The Tax Policy Blog

In a press conference this weekend, Minnesota lawmakers announced an overview of their budget agreement. Though some details remain unspecified, the major tax provisions are disappointing.

Here’s what we do know. The overall plan includes $2 billion in additional tax revenues over the next biennium—specifically a hike on taxes paid by higher-income taxpayers and smokers. Governor Mark Dayton’s (D) original budget, introduced earlier this year, contained both of these provisions. The tax increases are a way to fill a projected budget deficit of $627 million and fund additional spending.

The budget adds another income tax bracket on single filers earning $150,000 or more annually. The state’s top rate will now be 9.85 percent, making it the fourth highest top rate in the country. Politicians are spinning this as only affecting the “top 2 percent,” but that misses the point.

Pushing more of the tax burden onto a smaller, wealthier group is poor policy, not because I care about rich people more (an absurd and inaccurate, but unfortunately common, assertion), but because those incomes are volatile. Income tax revenues that derive a large share of receipts from the wealthiest are unstable, and there’s a lot of research to back that up (a few examples can be found here and here). This point is exacerbated by the fact that lawmakers might also throw in an additional temporary income tax surcharge on those earning $500,000 or more.

Tobacco taxes will also rise, but the exact magnitude of the tax increase is yet to be determined. This is another bad policy move. I find it concerning that lawmakers want to push more of the tax burden onto a group of shrinking, politically unpopular people. Research shows that cigarette taxes do in fact decrease consumption. As the pool of tobacco-users shrinks over time, that revenue source will dry up, leaving the state right back where it started. Cigarette tax hikes are also counter to many progressive goals—that is, they tend to hit the poor hardest.

This week's map shows the percentage of federal tax returns in each state claiming Schedule A itemized deductions, the biggest of which are for charitable contributions, state and local taxes, and mortgage interest. Because every taxpayer is able to claim a minimum standard deduction (currently $5,950 for single filers and $12,200 for joint filers) these deductions only provide a benefit if they add up to be more; they therefore benefit mainly higher-income taxpayers, and wealthier states have a higher percentage of itemizers.

Click on the map to enlarge it.

View previous maps here.

Last week, the IRS shocked me by dropping its claim that it could read taxpayers' e-mails without getting a warrant. They had lost a court case but had seemed determined to fight it out, so while I was happy about the victory, it was a surprising and sudden change of heart.

As we now know, they were clearing the decks for a late Friday revelation: Tea Party and conservative organizations were subject to intentional delays and unnecessary information demands as they sought 501(c)(4) tax-exempt status. They apologized and promised that changes had been made.

The full report from the Inspector General came out yesterday, and the findings are scathing. From April 2010 to December 2011, the IRS shunted all targeted applications to one employee, creating an enormous backlog. A memo was distributed ("BOLO"=Be On the Lookout) to flag applications with "Tea Party," "Patriots," "9/12," issues on government spending or debt or taxes, educating the American public to "make America a better place to live," and constitutional education efforts. In early 2012, additional specialists had been added but they began demanding absurd amounts of information to process applications, setting a 2 or 3 week deadline. Slate's Dave Weigel obtained one information demand letter from the IRS to the Hawaii Tea Party dated January 26, 2012:

1) You are a membership organization. Provide details regarding all dues and benefits.

2) Provide actual financial information for 2009, 2010 and 2011. Include details regarding each item listed.

3) Provide copies of your monthly newsetters since October of 2010.

4) You will sell merchandise. Provide a list of all merchandise you will sell, your cost and the sale price.

5) Provide details regarding your relationship with the Leadership Institute. Provide copies of their training material.

6) Provide details regarding your relationship with Dylan Nonaka. Provide copies of the training material used by Dylan Nonaka.

7) Provide details regarding all other training you have received. Provide copies of the training material.

