1. Progressive tax code
2. Permanently link taxes to the unemployment rate
3. Backstop rules
4. Independent institutions

I have my doubts…

Take less of your income when economy is bad and more when economy is good.  The degree of progressivity of the tax code, however, is an item up for much debate.  There is not one clear method to make the tax code progressive.  Further, the question is complicated by the fact that newly poor individuals receive in-kind benefits (e.g., Medicaid, TANF, food stamps) but it takes some time before these benefits arrive.

Permanently link the tax to the unemployment rate works if there is an equilibrium unemployment amount that policymakers can estimate.  In practice, however, difficult to determine if changes in unemployment are cyclical shifts around a stable equilibrium unemployment value or a change to a new equilibrium value.  Orzag’s recommendation #2 works if it is the former, but if it is the latter, taxes will consistently be too low (or too high).

Backstop rules are events that take place if Congress doesn’t act.  However, these are only effective if there is not a big lobby to fight against these default changes.  Once lobbyists are appraised of automatic changes in spending to their constituents, one can be sure that politicians will be informed of these ‘automatic’ changes and many will get reversed.  For instance, the sustainable growth rate (SGR) aims to reduce Medicare spending for physician services gradually over time. However, Congress has reversed these ‘automatic’ changes each year and thus the backstop rules—for Medicare payments at least—have been wholely ineffective.

Independent Institutions are generally a good idea when tough decisions need to be made. Orzag cites a commission that was established to close military bases in the 1980s.  The reason Orzag needs to use this example is that independent institutions are not always as independent as intended.  The recommendations of the most recent fiscal commission to reduce the deficit were largely ignored.  Further, choosing an impartial group of individuals to sit on any committee is difficult.  Once must balance the additional expertise insiders bring to the discussion against the vested interests these individuals may have.  Further, voters may not like independent institutions because they are not held accountable by voters.  Orzag also cites the Independent Payment Advisory Board (IPAB) created by health reform, by IPAB’s is so new its success cannot be judged.

Does that seem a little high?  If you check your paycheck, the amount of money that is actually deducted from your paycheck for Social Security and Medicare is only 7.65%.  Employers, however, pay an equal amount of taxes on your behalf (i.e., an additional 7.65%).  Previous studies have indicated that all taxes employers pay on employees behalf is funded through lower employee earnings.  In other words, if the employer didn’t have to pay these taxes, your salary would be 7.65% higher.  Ouch!

Here is the breakdown of what where your payroll tax deductions are going.

Notes that OASDI (Old Age Survivors and Disability Insurance) is Social Security and HI (Hospital Insurance) covers only for Medicare beneficiaries’ Part A  (i.e., hospital) medical costs.

Source: A SUMMARY OF THE 2011 ANNUAL REPORTS

Congress did save $78.5 billion in their latest agreement. Since the original budget deficit for fiscal year 2011 was $1.6 trillion,  however, the negotiated savings only amounted to 5% of the deficit.

Lots of rhetoric; little action.

“The plans were intended to give the private sector, community and charitable groups greater involvement in woodlands by encouraging a “mixed model” of ownership.

But critics argued it could threaten public access, biodiversity and result in forests being used for unsuitable purposes.”

Should the government own forests?  In general, I would say no.  If private firms or organizations would want to pay to access these forest, they should be able to do so.  Some of the businesses who buy the land may want to harvest trees or start building apartment buildings.  Others may want to create eco-tourism sites or private NGOs could buy the land to maintain it in its natural state.  Regardless, individuals, firms, or organizations with the highest willingness to pay should be able to purchase the property.

Once exception may be the production of oxygen.  Trees produce oxygen for the whole country.  However, oxygen is generally non-excludable.  Thus, by cutting down trees, businesses who decide to deforest land impose an externality on others, especially if there are few forests left.

To solve this problem, the government would create an oxygen tax.  The tax would basically mandate that you need to have a certain number of trees per acre on your land or else you would pay the tax.  This could apply to all land, not just forests.  With the cost of apartments in central London, it is of course optimal to simply pay the tax and create dense neighborhoods.

The oxygen tax is not without its flaws.  If the tax is based on the number of trees on the property, one could simply buy lots of young trees to avoid the tax.  Young, smaller trees, however, will not produce as much oxygen as larger older trees.  One could estimate the aggregate biomass of trees on any property, but this would of course require regulators to ensure that people don’t lie about the biomass on their property.

Is the oxygen tax a good idea?  If deforestation becomes severe enough, it may be.

