Taxes – Divide, Confuse and Conquer

Better than reruns of Two and a Half Men are the nightly television news reports of our government’s dealing with deficits and debt.  As you know, the government deficit is defined as the difference between government revenues and government spending. The Federal government deficit according to the CBO was $1.29 trillion in 2010 and will be $1.48 trillion this year.  According to the CBO’s baseline estimates it will bottom at $610 billion in 2018 and then start rising again. As a result of all these deficits the privately held debt of the nation will rise from 62% of GDP in 2010 to about 76% by 2019. Our government, therefore,  is presently discussing plans for reducing the deficit for this year, plans for next year, and, of course, what to do about these deficits through at least 2019.

I wrote several postings in the last months about government spending but have shied away from taxation. Why? I am not sure. It might be because I just paid my annual tax payment and I feel poor. Or it might be because I am just like Albert Einstein who once said, “The hardest thing in the world to understand is the income tax.” Or Ben Franklin who said, “In this world, nothing can be said to be certain except death and taxes.” And finally Mark Train said, “I shall never use profanity except in discussing housing rent and taxes.”  Damn, why get into something that Einstein can’t understand and that reminds you of death?

Anyway, it was either this or going shopping with Betty. This one post does little to solve the issue of using tax revenues to resolve the current and future government budgeting mess. But what I have tried to do is get my arms around Roseanne Barr, err I mean get my arms around some of the many issues that make the tax debate so complicated. You see, complication is the power tool of government.  The more complicated the topic is and the more they can discuss all its ramifications, the more they can dither and do nothing about it. 

You will see below a list of many tried and true (old) aspects that relate to taxation. Hopefully you will come away from this list with a realization of how these folks in Washington are trying to evade real decisions. This list is a minefield of special interest bombs that are sure to keep the enemy from the real fighting. If debts and deficits are the number one issue it is hard to imagine (forecast) progress. It is time to demote some of these issues – at least for a while – so we can work on our biggest worry – how to reduce debt and deficits before our economy implodes. I argue below that much of the work should be devoted to the spending side while admitting that longer-term issues probably cannot totally avoid some revenue increases. 

Taxes are part of the calculation of the government budget balance, where balance equals government taxes (T) minus government spending (G)

Balance = T – G.

If G is greater than T, Balance is negative or what we call a deficit. The 2010 budget deficit was as follows:

      -$1.294 trillion = $2.162 - $3.456

A higher T with G held constant, would create a smaller government deficit. So increasing T makes mathematical sense as one discusses policies. Of course, reducing G also makes sense. But this post is about T so let’s work on that.

Federal tax revenues equaled $2.162 trillion in 2010. In 2007 T had reached a high of $2.568 but then the recession came and tax revenues fell to a low of $2.105 trillion in 2009 before starting to climb again in 2010. It may take until 2012 before tax revenues recover again and get back to their value in 2007. The baseline CBO estimate for 2013 has T at about $3.1 trillion. Baseline estimates do not incorporate any changes from the 2010 revenue laws. So T is expected to recover quite a bit even without any policy changes in 2011 or beyond. From where they were in 2010, without any change in policy they will increase by about a trillion dollars or by almost 50% in three years.

Federal tax revenues come from several sources. In 2010 the breakdown for the full $2.162 billion Federal T was as follows below. Notice that what we call our Social Security Taxes are almost as large as all individual income taxes.

                           Individual Income Taxes                $ 899 billion

                           Corporate Income taxes                    191

                           Social Insurance Taxes                      819

                           Other Revenues                                 207

When discussing a nation’s tax revenue it is incomplete to leave out the state and local governments.  In 2010, State and Local government units collected taxes of approximately $1.425 trillion making national T equal to $3.588 trillion. State and Local T was about the same in 2010 as it was in 2007 – meaning that the recession had a less proportional impact on state and local revenues. State and Local governments get their revenues from sales taxes, property taxes, individual and corporate income taxes, and various licenses and fees. Total government revenue was about 25% of GDP in 2010. It averaged 28% from 1990 to 2007.

It is important to note that tax revenues can change without any change in policy. That is, both tax revenues and government spending are automatically impacted by changes in the economy. Congress could be on vacation in a Holiday Inn Express in Illinois – a state proven to be a very popular place for state legislators – and the deficit could change in leaps and bounds simply because evil super villains caused the economy to contract and that automatically reduces tax revenues and increases government spending. Of course if super heroes in tight pants somehow cause the economy to grow rapidly, the tax revenues would gush and spending would dip – leading to an automatic surplus. We use the following fancy words to describe these automatic changes as cyclical.

Change in deficit = cyclical (automatic) change in deficit + cyclically adjusted (policy) change in deficit

The policy induced changes in taxes or spending are referred to as “cyclically-adjusted.” So when you read that the cyclically adjusted deficit got bigger, you know it was because the government enacted laws to change taxes or spending.  For example in 2010, removing the dip in the economy tax revenues (without automatic stabilizers) would have been $2.454 trillion. That compares to the $2.162 of actual T – implying that the negative state of the economy automatically decreased T by $292 billion dollars. As the economy recovers, that amount of taxation should return automatically without any policy.

Taxes can be defined as the rate of taxation multiplied by the tax base.  In a definitional sense, we raise taxes either by raising the tax rate and/or the tax base. It sounds easy to raise taxes by increasing the tax rate. It sounds like a bunch of fun if you raise the tax on other people like the neighbor who doesn’t trim his trees properly and lets his leaves fall on your lawn when you would be rather drinking mint juleps than raking leaves. The challenge is that the tax base does not stay constant as you are raising the tax rate.

