As we draw nearer to the November 23 deadline for the Special Joint Committee on Deficit Reduction—better known as the super committee—the pressure is rising to come up with a deal that hits the target of $1.5 trillion in deficit reduction. Obviously, one of the most crucial fault lines is the issue of tax revenue.
Democrats, along with nearly all independent and bipartisan experts, and even some conservatives, believe that deficit reduction cannot be accomplished through spending cuts alone and are therefore pushing for some additional tax revenue to help close the budget gap. Unfortunately, the six Republicans on the 12-member panel seem as intransigent as ever, and so far appear to be unwilling to accept even modest revenue enhancements.
With the super committee at an apparent impasse, some are looking to the so-called Gang of Six proposal—a deficit plan from three Democratic senators and three Republican senators hatched earlier this year—as a potential template for finding common ground. The Gang of Six plan has much to recommend it, but lawmakers on the super committee and ultimately everyone in Congress should be wary of at least one of its key aspects—a figure-it-out-later proposal on tax reform.
The Gang of Six—Sens. Saxby Chambliss (R-GA), Tom Coburn (R-OK), Kent Conrad (D-ND), Mike Crapo (R-ID), Dick Durbin (D-IL), and Mark Warner (D-VA)—endorsed fundamental income tax reform but declined to actually design one. Instead, the gang set forth a few important standards that reform must meet, leaving details to be determined at a later date. The advantages of this approach are obvious. By leaving the nitty gritty for later, the Gang of Six avoided the tricky business of deciding exactly whose taxes will go up and whose will go down, and by how much. They avoided the political pitfalls of explicitly identifying specific tax expenditures that are to be scrapped or fundamentally altered. And they allowed themselves to simply assert that tax reform would raise more money while at the same time lower everyone’s marginal tax rates—and still maintain the same progressivity in the code.
In the midst of difficult bipartisan negotiations in which tax revenue is a major sticking point, it is easy to understand why the Gang of Six opted for this kind of “reform.” And it is also easy to imagine the super committee following their lead. But a close look at the Gang of Six “reform” conditions makes it crystal clear that both conservatives and progressives should be skeptical of the figure-it-out-later approach. They may end up embracing a reform plan that they didn’t expect.
The Gang of Six plan delegates to the Senate Finance committee the responsibility for crafting a tax reform plan that meets several criteria. Specifically, the plan:
- Must have just three tax brackets with rates of between 8-and-12 percent, 12-and-22 percent, and 23-and-29 percent
- Must reform, but not eliminate, tax breaks for homeownership, health, charitable giving, and retirement
- Must maintain the earned income tax credit and child tax credit for low-income workers and their families
- Must raise about $2.2 trillion above what the current tax code would generate over the next 10 years
- Must not diminish the progressivity of the tax code
In theory, it might be possible to design a tax reform plan that meets all these criteria, but it would require some very challenging contortions. In practice, a reform plan that tried to meet all of these conditions would face more practical and political challenges than it seems.
To see why, let’s start with the tax rates and some real numbers. If in 2007, the last year before the onset of the Great Recession, the tax rates had been 10, 22, and 28 percent—the highest rates allowed by the Gang of Six that don’t result in a marginal tax rate increase for anyone, and generate the most revenue*—then the tax code would have generated about $180 billion less than it really did that year. That’s $180 billion that would have had to come from cutting and reforming tax breaks. But the Gang of Six also wants the tax code to generate about 13 percent more than it did under 2007 tax policies, which means their plan would need to come up with another $130 billion in tax expenditure reforms and cuts.
So, in 2007, their tax rates would have yielded a total revenue shortfall of over $310 billion.
Could tax expenditure reform come up with $310 billion in new revenue? Sure, it could. In 2007, the revenue loss from all tax expenditures combined was about $750 billion, so $310 billion is within the realm of possibility. But there’s a catch. Three catches, actually.
The first catch is that the largest tax benefits are those that the Gang of Six specifically says we can’t eliminate. Tax expenditures for homeownership, health care, retirement savings, charitable giving, and those for low-income workers totaled about $450 billion in 2007, or about 60 percent of the value of all tax expenditures that year. In other words, even if reform eliminated every single other tax expenditure, it still wouldn’t be quite enough to fill the $310 billion gap.
