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Posts Tagged ‘fiscal policy’

According to an article in the New York Times, the Obama Administration is seriously examining a proposal to reduce America’s anti-competitive 35 percent corporate tax rate.

The Obama administration is preparing to inject an unpredictable new variable into its economic policy clash with Republicans: a plan to overhaul corporate taxes. Economic advisers have nearly completed the process initiated in January by the Treasury secretary, Timothy F. Geithner, at President Obama’s behest. That process, intended to make the United States more competitive internationally, has explored the willingness of business leaders to sacrifice loopholes in return for lowering the top corporate tax rate, currently 35 percent. The approach officials are now discussing would drop the top rate as low as 26 percent, largely by curbing or eliminating tax breaks for depreciation and for domestic manufacturing.

This may be a worthwhile proposal, but this is an example where it would be wise to “look before you leap.” Or, for fans of Let’s Make a Deal, let’s see what’s behind Door Number 2.

To judge Obama’s plan, it is important to have the right benchmark. An ideal corporate tax system obviously should have a low tax rate. And it also should have no double taxation (tax corporate income at the business level or tax it at the individual level, but don’t tax it at both levels).

But it’s also important to have a simple and neutral system. The right definition of corporate income for any given year is (or should be) total revenue minus total costs. What’s left is income.

This may seem to be a statement of the obvious, but it’s not the way the corporate tax code works. The system has thousands of complicated provisions, some of which provide special loopholes (such as the corrupt ethanol credit) that allow firms to understate their income, and some of which impose discriminatory penalties by forcing companies to overstate their income.

Consider the case of depreciation. The vast majority of people understandably have no idea what this term means, but it sounds like a special tax break. After all, who wants big corporations to lower their tax bills by taking advantage of something that sounds so indecipherable.

In reality, though, depreciation simply refers to the tax treatment of investment costs. Let’s say a company buys a new machine (which would increase productivity and thus boost wages) for $10 million. Under a sensible and simple tax system, that company would include that $10 million when adding up all their costs, which then would be subtracted from total revenue to determine income.

But the corporate tax code doesn’t let companies properly recognize the cost of new investments. Instead, they are only allowed to deduct (depreciate) a fraction of the cost the first year, followed by more the next year, and so on and so on depending on the specific depreciation rules for different types of investments.

To keep the example simple, let’s say there is “10-year straight line depreciation” for the new machine. That means a company can only deduct $1 million each year and they have to wait an entire decade before getting to fully deduct the cost of the new machine.

Ultimately, the firm does deduct the full $10 million, but the delay (in some cases, about 40 years) means that a company, for all intents and purposes, is being taxed on a portion of its investment expenditures. This is because they lose the use of their money, and also because even low levels of inflation mean that deductions are worth significantly less in future years than they are today.

To put it in terms that are easy to understand, imagine if the government suddenly told you that you had to wait 10 years to deduct your personal exemption!

Let’s now circle back to President Obama’s proposal. With the information we now have, there is no way of determining whether this proposal is a net plus or a net minus. A lower rate is great, of course, but perhaps not if the government doesn’t let you accurately measure your expenses and therefore forces you to overstate your income.

I’ll hope for the best and prepare for the worst.

P.S. It’s also important to understand that a “deduction” in the business tax code does not imply loophole. If you remember the correct definition of business income (total revenue minus total costs), this means a business gets to “deduct” its expenses (such as wages paid to workers) from total revenue to determine taxable income. Some deductions are loopholes, of course, which is why a  simple, fair, and honest system should be based on cash flow. Which is how business are treated under the flat tax.

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Republicans are fighting about taxes. But they’re fighting with each other, not Democrats. I’ve already written about this topic once, but the issue has become more heated, and the stakes have become much larger. And this time I’m going to focus on the political implications.

First, some background. One side of this battle is led by Grover Norquist of Americans for Tax Reform, who is the organizer of the no-tax-increase pledge. Grover argues that America’s fiscal problem is too much spending and that higher taxes are economically and politically foolish.

The other side of the conflict is led by Senator Tom Coburn of Oklahoma, who argues that America’s fiscal problem is too much red ink and that higher taxes are a necessary price to strike a deal with Democrats that supposedly will reduce budget deficits.