Tax rates have a behavioral aspect. If you raise tax rates as a means to increase tax revenue, it is believed that the higher rates could create disincentives to produce within the taxing district. As a result a rise in the tax rate could reduce the tax base. If the latter is large enough we could get the self-defeating result that a rise in tax rates causes tax revenues to decline. Or looked at in reverse, a reduction in the tax rate that increases the tax base enough might cause tax revenues to rise. As a result of this discussion (assuming you are still awake) much of the debate about how to raise tax revenue involves beliefs or estimates of the behavioral impacts of changes in tax rates. How much does a change in tax rate impact the tax base? This is highly complicated and therefore controversial. We can argue about this until the cows come home (where did the cows go? Vegas? Asolo?).

Tax revenues are part of the process of paying for government spending.  While we might have different opinions about how large the government should be or how much it should spend, most of us agree that local, state, and federal governments have legitimate and constitutional bases for spending. The real question involves how much is enough. Federal government spending averaged approximately 20% of GDP from 1990 to 2007. It was about 24% of GDP in 2010. If taxes are levied to pay for government, then tax revenues should be the same percent of the economy.  So part of the solution for T is that we decide about G. As you know, this is not an easy one either.

Part of the spending story relates to the longer-term adequacy of taxes to meet the needs of an aging population. This focuses our attention on Medicare, Medicaid, and Social Security. Some politicians pretend that we can somehow separate these programs from the rest with little lock boxes with Al Gore’s picture on them. Others stand with arms crossed on their heaving chests and tell us we cannot jeopardize the future of our senior citizens.  It looks more like opera than government! The only thing that matters for the short-term or the long-term is the amount of tax revenues to collect relative to the government spending. 

Some people believe that tax increases will never reduce government deficits. They believe that an increase in taxes simply makes it more possible for governments to spend more. While an increase in tax revenues reduces government deficits by definition, another behavioral implication is that this increase in T gives government higher incentive to spend more.” Bertha, you just spent your whole month’s allowance in the first week.”” Dad, please give me a loan of next month’s allowance.”  “Of course, honey, because I love you more than Mom.” Right!

Taxes are also used for income redistribution. Most countries use higher tax rates on the rich to help lower income persons, who have lower or zero tax rates; or who receive transfer payment from the government.  Each time a government decides to raise taxes there is an inevitable debate about how much of the tax increase ought to be levied against the rich, the middle class, and the poor.

One report from the Tax Foundation http://www.taxfoundation.org/blog/show/27134.html  that used one set of data to show that the US actually has a very progressive tax system – meaning that when we compare ourselves to other nations, our rich pay the largest share of taxes absolutely and relative to income. In other words, the top 10% of the income earners in the USA pay a higher share of Federal government taxes than the comparable set of rich folks in Sweden, Finland, Canada, Australia, Germany and many more. This report shows one side of the argument. Others question specifics of such a report. Still others might acknowledge its truth and still lament that something must be done to stop an apparent movement of income and wealth from the poorest to the richest citizens.

Jeffrey Sachs  http://www.ft.com/cms/s/0/8836f284-592a-11e0-b9f6-00144feab49a.html   decries cuts to austerity programs that hurt low income families and tax cuts that largely benefits the rich. While he acknowledges that some attention needs to be paid to the spending side, he emphasizes that taxes need to be raised – especially on the rich. Recent news about GE’s tax situation in 2010 just added fuel to that fire.

Taxes are used to promote other economic ends….this is where the word loophole comes in. A loophole is a tax regulation that allows someone to avoid a tax that others pay. If a company locates a new factory in your town they may not have to pay local taxes for several years. If you pay interest on the mortgage on your primary residence you are allowed to reduce your tax payment by writing off your mortgage interest against your taxable income. When you receive a tax loophole you plainly see the incentive effect it creates – the positive impact it has on you and the economy. When others receive a loophole and you don’t, you often see it as a drain on the government’s taxes and a waste of taxpayer money. So loopholes are very controversial. 

The government could raise a lot more revenue if it closed all loopholes. But such a closing would have negative impacts on policies to attract new companies, would make housing more expensive, and more.  Accordingly any tax changes that close loopholes will set off a chorus of howling guaranteed to stall progress

Taxes are used for short-term stimulus or stabilization. Whether it was an extension of the Bush tax cuts or Obama-inspired tax changes, it is clear that much was done to offset a recession. One would think that it is not controversial to remove these tax changes once the recovery set in. But the questions continue. Will removing tax cuts some two years after the beginning of the recovery risk damage to a fragile economy? I doubt it but many leaders are wringing their hands (that must hurt) daily (in in front of numerous cameras) to show their support and kinship with working people.

My take from all this is that taxes are abnormally low right now because of a combination of cyclical effects from the recession as well as legislated changes in policy as part of a short-term stimulus package. As the economy improves, tax revenues will increase automatically. As we move into a more stable expansion period legislation can remove tax changes designed for short-run stimulation. Thus, one can “vote for” higher tax revenues simply based on these two elements which shouldn’t be highly controversial. Second, taxes are low compared to extrapolations of government spending in the near-term and long-run. This is where it gets sticky. 

But this is where one needs to create some priorities about government spending. To me the main issue now is the financial health of the country. Because that is my first concern, I think the main focus ought to be on a believable plan to attack future deficits. To do that means most of the focus has to be on the spending side. Raising taxes for this purpose is not going to be very effective since spending always seems to adjust to revenues.  But it might entail some tax increases.  It will be easy to scream about every impact on distribution of income, on legitimate uses of government spending, on the old versus the young, etc. But if we let all those issues distract us from the central one – then we very seriously risk being the generation of people who let government turn us into a second class nation.