Arnold Kling  

Deficit Reduction and Tax Policy

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Deficit Reduction Politics... Health Care and Socialist Calc...

Mark Thoma writes,


Why, for example, are tax cuts included in a proposal to reduce the national debt? That makes no sense at all except as an attempt to impose a particular ideology on the tax code.

For decades, economists have suggested broadening the tax base while reducing marginal disincentives. Tax reform of this sort is typically popular with economists of all political persuasions. We see it as a "win, win." It can bring in more revenues (which the Bowles-Simpson plan would do) while promoting economic growth.

Thoma now characterizes this form of tax reform as ideologically charged. I would have thought that tax reform in order to reduce the deficit is about as centrist an economic policy as one could propose.

But the center is not what it used to be.


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COMMENTS (21 to date)
Hyena writes:

I've never really understood the opposition to broadening the tax base. It's not as if a few percentage points in marginal tax rates is about to push anyone into poverty.

Of course, it's true that the wealthy don't pay "their fair share", but I don't think that's not a marginal rates question for the most part.

Thucydides writes:

I think it is a mistake to define the problem as "deficit reduction." To do so completely sweeps under the rug the issue of how much of our production the government should consume. It treats it as a matter of indifference whether the deficit is reduced by higher taxes or lower spending.

GU writes:

Under-informed leftists are confusing the current controversy surrounding the Bush Tax Cuts with what we should if we enact fundamental tax reform. They are two completely separate issues.

As Arnold correctly notes, base broadening with concomitant rate reductions is tax policy 101. It is not a partisan point, but rather something anyone who knows anything about tax policy thinks is a good idea. Tax rates should be as low as possible—only has high as necessary to raise the needed revenue. The deadweight loss from taxes increases with the square of the rate. There is no coherent political philosophy that supports a particular top marginal tax rate.

It is really sad to see so many people who are apparently clueless (I say apparently because I think some of this is utter dishonesty).

I would urge those who don't know much about tax policy to read a book on the topic. I recommend Taxing Ourselves, by Slemrod & Bakija. It is a very gentle introduction to tax policy, that is for the most part nonpartisan (though the authors' left-wing views occasionally make an appearance). Why not learn something on the topic before commenting on it?

MattW writes:

The deficit would be reduced more quickly by expanding the tax base without reducing any marginal rates. I think that's what Thoma means.

Lord writes:

If you believe the problem is too high marginal rates, this is the solution. If you believe the problem is an insufficiently progressive tax system, this is the problem.

Dale Moses writes:

It is politically charged because the plan is ostensibly about reducing the deficit, and not about changing the ideological framework of how taxation works.

In a more in-depth examination of unstated implicit assumptions it may be that the "broadening of the tax base" tends to fall on the middle class while the "lowering of marginal disincentives" tends to fall on the wealthy.

Or, to put it more simply. How in the world does capping receipts and reducing the top marginal tax rate decrease the deficit? A: It doesn't.

As for marginal disincentives on the top income, while its a convenient theoretical framework, I am not sure it really holds in terms of real production.

Ignoring for a second the standard backward bending labor supply curve lets look at exactly what the incentives for working are. Rather than high income earners being paid for production they are typically paid on a salary basis. Because of this there is no margin as we typically define it based on pay level, people choose either to work full time or not to work. Such, productivity would tend not to vary with income, but with the liklihood of being fired(absent internal factors), and any variation due to the salaried pay would be incidental correlation with the expectation of replacement. Full production would be a function of whether or not to work.

O.K. so we have established that we won't see productivity gains unless we see correlation with the liklihood of replacement. So do we expect that wages will correlate with the liklihood of replacement? Lets assume that the higher real, after tax, wages, the more people are willing to get into the labor pool that is associated with those wages. As well, the lower cost of employment means that employers would tend to hire more people. So we can't really say whether or not lower marginal taxes would have any effect on the productivity of the workers.

But does it have an effect on productivity overall? Maybe. Any situation that reduces taxes on any one group will tend to increase aggregate productivity due to substituting to more revenue productive methods(a proportional decrease may not, so long as the substitution effects cancel out). But the real question is "how much?". I don't know of a way to really determine what kind of gains we would be seeing. (note: in order for this to be true we have to assume that revenue productivity corresponds with true social productivity. Establishing this for the real world is not a simple proposition)

Ok. So we have established that we probably won't see high income earners work any less and we probably won't see many gains from substitution effects.

Next we would have to examine whether or not decreasing taxes cause people to want to work more or want to work less as a whole?[I.E. does full employment productivity shift] Lets examine this question by looking at a typical person's decision to work over time. Let us say that people tend to work until they have sufficient retirement after which they stop working and go entirely for leisure until they die. In this scenario decreasing taxes ought to tend to reduce labor supply as, in the long term, people are able to save for retirement earlier. Now, it could also induce people to save more for retirement which would tend to ameliorate this effect(and may overpower it).