1. Enact tough discretionary spending caps and provide $200 billion in illustrative domestic and defense savings in 2015.
2. Pass tax reform that dramatically reduces rates, simplifies the code, broadens the base, and reduces the deficit.
3. Address the “Doc Fix” not through deficit spending but through savings from payment reforms, cost-sharing, and malpractice reform, and long-term measures to control health care cost growth.
4. Achieve mandatory savings from farm subsidies, military and civil service retirement.
5. Ensure Social Security solvency for the next 75 years while reducing poverty among seniors.

I will review each of these topics in turn.

Cut Discretionary Spending

To cut discretionary spending, the Commission proposes rolling discretionary spending back to FY2010 levels for FY2012, and requiring a 1% cut in discretionary budget authority every year from FY2013 though 2015. This includes $100 billion in discretionary military spending such as: freezing noncombat military pay at 2011 levels for 3 years, reducing procurement by 15%, modernize TRICARE, and reducing overseas bases by one-third. The other $100 billion in goes for non-military discretionary spending. Some of these cuts include: freezing federal salaries at non-Defense agencies for three years, cut the federal workforce by 10%, eliminate 250,000 non-defense service and staff augmentee contractors, slow the growth of foreign aid, and eliminating all earmarks. All of these suggestions are entirely reasonable.

Tax Code Reform

The tax reform is based on eliminating large tax expenditures while also lowering marginal tax rates.  The overall effect will be an increase in tax rates, especially for the richest and poorest who receive the largest shares of tax expenditures.  However, the simplification of the tax code is a key benefit.  The key aspects of the plan include:

• Consolidate the tax code into three individual rates and one corporate rate
• Eliminate the AMT, Pease, and PEP
• Eliminate all $1.1 trillion of tax expenditures
• Dedicate a portion of savings to deficit reduction and apply the rest to reduce all marginal tax rates

Key tax expenditures proposed to be cut include: the mortgage interest, health insurance, retirement savings, the state & local tax deduction, the child tax credit, and the EITC.  In addition, the proposal would treat capital gains and dividends as ordinary income, repeal the Alternative Minimum Tax (AMT).  Of these tax expenditures, I would support keeping the child tax credit and EITC as deduction, but would eliminate the tax deductibility of mortgage interest, state and local taxes, health insurance, and 401(k)/IRA contributions.

The National Commission also would gradually increase gas tax by $0.15 to fund transportation spending.  I agree with this tax increase as well as it will incentivize citizens to cut back on their gas consumption and thus pollution will decrease.

Decrease Health Care Spending

• Pay doctors and other providers less, improve efficiency, and reward quality by speeding up payment reforms and increasing drug rebates
• Pay lawyers less and reduce the cost of defensive medicine by adopting comprehensive tort reform
• Expand cost-sharing in Medicare to promote informed consumer health choices and spending
• Expand successful cost containment demonstrations
• Strengthen Independent Payment Advisory Board (IPAB)

Currently, the Sustainable Growth Rate as it is on the books would cut Medicare physician compensation by about 25% if it were not to be repealed by Congress.  This is, of course, a very steep discount.  The Commission sensibly proposes to replace cuts required by SGR through 2015 with modest reductions.  However, reducing overall physician spending is not the answer; physicians who spend time visiting patients are not compensated generously.  Physicians who perform procedures, however, receive lucrative compensation.  Thus, not only is reducing physician compensation needed, but also changing the distribution of how physicians are paid.  The cuts could reduce the quality of care physicians provide or the number of physicians who want to accept Medicare coverage.  Allowing for balance billing would allow physicians to earn more money and would allow beneficiaries choose between high quality and low cost.

The authors also call for increased Medicare cost-sharing.  In particular, they call for “replacing existing cost-sharing rules with universal deductible, single coinsurance rate, and catastrophic cap for Medicare Part A and Part B.” Increased cost sharing will help decrease the moral hazard problem, while the catastrophic cap will ensure that very sick individuals are not bankrupted by their illnesses.

Paying lawyers less and capping non-economic and punitive damages may sound like a good idea, but (as I mention here), this provision will likely have little impact on overall healthcare spending.

In the long-term, the Commission also calls for Congress to contain growth in total federal health spending to GDP+1% after 2020 by establishing a process to regularly evaluate cost growth.  If health care spending growth exceeds GDP+1% over the previous five years, the Commission calls for options such as: increasing premiums (or further increase cost-sharing), overhauling the fee-for-service system, develop a premium support system for Medicare.  Without a doubt, if Medicare costs continue to climb, something must be done.

