CRS's “Tax Policy Options for Deficit Reduction”
A recent Congressional Research Service (CRS) report has examined a number of tax policy options facing Congress in light of the dual goals of fundamental tax reform and deficit reduction. The report provides an overview of many types of revenue-based reform options, then analyzes the specific proposals made by the President's Fiscal Commission and the Debt Reduction Task Force, both of which advocated increasing the share of wages subject to payroll tax, broadening the tax base and reducing the rates for both corporate and individual taxes.
Current fiscal situation. From ’80 to 2010, the average budget deficit (i.e., difference between federal revenues and governmental outlays) was 3% of gross domestic product (GDP). That figure rose to 8.9% for fiscal year (FY) 2010, attributed in part to the fiscal stimulus and other policies enacted in response to the financial crisis, and it is estimated to be even higher in FY 2011.
The CRS report says that the current fiscal situation is not likely to be sustainable—in other words, that the national debt is growing faster than the GDP. The potential consequences are that a greater share of the national income will have to be used to make interest payments, investors will lose faith in the government's ability to make interest payments on or otherwise manage its debt, and investors will become reluctant to hold government debt at normal interest rates. However, the fact that Treasury has thus far been able to continue issuing debt at historically low interest rates suggests that investors don't feel the current situation is irreversible.
Options for tax reform. In FY 2010, federal revenues were $2.2 trillion, over 80% of which reflected individual income and payroll taxes. Other revenue sources included corporate tax (8.9%), excise taxes (3.1%), and estate and gift taxes (0.8%). Besides examining the option of increasing income tax rates, the CRS explores a number of tax reform options in its report, each of which is briefly described below, and outlines associated policy-related concerns in certain areas:
... Broadening the individual income tax base. By eliminating various exemptions, deductions, and credits, policymakers could potentially reduce tax rates while simultaneously increasing the amount of revenue generated by income taxes, and could also promote tax equity by eliminating tax preferences that tend to benefit those with higher incomes. The report evaluates the largest individual income tax expenditures of 2010 and determines that many of them, including the exclusion of contributions to retirement plans, the mortgage interest deduction, and reduced rates for dividends and capital gains, are “upside-down subsidies”—meaning that as a result of the progressive nature of the income tax structure, they provide a greater benefit to high-income taxpayers. In contrast, the report notes that the earned income tax credit (EITC) and child tax credit provide greater benefits to lower-income taxpayers, and their elimination, despite raising revenue, would decrease the progressivity of the tax system.
... Social insurance tax reform. Due to the dramatic increase of mandatory spending for entitlement programs such as social security and medicare, and the expected increase in the number of recipients of such payments as the “baby boom” generation ages, the trust funds from which these benefits are paid are expected to be fully exhausted within 30 years. The report focuses on two ways to increase revenues: by increasing payroll tax rates (which were decreased by the 2010 Tax Relief Act by two percentage points for employees in 2011, and by increasing the cap on taxable earnings. An estimated $669 billion would be generated over 10 years if the cap, which is currently at $106,800, were increased to cover 92% of earnings—although this alone wouldn't “fix” social security.
... Corporate tax reform. Congress is currently evaluating ways to reform the corporate tax system, but not necessarily with the objective of reducing the deficit. Similar to individual tax reform, the primary focus is on broadening the base and reducing statutory rates. The report examines the biggest corporate tax expenditures in 2010, the top three of which are bonus depreciation (which was expanded and extended by the 2010 Tax Relief Act), deferral of discharge of indebtedness (DOI) income (temporary provision for DOI occurring 2009 and 2010), and deferral of the active income of controlled foreign subsidiaries (CFCs).
... Estate tax reform. Noting the relatively small share of federal revenues represented by estate and gift taxes, the report states that reducing the exemption amount or increasing the maximum rate is one option for raising revenue, but that the potential for revenue generation is small compared to other options. (For an overview of estate taxation under the 2010 Tax Relief Act in 2011–2012)
... Addition of consumption taxes. The U.S. currently has no broad-based federal consumption tax. Three possible forms of federal consumption taxes include a value-added tax (VAT), a national sales tax, and a consumed-income tax. The first two options are often considered regressive, but the consumed-income tax could potentially be structured in a progressive way. The potential for raising revenue would depend on the taxable base and rates. For example, if the taxable base excluded food, healthcare, housing, higher education, and social services, a 3% VAT rate would yield an estimated $153 billion. The report noted, however, that a high VAT rate could lead to behavioral changes and economic inefficiencies.
... Carbon tax. A carbon tax would potentially provide up to an estimated $100 billion annually beginning in 2014, and it would also likely reduce greenhouse gas emissions. However, since a carbon tax would likely have the effect of raising energy prices, it would also be regressive. Its capacity to raise revenue would also be offset by the amounts by which collections would be used to compensate low-income persons affected by it.
... Motor fuel excise tax. The U.S. currently has a 18.4¢ per-gallon federal excise tax on motor fuel, which hasn't been increased since the mid’90s. However, the report stated that, relative to other potential revenue sources, the revenue potential from increasing this tax is small.
Proposals by the Fiscal Commission and Debt Reduction Task Force. The CRS report then examines two specific proposals by the Fiscal Commission (FC) and the Debt Reduction Task Force (DRTF) and compares them to current law (CL). (For purposes of the comparisons below, FC and DRTF recommendations are listed only if they would change the existing law.)