From here its fairly easy to say that the effect of marginal taxation rates on production in total is indeterminate.

And since this is a budget issue and not a quality of life issue we can forgo an analysis of whether or not production reductions due to increased leisure time are adequate compensation for public services.

At the end of all of this then we can make a fairly non-controversial comment. There is no clear rational for either higher or lower top marginal taxes, there is only a clear rational for taxes which are adequate to support the spending of a "proper" government.[ignoring cyclical spending we can say that so long as we have a proper spending regime, funding it too much is explicitly bad as it distorts the labor leisure trade off more than is necessary to sustain the govt, and funding it too little will require funding it more later, and the consequent reduction of "smoothness" of consumption curves]

In this case, capping revenues presumes what a "proper" government is and becomes strictly partisan and ideological.

Or to put it another way. "If everyone believes we should only tax enough to support 'good government', then putting a target on revenues puts a target on 'good government'. I hope we can all agree that people indeed do disagree about what the proper role of government is"

Well unless there is some taxation efficiency reason that a proper government cannot be larger than 21% of GDP. As a friend of mine has said to me on the laffer curve, "Its fairly obvious that we don't want to be on the [downward sloping side of the] curve but it isn't so easy to answer why we should be on the [upward sloping side]."

Les writes:

Some people seem to be confusing tax rates with tax revenues. Cutting tax rates has been known to increase tax revenues. Raising tax rates may well result in reduced tax revenues.

An example of the latter is European professional athletes who move to Monte Carlo (where income tax rates are zero) once they become stars.

Lord writes:

Utility theory would recommend a logarithmic, not a flat scale. A large enough increase in the exemption level could remedy this, but that is not in their proposal.

Dale Moses writes:

Les Wrote:

"Some people seem to be confusing tax rates with tax revenues. Cutting tax rates has been known to increase tax revenues. Raising tax rates may well result in reduced tax revenues."

Maybe people are confusing effective tax rates with nominal tax rates, but no one is confusing tax rates with tax revenues. Cutting tax rates has not been known to increase tax revenues.

While it is true that there are individuals who are indeed successful at evading taxes or moving income around to reduce their tax burden. It is not the case that these individuals make up enough of the tax base such that an increase in taxes cause a decrease in revenues(or the other way around). In short, you are failing to hold other things constant when you talk about professional athletes as the example of the behavior.

This doesn't mean we want to have high taxes. No one thinks high taxes for the sake of high taxes are good(unless you want to count the Pigovian situation). But again, thinking about a long term taxation level is necessarily thinking about a long term spending level the two are inseparable.


Lord Wrote:

"Utility theory would recommend a logarithmic, not a flat scale. A large enough increase in the exemption level could remedy this, but that is not in their proposal. "

I don't see that. Utility theory would suggest that we tax only the rich and do so at a flat scale, since they get the least marginal gain from that dollar, the least utility is removed from the system.

[Frankly i don't see any clear taxation prescription from utility theory. Its not scaled between people so there is no way to know how to minimize utility drained in the system based on taxing different income levels. That utility is diminishing doesn't say anything about whether or not we should tax an increasing, decreasing, or percent of utility because we don't know rates of substitution away from income earning. I.E. that utility is diminishing marginally does not tell us that taxing at an increasing marginal rate means anything for our revenues or for the persons total utility since total utility will be based on the total effective rate and not the marginal rate(each dollar taxed always comes from the end, even if it was the first dollar taxed).

So when we think about utility theory and taxation all we really know is that whatever the taxation scheme, people will try and maximize their utility within that scheme.]

Kevin writes:

"Mark Thoma" strikes again. Mark Thoma is way too smart to say anything as stupid as what "Mark Thoma" says. Right?

John Thacker writes:
If you believe the problem is too high marginal rates, this is the solution. If you believe the problem is an insufficiently progressive tax system, this is the problem.

Unless you're one of those who believes that the tax system is insufficiently progressive because of all the deductions and tax preferences that the upper middle class and wealthy are allowed to take. I thought that was a standard progressive talking point. Was I wrong?

Or, to put it more simply. How in the world does capping receipts and reducing the top marginal tax rate decrease the deficit? A: It doesn't.

You're only discussing whether people choose to work or not. You're completely ignoring the issue of whether, as marginal tax rates rise, people tend to prefer that their compensation be provided in tax-advantaged ways. E.g., if marginal tax rates are high, you might prefer that your company provide more expensive health insurance, provide more fully deductible snacks and meals for all employees at work, and so on, rather than paying you extra. Almost all of those tax-advantaged sources of income would be less economically efficient in the absence of the tax distortion.

