A Curmudgeon's Notebook: Extend federal tax cuts for several years

2010 November 13
Last edit: 2011 Jan 29. Click on History for changes and updates.

Everyone needs more stability and predictability on tax issues. The current gridlock in Congress and with the White House seems to be based on ideology, rather than good public policy. Class warfare helps no one.

The continuation of this post discusses a few ideas to use the expiration of the tax cuts to address long-standing issues in the tax policy.

Don Nordeen
===========
Continue reading Extend federal tax cuts for several years.

Key Words: Federal budget, Federal income taxes, Federal business taxes, pubic policy, economy, Arthur Laffer, Dr. Christina Romer, Congressional Budget Office

Click Continue for the Continuation of this Post and any Comments. Or Click Show All for the Above Introduction and the Continuation of this Post and any Comments.

Extend federal tax cuts for several years (continued)

Introduction
Since extending the federal tax cuts for one or several years may be the only alternative that can be passed by the lame-duck Congress, it is time to take that action. However, it could just "kick the can down the road" if six months of the time isn't used to provide the new Congress to decide a better longer-range tax plan. This will challenge the new Congress to quickly address one of the uncertainties affecting our economy, and do so in an off-election year.

Tax Issues are Complex
Avoid Tyranny of the Majority — In our Constitutional republic, most individual rights are defined in the Constitution and not dependent upon approval of the majority. This prevents tyranny of the majority for those defined rights. But tyranny of the majority occurs when a large tax burden is imposed on a minority. We joke about this reality by the saying, "Don't tax me; don't tax thee; tax that fellow behind the tree." Many Americans recognize the unfairness (tyranny) of the majority in imposing a large tax burden on only a few. Moreover, for most Americans to be concerned about the wise use of public funds, as responsible citizens they should pay for part of the taxes. These are questions about self reliance, respect for others, and integrity. Much more debate is needed.
Expiration Provides Opportunity — The expiration of the tax cuts provides many other opportunities to improve the fairness in the income tax as well as bring the tax revenues in balance with spending which must be greatly reduced. (added 2010 Dec 07)>>> As Voinovich leaves the Senate, he sees a deficit of good sense:

"George Voinovich, retiring from the Senate this month, is leaving behind an elegant legislative proposal for the Congress in which he served for a dozen years." ... "What has lighted Voinovich's fuse is the legislature's utter inability to do anything about the looming debt crisis." ... "The one theme that tied his thoughts together was exasperation with the failure to act on the debt." ... "Things have gotten to the point right now where the pledge we need to make is to the people of America to do something about this, this problem with debt." ... "The senator suggested that his colleagues spend a couple of days talking about their shared "vision for the country.""<<<

(added 2010 Nov 26)>>> However, unless the mindset in Congress changes, any increase in taxes will lead to less discipline on spending. See 2010 Nov 21 WSJ Opinion, "Higher Taxes Won't Reduce the Deficit: History shows that when Congress gets more revenue the pols spend it." <<< My suggestions for other changes for personal taxes to be part of a new tax plan include:

Permanently fix the alternative minimum tax to provide the intended purpose (for all taxpayers to pay a fair amount of income tax) without creating unintended consequences. The tax rates apply to high-earners with salaries, but not necessarily to those in private business and investment activities.
Eliminate all double taxation. There are many areas involved.
- Dividends and interest should be deductible where paid and income where received. All interest should be deductible. In addition to double taxation, the current income taxes always require declaration of interest income but allow only some interest expense as deductible. This should be corrected to be neutral regarding loans and investment.
- State and local taxes should be deductible which has the effect of being paid with before-federal-tax income. Otherwise, federal tax would be paid on the income used to pay state and local taxes — double taxation.
Provide a consistent tax treatment for health-care insurance premiums. Currently, the premiums paid by employers are paid with before-federal-tax income and those paid by individuals are paid by after-federal-tax income. My recommendation is that health-care premiums be paid with after-federal-tax income which would require imputed income for those paid by employers.
Provide sensible capital gains provisions that should be stable over time, such as in the current law.
Eliminate trying to pick winners and losers in the tax law. Let the market place make the selection. Phase out those tax preferences. Do same for corporation taxes.
Eliminate the phase-out of the deduction for exemptions which has the effect of increasing the top marginal tax rate, but still allows politicians and others to quote a lesser maximum tax rate that exists in reality.
Examine the inheritance and estate taxes to understand what really exists and how the current law creates methods for avoiding taxes. Require all taxes to be paid based on current value of assets. Eliminate all tax forgiveness provisions for unpaid (deferred) taxes. Beneficiaries thus would inherent the assets at the current value with no unpaid taxes. A gradual transition is required.
Revise the tax code so that when used to create incentives for preferred activities, the tax reduction is calculated as a tax credit after calculating the income tax due with a simple requirements. This would provide the revenue loss associated with each incentive as a separate line item. (added 2010 Dec 26 & 2011 Jan 29)>>>A better alternative would be for the tax incentives to be a tax expense, or subsidy as it is for farm supports, and require an application for the subsidy. Make the incentives an appropriate which would ensure their annual review and separate accounting. Either method would provide direct accounting for the cost of the tax incentives.<<<
(added 2010 Nov 29)>>>Some of these items are in the proposal by the Debt Commission Co-Chairs, Co-Chairs' Proposal, along with others that can simplify the tax code.<<<