... Tax rates. Until 2013, CL has six different rates ranging from 10%–35%. FC proposed three rates, at 12%, 22%, and 28%, and DRTF proposed two rates of 15% and 27%.
... AMT, PEP, and Pease. Both FC and DRTF would eliminate the CL alternative minimum tax (AMT). FC would also eliminate the “PEP and Pease” rules (i.e., limitations on personal exemptions and itemized deductions). Under CL, the PEP and Pease limitations don't apply in 2011 or 2012, and they didn't apply for 2010, but they will return in 2013 absent Congressional action.
... EITC. The EITC under CL is refundable and varies in amount based on the number of children and filing status of the taxpayer (harsher rules scheduled to apply after 2012). DRTF instead recommended an earnings credit of 31.3% for the first $20,300 in earnings.
... Child tax credit. DRTF recommended a $1,600 per-child credit, up from CL's partially refundable per-child credit of a maximum of $1,000 (scheduled to drop to $500 after 2012 absent Congressional action).
... Standard deduction and exemptions. FC would eliminate itemized deductions but retain the standard deduction for all individuals ($5,700 under CL). DRTF would eliminate both the standard deduction and personal exemption ($3,650 under CL).
... Mortgage interest. CL allows itemizing taxpayers to deduct their mortgage interest on up to $1 million of qualifying acquisition debt on a qualified principal or secondary residence, and it also allows a deduction for an additional $100,000 for home equity. FC would allow a 12% non-refundable credit on up to a $500,000 mortgage, with no credit for a second residence or for home equity. DRTF would have a 15% refundable tax credit, capped at $25,000.
... Employer-provided health insurance. CL excludes employer-provided health insurance from income, and will impose a 40% excise tax on high-cost plans effective 2018. FC would cap the exclusion at the 75th percentile of premium levels in 2014, whereas DRTF would eliminate the exclusion altogether. (For more on this subject)
... Charitable giving. CL allows itemizing taxpayers to deduct their charitable contributions. FC's proposal would instead have a 12% non-refundable tax credit, and DRTF's proposal would have a 15% refundable tax credit.
... Retirement plan contributions. Both FC and DRTF would cap tax-preferred contributions at the lower of $20,000, or 20% of income and expand the saver's credit (up to $1,000 under CL). FC would also consolidate retirement accounts.
... Other tax expenditures. There are over 150 tax expenditures under CL. FC and DRTF would both eliminate most of them.
... Capital gains and dividends. FC would tax all capital gains and dividends at ordinary rates (top rate of 15% under CL). DRTF would have a $1,000 exclusion for capital gains or losses, then tax all other capital gains and dividends at ordinary rates.
... State and municipal bonds. FC would tax the interest on newly-issued bonds (exempt under CL). DRTF would continue the exemption only for public purpose debt.
... Payroll tax cap. Both FC and DRTF would increase the payroll tax cap ($106,800 under CL) to cover 90% of wages.
... Payroll tax holiday. For 2011, employees have a two-percentage-point reduction in payroll tax. DRTF would also extend the payroll tax holiday to employers.
... Corporate income tax rates. FC and DRTF would reduce the top corporate tax rate (35% under CL) to 28% and 27%, respectively.
... International corporate income. CL allows for deferral of the international income of U.S. subsidiaries operating abroad by only taxing it upon repatriation. FC would adopt a territorial tax system.
... Corporate tax expenditures. There are over 75 corporate tax expenditures under CL. FC would eliminate them all, and DRTF would eliminate most of them.
... Motor fuel excise tax. FC would increase CL's 18.4¢ per-gallon tax on gasoline by 15¢.
... Excise tax on alcoholic beverages. Distilled spirits are taxed at $13.50 per proof gallon under CL, with reduced rates for wine and beer. DRTF would increase the tax on alcoholic beverages by 25¢ per ounce.
... Estate tax rate. DRTF would increase the rate to 45% for 2012 (35% under CL).
... Estate tax exemption. DRTF would extend the 2009 exemption of $3.5 million ($5 million under CL, $10 million for couples).
... National sales tax. DRTF would create a new 6.5% debt reduction sales tax.
... Sweetened beverage tax. DRTF would create a new tax on sweetened beverages.
If FC's plan was adopted, the reforms would generate over $1 trillion in additional revenues, and reduce budget deficits by an estimated $4.1 trillion, from 2012–2020. The average tax rates would increase for all income groups, but the overall share of taxes paid by lower- and middle-income groups would be reduced or maintained.
Over the same time period, adoption of DRTF's proposal would raise approximately $2.3 trillion in additional revenues (almost $3 trillion, not including the payroll tax holiday), largely attributable to the proposed 6.5% sales tax. However, the CRS noted that sales taxes generally tend to be regressive. The average tax rates would increase for all but the lowest-income group, and the overall share of the tax burden would be reduced or maintained for all lower-income groups.
Conclusion. The CRS concludes that, in order to achieve fiscal sustainability and bring the national debt to sustainable levels, Congress will likely have to make both spending and revenue raising changes. Broadening the tax base will generally enhance revenues, and can potentially promote economic efficiency by allowing for lower overall rates. However, the report cautions that while tax reform could play an important role in bringing the nation's debt under control, tax policies that enhance equity and efficiency may not necessarily lead to deficit reduction.