If you remove deductions and exemptions and at the same time reduce the rates, you reduce the tax distortion and promote more economically efficient behavior, *and* you increase revenues.

Cutting tax rates has not been known to increase tax revenues.

Eliminating deductions and tax preferences while specifically lowering the tax rates only an equal amount to the deductions and tax preferences absolutely has been known to increase tax revenues. At the very least it should be revenue neutral-- it's designed in the plan to be revenue neutral strictly from a static perspective-- and to the extent that it causes compensation to shift from tax-deductible forms to taxable forms, it increases tax revenue.

John Thacker writes:

I am amazed that eliminating deductions, tax preference, and tax expenditures and lowering the tax rate by the amount of revenue currently forgone by the deductions appears to be so controversial. People on the left and center-left are immediately staking out maximal positions that insist on a net tax rise. People on the right and center-right seem much more willing to say that they think that spending and taxes would still be too high, but that as a compromise and a starting point, this is still a worthy tradeoff compared to the status quo.

Is it that ridiculous to take a near-Pareto improvement as a starting point for discussion? Why exactly are so many people here opposed to eliminating deductions in a revenue-neutral fashion? (That has an excellent change to be revenue-positive, by decreasing tax avoidance and the shifting of compensation to tax advantaged methods.)

John Thacker writes:

Fewer deductions and complexities also means fewer compliance costs, which means more effort on productive output instead of shuffling around forms, which on the whole is good for the economy (even if bad for some accountants, tax preparers, and tax lawyers.) Channeling money, time, and effort into more productive and efficient uses helps the economy, which again brings more revenue.

So if we set up the exchange to be putatively revenue neutral, we have every reason to expect that it will be revenue positive, by shifting economic behavior away from inefficient tax-advantaged behavior and compliance into productive effort.

Elvin writes:

High income people do make decisions based on marginal tax rates. Yes, salaries are a lumpy, so marginal rates don't make a difference--no one turns down a raise--, but two couple households do have some marginal trade-offs. Consider a $220k a year husband and $70k school teacher wife. She might just decide that she is better off staying at home if high income tax rates are increased.

Also, celebrities pay close attention to marginal rates. (See Mankiw's link to an article on the Rolling Stones.) I could see a basketball star like LaBron James turn down some additional endorsements if marginal rates are increased. Texas and Florida are considered slightly better places for athletes because no state income taxes. Why do you think so many TV shows and movies are produced in Canada?

In the longer run, higher marginal rates will just push for more deferred compensation, movement to low tax countries, and lobbying for more tax-advantaged perks and fringe benefits.

Tax reform is a great idea.

Hyena writes:

Elvin,

You've basically described my parents' situation and that of a number of friends. In no case has anyone stopped working, however; work is a symbol of the lesser-earning partner's contribution to the household and of their potential independence. They don't give it up.

There's also less movement of people for tax reasons than you'd think. The tax base of California or New York hasn't actually disappeared. Athletes don't have portable incomes; if you play for the LA Dodgers, your money is earned in California, your residence matters not at all. In fact, only states in the Northeast need really worry about tax relocations; they're the only states packed in close enough that switching jurisdictions is a live option.

In all, it's not really a danger and jurisdictions will tax until they have no resident advantages.

Dale Moses writes:

John Thacker Wrote:

"You're only discussing whether people choose to work or not. You're completely ignoring the issue of whether, as marginal tax rates rise, people tend to prefer that their compensation be provided in tax-advantaged ways."

This is true that I am only discussing whether or not people choose to work and not whether or not people prefer their compensation in tax advantaged ways.

This is because it doesn't matter if people prefer tax advantaged compensation unless the amount of that compensation becomes strong enough that it reduces revenue.

And we can be reasonably sure, from study after study, that revenues are not decreased until marginal tax rates are far in extreme of the proposed and current values

Elvin Wrote:

"High income people do make decisions based on marginal tax rates[...]Also, celebrities pay close attention to marginal rates. "

Yes, i considered the question of "whether or not people decide to work" and explained why we don't really care about celebrities. The effect of marginal taxation is still not clear from a theory point of view.

Lord writes:

The deductions and tax preferences of the wealthy are subject to shifting to business, so whatever is done to individuals can be undone by business, and no individual treatment is sufficient in itself. The biggest is the choice to defer tax and take income in the form of capital gains. Even though this raises those taxes, people are familiar enough to know they only have to wait for that preference to be reestablished. The tax game is unproductive. It can generate revenue by changing rules only for as long as the system adjusts to the new ones and then must be changed again. This is why this approach doesn't last, and following it new deductions and preferences have to be established until it has to be redone. At least if you are going to do this, the exemption level must be raised as well because that is really what provides progressivity, not tax rates. Something like 25k should do well.

