Topic: Tax and Budget Policy

A Fiscal Lesson from Germany

Germany isn’t exactly a fiscal role model.

Tax rates are too onerous and government spending consumes about 44 percent of economic output.

That’s even higher than it is in the United States, where politicians at the federal, state, and local levels divert about 39 percent of GDP into the public sector.

Germany also has too much red tape and government intervention, which helps to explain why it lags other European nations such as Denmark and Estonia in the Economic Freedom of the World rankings.

But I have (sort of) defended Germany a couple of times, at least on fiscal policy, explaining that the Germans didn’t squander much money on Keynesian spending schemes during the downturn and also explaining that Paul Krugman was wrong in his column on Germany and austerity.

Today, though, I’m going to give Germany some unambiguous praise.

If you look at last decade’s fiscal data, you’ll see that our Teutonic friends actually followed my Golden Rule on fiscal policy for a four-year period.

Here’s a chart, based on IMF numbers, showing total government spending in Germany from 2003-2007. As you can see, German policy makers basically froze spending.

German Fiscal Restraint

I realize that I’m a libertarian and that I shouldn’t be happy unless the burden of spending is being dramatically reduced, but we’re talking about the performance of European politicians, so I’m grading on a curve.

By that standard, limiting spending so it grows by an average of 0.18 percent is rather impressive. Interestingly, this period of fiscal discipline began when the Social Democrats were in power.

And because the economy’s productive sector was growing at a faster rate during this time, a bit more than 2 percent annually, the relative burden of government spending did fall.

The red line in this next chart shows that the public sector, measured as a share of economic output, fell from almost 49 percent of GDP to less than 44 percent of GDP.

German Spending+Deficit as % of GDP

It’s also worth noting that this four-year period of spending restraint also led to a balanced budget, as shown by the blue line.

In other words, by addressing the underlying problem of too much government, the German government automatically dealt with the symptom of red ink.

That’s the good news.

The bad news is that the German government wasn’t willing to sustain this modest degree of fiscal discipline. The Christian Democrats, who took office in mid-2005, allowed faster spending growth beginning in 2008. As I noted above, the budget increases haven’t been huge, but there’s been enough additional spending that Germany no longer is complying with the Golden Rule and the burden of the public sector is stuck at about 44 percent of GDP.

The moral of the story is that Germany shows that good things happen when spending is restrained, but long-run good performance requires long-run spending discipline.

That’s why I’m a fan of Switzerland’s spending cap. It’s called the “debt brake,” but it basically requires politicians to limit spending so that the budget doesn’t grow much faster than inflation plus population.

And that’s why Switzerland has enjoyed more than a decade of good policy.

To see other examples of nations that have enjoyed fiscal success with period of spending restrain, watch this video.

The Canadian example is particularly impressive.

Tax Reform Error #2: Phasing-in Lower Tax Rates

Since 1981, Republican legislators have shown a strong penchant for phasing-in tax rate reductions over several years.  That tradition is maintained in Ways and Means Committee Chair Dave Camp’s proposed 979-page “simplification” of the U.S. tax system.  The Camp draft retains a very high top tax rate of 38.8 percent on businesses that file under the individual income tax as partnerships, proprietorships, LLCs or Subchapter S corporations. For those choosing to file as C-corporations, by contrast, the Camp proposal would gradually reduce the corporate tax rate by two percentage points a year over five years, eventually reducing it from 35 to 25 percent. 

The trouble with phasing-in lower tax rates is that it creates an incentive to postpone efforts and investments until later, when tax rates will be lower.  Reducing the corporate tax rate by two percentage points a year would create an incentive to repeatedly delay reported profits, year after year, holding back the economy and tax receipts.  Sensible tax planners would write-off expenses soon as possible, including interest expenses, but defer investment until future years when the tax rate would be reduced on any resulting added earnings.  

Meanwhile, the widening gap between corporate and noncorporate tax rates (a difference of 13.8 percentage points after five years) would encourage many small businesses, farms and professionals to set up C-corporations to shelter retained earnings.  Owners of closely-held private corporations can defer double taxation indefinitely by not paying dividends and taking most compensation in the form of tax-free corporate perks. Many enterprises contemplating the new incentive to shift income from individual to corporate tax forms after five years would postpone expansion plans until after they made that switch, further depressing the economy and tax receipts.

The Republican Party’s proclivity for phased-in tax cuts may have originated with former Federal Reserve Chairman Alan Greenspan.  In his January 25, 2001 testimony before the Senate Budget committee, Chairman Greenspan said, “In recognition of the uncertainties in the economic and budget outlook, it is important that any long-term tax plan … be phased in.”  That was the same advice he gave in January 1981 when Greenspan and I served on President Reagan’s transition team.  Unfortunately, his advice to phase-in lower tax rates was followed both times, with disastrous results.