The first  skirmish in this fight involved ethanol tax credits. Senator Coburn wanted to get rid of the credit, which everyone agrees is economically destructive and fundamentally corrupt.

But there’s a catch. when you get rid a tax preference, even an odious one, that means the government gets more money. In other words a tax increase. Senator Coburn has no problem with that outcome.

Grover Norquist says that all of the arguments against ethanol are correct, but he says that any proposal to get rid of the credit should be accompanied by a tax cut of equal magnitude.

If the ethanol credit is worth about $6 billion per year, as Senator Coburn’s office states, then find a tax cut of similar size, pair it with the ethanol credit, and kill two birds with one stone. Seems like the best of all possible outcomes, which is why Grover is correct from a policy perspective.

The fight over the ethanol credit may seem like a tempest in a teapot, but it was symbolically important – particularly since it is a precursor for the much bigger fight about whether GOPers should agree to a budget deal with Democrats.

Indeed, this may already be happening as part of the “Gang of Six” negotiations, with Senator Coburn and two other Republican Senators joining three Democrats in putting together some sort of grand compromise (presumably something similar to what was proposed by Obama’s Fiscal Commission).

In this case, the tax increase could be enormous, well over $1 trillion. No wonder this battle is getting heated. Here are some excerpts from a recent story in the Washington Post.

Republicans are feuding over whether to abandon the party’s long-held opposition to higher taxes in pursuit of a deficit-cutting deal with Democrats. …both sides say this cuts to the core of a quandary for the GOP: Will the cause of trimming deficits run aground on the conservative principle that the government must not increase the amount of money it takes in through taxes? …“If we don’t do something, what we’ve done is put the country at risk,” Coburn said in an interview. “I agree we ought to cut spending, but will we ever get the spending cut to the level that we need to without some type of compromise?” Norquist…argues that bipartisan deals struck by Presidents Ronald Reagan in 1982 and George H.W. Bush in 1990, both of which entailed increased taxes, resulted in bigger government rather than spending cuts that both men thought they had secured. “This is a fantasy on the part of the liberal Democrats that the Republicans would be stupid enough to repeat 1990 and throw away a winning hand politically,” Norquist said.

As the excerpt correctly acknowledges, this issue deals with both economics and politics. From an economic perspective, there are all sorts of important issues:

1. What is better for the economy, lower spending or higher taxes?

2. Is it possible to balance the budget without higher taxes?

3. Would tax increases be used for deficit reduction or more spending?

But I covered these issues in my earlier post, so lets’ look at the political implications. Grover asked, in the Washington Post article, “Why would you elect a Republican Senate if they just sat down with Obama and raised everyone’s taxes?” And I was quoted about how abandoning the no-tax-hike position would heavily damage the GOP.

How the debate among Republicans is resolved in the coming weeks will play a large role in determining whether a grand bipartisan bargain on deficit reduction is possible. “There’s a significant split over whether to put taxes on the table,” said Dan Mitchell, an economist at the libertarian Cato Institute and a Norquist ally. Mitchell said the disagreement largely pits House and Senate Republicans against each other and gives Democrats a potential political edge. “Obama has it within his power to drive a big wedge between House and Senate GOP-ers and turn the tax issue from something that works on behalf of Republicans into something that works against them,” he said.

To elaborate on the last point, the no-tax-increase pledge helps the GOP because it sends a signal to all voters that they will not be raped and pillaged (at least in excess of what is happening now).

This puts Democrats in a tough position. They can play the politics of class warfare (as Obama likes to do) and say only the “rich” will pay higher taxes, but voters don’t dislike their upper-income neighbors. Moreover, they probably suspect that Democrats have a very broad definition of what counts as rich, so they instinctively gravitate to the GOP position. After all, the only sure way of avoiding a tax hike on yourself is to oppose tax hikes for everyone.

If Republicans put tax increases on the table, however, the politics get turned upside down. Instead of being united against all tax increases, voters realize somebody is going to get mugged and they have an incentive to make sure they’re not the ones who get victimized.

That’s when soak-the-rich taxes become very appealing. Democrats, for all intents and purposes, can appeal to average voters by targeting the so-called rich. And even though voters will be skeptical about what Democrats really want, they don’t want to be the primary target of the political predators in Washington.