8) Have you added or replaced any board members, officers, or key employees since October of 2010? If yes, submit the following information: (a) Provide a resume for each. (b) Indicate the number of hours per month each individual has provided or is providing services to you. (c) Provide a description of all the services each individual provides or has provided to you. (d) Indicate the total compensation provided to each individual. (e) Indicate if any of your current or former officers, directors, and key employees are related to each other (include family and business relationships) and describe the nature of the relationship.

[...]

11) Provide minutes of all board meetings since October of 2010.

[...]

25) Have any candidates for public office spoken at a function of the organization other than a candidate forum? If yes, provide the following: a) The names of the candidates; (b) The functions at which they spoke; (c) Any materials distributed or published with regard to their appearance at the event; (d) Any video or audio recordings of the event; (e) A transcript of any speeches given by the candidate(s).

And so on. (It looks like that particular one did not demand donor information, but the Inspector General found that others routinely demanded lists of donors, contributions, and use of the money. The IRS demanded one group provide lists of books read by members of the organization; they snarkily sent a copy of the Constitution.) By February 2012, after some organizations began complaining to the media about IRS harassment, the IRS stopped demanding more information and instead granted 60 day extensions to satisfy existing information requests. From May 2012 to December 2012, the IRS began approving applications, telling a number of the organizations that they no longer needed to respond to the information requests. All told, the average organization was approved in 238 days, but the average targeted group took 574 days to get approval.

While there are tax-exempt organizations out there that perhaps don't deserve that status, many of the IRS's questions were unnecessary toward such an inquiry, and in any event, the one-sided scrutiny was evidently designed to be harassing and delaying rather than true investigatory work. It also wasn't one or two renegade employees, and indeed, the current Acting IRS Commissioner is the head of the Exempt Organizations division. The IRS has apologized, but as Jon Stewart noted, the IRS rarely accepts an apology from a taxpayer accused of wrongdoing. They should be held to the same standard.

Inspector General report:

AIG aduit of IRS abuses by Dave Weigel

IRS Letter to Tea Party Hawaii:

Hawaii Irs Response by Dave Weigel

Some worry the IRS scandal will divert resources away from the comprehensive tax reform discussion. But both Chairman Camp and Chairman Baucus seem dedicated to reform, unveiling their new website and joint twitter account last week.

France is considering a tax on smartphones to help fund their cultural programs.

Australia hopes to cover for its $17 billion deficit by cracking down on tax evaders. If the experience of Greece is an indicator, the push won’t do much to fill Australia’s treasury. So far they have only be able to collect 19 million euros worth of the estimated 13 billion euros the government says its 1,500 biggest tax debtors owe.

Vice President Biden suggested a new sin tax on violent video games, stating “there’s no legal reason why they couldn’t” tax those companies. Legality of the tax aside, taxes shouldn’t micromanage individuals’ choices.

Time points out that maybe not all of the groups currently tax exempt should be. Currently, oraganization like the NFL and PGA receive tax-exempt status - something that Republican Senator Tom Coburn has taken an interest in eliminating.

This year it was the medical excise tax, next year it will be the “annual fee on health insurance.”

Last week, the Subcommittee on Health and Technology held a hearing to discuss the next tax to go into effect to fund Obamacare: the “annual fee” (tax) on health insurance. In the first year, this tax will total $8 billion, apportioned among health insurance companies based on their net premiums. The total cost of this tax will then grow to more than $14 billion in 2018, after which it will be set to grow indefinitely, indexed to the growth of healthcare premiums.

Prior to the hearing they released a memo discussing the new tax’s possible effects on small business and the economy.

The memo highlights research on the downsides of the tax:

Both the JCT and CBO estimate that a vast majority of the tax will be passed on the consumers. Specifically, the JCT estimated that getting rid of this tax would save families $350 to $400 on their premium in 2016.

Even more, since there is an exemption for those who self-insure—most commonly large employers—the majority of this tax will fall on small businesses. According to a study by the Nation Federation of Independent Business Research Foundation, the increased premiums on businesses “could reduce private sector employment by 146,000 to 262,000 in 2022, with a majority of those losses falling in the small business sector.”