During the deep recession from July 1981 to November 1982, Congress opted to postpone most tax relief until the 1983-84 tax years.  Individual tax rates were ostensibly reduced by 5 percent in October 1981, but with only three months left in the year that meant just 1.25 percent.   Rates were again reduced by 10 percent in July of 1982, but that applied to only half of that year’s income.  Meanwhile, bracket creep from high inflation kept pushing people into higher tax brackets (until indexing took effect in 1985), negating much of the intended effect.  The final 10 percent reduction in July 1983 was not fully effective until calendar year 1984. 

Oddly enough, the painful blunder of phasing-in the Reagan tax cuts after a recession was repeated by the Bush administration in March 2001, three months after the economy slipped into recession.  Aside from the fiscal frivolity of adding a 10 percent tax bracket on the first $12,000 of income (cutting taxes $300-600 at all incomes), reductions in the four highest tax rates were originally scheduled to be very gradually phased-in by 2006.  Congress later came to its senses in May 2003 and reduced marginal tax rates. Yet substantial damage was already done.   University of Michigan economists Christopher House and Matthew Shapiro found, “The phased-in nature [of lower tax rates] contributed to the slow recovery from the 2001 recession, while the elimination of the phase-in helped explain the increase in economic activity in 2003.” The harmful impact of the phase-in was confirmed by Cornell University economist Karel Mertens and Morton Ravin of University College London. 

Mertens and Ravin also found that lower corporate tax rates do not reduce U.S. tax revenues, partly because lower tax rates increase domestic investment while reducing tax incentives to take on excess debt.  The Camp plan to phase-in a 25 percent corporate tax rate over many years would be as unnecessary as it would be counterproductive.  Most other countries reduced their corporate tax rates to 25 percent or less long ago – creating marginal effective rates on new investment that are commonly less than half the U.S. level – with clearly beneficial effects on their economies and tax receipts.  

The important, unlearned lesson of 1981 and 2001 is that phased-in reductions in marginal tax rates can make things worse before they make things better.

An uncompetitive U.S. corporate tax rate fosters excessive tax-deductible debt and gives a big cost advantage to foreign enterprises.  There is nothing to be gained, and much to be lost, by improving the U.S. tax climate slowly rather than quickly.

Tax Reform Error #1: Confusing Tax Expenditures with Revenues

House Ways and Means Chairman Dave Camp has released a complex 182-page “discussion draft” called The Tax Reform Act of 2014. Rather get bogged down in details, I will take this opportunity to review several fundamental errors that repeatedly plagued most past and present efforts to reform the federal income tax, including the Camp proposal.

One of the most pernicious errors among would-be tax reformers is to assume that, as the Tax Policy Center asserts, “tax expenditures are revenue losses” attributable to various “loopholes.” On the contrary, the Joint Committee on Taxation (JCT) clearly states that the estimated dollar value of any “tax expenditure … is not the same as a revenue estimate for the repeal of the tax expenditure provision.” As the JCT explains, “unlike revenue estimates, tax expenditure calculations do not incorporate the effects of the behavioral changes that are anticipated to occur in response to the repeal of a tax expenditure provision…. Taxpayer behavior is assumed to remain unchanged for tax expenditure estimate purposes … to simplify the calculation.”

One glaring difference between revenue estimates and tax expenditure estimates involves taxation of capital gains if those gains are realized by selling assets from a taxable account (unlike IRAs or most home sales). Estimated tax expenditures from not taxing realized capital gains at the top income tax rate of 43.4 percent is listed as a big revenue-losing tax expenditure, even though Treasury, the JCT and the Congressional Budget Office (CBO) revenue estimates would rightly predict that the behavioral response to such a high tax would crush asset sales and thus lose revenue. 

Mainly because the artificially estimated “tax expenditure” from a lower capital gains tax is wrongly equated with estimated revenues, the Simpson-Bowles plan hopes to raise an extra $585 billion over ten years. In reality, investors realize fewer gains when the tax rate goes up, so the higher tax on fewer transactions means revenues fall rather than rise.

The Need for Discretionary Spending Restraint

The Obama administration released its 2015 budget this week. The budget shows federal debt held by the public falling from 74 percent of gross domestic product (GDP) this year to 69 percent by 2024. That reduction occurs even though entitlement and interest spending are projected to rise substantially as a percent of GDP.

One of the tricks behind the projected falling debt is that the administration assumes that discretionary spending falls sharply as a percent of GDP in later years. Congressional Budget Office (CBO) projections show a similar decline in discretionary spending in coming years.

I favor large discretionary reductions, and I have proposed many specific cuts. But does the Obama administration really favor the reductions down the road shown in its own budget? I doubt it. After all, the administration’s new spending proposals would break existing budget caps, and that would come in the wake of both parties breaking caps under the Ryan-Murray budget deal. So projecting declining discretionary spending in later years is an accounting ploy to make the fiscal outlook look better than it really is.

If policymakers don’t restrain discretionary spending, deficits and debt will be higher in coming years than shown in official projections. Let’s call this the “business as usual discretionary spending” scenario.

