Why taxes need to come up, but tax rates don't have to

Today’s blog post by Donald Marron and column by the Washington Post’s Ruth Marcus give me occasion to say “here, here” as well as an excuse to trot out yet again a really old point (or maybe three points) I’ve made over and over again on this blog (but which I personally never tire of as long as it’s clear most Americans and our policymakers still don’t get it):

1. We need more tax revenue;
2. the current-law baseline is a good “role model” for the right level of revenue; but…
3. sticking to current-law baseline revenue levels doesn’t require sticking to current tax law, and doesn’t even require seeing marginal tax rates go up.

Donald explains “why taxes are [inevitably] going up” (it’s going to be impossible to flat-line health spending or otherwise reform entitlements fast enough), and he points out that the CBO baseline shows us that taxes are already scheduled to go up according to what’s already in current tax law:

Revenues are already on track to rise substantially in coming years. And not just because of an economic rebound and expiring tax cuts. There are structural reasons why tax revenues will grow faster than the economy. The Congressional Budget Office estimates that tax revenues will rise from 14.9% of GDP in 2010 to 20.7% in 2020 and 23.3% in 2035 if current law remains in place…

That rapid growth reflects six factors. First, the economy will recover, lifting revenues from currently depressed levels. Second, the 2001 and 2003 tax cuts will expire, as will tax cuts enacted in the 2009 stimulus. Third, the Alternative Minimum Tax, which is not indexed for inflation, will boost taxes for millions more taxpayers. Fourth, the new taxes that helped pay for the recent health legislation will go into effect. Fifth, retiring baby boomers will make more taxable withdrawals from tax-deferred retirement accounts. Finally, in a phenomenon known as bracket creep, growing incomes will push taxpayers into higher brackets and reduce their eligibility for various credits.

So one way to achieve a more sustainable outlook as far as the revenue side of the budget goes is to just let current tax law happen–and avoid passing any new tax legislation, including any extension of any of the Bush tax cuts. But that’s not the only way…

Ruth discusses an alternative tax policy strategy made popular by President Obama: raise taxes only on the rich. (You see, the trouble with currently scheduled revenue increases is that much of that revenue would come from the middle class.) It sounds like a great idea, until you realize that relying on such a small fraction of the population for most of the needed tax revenue sets up a really tiny tax base that requires really high marginal tax rates in order to raise the required level of revenue–precisely the economist’s definition of a highly inefficient tax system. It gets all economists, even those not considered “supply-side” economists, nervous. And it sets up a bad political dynamic where people will be encouraged to clamor for more government spending without regard for its cost, when they think that it’ll always be someone else (those ultra-rich people and those evil corporations) who will pay for it.

But we also probably don’t want to let current tax law totally play out because some of those tax increases Donald lists we really don’t want to see–such as an alternative minimum tax that would extend its reach down to those considered truly “middle class.” And even those tax increases that don’t seem quite so objectionable–such as letting the entirety of the Bush tax cuts expire (at least eventually) and going back to Clinton-era income tax rates across the board–still raise marginal tax rates in ways that would increase the inefficiency of the federal tax system and could at least partially offset the positive economic effects of deficit reduction.

The CBO long-term budget outlook shows us that sticking to current-law baseline revenue levels is a good and fairly immediate strategy for fiscal sustainability (where debt/GDP is relatively stable, staying below 80 percent over the next 25 years). In contrast, CBO’s “alternative fiscal scenario” assumes the bulk of the Bush tax cuts, the ones President Obama wants to keep, are extended, which leads to debt reaching 185 percent of GDP in 25 years (and continuing to grow exponentially thereafter). Donald Marron labels this scenario as “Temptation” in his graph above but I think it should be more accurately labeled “Done Deed”, those being the tax cuts exempted from the statutory pay-as-you-go rule.

But the funny thing is that current tax law is probably not the best way to raise the current-law level of revenues. Put this challenge to any tax economist: how can we raise that given level of revenue most efficiently? –and you will get the answer that we need to find the marginal (new) sources of revenue from the broadest, most neutral/efficient tax bases available to us. There are two main possibilities here, and I think we ought to seize both possibilities:

1. reform the existing federal income tax system to clean up and broaden the income tax base–e.g., close up inefficient tax expenditures that “poke holes” in the income tax base (the many exclusions/exemptions, deductions, and credits); or
2. add on “cleaner” (broader, purer, or externality-correcting) new tax bases–e.g., an add-on value-added tax (VAT) or environmentally-motivated taxes such as a carbon tax.

With these sorts of base-broadening strategies to achieve current-law revenue levels, marginal tax rates on productive economic activities don’t have to come up. Thus there doesn’t have to be a tradeoff between the positive economic growth effects of deficit reduction and the negative economic growth effects of higher marginal tax rates on income. There doesn’t have to be a tradeoff at all.

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