Changes in tax code should be implemented gradually with advance time for indivuduals to plan accordingly. Our society and economy do not absorb large changes very well.

Revenue Shortfall as a % of GDP
Shown at the left is an interesting chart from USA Today (To help control the deficit, let the Bush tax cuts expire, 2010 Jul 21) of revenues as a % of GDP for years 2000-2010. The tax cuts in 2001 and 2003 indeed resulted in a reduction in revenue. The revenue was partially recovered in 2006 and 2007. Tax cuts should provide increases in GDP and the associated tax revenue which did occur in the mid 2000s. Some likely claim that the increase in revenues was due to the reduction in taxes. But it clearly didn't offset the direct effect as shown for years 2001-2003. The reduction in revenue in the years 2008-2010 is likely the result of the recession.
(added 2010 Nov 24)>>> The increase in 2006 was unexpected are reported by the 2006 Jul 09 NY Times, Surprising Jump in Tax Revenues Is Curbing Deficit, stating, "An unexpectedly steep rise in tax revenues from corporations and the wealthy is driving down the projected budget deficit this year." The article provides the conflicting explanations by those with different points of view. Nonetheless, the rise in tax revenues was real.<<<
In part, the insufficient indirect offset was due to the tax cuts being extended across the board. The increases in GDP from investment and expansion are likely limited to high earners, but the tax reductions extended to all.
USA Today used this chart to support their editorial conclusion to let all the tax cuts expire as a way to get revenues up to the traditional 18% of GDP. In an opposing view Stop these tax hikes, Senator Orrin Hatch argued

"According to the Congressional Budget Office, our Gross Domestic Product (GDP) would take a 1.4% hit — potentially enough to trigger another recession, the last thing out-of-work Americans need."
"Dr. Christina Romer, chair of the president's Council of Economic Advisers, found that "tax increases are highly contractionary" and that there's "a powerful negative effect of tax increases on investment." Her analysis showed that $1 in tax cuts results in a $3 increase in GDP, demonstrating why lower taxes are key to investment and an economic recovery."

These observations argue for a gradual increase in taxes, but only after recovery is well underway.
(revised 2010 Nov 15, 2011 Nov 20)>>> The analyses by the Congressional Budget Office and Dr. Romer indicate why any changes in taxes must be based on careful analysis and hopefully consensus on expected results by the non-political economists. Dr. Romer's analysis suggests that the indirect effect of $1 in tax cuts on would be a $1 increase in GDP. With overall tax revenues of 18% of GDP, the indirect decrease in tax revenue is $0.18 for a net sum of direct and indirect effects of $0.82 decrease in tax revenues for every $1 in tax cuts. Conversely, for each $1 of tax increase, the sum of direct and indirect effects would be $0.82 increase in tax revenue. My calculations for the estimated indirect effect with the CBO estimate of 1.4% (within the range) is a 16% indirect effect. Both analyses indicate offsetting indirect changes in tax revenue association with changes in tax rates. The referenced articles do not state whether or not the change in interest cost is considered.<<< (added 2010 Dec 01)>>>These ideas are supported by a 2010 Dec 01 Opinion in the WSJ, Michael J. Boskin: Why the Spending Stimulus Failed; however, he appears to also have misinterpreted Dr. Romer's analysis as a one-year effect, not a three-year effect. <<<
Scheduling tax rate changes back to the 2000 levels appears to be required to provide tax revenues in the range of 18%, but should be changed gradually with a well-defined tax policy with an understanding of both the direct and indirect changes in tax revenues.

