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Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Saturday, July 13, 2013

CBPP: The Problem With Deficit-Neutral Tax Reform

CBPPCenter on Budget and Policy Priorities, The Problem With Deficit-Neutral Tax Reform, by Chuck Marr, Chye-Ching Huang & Nathaniel Frentz:

Given the nation’s long-term fiscal pressures, increases in revenues need to make a significant contribution to deficit reduction, alongside reductions in spending for mandatory programs.  Deficit-neutral tax reform would, as a result, be highly problematic.

Tax reform generally refers to a process through which policymakers would scale back the vast collection of tax deductions, credits, and other preferences, known collectively as “tax expenditures.”  (For example, Senate Finance Committee Chairman Max Baucus and ranking Republican Orrin Hatch are undertaking a process in which Finance Committee members will examine and be asked to defend each tax expenditure that they want to retain in the code. If tax reform were revenue neutral, it would use up the politically achievable savings from tax expenditures to lower rates without producing any deficit reduction, and it would effectively take revenue off the table for deficit reduction for years to come.  It likely would take major mandatory programs off the table as well, because many policymakers would justifiably resist changes in those programs — which could significantly affect millions of people with relatively modest incomes — if they were not accompanied by revenue increases from reforming inefficient tax expenditures that disproportionately benefit the most affluent households.

Aggravating these risks, some prominent proponents of deficit-neutral tax reform have set, as a key tax-reform goal, a sharp cut in the top income tax rates.  The House-passed budget resolution of this spring, for example, calls for setting a goal of cutting the top individual and corporate rates to 25 percent and offsetting that cost through unspecified tax-expenditure savings.  The House rate-cut goals would dig a $5.7 trillion revenue hole over the next ten years, the Urban Institute-Brookings Institution Tax Policy Center (TPC) has estimated, with the tax benefits heavily skewed to people at the top. The task of finding anything close to that amount in tax expenditure savings would be politically herculean, given the popularity of such major and expensive tax expenditures as the mortgage interest deduction, the charitable deduction, and many others.

Consequently, policymakers would have strong incentive to use budget gimmicks and optimistic revenue forecasts (including the dubious tactic of “dynamic scoring”) to reach the stated goal of deficit-neutral tax reform.  Thus, a purportedly revenue-neutral tax reform bill might be revenue neutral only cosmetically (or might be revenue neutral only over the first ten years and lose revenue after that due to the use of “timing-shift” gimmicks).  If so, tax reform could wind up raising less revenue than current law over the long term, making long-term deficits worse.

Revenue-neutral tax reform also could lengthen the amount of time that policymakers leave the “sequestration” budget cuts in effect by making it harder to craft a balanced, long-term budget agreement to replace them.  Sequestration, with its equal defense and nondefense cuts, was designed to bring bipartisan negotiators to the table in search of a broader agreement that would include both mandatory spending cuts and revenue increases.  Revenue-neutral tax reform could doom that prospect as well. ...

The primary goal of tax policy should be to raise additional revenue, in a progressive fashion, as part of a balanced approach to long-term fiscal health.  The primary goal should not be to cut tax rates further.

Tax expenditures should be a prime target for revenue raising.  For one thing, they suffer from a key design flaw — their value rises as household income rises, so they provide the biggest benefits to the people who least need a tax incentive to buy a home, save for retirement, send a child to college, or the like.  For another, they make the tax code less efficient by favoring some activities over others.  Thus, policymakers can secure tax-expenditure savings while, at the same time, boosting the efficiency of the tax code.  Yet most large tax expenditures are popular and deeply embedded in the tax code.  Policymakers must be realistic about the amount of savings they can generate — and they should not apply them solely to cutting tax rates and, thus, creating new obstacles to deficit reduction.

Policymakers should follow a first-things-first sequencing.  They should pursue tax-expenditure reform as part of a balanced long-term deficit plan that also includes spending reductions.  And policymakers should apply a share of the proceeds to lower rates only if they have first met the revenue targets of such a balanced deficit plan.

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