Think of it this way. You’re a wildebeest running away from a pack of hyenas, but you know one member of your herd will get caught and killed. You despise hyenas, but at that critical moment, you’re main goal is wanting another member of the herd to bite the dust.

This is why surrendering to tax increases put Republicans in a no-win situation. They oppose class-warfare taxes because they understand the disproportionately damaging impact of higher top income tax rates and increased double taxation of dividends and capital gains. So when GOPers get bullied into agreeing to raise taxes, they want to target less destructive sources of revenue. But that usually means that taxes that are more likely to hit the middle class.

Needless to say, Democrats almost always win if there is a fight on whether to tax the middle class or to tax the rich.

Senator Coburn’s heart is in the right place, but he is creating a win-win situation for Democrats. By putting taxes on the table, he is giving Democrats a policy victory and a political victory.

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America is in fiscal peril in the short run because of a 10-year spending binge by Bush and Obama and in the long run because of a toxic combination of entitlement programs and demographics.

Congressman Paul Ryan has introduced a budget plan to address America’s fiscal crisis, but Senator Reid and President Obama have summarily rejected his proposal, so it appears the United States will continue to drift in the wrong direction.

Something is needed to compel action. One might think that such an impetus would have been provided by the recent decision by Standard & Poor to downgrade the fiscal outlook for the United States. But this development hasn’t affected the spending culture in Washington.

But there is hope. Senator Corker has legislation that would force Congress to act – and automatically impose fiscal discipline if they don’t. His bill caps – and then slowly reduces – government spending as a share of national economic output (gross domestic product).

I’ve already written about the merits of this proposal, including an explanation of the all-important enforcement mechanism of sequestration (automatic spending cuts). Here’s Senator Corker’s description of his plan, as delivered at a Cato Institute conference on the Economic Impact of Government Spending.

To build on the Senator’s comments, there are two things that deserve special emphasis.

1. He correctly understands that the problem is the size of government. As explained in this video, spending is the problem and deficits are a symptom of that problem.

Unfortunately, many policy makers focus on the budget deficit, which often makes them susceptible to misguided policies such as higher taxes. At best, such an approach merely substitutes one bad way of financing federal spending with another bad way of financing federal spending. And it’s much more likely that higher taxes will simply lead to more spending, thus exacerbating the real problem.

2. Senator Corker’s legislation has a real enforcement mechanism. If Congress fails to produce a budget that meets the annual spending cap, there is a “sequester” provision that automatically takes a slice out of almost every federal program.

Modeled after a similar provision in the successful Gramm-Rudman-Hollings law of the 1980s, this sequester puts real teeth in the CAP Act and ensures that the burden of government spending actually would be reduced.

Some people complain that Senator Corker’s plan is too timid and that it doesn’t balance the budget by 2021. While it would be desirable to impose additional fiscal restraint, the Tennessee Senator has deliberately chosen a more modest goal in order to attract support from colleagues on the other side of the aisle. And he does have Democratic co-sponsors, something that is critical given the composition of the Senate.

Since I’m just a policy wonk, I’ll leave it to the other people to argue about what’s feasible in the current political environment. My final comment, though, is that we’re on an unsustainable path that will lead to the end of American exceptionalism and turn the United States into a decrepit, European-style welfare state. So I’m not going to complain if someone has a plan that finally moves policy in the right direction, albeit not quite as fast as I prefer.

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The recent agreement between Obama and Boehner supposedly cuts spending by $38 billion. I’ve already explained that this number is disappointingly small and noted that the effect on spending for the current fiscal year is almost too small to measure.

But my analysis was entirely too kind. My Cato Institute colleagues have put together a clever one-minute video mocking both Obama and Boehner for using the dishonest Washington definition of a spending cut – meaning they claim spending cuts merely because they increase the budget by less than previously planned.

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By taking advantage of  “must-pass” pieces of legislation, Republicans have three chances this year to restrain the burden of government.  They didn’t do very well with the ‘CR fight” over appropriated spending for the rest of FY2011, which was their first opportunity. I was hoping for an extra-base hit off the fence, but the GOP was afraid of a government shutdown and negotiated from a position of weakness. As such, the best interpretation is that they eked out an infield single.