Stop the Class Warfare
The Bush tax cuts extended to everyone, not just to the high-income earners. The class warfare has been introduced by President Obama and the Democrats by not supporting similar across-the-board changes with the expiration of the cuts. Their decision is based on ideology, as Don Campbell noted in "The Obama makeover " (USA Today, 2010 Oct 29) Remember the "share the wealth" statement President Obama made to Joe the plumber.
The 2010 Nov 14 Detroit News editorial states

"The tax reductions, approved by Congress during the first term of George W. Bush's presidency, lowered the rates paid in all income tax brackets, doubled the child care tax credit available to working families and eliminated the "marriage penalty" for couples filing joint returns. They also reduced capital gains taxes, eliminated a scheduled phase-out of personal exemptions for Americans earning more than $122,500 and prevented the loss of itemized deductions for those with higher incomes."

This again illustrates that the Bush tax cuts extended to all. Another analysis is published by 2010 Nov 19 U. S. News, 10 Things You Didn't Know About the Bush Tax Cuts. Both provide the facts that the Bush tax cuts extended to everyone.

But President Obama and many Democrats want to "cherry pick" the expiration for idealogical reasons — their class warfare.

Effect of Maximum Marginal Tax Rate on Tax Revenues
The definitive work has been done by Arthur Laffer and is characterized by the Laffer curve. The theory is that if the maximum marginal tax rate is reduced, the reduced taxes paid by the high earners will be used for investment and expansion which will in turn increase the GDP and tax revenues. A decrease in the maximum marginal tax rate will produce a direct effect of reduction in tax revenue. The investment and expansion will provide an increase in GDP and tax revenue. These effects are always present in a tax reduction. The critical question is, "Under what conditions will the indirect effect be larger than the direct effect?"
For tax increases, the same process works but with the opposite effect. In any event, the direct effect on tax revenues is always tempered by an offsetting indirect effect. This is one of the conclusions from the analyses done by the Congressional Budget Office and Dr. Cristina Romer, quoted above by Senator Hatch.

The chart to the left showing the maximum marginal tax rate over time is from USA Today (Let the Bush cuts expire, and bring spending under control, too. 2010 Oct 15). Arthur Laffer's work indeed shows that decreasing high marginal tax rates (higher than 60%) has resulted in increased tax revenue. His empirical work is based on three time periods: the Harding-Coolidge cuts of the mid-1920s; the Kennedy cuts of the mid-1960s; and the Reagan cuts of the early 1980s. Those tax reductions are indicated for the years 1920's, 1960's and 1980's. In all three cases, tax revenues did increase with a decrease in the high marginal rates. The work is reported by the Heritage Foundation at

Executive Summary — Executive Summary: The Laffer Curve: Past, Present, and Future | The Heritage Foundation, May 1, 2004.

Full Report — The Laffer Curve: Past, Present, and Future | The Heritage Foundation, May 1, 2004.

A significant aspect of Mr. Laffer's work is that tax changes on the highest marginal rate produce both a direct effect (change in taxes collected) and an offsetting indirect effect (tax in tax revenues due to change in economy resulting the tax rate change). When is the indirect effect larger than the direct effect? Mr. Laffer's work indicates that the indirect effect is larger than the direct effect when the marginal rate is 60% or higher. The breakeven point is obviously at a lower maximum marginal tax rate, but is not defined by Mr. Laffer.
(revised 2010 Nov 15)>>> At the present time, the highest federal marginal rate is 35%. However, other marginal tax rates must also be considered — up to 2% for the phase out of deductions for exemptions plus up to 10% state income tax — for a total of 47%. Both of these additional items either didn't exist or were smaller for the years in Mr. Laffer's study. The maximum marginal rate of 47% is smaller than those used in the conclusion by Professor Laffer. However, the same direct and indirect effects still apply. Allowing the Bush tax cuts to expire for high income earners would increase the maximum marginal rate to 51%. The direct increase in tax revenue will be offset by the indirect decrease in tax revenue with lesser investment and expansion. Which will be larger? In any event, using only the direct effect of $700 billion over ten years as the effect of allowing the tax cuts on the high earners to expire ignores the indirect effect and is clearly wrong.<<<
The easiest way to answer today's critical question is to ask Mr. Laffer, "Will allowing the Bush tax cuts to expire for the high earners decrease total tax revenues?" (added 2012 Feb 22)>>> This question was directed to Mr. Laffer in an interview reported in the 2007 Dec 06 Time Magazine, Tax Cuts Don't Boost Revenues. The author reports:

   "I decided to find out what Arthur Laffer thought.
   • • •
   About the best I could get out of him on the question of whether the Bush tax cuts have paid for themselves was "I don't know."