Mandatory Savings

The mandatory savings provisions include:

• Shifting to chain-weighted CPI for all indexed programs in order to account for substiution bias towards cheaper goods,
• Reduce farm subsidies by $3 billion per year,
• Savings from military and civil service retirement (e.g., asking workers to contribute 50%–rather than 7%–of retirement costs; )
• Eliminate in-school interest subsidies for student loans;
• Index all fixed-dollar user fees to inflation; and
• End payments to states and tribes for abandoned mines (who knew we were making these payments?!?!).

All these savings measures all seem reasonable to me.

Social Security Reform

Reforming Social Security, in the eyes of the Commission, does not simply involve cutting benefits. Benefits for the poorest Americans would actually increase under their plan as a special minimum benefit would be established. Additional details are as follows:

• Overall Social Security Benefits would be indexed to chained-CPI, but the special minimum benefit would be indexed to wages.
• The plan would make Social Security benefits even more progressive than they are now, effectively cutting benefits to richer retirees.
• The retirement age would also be indexed to longevity.  Thus, the retirement age would likely be 68 by 2050 and 69 by 2075.
• Broaden the tax base by gradually increasing the taxable maximum

As the tax base increase and benefits are cut for richer workers, Social Security will function more like a flat guaranteed benefit than–as it is perceived by many today–a retirement account.

“The figures vary from nation to nation, but the general picture is that people do not feel their taxes are well spent.  In Columbia and Pakistan, the average estimate of the amount of tax not spent in the public interest was more than two-thirds.

In not country was it less than one-third.  Spain, at 34%, was the only one that came close to that.“

This paper uses data from the 1983-1995 National Compensation Surveys to determine that “there is a moderately sized elasticity of insurance offering with respect to after-tax prices (-0.25), and a larger elasticity of insurance spending (-0.7). We also find that the elasticities are driven primarily by small firms, for whom the elasticity is larger.” Additionally, the authors claim that if the tax subsidy to employer-provided health insurance were eliminated, 15 million fewer workers would be offered health insurance.

The key regressor of interest is the tax-price of insurance for each worker. This is computed as:

• TP=(1 – τ_f – τ_s - τ_ss - τ_mc)/(1 + τ_ss + τ_mc).

The variable τ_f is the federal income tax marginal rate, τ_s is the state income tax marginal rate, τ_ss is the marginal payroll tax rate for the OASDI program, and τ_mc is the marginal payroll tax rate for the Medicare HI program.  Gruber and Lettau also include firm characteristics, and state and year dummy variables as explanatory variables in their regression.

The authors rightly worry that “variables used to create the tax measure (hours, industry, occupation, earnings, state, and year) could be simultaneously correlated with the demand for insurance, biasing our estimates in an indeterminate manner.” To counteract this endogeneity problem, the authors use the individual’s simulated (rather than actual) tax price based on his or her state or residence, the year, and their income decile. Because state and year dummy variables are already included, the model is identified only through the interaction of states, earnings groups and years.

Using this specification, the authors find that the elasticity of health insurance offer is about -0.25. However, for firms with fewer than 100 employees, this elasticity grows in magnitude to -0.69. For firms with 100-999 employees, the elasticity is -0.195. On the other hand, for large firms, almost all firms offer health insurance to their employees and thus no elasticity can be calculated.

• Jonathan Gruber and Michael Lettau (2004) “How Elastic is the Firm’s Demand for Health Insurance?” Journal of Public Economics 88, 1273–1293.

In “Obama’s Prescription for Low-Wage Workers,” Michael Cannon notes that one also can see these subsidies as increasing the marginal tax rate.  For instance, let us John makes $16,000 and has a 25% income tax rate.  Under the new health reform bill, John would also receive a subsidy to purchase health insurance.  Let us assume the subsidy is $5000.  Thus, his after tax income is $17,000 [(1-.25)*16,000+5000].

What happens if John has the option to work at a new job that pays him $20,000?  Of course, he will earn more income but his health insurance subsidy will also decrease.  If the health insurance subsidy decreases to $3,500, then his after tax income in your new job is now $18,500 [(1-.25)*20,000+4000].  Although John’s gross income increased by $4000 when taking the new job, his after tax income only increased by $1500.  This is in a marginal tax rate of 62.5%.  In fact, Mr. Cannon’s research finds that mandates and subsidies impose effective marginal tax rates on low-wage workers “averaging between 53 and 74 percent.”  When marginal tax rates are high, extra hours worked lead to a smaller increase in after-tax income.  Thus, the labor supply decreases.