The next chance to impose fiscal discipline will be the debt limit. Currently, the federal government “only” has the authority to borrow $14.3 trillion (including bookkeeping entries such as the IOUs in the Social Security Trust Fund). This is a very big number, but America’s gross federal debt will hit that limit soon, perhaps May or June.

Republicans say they will not raise the debt limit unless such legislation is accompanied by meaningful fiscal reforms. The political strategists in the Obama White House understandably want to blunt any GOP effort, so they are claiming that any delay in passing a “clean debt limit” will have catastrophic consequences. Specifically, they are using Treasury Secretary Tim Geithner and Federal Reserve Bank Chairman Ben Bernanke to create fear and uncertainty in financial markets.

Just a few days ago, for instance, the Treasury Secretary was fanning the flames of a financial meltdown, as noted by Bloomberg:

“Default would cause a financial crisis potentially more severe than the crisis from which we are only now starting to recover,” Geithner said. “For these reasons, default by the United States is unthinkable.”

The Fed Chairman also tried to pour gasoline on the fire. Here’s a passage from an article in the New York Times earlier this year:

Mr. Bernanke said the debt ceiling should not be used as a negotiating tactic, warning that even the possibility of the United States not being able to pay its creditors could create panic in the debt markets.

There are two problems with these statements from Geithner and Bernanke. First, it is a bit troubling that the Treasury Secretary and Fed Chairman are major players in a political battle. The Treasury Secretary, like the Attorney General, traditionally is supposed to be one of the more serious and non-political people in a  President’s cabinet. And the Fed Chairman is supposed to be completely independent, yet Bernanke is becoming a mouthpiece for Obama’s fiscal policy.

But let’s set aside this first concern and focus on the second problem, which is whether Geithner and Bernanke are being honest. Simply stated, does a failure to raise the debt limit mean default? According to a wide range of expert opinion, the answer is no.

Donald Marron, head of the Urban-Brookings Tax Policy Center and former Director of the Congressional Budget Office, explained what actually would happen in an article for CNN Money.

Our monthly bills average about $300 billion, while revenues are about $180 billion. If we hit the debt limit, the federal government would be able to pay only 60 cents of every dollar it should be paying. But even that does not mean that we will default on the public debt. Geithner would then choose which creditors to pay promptly and which to defer. …Geithner would undoubtedly keep making payments on the public debt, rolling over the outstanding principal and paying interest. Interest payments are relatively small, averaging about $20 billion per month, and paying them on time is essential to America’s enviable position in world capital markets.

And here is the analysis of Stan Collender, one of Washington’s elder statesman on budget issues (and definitely not a small-government conservative).

There is so much misinformation and grossly misleading talk about what will happen if the federal debt ceiling isn’t increased that, before any more unnecessary bloodcurdling language is used that increases everyone’s anxiety, it’s worth taking a few steps back from the edge. …if a standoff on raising the debt ceiling lasts for a significant amount of time, the alternatives to borrowing eventually may not be enough to provide the government with the cash it needs to meet its obligations. Even at that point, however, a default wouldn’t be automatic because payments to existing bondholders could be made the priority while payments to others could be delayed for months.

The Economist magazine also is nonplussed by the demagoguery coming from Washington.

Tim Geithner, the treasury secretary, sent Congress a letter on January 6th describing in gory detail the “catastrophic economic consequences” such an event would entail. …Even with no increase in the ceiling, the Treasury can easily service its existing debt; it is free to roll over maturing issues, and tax revenue covers monthly interest payments by a large multiple. But in that case it would have to postpone paying something else: tax refunds, Medicare or Medicaid payments, civil-service salaries, or Social Security (pensions) cheques.

There are countless other experts I could cite, but you get the point. The United States does not default if the debt limit remains at $14.3 trillion. The only exception to that statement is that default is possible if the Treasury Secretary makes a deliberate (and highly political) decision to not pay bondholders. And while Geithner obviously is willing to play politics, even he would be unlikely to take this step since it is generally believed that the Treasury Secretary may be personally liable if there is a default.