What’s more, the list of eliminated tax benefits would have to include exempted interest from public-purpose bonds, which finance local road and school construction, among other things, as well tax exclusions for most Social Security benefits and veterans’ disability compensation and death benefits, and state and local tax deductions. Higher education and child care tax credits would disappear entirely. And strange economic concepts such as “net imputed rental income”—which measures the value a homeowner would receive if he were to rent out his house—would suddenly be treated as income to be taxed. And if reform spared some of these popular tax breaks, then it would have to dig into the megapopular ones such as the home mortgage interest deduction and the employer-provided health care exclusion.
The second catch is distributional. The Gang of Six stipulates that any reform must not skew the tax code any further toward the wealthy. But cutting the marginal rates would deliver a huge benefit to those at the top, and a much smaller benefit to those at the bottom. Households earning more than $1 million in adjusted gross income would reap an average benefit of over $100,000, while those closer to the median household income of about $50,000 would gain only about $1,000 in reduced taxes.
Because many tax expenditures currently benefit the wealthy disproportionately, some of the disparity could be reduced by reforming or eliminating existing tax benefits—but only up to a point. In 2007, even if tax expenditures had been reformed in such a way as to tax the full income of a millionaire (including capital gains income) without allowing any deductions or exemptions that would have generated just $38 billion in additional tax revenue. That still leaves more than $270 billion to be raised from the middle class and the poor. In other words, with high income marginal rates so low, it will be next to impossible to achieve the overall revenue target without shifting at least some of the burden onto the middle class and the poor.
The third catch is technical. The estimates of how much most tax expenditures cost depend on the marginal tax rates. After all, the higher the tax rate, the greater the revenue loss if a taxpayer is able to shield some of his or her income from that rate. All existing estimates of tax expenditures assume that the top income tax rate will be either 35 percent or 39.6 percent—the 2007 estimates, for example, are based on that year’s top rate of 35 percent. Dropping the top rate down to 28 percent or 29 percent not only reduces the revenue that the tax code generates but also reduces the revenue gain that comes from reforming the very tax expenditures that the Gang of Six is relying on to get them to their revenue target.
How big a problem this will be is hard to gauge right now. But suffice it to say that any revenue estimates that come from reforming tax expenditures, including the ones used here, are likely to be overestimates.
And of course, the entire exercise becomes even more difficult as the tax rates go down. If, for example, the rates in 2007 were set at the bottom of the Gang of Six’s acceptable range, rather than at the top, then the revenue gap would have surpassed $500 billion instead of $310 billion.
None of this is meant to suggest that the super committee or Congress should avoid reforms to the tax code entirely. On the contrary, with revenues at historic lows, and given the contribution made by repeated tax cuts to our current federal deficit woes, it is imperative that the Super Committee find ways to increase overall revenue. But simply setting out a few parameters and then charging someone else to figure it out later is extremely risky. The enormous difficulty inherent in actually crafting a plan that meets those standards will likely doom the effort to failure. Which means it won’t actually raise the needed revenue.
A much better approach would be to identify specific problems in the tax code—tax benefits that primary benefit the wealthy, or those that unfairly and unnecessarily advantage one type of business over another—and propose concrete fixes for those problems. That way the super committee can be sure it will produce the revenue it needs to meet its mandate to reduce the federal deficit and at the same time make material improvements to our tax code.
Of course, given conservative opposition to cutting inefficient spending programs if those programs are classified as tax breaks, it seems unlikely that the super committee will be able to garner majority support for this more sensible approach. This being the case, it is understandable that some might look to the Gang of Six model as one to be replicated. But caution should be the watchword. The Gang of Six’s figure-it-out-later approach is attractive precisely because it doesn’t make the hard choices and grapple with the painful tradeoffs. If the super committee travels down the same path, they might not like where it leads.
Michael Ettlinger is Vice President for Economic Policy at the Center for American Progress. Michael Linden is Director of Tax and Budget Policy at the Center.
*The top rate allowed by the Gang of Six is 29 percent, but we used 28 percent here to be as fair to the proposal as possible. If we had used 29 percent, all of the income currently taxed at 28 percent would have to be dropped into the 22 percent bracket. That would actually result in slightly less revenue than setting the top rate at 28 percent and taxing all income currently in the 28, 33, and 35 percent brackets at 28 percent. Additionally, the top rate for the lowest bracket allowed by the Gang of Six is 12 percent. We used 10 percent so that no one in the current 10 percent bracket would face a marginal rate increase. In this analysis, we also assumed that the tax bracket break-points would match current break-points, again so that no one would face a marginal rate increase.