John Thacker writes:
This is because it doesn't matter if people prefer tax advantaged compensation unless the amount of that compensation becomes strong enough that it reduces revenue.

So you don't think that the amount of compensation in employer-provided health insurance is significant? The Bowles-Simpson plan includes removing the deduction for employer-provided health insurance.

And we can be reasonably sure, from study after study, that revenues are not decreased until marginal tax rates are far in extreme of the proposed and current values

You surely can't mean that literally. You may mean that "revenues are not decreased significantly," but no study suggests a zero elasticity of income in response to marginal tax rates.

I suggest this study by Marty Feldstein on the 1986 Tax Reform Act, orthis one by Emmanueal Saez on real bracket creep, both of which suggest that the elasticity of (reported) income with respect to marginal tax rates is "significantly higher than those derived in labor supply studies." (Saez found a lower rate when studying the relatively hidden effects of real bracket creep than Feldstein did with 1986 Tax Reform Act.)

I'm not sure which studies you're referring to, but the ones I'm familiar with show a much larger response of income to marginal tax rates than you're suggesting. I hope you're not assuming that Kling or I are suggesting that we're on the other side of the Laffer Curve. We're not assuming that a cut in marginal tax rates would result in an increase in net revenue by itself. We're arguing, and study after study agrees, that there's an elasticity of income with respect to marginal tax rates that does not apply to deductions, and thus that a trade of deductions for marginal tax rates would provide somewhat more revenue than a static analysis would suggest. It would be unwise to build that extra revenue into one's calculations, but it's surely a reason to do the tax reform.

In any case, there are no assumptions of any sort of effect in the proposal. It is at least revenue-neutral (actually slightly better than it), and could be better, but there's no reason to characterize it as a "tax cut" instead of a tax reform.

Dale Moses writes:

John Thacker Wrote;

"I hope you're not assuming that Kling or I are suggesting that we're on the other side of the Laffer Curve."

This is precisely what you're suggesting when you claim (as you have been) that decreasing taxes increases revenues.

You talk about tax avoidance and yes, we all understand that it happens, but from a revenue standpoint it doesn't matter. What we care about is production and tax revenues.

Now, if this were a tax commission then it might make sense to say "lets modify the structure of marginal taxes(to shift the burden of taxes from the wealthy to the less so)". But its not a tax commission, its a budget commission, so when it starts saying "about them tar tax reform" people start to wonder whats up, because we are on the upward sloping side of the laffer curve and so decreasing taxes decreases revenues. OK. So lets say it is budget neutral, that it doesn't change the effective tax rate. How does this help the budget again?

If the commission said "we want to raise the effective rate by closing some deductions" then that would be fine and dandy.

But as it is, its like saying "Our proposal to balance the budget takes half the money that the military gets and instead spends it on flowers". It doesn't do anything for the budget, even if it might make the hippies happy.

I mean, great, you like it. Of course you like it, its a marginal tax structure that suits your ideological predilections. You believe in "small government" and so capping revenues makes sense. You believe in flat taxes, and so reducing the marginal structure makes sense. Well, not everyone does. Some people believe that the Government should be as big as it needs to be in order to fulfill its role in society and so putting a cap on revenues doesn't make much sense(especially if you're trying to reduce the deficit). And some people believe that a strongly progressive marginal tax rate is best able to achieve the social goals of the state and so reducing the progressiveness of the tax structure doesn't make sense.

And some people will be willing to compromise their ideals in order to fix a structural deficit... but why in the world are they going to be asked to compromise their ideals in order to NOT fix a structural deficit?

Rick Stewart writes:

There is no suitable catch phrase that everyone who votes can latch on to and say, "I agree with ___ ___s."

I recommend 'tax swap.' What it means is - the revenue neutral elimination of lower taxes for a few, replaced by lower taxes for all.

Were I the president (I am not) I would present Congress with one tax swap per week, starting with tax swaps that were so obvious, and of such small total dollar value, that 99.9% of Americans would say, "I agree."

Then, every Monday morning, I would up the ante, with the tag line, "I expect Congress to pass this tax swap in time for me to sign the bill on Friday, before I quit working to spend the weekend with my family."

Practice it with me. Say, "I agree with tax swaps." Doesn't that feel good?

Dan Weber writes:

They say that people get the government they deserve. I've been watching our government and wondering what kind of monsters we must be.

Watching the reaction to the budget commission, I am no longer wondering.

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