Another study found that the insurance fee will increase premiums by 1.9 percent to 2.3 percent in the first year of this tax and a projected annual growth of premiums of 1.8 percent after that. This translates to an additional $2,794 for individuals and $5,140 for families over the next ten years. Even more, the study said that some small businesses could see dramatic premium increases.

However, testimony from CBPP argues that combined with all the other provisions in Obamacare, the effect of the tax will be negligible to employers. In their testimony, they cite the CBO which claims that that Obamacare’s effect on premium prices will be between a 1 percent increase and a 2 percent decrease.

This assumes, of course, that the highly complex structure of Obamacare created all the right incentives and all those incentives line up correctly and lead to lower health insurance costs, mitigating all negative effects of this tax. With all the implementation issues and political issues Obamacare faces, this seems like a dream rather than a reality.

It is more likely that Obamacare won’t work perfectly: the fee will raise premiums and there will be some negative effect on employment. If this is the case, the effects of this new fee on premiums seem to contradict the purpose of Obamacare, which was meant to reduce the cost of healthcare, not increase it.

Can a tax cut pay for itself? Most economists would probably agree that the answer is generally “rarely, but usually not.” However, this question is often mixed up with a different one – “can reforms that lose revenue on a static basis pay for themselves?” It’s incredibly important to realize that the second question is distinct from the first, and that the answer can easily be “yes.” Tax reform is not a matter of raising or lowering a single tax - it’s a combination of tax cuts and tax hikes, and the swapping of particular sources of revenue for others. Since the economic effects of different taxes differ, reforms that are scored as a static revenue loss (and thus be popularly thought of as a “tax cut”) can easily raise revenue when their economic effects are accounted for. The people who completely dismiss the idea that a tax cut can pay for itself are usually on solid ground when considering a single tax only, but it’s wrong to extend this skepticism to any tax reform that shows a static revenue loss.

It is true that with any tax, there is a point where a high enough rate causes sufficient economic damage that further rate increases reduce revenue rather than raise it. For example, an income tax rate of 100% would raise no revenue because there’d then be no reason for anyone to work or invest, and consequently no income to tax. This idea can be expressed graphically as the controversial “Laffer curve,” but the basic concept isn’t disputed – for any tax, there exists a revenue-maximizing rate beyond which further rate increases are counterproductive. The dispute between left-leaning economists and right-leaning economists is therefore not so much over whether the Laffer curve exists (it does) but what shape it has.

To illustrate this, consider three hypothetical taxes. Revenue estimates for each are presented below, with the (tax-inclusive) rate ranging from 0% to 100%. The orange dotted line is the “static” revenue estimate that assumes no Laffer-type effects – that is, no changes to the economy resulting from the tax. The blue line is the revenue that is actually raised once these effects are accounted for:

Tax A is a good tax – that is, one that causes minimal economic damage. Consequently, the static revenue estimate and the dynamic revenue estimate are more or less the same until rates get prohibitively high. Left-leaning economists probably imagine most taxes to look something like this; those who lean right are not as optimistic. Tax B is an okay tax – it causes relatively little economic damage at low rates but the effects start to add up at higher rates; the revenue maximizing rate is about 45%, and beyond 70%, the tax is so damaging to the economy that more revenue would be raised by simply not levying the tax at all (because revenue from other taxes is also depressed by the damaging tax.) Tax C is a terrible tax – even at low rates, the damage it causes is bad enough to cause total tax revenue to go down.

Most taxes aren’t so bad as Tax C – it’s an exceptional case. That’s why skepticism is warranted when somebody claims that a tax cut will pay for itself. However, consider a more realistic (but still somewhat simplified) scenario. A government levies two taxes – one looks like Tax A and the other looks like Tax B, both at rates of 20%. A tax reform bill comes along that lowers Tax B from 20% to 10%, and raises Tax A from 20% to 30%. Government analysts perform a static revenue analysis and find that cutting Tax B loses $500 billion dollars, and raising tax A brings in $400 billion dollars. That’s a deficit of $100 billion, and the bill’s opponents argue that such a huge “tax cut” is irresponsible. “But wait!” says a renegade economist. Her dynamic analysis shows that while raising tax A does indeed bring in $400 billion dollars, cutting Tax B has some dynamic economic benefits – certainly not nearly enough that the cut “pays for itself,” but enough that it loses only $400 billion instead of $500 billion in revenue. The static $100 billion deficit has disappeared.

At this point, the economist would likely be ridiculed as a crank who believes that tax cuts always pay for themselves. But this is unfair – it’s a distortion of what was actually said. She never argued that cutting Tax B alone pays for itself – that would indeed be an extraordinary claim deserving of considerable scrutiny. Rather, she merely argued that cutting Tax B isn’t quite as expensive as the static analysis would suggest, and that’s enough to make the entire bill revenue-neutral.

It’s one thing to laugh off claims that cutting a single tax pays for itself – it’s quite another to dismiss similar claims about a comprehensive tax reform bill. As long as there is a differential between the dynamic effects of the tax cuts vs. the tax increases, it’s quite plausible that the static score shows a deficit increase and the dynamic score shows a reduction. This isn’t the same thing as saying a tax cut pays for itself, and it shouldn’t be treated as such.

Last February, the Ways and Means Committee ranking members announced the formation of 11 “working groups” that would focus on different areas of tax reform. Their goal was to  “to review current law in its designated area, research relevant issues, and compile related feedback from stakeholders, academics and think tanks, practitioners, the general public, and colleagues in the House of Representatives.”

Earlier this week, the Joint Committee on Taxation released a report outlining the feedback that these working groups received (starting on page 490).

Underscoring the political challenges to tax reform, a range of conflicting suggestions was given to these different working groups.

A good example of the range of policy choices surrounding tax reform are the suggestions given to the Working Group on Debt, Equity and Capital regarding the tax rate of dividends and capital gains.

Groups suggested the following regarding both:

Capital Gains:

·         Retaining low rates on capital gains;

·         Retaining the present-law tax rate on capital gains

·         Taxing capital gains at a maximum 28 percent

Dividends:

·         Providing low tax rates on dividend income;

·         Retaining the present-law statutory top rate on qualified dividends paid by C corporations;

·         Treating dividends as ordinary income subject to the top individual tax rate;

As you can see, some want these taxes lowered, some want them kept the same, while some want them to be increased. I want to focus on the two specific suggestions to raise taxes on capital gains and dividends. What would these changes theoretically look like compared to the OECD average tax rates on dividend and capital gains income?

For capital gains, the current law is already out-of-step with international standards. After the fiscal cliff, combined state and federal capital gains rates increased from 19.1 percent to 28 percent. This is more than 10 percentage points higher than the international average. One suggestion, of course, is to tax capital gains at the rate at the 1986 rate of 28 percent. This would push America’s average combined federal and state capital gains rate to more than 35 percent, more than double the international average.

As for dividend taxation, the United States used to have a rate lower than the international average, but after the fiscal cliff deal the average rate increased to over 28 percent. Again, one of the suggestions above is to treat dividends as ordinary income. This would push the tax rate on dividends to more than twice as high as the OECD average to the top marginal combined state, local and federal income tax rate of 47.9 percent.

Internationally, our capital gains and dividend tax rates are too high already. For the past 3 decades, countries throughout the world have been lowering their individual capital gains and dividends tax rates. Following these suggestions and raising these tax rates would be a bad idea and in total opposition to current international trends. These trends reflecting the realization that lowering your tax burden on saving spurs investment, increases a country’s economic competitiveness and spurs economic growth. Raising these taxes would put America further at risk for losing its competitive edge.