The article discusses the work of other economists on the validity of the Laffer curve as applied to the Bush tax cuts.<<< His prior work indicates that the indirect effect is large compared to the direct effect. All economists who opine on the effect of letting the tax cuts on the high-income earners to expire should be asked that question. Similarly, the question should be posed to President Obama and the White House.

Business Taxes must be Competitive
Currently, the US has the highest corporate tax rate among the major countries. This obviously hurts US business in the global market. Accordingly, the corporate taxes must be made competitive.
Another factor is the disadvantage for the US in not rebating embedded taxes for products exported. In countries with a Value Added Tax, the embedded VAT is rebated for products exported. The countries add the VAT for products imported. Consequently, US products sold in VAT countries have the embedded US taxes plus the VAT added to the imported products. On the other hand, the US does not impose the equivalent of a VAT on products imported.
The overall result from these taxation policies is that they are unfavorable to US products in the US and in the VAT countries.
Hence, the change in business taxes must include:

Reduction in corporate tax rate to ensure competitiveness of US originated products.
Rebate of embedded US taxes on US products that are exported. A tax should be added in imported products equivalent to the embedded tax on the products if manufactured in the US. This should be handed on a reciprocity basis.
Phase out the subsidy on ethanol because it is not cost effective. Not only are taxpayers paying for the subside, they are paying the higher food costs because of the increased demand for corn.
Examine all the areas where tax policy is trying to pick winners and losers and where tax policy is used to support uncompetitive products and technologies. Such targeted "winners and loser" appears to be idealogically related with the Democrats unwilling to provide more competitive taxes across the board and unwilling to let businesses and ingenuity work through the market.
Reduce the costs for the United Nations. Just as most member countries are tightening their belts, the UN must do likewise. Retain only those programs that have a reasonable likelihood of delivering the promised results.
Reduce support to states and local governments to those that are the obligation of the federal government. States and local governments can best decide how the limited public funds should be used.
(added 2010 Nov 29)>>> The recommendations in the proposal by the Co-Chairs of the Debt Commission, Co-Chairs' Proposal, should also be considered — particularly the elimination of tax preferences which reduce tax revenue (higher tax rate on others) and distort economic activity.<<<

Customers should ultimately benefit from Item 1 as the reduction in taxes is reflected in the price of products.
The effect on taxes for each trade agreement should be analyzed and known. The term "free trade agreement" is misleading. Trade agreements should be nogotiated based on mutual interest. Trade agreements based on mutual interest should be neutral or favorable for both taxes and balance of payments.
With the current unfavorable balance of payments, the second change should yield substantial tax revenue. Obviously study is required to quantify all of the effects.
(added 2010 Nov 19)>>> Changes in tax code should be implemented gradually with advance time for businesses to plan accordingly. Our society and economy do not absorb large changes very well.<<<

Other Taxes
Other taxes should be examined for fairness and necessary funding — particularly the Highway Trust Fund. The improvements in vehicle fuel economy have reduced the revenue from fuel sales. Perhaps a permanent adjustment should be made to the fuel tax based on national fuel economy results.
All of the individual funds should be budgeted and accounted for separately to avoid the distortion in the real deficit for the general fund.

Conclusion
We need to take a much broader view on taxes than just the specifics related to the expiration of the Bush tax cuts. Many changes are needed. Part of that broader view is to use the methodology and presentation in the documentary, I.O.U.S.A. in the development of the federal budget. Another is to separate the Funds from the general budget to provide a better understanding of the status of the Funds and the general budget. Hopefully, the new Congress will develop a longer-range plan to provide more stability and certainty and to address the deficit and debt challenges.

History: Changes are usually identified in the text with the date which facilitates searching by date. Edits are usually noted by add and ~~delete~~ changes.

2012 Feb 22 — Add reference concerning the validity of the Laffer curve.
2012 Jan 03 — Edited for posting to this weblog provider.
2010 Dec 26 — Added discussion about using a tax expense or subsidy for tax incentives.
2010 Dec 07 — Added link to Op-Ed re comments by Senator Voinovich.
2010 Dec 01 — Added another reference re indirect effect of changes in tax rates.
2010 Nov 29 — Added references to the proposal by the Co-Chairs of the Debt Commission.
2010 Nov 19 — Added paragraphs concerning making changes gradually.
2010 Nov 15 — Added more discussion of the indirect effects of tax changes. Also added discussion regarding using the tax code to pick winners and losers.
2010 Nov 13 — Initial Post

Links: Extend federal tax cuts for several years at [http://curntbk.blogspot.com/2010/11/extend-federal-tax-cuts-for-several.html]

A Curmudgeon's Notebook

November 13, 2010

Extend federal tax cuts for several years

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