Here are the implications of the scenario, based on the CBO baseline and my calculations. Let’s suppose discretionary spending remains at the 2014 level of 6.9 percent of GDP through 2024, rather than falling to 5.2 percent as shown by CBO. That higher spending results in interest costs 0.4 percentage points of GDP higher by 2024.

Under this scenario, total outlays would rise from 20.5 percent of GDP today to 24.5 percent by 2024. The deficit would rise to a dangerous 6.2 percent of GDP.

Under the CBO baseline, federal debt rises from 74 percent of GDP today to 79 percent by 2024. But under my business as usual scenario, debt would soar to 91 percent by 2024, as shown in the chart. It would keep rising rapidly after that.

In sum, I hope that discretionary spending as a percent of GDP falls, as shown in the CBO and Obama projections. But without proactive efforts to cut and terminate programs, that may not happen. Of course, entitlement spending also needs to be cut.

However, if business as usual prevails in Washington with entitlement spending gobbling up more of GDP and discretionary spending not cut, we’ve got a really big fiscal crunch coming.

More Taxes than Meet the Eye in Obama’s Budget

Yesterday’s budget from President Obama claimed to raise taxes by $650 billion, which would come in addition to the $650 billion in tax hikes in January 2013. However, it appears that the president wants much more money from our pocketbooks. The exact amount isn’t entirely clear due to the games the Office of Management and Budget is playing with its various tables. But if the president had his way, more than $1 trillion in tax hikes would be coming.

Here are some of the tax hikes the president is proposing:

  • “Buffett tax” ($53 billion): President Obama resurrected this tax idea, which would require high-income individuals to pay at least 30 percent of their incomes in taxes.
  • Limiting tax deductions ($598 billion): President Obama would limit the value of itemized deductions for high-income earners.
  • Changes to the “death tax” ($131 billion): The president suggests going back to the estate tax rules of 2009, which would increase the marginal tax rate on estates and lower the exemption, subjecting more assets to taxation.
  • Changes to oil and gas taxation ($44 billion): Frequently criticized by the president, these tax provisions are generally not subsidies to oil and gas companies, but instead ameliorate the tax code’s improper treatment of capital expenditures.
  • Changes to international taxation ($276 billion): Instead of moving the United States to a territorial tax system like most other industrialized countries, the president moves in the opposite direction and proposes further raising taxes on corporations with overseas earnings.
  • Cap on 401(k) and IRA contributions ($28 billion): This provision would prohibit individuals from contributing to retirement accounts if their balances were greater than $3 million.
  • Increase in tobacco taxes ($78 billion): To pay for his universal pre-K proposal, President Obama would increase the tobacco tax from $1.10/pack to $1.95/pack.

On tax policy, the president’s budget trots out old, tired, blame-the-rich rhetoric rather than tackling the country’s real problems.

Obama’s New Budget: Burden of Government Spending Rises More than Twice as Fast as Inflation

The President’s new budget has been unveiled.

There are lots of provisions that deserve detailed attention, but I always look first at the overall trends. Most specifically, I want to see what’s happening with the burden of government spending.

And you probably won’t be surprised to see that Obama isn’t imposing any fiscal restraint. He wants spending to increase more than twice as fast as needed to keep pace with inflation.

Obama 2015 Budget Growth

What makes these numbers so disappointing is that we learned last month that even a modest bit of spending discipline is all that’s needed to balance the budget.

By the way, you probably won’t be surprised to learn that the President also wants a $651 billion net tax hike.

That’s in addition to the big fiscal cliff tax hike from early last and the (thankfully small) tax increase in the Ryan-Murray budget that was approved late last year.

P.S. Since we’re talking about government spending, I may as well add some more bad news.

Nothing to Celebrate in Obama’s Budget

President Obama released his fiscal year 2015 budget request today. Sadly, for those who support smart, sensible budgeting, the president’s budget is nothing to celebrate. The budget increases spending and fails to tackle the main driver of our budget problem—entitlement spending. All deficit reduction included in the budget is from revenue increases, not spending cuts.

In coming days, we’ll be analyzing the president’s budget in detail, but here are the top-line numbers:

1. The president’s budget proposes spending more than the Ryan-Murray budget deal passed in December. Under the agreement reached by Congressman Ryan and Senator Murray, and supported by the president, discretionary spending for fiscal year 2015 should be $1,014 trillion. The president’s budget includes a section that bumps that up by $56 billion, paid for mostly by tax increases.

2. Over the 10-year budgetary window, the president spends $171 billion more than Congressional Budget Office (CBO) baseline. The budget also runs large deficits every single year.

3. According to Obama’s budget, the federal government will collect $3.3 trillion in tax revenue in 2015, more than any other year in history. The budget includes $650 billion in new revenue though various tax hikes. The president’s Office of Management and Budget also made rosier assumptions about economic growth over the next 10 years than did the CBO. As a result, the president’s budget would collect an additional $3.1 trillion in revenue over 10 years than CBO assumes.