The purpose of this post is not to argue that the debt limit should never be raised. That would require an instant 40 percent reduction in the size of government. And while that may be music to my ears (and some people are making that argument), I have zero faith that politicians would let that happen. Instead, my goal is to help fiscal conservatives understand that Geithner and Bernanke are being dishonest and that they should not be afraid to hold firm in their demands for real reform in exchange for a debt limit increase.

Last but not least, with all this talk about the debt limit, it’s worth reminding everyone that deficits and debt are merely symptoms of too much government spending. As this video explains, spending is the disease and debt is merely one of the symptoms.

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President Obama didn’t offer a budget plan yesterday. The White House hasn’t released anything beyond a set of talking points.

But that’s not terribly surprising since his speech was really the opening salvo of his 2012 reelection fight. And it’s clear that a central theme of his campaign will be class warfare.

But if we translate his campaign-style demagoguery into the overall budget framework, we get something like this fiscal continuum. Obama, for all intents and purposes, has taken the moderately left-wing proposal crafted by his Fiscal Commission and moved it significantly in the wrong direction by adding class-warfare tax policy. As such, he is close to the left end of the line, which represents “Statism.”

The Ryan plan, by contrast, is the moderately right-wing mirror image of the Fiscal Commission. But rather than cementing in place bigger government, as proposed by Simpson and Bowles,  Ryan’s budget slowly shrinks the fiscal burden of government. As such, it is on the “Liberty” side of the continuum.

America’s Founding Fathers had the right idea, of course, They envisioned a very limited central government, and for much of our nation’s history, the federal budget consumed about 3 percent of GDP. Unfortunately, the Hoover-Roosevelt policies began the process of moving America in the wrong direction, and federal spending now consumes nearly one-fourth of America’s economic output.

But enough history. Let’s revisit Obama’s speech and the accompanying talking points. In addition to the class warfare (more on that below), we also see an explicit call to reduce the growth of Medicare spending by “strengthening the Independent Payment Advisory Board.”

In other words, Obama wants to use his control of the purse strings to give bureaucrats more ability to decide what kind of care seniors can receive. It’s politically incorrect to call this type of entity a “death panel,” so I’ll simply contrast Obama’s top-down bureaucratic approach with the Ryan plan, which is based on giving vouchers to future seniors so they can pick the health plans that best fit their needs (people over 55 would be stuck with the current system). And since this is very similar to the system used to provide health care for Members of Congress and their staff, you know it must work reasonably well.

Let’s briefly return to the tax side of the fiscal equation. I’ll have more to say about this in a separate post giving a behind-the-scenes look at what Democrats really hope to achieve in the area of tax policy, but I want to offer a basic explanation of why the soak-the-rich approach is doomed to fail. There are five reasons in this video to reject class warfare, including a very important warning that high tax rates on the rich almost always are a tactical move to facilitate higher taxes for the rest of us.

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Some people thought I was being unfair when I referred to the budget deal as a kiss-your-sister agreement.

But as more information is revealed, it looks like the GOP got the short end of the stick – largely because they were afraid of a government shutdown (even though I explained Republicans actually did very well during and following the 1995 fight with Clinton).

National Review has retracted its kind words about the deal, writing that:

There’s realism and then there’s cynicism. This deal — oversold and dependent on classic Washington budget trickery — comes too close to the latter. John Boehner has repeatedly said he’s going to reject “business as usual,” but that’s what he’s offered his caucus. It’s one thing for Tea Party Republicans to vote for a cut that falls short of what they’d get if the controlled all of Washington; it’s another thing for them, after making so much of bringing transparency and honesty to the Beltway, to vote for a deal sold partly on false pretenses.

And Philip Klein, writing for the Washington Examiner, says:

…a new Congressional Budget Office report showing that the deal that purported to slash spending by $38.5 billion for the remainder of the year, really only reduces outlays by a fraction of that amount, and only cuts this year’s deficit by a mere $352 million. If the $38.5 billion was chump change in the context of $14 trillion debt, I wouldn’t even know what to call $352 million. Bread crumbs, maybe?

The moral of the story is that Republicans need to make a fundamental decision. Are they serious about protecting taxpayers and America, or are they in the business of blowing smoke while getting a cut of the corruption in Washington? I explained yesterday that GOPers in Washington are governed by noble and base impulses. The budget deal was an example where the devil on one shoulder had more influence than the angel on the other shoulder.

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