One thing Mr. Cannon ignores, however, is the current Medicaid poverty trap.  Poor individuals are eligible for Medicaid.  However, if they get a better job paying them more money, they may lose their Medicaid eligibility.  Poor individuals may refuse to take better paying jobs to keep their Medicaid coverage.

Once the subsidies are implemented, however, poor individuals will be more likely to take a better-paying job since they can receive subsidies to buy private health insurance even if they lose their Medicaid coverage.  The high marginal tax rates are more likely to affect the labor supply of the lower-middle class and middle class individuals.  These individuals are in the same scenarios as John is above.  Higher pre-tax earnings will not necessarily translate into significantly larger after-tax earnings.  I predict that the higher marginal tax rates Mr. Cannon mentions will decrease the labor supply most for individuals in the middle class.

If you want a high quality tax preparer, there are many reputable companies that can prepare your taxes.  These tax preparers will be well trained and you’ll pay more for them.  Firms have an incentive to maintain this quality so their customers continue to require their services.  If quality is above average over the long run, they can build a reputation and charge higher prices.  Thus, for individuals who already have high quality tax preparation, there is no benefit.  In fact, there could be an increase in cost to these individuals if the government standards require additional training that does little to improve quality.

This idea will most certainly hurt poor immigrants.  When I was in college, I spent my Saturdays in the spring doing tax preparation for immigrant farm workers in Kennett Square, PA.  I worked for a non-profit legal firm.  I receive training on the basics of tax preparation.  Because most of these migrant workers had little assets and no mortgage, doing their taxes was simple.  If an individual had a more complex tax return (e.g., if they had a mortgage), I would refer them to the supervising lawyer.  The migrant workers received their tax preparation for free since we were volunteers.  However, this practice may not continue into the future.

If the government requires everyone who prepares taxes to pass through an onerous training program, fewer volunteers will decide to participate in free tax clinics.  Many non-English speaking Americans may not fill out their taxes themselves.  Further, the non-profit’s scope of their program will likely decrease if they have to pay for additional training for all their staff. 

Also, how will the government guarantee people will act ethically?  Will they give them a test of what is ethical?  Will they ask nicely ask people not to do a bad job?  

In short, licensing tax preparers is a bad idea.

Initially, one would say yes.  If the government hires more workers, this is job creation.  If the government hires more contractors, this is job creation.  If the government gives subsidies to businesses to increase employment, this is job creation.  Isn’t it?

One must first wonder where the government is getting the money to pay for the job creation programs.  Let us assume that it is from taxpayers.  In this case, the government is taking money from individuals to ‘create jobs.’  However, by increasing taxes, consumers have less money to spend on goods and services.  When consumers buy less stuff, firms will cut jobs.  The net effect likely will be a wash.  The government ‘creates’ jobs by paying money itself and destroys jobs by raising taxes.

What if the government funds the job creation with debt?  If the debt is only purchased by Americans, we have the same problem.  Consumers purchase government debt rather than buying products.  Again the net effect is likely a wash.

Now let us think expand our thinking.  Assume we live in a global economy where foreigners buy our bonds.  In this case, the government may be able to create jobs somewhat in the short run .  Foreigners will have less money to buy American exports if they buy our bonds, but likely only a fraction of foreigners income is spent on American goods.  Thus, the extra money the government receives from foreigners can create American jobs in the short run.  Subsequent generations, however, will have to pay back the loans from foreigners in the form of higher taxes.  Thus, increased job creation now comes at the expense of decreased job creation in the future.

Let us also think about business cycles in the creation of jobs.  The U.S. just went through a bad economic downturn.  Individuals and firms were saving more and buying/investing less.  Thus, firms had a smaller market to which they could sell goods.  If the government taxes (or borrows) from individuals and firms, and decides to spend all this money on ‘job creation,’ employment could actually increase.  Currently, the marginal propensity to spend will likely be higher for the government than for consumers or firms.  However, increased marginal propensity to consume implies a decreased marginal propensity to save.  With lower savings rates, there are fewer funds available to investors to invent new ideas, invest in new technologies and provide the foundation for long-run technical growth.  Interest rates will rise.  Currently, the Federal Reserve has held down interest rates by printing more money, but this will likely cause inflation in the near- to medium-term.

As any economist knows, there is no free lunch.  The government may be able to create jobs in the short run to counteract dips in the business cycle, but these debts must be repaid in the long-run.  Thus, in the long-run the government does not create jobs.  Innovative individuals and firms create jobs.  Further, this post has not even discussed the problem that the government will likely misallocate funds and may hire the wrong type of workers for long term economic growth.

If the government really could create jobs in the long-run, then the government might be able to maximize job growth by spending ad infinitum.