tax breaks and pay higher total taxes in exchange for a simpler code and a lower rate, although this didn’t make it into the final bill.

Obama’s panelists should draw on this experience. They could advocate trimming some of the $90 billion in annual business tax breaks and subsidies while also paring the tax rate on profits, currently the second highest among advanced economies. And if they want to trim tax breaks for individuals, sharply lower marginal rates should accompany.

Austerity alone won’t solve America’s debt problem. We also need to boost growth. Some on the Obama panel seem to have forgotten this.


Any free marketer should be against all these welfare giveaways. We use euphemisms like “tax credits” but in reality they are not different than entitlement payments. They distort the free marker and have one group of people (renters) subsidize another group (mortgage debtors).

If the new Congress is truly free marketers, they will eliminate all these unfair welfare giveaways.

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Austerity by default

Oct 26, 2010 13:55 UTC

Some folks want austerity in the worst way. They may just get it, says the NYTimes:

What could result is “deficit reduction by gridlock,” said John Podesta, the president of the progressive Center for American Progress and a chief of staff in the Clinton White House. That would be the outcome if Republicans, as expected, block additional unemployment aid and if the parties deadlock in the lame-duck session over pending appropriations and the Bush tax cuts that expire Dec. 31. That would leave lower spending levels in place for the fiscal year 2011 and force Mr. Obama and Republicans to try to reach a tax compromise next year.

Again, I find it hard to believe that Congress would ensure a recession by letting all the Bush tax cuts expire. I still think a deal gets struck in January.

Obama deficit panel partying like it’s 1986

Oct 25, 2010 14:19 UTC

The WSJ says President Obama’s deficit panel is looking at cutting various tax breaks — also known as “tax expenditures” — as a way of reducing the budget deficit:

Sacrosanct tax breaks, including deductions on mortgage interest, remain on the table just weeks before the deficit commission issues recommendations on policies to pare back with the aim of balancing the budget by 2015.

The tax benefits are hugely popular with the public but they have drawn the panel’s focus, in part because the White House has said these and other breaks cost the government about $1 trillion a year.

At stake, in addition to the mortgage-interest deductions, are child tax credits and the ability of employees to pay their portion of their health-insurance tab with pretax dollars. Commission officials are expected to look at preserving these breaks but at a lower level, according to people familiar with the matter.

A few thoughts here:

1.  Lots of this stuff distorts markets, particularly in housing and healthcare. We get too many resources devoted to building McMansions and giving workers gold-plated health plans.

2.  So I am all for reducing/phasing out hundreds of billions in these tax breaks in a 1986-style tax reform bill.

3. But at the same time, we should be reducing marginal tax rates. The code should be simpler, broader and flatter.

4. And only by reducing marginal rates, at least somewhat, would such a plan ever pass.

5. In fact, it took a deep cut in marginal rates to get the 1986 reform done. Individual taxes went down, business taxes went up, though many CEOs didn’t mind so much since the system was simpler.

6. Take another look at the Wyden-Gregg plan for tax reform, since it may be a model for the panel.

Pay attention: How New Zealand cut spending and taxes

Oct 19, 2010 16:03 UTC

A fantastic Reason article looks at how Canada and New Zealand cut government spending.  Since GOPers often cite NZ’s experience, I found that portion of the piece particularly interesting. Over the span of a decade from the mid 1980s on,  the government’s share of GDP  fell to 27 percent from 45 percent. Here is a bit on how they did it, according to former government official Maurice McTigue (but please read the whole thing):

Privatization: From 1986 through the mid-1990s, New Zealand sold off airlines, airports, maritime ports, shipping lines, irrigation projects, radio spectrum, printing offices, insurance companies, banks, securities, mortgages, railways, bus services, hotels, farms, forests, and more.

Rightsizing government agencies: After we eliminated those government functions, the bureaucracies that used to perform them were too large to perform their remaining tasks. So the civil service was reduced by 66 percent. Some agencies remained almost the same size, while others were reduced by 90 percent to 100 percent.

Cutting taxes: At the same time, we reformed the revenue system by eliminating capital gains taxes, inheritance taxes, luxury taxes, and excise duties and by allowing income to be taxed only once. We halved tax rates, eliminated all deductions that were not a cost of earning income, and created a system where one-third of revenue came from consumption taxes and two-thirds came from income taxes. Under the simplified system, about 65 percent of the population no longer had to file tax returns—a major selling point for reform.

Reforming the appropriations process: With the State Sector Act of 1987 and subsequent laws, funding was linked directly to results. Agency heads were now CEOs, chosen for capability. They received fixed-term contracts: five years with a possible three-year extension.

U.S. states in a $3.2 trillion pension hole

Oct 12, 2010 20:06 UTC

Some scary numbers from new research by finance professors Robert Novy-Marx of the University of Chicago and Joshua Rauh, Associate Professor of Northwestern University in Evanston, Illinois.

We begin this article by discussing the true economic funding of state public pension plans. Using market-based discount rates that reflect the risk profile of the pension liabilities, we calculate that the present value of the already-promised pension liabilities of the 50 U.S. states amount to $5.17 trillion, assuming that states cannot default on pension benefits that workers have already earned. Net of the $1.94 trillion in assets, these pensions are underfunded by $3.23 trillion. This “pension debt” dwarfs the states’ publicly traded debt of $0.94 trillion. We show that even before the market collapse of 2008, the system was economically severely underfunded, even though public actuarial reports presented the plans’ funding status in a more favorable light. While we take no stand regarding the optimal amount of state government debt, we do believe it is important to point out that total state debt with pension liabilities included is actually almost 4.5 times the value of outstanding state bonds.


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Uncle Sam has plenty of dough

Sep 16, 2010 18:15 UTC

Here is a point that has gotten lost in the Bush tax cut debate. Even with the tax cuts, Uncle Sam will have plenty of revenue. As I wrote earlier this week:

Now let’s say all the tax cuts were permanently extended — Orszag’s nightmare scenario. According to Orszag’s old pals at the Congressional Budget Office, federal tax revenue would be 18.6 percent of GDP in 2020, 19.2 percent in 2035, 19.8 percent in 2050 and 22 percent in 2080. In other words, even with all the tax cuts extended, government revenue would still rise well above its historical average of roughly 18 percent since World War Two.

And this chart also illustrates the point:


Here it comes … higher taxes on middle class

Sep 7, 2010 12:38 UTC

An NY Times op-ed by just-departed WH budget chief Peter Orszag is getting lots of play because he advocates temporarily extending all the Bush tax cuts. After that, though, he wants all of them to expire. This is the part that really got my attention:

More troubling, middle-class and lower-class families would be saddled with higher taxes. That’s a legitimate concern, but also a largely unavoidable one if we are to tackle the medium-term fiscal problem.

Me: Again,  Orszag accepts that Americans are undertaxed, which is left-center dogma.  Of course, the real problem is not that tax revenues will be dramatically lower long term, it is that spending will be dramatically higher.

The budget deficit examined

Aug 31, 2010 18:48 UTC

Nice chart from Jim Glassman over at JPMorgan on why we have a such a giant budget deficit: