Voice For Liberty

Category: Taxation

  • Federal grants increase future local spending

    “Nothing is so permanent as a temporary government program.” — Nobel Laureate Milton Friedman

    Is this true? Do federal grants cause state and/or local tax increases in the future after the government grant ends? Economists Russell S. Sobel and George R. Crowley have examined the evidence, and they find the answer is yes.

    This paper is especially important as south-central Kansas starts a comprehensive planning process under a HUD Sustainable Communities Regional Planning Grant — a federal grant. Some officials have justified their votes in favor of the planning grant because the grant is “just for planning purposes.” It does not bind us to future actions that might raise taxes, they say. But this attitude is naive and dangerous.

    The research paper is titled Do Intergovernmental Grants Create Ratchets in State and Local Taxes? Testing the Friedman-Sanford Hypothesis.

    The difference between this research and most other is that Sobel and Crowley look at the impact of federal grants on state and local tax policy in future periods.

    This is important because, in their words, “Federal grants often result in states creating new programs and hiring new employees, and when the federal funding for that specific purpose is discontinued, these new state programs must either be discontinued or financed through increases in state own source taxes.”

    The authors caution: “Far from always being an unintended consequence, some federal grants are made with the intention that states will pick up funding the program in the future.”

    The conclusion to their research paper states:

    Our results clearly demonstrate that grant funding to state and local governments results in higher own source revenue and taxes in the future to support the programs initiated with the federal grant monies. Our results are consistent with Friedman’s quote regarding the permanence of temporary government programs started through grant funding, as well as South Carolina Governor Mark Sanford’s reasoning for trying to deny some federal stimulus monies for his state due to the future tax implications. Most importantly, our results suggest that the recent large increase in federal grants to state and local governments that has occurred as part of the American Recovery and Reinvestment Act (ARRA) will have significant future tax implications at the state and local level as these governments raise revenue to continue these newly funded programs into the future. Federal grants to state and local governments have risen from $461 billion in 2008 to $654 billion in 2010. Based on our estimates, future state taxes will rise by between 33 and 42 cents for every dollar in federal grants states received today, while local revenues will rise by between 23 and 46 cents for every dollar in federal (or state) grants received today. Using our estimates, this increase of $200 billion in federal grants will eventually result in roughly $80 billion in future state and local tax and own source revenue increases. This suggests the true cost of fiscal stimulus is underestimated when the costs of future state and local tax increases are overlooked.

    So: Not only are we taxed to pay for the cost of funding federal and state grants, the units of government that receive grants are very likely to raise their own levels of taxation in response to the receipt of the grants. This is a cycle of ever-expanding government that needs to end, and right now.

    An introduction to the paper is Do Intergovernmental Grants Create Ratchets in State and Local Taxes?.

  • Cronyism in the tax code

    Why is so much money spent on lobbying government? In a short video, Professor Randall G. Holcombe explains: “The reason you have so much lobbying and so much special interest activity in Congress is because government is so big. Government taxes a lot, government spends a lot, and so as a result there’s a lot of reward to people from going to Congress trying to get a piece of the action. Whether the piece of the action is a tax cut or a subsidy, I don’t think there’s any real solution to those special interest benefits outside of cutting the size of government.”

    Holcombe also explained how tax law is formed: “If you really want to understand the nature of our tax code, don’t ask yourself ‘Why are these provisions in the public interest?’ That’s not how taxes are passed. Ask yourself ‘Who benefits from these taxes, and how much political power do they have?’”

    This is not only a problem at the federal level. In Kansas last week special interest groups were able to extend using the Kansas tax code to funnel millions to special interests at the expense of the general public by extending the STAR bonds program.

    In Wichita, a special interest group recently persuaded the city council to manipulate property tax law in their favor by forgiving property taxes to new home buyers, again at the expense of the general public.

    I do have one disagreement with Holcombe when he says there are not groups that lobby Congress on behalf of the general public for tax reform. There are groups like Americans for Prosperity, Cato Institute, Tax Foundation, Americans for Tax Reform, Heritage Foundation, and many others that advocate for tax simplification and lower rates that benefit everyone. Not all these groups explicitly engage in lobbying, but they produce research and spread the message.

  • Brownback, Moran wrong on wind tax credits

    In the following commentary, Kansas Governor Sam Brownback and U.S. Senator Jerry Moran of Kansas make the case for extending the production tax credit (PTC) for the production of electrical power by wind.

    The PTC pays generators of wind power 2.2 cents per kilowatt-hour produced. To place that in context, a typical Westar customer in Kansas that uses 1,000 kilowatt-hours in the summer pays $95.22 (before local sales tax), for a rate of 9.5 cents per kilowatt-hour. (This is the total cost including energy charge, fuel charge, transmission charge, environment cost recovery rider, property tax surcharge, and franchise fee, according to a March 2010 illustration provided by Westar.) So 2.2 cents is a high rate of subsidy for a product that sells for 9.5 cents.

    The authors contend that the PTC is necessary to let the wind power industry “complete its transformation from being a high tech startup to becoming cost competitive in the energy marketplace.” The problem with this line of argument is that wind is not an industry in its infancy. The PTC has been in place since 1992, a period of twenty years. If an industry can’t get established in that period, when will it be ready to stand in its own?

    The authors also contend that canceling the PTC is, in effect, a “tax hike on wind energy companies.” To some extent this is true — but only because the industry has enjoyed preferential tax treatment that it should never have received, coupled with a misunderstanding of the tax credit mechanism.

    The proper way to view the PTC is as a government spending program. That’s the true economic effect of tax credits. Only recently are Americans coming to realize this, and as a result, the term “tax expenditures” is coming into use to accurately characterize the mechanism of tax credits.

    Amazingly, Brownback and Moran do not realize this, at least if we take them at their written word when they write: “But the wind PTC is a winning solution because it allows companies to keep more of their own dollars in exchange for the production of energy. These are not cash handouts; they are reductions in taxes that help cover the cost of doing business.” (Emphasis added.)

    It is the mixing of spending programs with taxation that leads these politicians to wrongly claim that tax credits are not cash handouts. Fortunately, not everyone falls for this seductive trap. In an excellent article on the topic that appeared in Cato Institute’s Regulation magazine, Edward D. Kleinbard explains:

    Specialists term these synthetic government spending programs “tax expenditures.” Tax expenditures are really spending programs, not tax rollbacks, because the missing tax revenues must be financed by more taxes on somebody else. Like any other form of deficit spending, a targeted tax break without a revenue offset simply means more deficits (and ultimately more taxes); a targeted tax break coupled with a specific revenue “payfor” means that one group of Americans is required to pay (in the form of higher taxes) for a subsidy to be delivered to others through the mechanism of the tax system. … Tax expenditures dissolve the boundaries between government revenues and government spending. They reduce both the coherence of the tax law and our ability to conceptualize the very size and activities of our government. (The Hidden Hand of Government Spending, Fall 2010)

    U.S. Representative Mike Pompeo of Wichita recognized the cost of paying for tax credit expenditures when he recently wrote: “Moreover, what about the jobs lost because everyone else’s taxes went up to pay for the subsidy and to pay for the high utility bills from wind-powered energy? There will be no ribbon-cuttings for those out-of-work families.” See Mike Pompeo: We need capitalism, not cronyism.

    So when Brownback and Moran write of the loss of income to those who profit from wind power, we should remember that these profits do not arise from transactions between willing partners. Instead, they result from politicians like these who are willing to override the judgment of free people and free markets with their own political preferences — along with looking out for the parochial interests of the home state. We need less of this type of wind power.

    Strengthening our Nation’s Domestic Energy Supply

    By Kansas Governor Sam Brownback and U.S. Senator Jerry Moran of Kansas.

    The increasing cost of conducting business in the United States threatens innovation and investment in new technologies. In today’s unstable business environment, American industries are understandably reluctant to invest the time and resources necessary to grow their businesses. This is especially true for domestic energy production.

    Energy production is one of the most highly regulated markets in the United States today. Government policies are hurting our country’s ability to compete within the global economy, limiting our domestic energy supply and driving up the cost of energy for consumers. To ensure Kansans have access to a reliable and affordable supply of energy, we must develop more of our nation’s natural resources.

    One resource that is plentiful in Kansas is wind. Our state has the second highest wind resource potential in our country and leads the nation in wind production capacity currently under construction. If we expect the wind energy industry to provide for our country’s future energy needs and make long-term investments in their businesses, Congress must reauthorize the wind production tax credit (PTC) that expires this year. By extending the wind PTC, Congress will allow the wind industry to complete its transformation from being a high tech startup to becoming cost competitive in the energy marketplace. Failure to do so will result in a tax hike on wind energy companies and will only further delay this industry’s ability to compete.

    There are those who view government intervention in the energy sector as picking winners and losers. But the wind PTC is a winning solution because it allows companies to keep more of their own dollars in exchange for the production of energy. These are not cash handouts; they are reductions in taxes that help cover the cost of doing business. Unlike President Obama’s failed stimulus plan that rewards individual, unproven companies like Solyndra with cash handouts, the wind PTC is an industry tax credit that has led to $20 billion in annual private investment in our energy infrastructure.

    Today, the American wind industry includes more than 400 manufacturing facilities in 43 states. In 2005, just 25 percent of the value of a wind turbine was produced in the United States compared to more than 60 percent today. Because of their close proximity to wind farms, American workers can produce the critical components at a lower cost than their European and Asian counterparts. As more components are manufactured in the United States and not overseas, the cost to produce electricity from wind farms will be further driven down.

    If the wind PTC is allowed to expire, local economies across our state will suffer. Kansas counties will lose $3.7 million in annual payments from wind companies. Kansas landowners will lose nearly $4 million annually in additional income they earn from leasing or selling their land for wind farms. And every Kansan will ultimately be affected because the power generated by these wind facilities contributes to our supply of electricity. By eliminating additional sources of electricity, utility rates will climb.

    To meet our country’s energy needs and remain competitive in the global market, Congress must develop a national energy policy. Recent events in the Middle East have demonstrated once again the importance of having access to an ample domestic energy supply so we are less dependent on foreign sources. If Congress fails, Kansans will soon be paying much higher energy prices — for the gas to fill up our cars, for the fuel to power our farm equipment, and for the electricity to turn on our lights.

    Temporarily extending the wind PTC is not about picking winners and losers — it is about preparing our country to meet our growing energy demand. Rather than make it more difficult for the private sector to develop energy sources, we should lower taxes, reduce regulations, and allow the private sector to succeed in the free market. In turn, the wind industry will grow and become fully competitive — no longer needing the wind PTC. By strengthening American energy production, our country’s future will be stronger and more secure.

  • Wichita turns taxation over to private interests

    In a free society with a limited government, taxation should be restricted to being a way for government to raise funds to pay for services that all people benefit from. But in the city of Wichita, taxation for private gain is overtaking our city.

    The Ambassador Hotel, part of a project known as Douglas Place, makes use of several of these private tax policy strategies. By private tax policy, I mean that the proceeds of a tax are used for the exclusive benefit of one person (or business firm), instead of used for the benefit of all. In one example related to this hotel, the Wichita City Council is allowing private parties to determine the city’s tax policy at their discretion, not the city’s.

    The tax in question is Wichita’s hotel guest tax. According to a description of the Tourism and Convention Fund in the city’s budget document, the goal of the guest tax is to “support tourism and convention, infrastructure, and promotion of the City.” Its priorities are to be “Fund priorities are: 1) debt service for tourism and convention facilities, 2) operational deficit subsidies and 3) care and maintenance of Century II.”

    But in the case of the Ambassador Hotel project, the city passed a charter ordinance that would route 75 percent of this tax directly back to the hotel owners for their own use. That’s not the proclaimed purpose of the guest tax.

    Instead, this is public taxation for private enrichment.

    Those who benefit from things like this and tax increment financing (TIF) districts say they aren’t really benefiting, as they are, in fact, paying taxes.

    But when taxes you must pay are routed back to you for your own exclusive use, what else can you call it except capture of a public function for your own personal use?

    Failure of Wichita city leadership

    If you need further evidence that Wichita is turning over taxation to private hands, consider this: The charter ordinance is subject to a protest petition. In the normal case, if sufficient signatures are gathered, the city council would have to either a) overturn the ordinance, or b) hold an election to let voters decide whether the ordinance takes effect. An effort that I have been involved with expects to turn in enough signatures this week to force this decision.

    Now, if this tax policy regarding the Ambassador Hotel is truly in the public interest, we would expect that the city council would decide whether to hold such an election and bear its costs itself. But that’s not the case. In the agreement between the city and the Douglas Place developers, we see this: “If Developer requests a special election solely for the purpose of passing the charter ordinance in the event a sufficient protest petition is submitted, Developer shall reimburse the City for the actual out of pocket costs and expenses of conducting such election.”

    In other words, the city is turning over to private interests the decision as to whether to have such an election, and also the responsibility for paying for it. This is a failure of Wichita city leadership to do the things that government, not private interests, should do.

    Private taxation funds political entrepreneurship

    In Wichita, especially in downtown, we see the rise of private tax policy, that is, the taxing power of government being used for private purposes. The above example is just one example. This private tax policy is pushed by Wichita’s political entrepreneurs. These are the people who would rather compete in the realm of politics rather than in the market.

    Examples of Wichita’s political entrepreneurs include the developers the Ambassador Hotel: David Burk of Marketplace Properties, and the principals of Key Construction.

    Competing in the political arena is easier than competing in the market. To win in the political arena, you only have to convince a majority of the legislative body that controls your situation. Once you’ve convinced them the power of government takes over, and the people at large are forced to transfer money to the political entrepreneurs. In other words, they must engage in transactions they would not elect to perform, if left to their own free will.

    In the free marketplace, however, entrepreneurs have to compete by offering products or services that people are willing to buy, free of coercion. That’s hard to do. But it’s the only way to gauge whether people really want what the entrepreneurs are selling. It’s also the way that wealth and prosperity are created. Government spending on business does not have this effect.

    One of the ways that political entrepreneurs compete is by making campaign contributions, and the developers of Douglas Place have mastered this technique. Key Construction principles contributed $13,500 to Mayor Carl Brewer and four city council members during their most recent campaigns. Council Member Jeff Longwell alone received $4,000 of that sum, and he also accepted another $2,000 from managing member David Burk and his wife.

    All told, Burk and his wife contributed at least $7,500 to city council candidates who will be voting whether to give Burk money. Burk and others routinely make the maximum contribution to all — or nearly all — candidates, even those with widely varying political stances. How can someone explain Burk’s (and his wife’s) contributions to liberals like Miller and Williams, and also to conservatives like Longwell, Meitzner, and former council member Sue Schlapp?

    The answer is: Burk will be asking these people for money.

    Wichitans need to rise against these political entrepreneurs and their usurpation of a public function — taxation — for their own benefit. The politicians and bureaucrats who enable this should realize they should be serving the public interest, not the narrow and private enrichment of the few at the cost of many.

  • Pompeo to introduce ‘Energy Freedom and Economic Prosperity Act’

    This week U. S. Representative Mike Pompeo of Wichita plans to introduce the “Energy Freedom and Economic Prosperity Act,” a bill that would eliminate all tax credits related to energy.

    Tax credits, sometimes called tax expenditures, are spending accomplished through the tax code rather than by legislative appropriations. Two prominent tax credits related to energy production are the tax credit for producing and blending ethanol with gasoline, and the production tax credit for wind and solar power production. These industries have claimed that the tax credits are necessary for these forms of energy to be economically viable.

    Pompeo’s office estimates that the bill could save up to $90 billion in tax expenditures over the next ten years. The legislation proposes that these savings be used to reduce the corporate income tax rate.

    The subsidies that would be repealed include, according to Pompeo’s office: Plug-In electric and fuel cell vehicles, Alternative fuel and alternative fuel mixtures, Cellulosic Biofuel Producer Credit, Alternative fuel infrastructure, Production Tax Credit for electricity produced from renewable sources, including wind, biomass, and hydropower, Investment Tax Credit for equipment powered by solar, fuel cells, geothermal or other specified renewable sources, Enhanced oil recovery credit, and credit for producing oil and gas from marginal wells, Advanced Nuclear Power Generation Credit, and Clean coal investment credits.

    This bill targets tax credits only. Loans and loan guarantees are not a subject. This bill would not affect the programs that funded Solyndra, a high-profile example of failure. This bill would not affect the $132.4 million loan guarantee recently given to a cellulosic ethanol plant in southwest Kansas, either.

    Pompeo’s office stresses that this is not a bill targeted at renewable forms of energy like ethanol and wind. It affects all tax credits, including those that are directed at the nuclear, coal, and oil and gas. The goal is to get government out of the energy sector and let markets direct energy investment.

    This bill represents a continued effort by Pompeo to reduce government intervention and to give more freedom to markets. Politically, it puts him at odds with many in this state who favor expansion of wind energy in Kansas. In particular, Kansas Governor Sam Brownback is a proponent of wind power and ethanol. Wichita Mayor Carl Brewer is also promoting Wichita as a place for wind power companies to locate.

  • Warren Buffet’s secretary: marginal vs. average, Hauser’s Law

    Some of the confusion surrounding Warren Buffet’s secretary and her taxes comes from the failure to distinguish between average and marginal tax rates. There’s also the fact that Social Security and Medicare payroll taxes are paid on only the first $106,800 of income.

    But considering income taxes alone and not payroll taxes, there’s often confusion between average tax rates (the total amount of tax paid divided by the amount earned) and marginal tax rates (the amount of tax paid on the next dollar earned).

    As an illustration, consider a single person earning $60,000. Plugging the numbers into the tax calculator at efile.com, and not taking any deductions other than standard and personal, produces a tax liability of $8,444. On income of $60,000, this is an average tax rate of 14.07 percent.

    But consider if the person earns another $100. (The calculator doesn’t work with fractional dollars, so we’ll use $100 instead of $1.)

    Now, the tax liability is $8,469. That’s an increase of $25 in taxes for an increase of $100 in income. In other words, this person is in the 25 percent tax bracket, meaning that each additional dollar earned results in an additional $0.25 in tax.

    Not all earnings are taxed at this 25 percent rate. Some is taxed at a much lower rate, and some not at all. By the way, the average tax rate has now increased to 14.09 percent.

    If the $60,000 wage earner is married with two children, the tax bill falls to $3,463, producing an average tax rate of 5.77 percent, and the marginal rate on the next dollar earned is 15 percent. This again assumes no deductions beyond the standard and personal.

    So what tax rate does Warren Buffet’s secretary pay? There can be many answers.

    One thing we can be certain of, however, is that wealthy people like Buffet have options in structuring their income that ordinary wage earners don’t. Buffet, for example, says he receives most of his income in the form of capital gains or dividends, which are taxed at 15 percent.

    This is an illustration of Hauser’s Law at work. Try as we might, raising tax rates won’t generate higher revenues (as a percentage of gross domestic product), due to Hauser’s law. W. Kurt Hauser explains in The Wall Street Journal: “Even amoebas learn by trial and error, but some economists and politicians do not. The Obama administration’s budget projections claim that raising taxes on the top 2% of taxpayers, those individuals earning more than $200,000 and couples earning $250,000 or more, will increase revenues to the U.S. Treasury. The empirical evidence suggests otherwise. None of the personal income tax or capital gains tax increases enacted in the post-World War II period has raised the projected tax revenues. Over the past six decades, tax revenues as a percentage of GDP have averaged just under 19% regardless of the top marginal personal income tax rate. The top marginal rate has been as high as 92% (1952-53) and as low as 28% (1988-90). This observation was first reported in an op-ed I wrote for this newspaper in March 1993. A wit later dubbed this ‘Hauser’s Law.’”

    People react to changes in tax law. As tax rates rise, people seek to reduce their taxable income and make investments in unproductive tax shelters. There is less incentive to work and invest. These are some of the reasons why tax hikes usually don’t generate the promised revenue.

    Any plan to generate substantially more revenue by raising tax rates will have to overcome this tax-avoiding behavior. Hauser’s law says this is not likely to happen.

    Hauser's LawHauser’s Law illustrated. No matter what the top marginal tax rate, taxes collected remain an almost constant percentage of GDP.

  • Tax expenditures, or loopholes

    While most critics of government spending focus on entitlements, regular appropriations, and earmarks, there is a category of spending that not many have paid much attention. This spending is called “tax expenditures.” This year as part of the debate or controversy over raising the federal debt ceiling, attention is being paid to the cost of these tax expenditures, although the term commonly used is “loophole.”

    It’s a big issue. As economist Martin Feldstein wrote in the Wall Street Journal, tax expenditures were thought to increase the federal budget deficit by $1 trillion in 2010.

    We know where President Barack Obama stands. He is firm in wanting to increase tax revenue by eliminating tax expenditures. He focuses on those that apply to the rich, although there are plenty of tax expenditures that apply to the working poor and middle class, such as the earned income tax credit and child care credit.

    To speak of these tax expenditures or loopholes having a “cost” makes sense only if you adopt a certain view of the world. It has to do with who owns what — you or government. George Reisman recently explained: “The underlying assumption of those who hold this view is that the government already owns the funds in question whether it has collected them in taxes or not. The government is the alleged owner of funds that belong to the taxpayer and which it abstains from taking. It allegedly spends these funds in allowing the taxpayers to keep them.”

    Reisman further explained that eliminating tax expenditures is a tax increase, pure and simple, and must not be embraced: “The notion of tax expenditures provides the pretext for massive tax increases in the name of reducing government spending. This notion must be cast aside, so that the target of tax reform will be reductions in actual government spending, which then must be followed by reductions in taxes.”

    Other economists agree. Thomas J. DiLorenzo, in his essay More Loophole Lobbyists, Please warns of the “oldest trick in the book,” which he says is “Give up your deductions, and we will reduce your income tax rate.”

    I agree with their arguments. Increasing tax revenue to the state by eliminating tax expenditures is not a good thing. At the same time, the tax expenditures are a problem. Their very existence, and the continual effort to expand them or prevent their closing, is harmful to the economy, too. Spending through the tax system is a major way of implementing crony capitalism, that is, political entrepreneurship instead of market entrepreneurship, as explained by Charles G. Koch in The Wall Street Journal: “Crony capitalism is much easier than competing in an open market. But it erodes our overall standard of living and stifles entrepreneurs by rewarding the politically favored rather than those who provide what consumers want.”

    Koch went on to explain that “Our elected officials would do well to remember that the most prosperous countries are those that allow consumers — not governments — to direct the use of resources. Allowing the government to pick winners and losers hurts almost everyone, especially our poorest citizens.”

    I agree with that, too. This is why this is a difficult issue.

    Tax expenditures are implemented through the tax system. It’s usually the income tax system, especially at the federal level, but also at the state level.

    Some of the tax expenditures consist of deductions: The government deciding not to collect tax on income that is spent for a specific purpose. An example is the deduction for home mortgage interest. For 2010, this is estimated to “cost” the federal government $103.7 billion in taxes that it would otherwise collect, according to the Joint Committee on Taxation.

    The tax expenditures that really “cost” the government — and by extension, other taxpayers that must pay unless spending is also reduced — are tax credits. These reduce the tax that must be paid dollar for dollar. An example is the “credit for alcohol fuels,” which is to say ethanol. The cost of this tax credit program for 2010 is given as $10.1 billion. Many credits are refundable, meaning that if the taxpayer has no tax liability, the government will send the recipient a check.

    Other examples of tax credits cited by Feldstein include “$500 million annual subsidy for the rehabilitation of historic structures and a $4 billion annual subsidy of employer-paid transportation benefits.”

    While supporters of many of these programs portray them as not costing the government anything, Feldstein writes that they do: “These tax rules — because they result in the loss of revenue that would otherwise be collected by the government — are equivalent to direct government expenditures.”

    I argued this in testimony I presented to a committee in the Kansas Legislature last year, when it was considering restoring and expanding the Kansas historic preservation tax credit program. I told committee members: “We must recognize that a tax credit is an appropriation of Kansans’ money made through the tax system. If the legislature is not comfortable with writing a real estate developer a check for over $1,000,000 — as in the case with one Wichita developer — it should not make a roundabout contribution through the tax system that has the same economic impact on the state’s finances.”

    In that committee, not one member voted against this program, even though the committee has some members who consider themselves very fiscally conservative and hawks on spending.

    In Wichita, the city council regularly steers spending to certain companies through the tax system by granting property tax exemptions and tax increment financing.

    Feldstein describes problems with spending implemented through the tax system:

    • Politicians use tax expenditures to grow the welfare state. While proposing a freeze on discretionary spending, President Obama at the same time proposed an expansion of a tax credit program for child or elderly care.
    • Once enshrined in the tax law, these appropriations don’t have to be reauthorized each year. They’re on auto-pilot, so to speak.
    • Eliminating tax expenditures is looked on by Republicans as a tax increase, so they are reluctant to support their elimination. Felstein counters: “But eliminating tax expenditures does not increase marginal tax rates or reduce the reward for saving, investment or risk-taking.”
    • Tax expenditures distort the economy in harmful ways: “[Eliminating tax expenditures] would also increase overall economic efficiency by removing incentives that distort private spending decisions.”

    Feldstein concludes: “Cutting tax expenditures is really the best way to reduce government spending. And to be politically acceptable, the cuts in tax expenditures must be widespread, requiring most taxpayers to give up something so that the fiscal deficits can decline.”

    The ‘Tax Expenditure’ Solution for Our National Debt

    The credits and subsidies that make the tax code so complicated cost big bucks. Reduce them by third and the debt will be 72% of GDP in 2020 instead of 90%.

    By Martin Feldstein

    When it comes to spending cuts, Congress is looking in the wrong place. Most federal nondefense spending, other than Social Security and Medicare, is now done through special tax rules rather than by direct cash outlays. The rules are used to subsidize a wide range of spending including education, child care, health insurance, and a myriad of other congressional favorites.

    These tax rules — because they result in the loss of revenue that would otherwise be collected by the government — are equivalent to direct government expenditures. That’s why tax and budget experts refer to them as “tax expenditures.” This year tax expenditures will raise the federal deficit by about $1 trillion, according to estimates by the congressional Joint Committee on Taxation. If Congress is serious about cutting government spending, it has to go after many of them.

    Continue reading at the Wall Street Journal (subscription required)

  • Obama’s tax hikes must be resisted

    As our nation’s leaders consider the possibility of raising income tax rates, we need to be aware of the negative impact of higher marginal tax rates on the economy and make sure we resist the lure of higher taxes. This is especially important even if the new higher tax rates are confined to to the rich.

    The concept of marginal tax rates is important to understand, as it holds the key to understanding how we can drive economic growth, and how we can kill it, too. President Barack Obama believes he has already cut taxes in the name of economic growth. These tax “cuts” — I use quotes deliberately — are part of the stimulus bill passed in February 2009.

    So what are the Obama tax cuts? There was one program that qualified — sort of — as a “cut,” and several tax credit programs. The largest item that benefited most people is the Making Work Pay Tax Credit, a two-year program that rebates $400 per year to individual taxpayers, or $800 per year for married couples.

    It’s important to note that this is not a reduction in marginal tax rates, which is the tax rate that people pay on the next dollar they earn. That’s what people focus on. The program will, however, reduce the average tax rate that people pay.

    This bears repeating: People can’t control the tax on income they’ve already earned. But they can decide whether to submit themselves to the marginal tax rate: The tax rate the government charges on the next dollar they may — or may not — earn.

    So why isn’t Obama’s Making Work Pay Tax Credit a stimulus boon to the economy? It’s not associated with any positive effort or activity by the recipients other than doing what they already do. (This applies to the Bush tax rebate in 2008, too.)

    For tax cuts to be productive in growing the economy, they have to be associated with something positive, namely with work, saving, or investment. What many people positively respond to is a reduction in marginal tax rates, that is, the tax that must be paid on the next dollar earned.

    Programs that reduce the average tax rate like Obama’s Making Work Pay Tax Credit and the Bush tax rebates of 2008 aren’t effective because they don’t affect the marginal rate — the rate paid on the next dollar earned. This is not to say that I am not in favor of these programs. Anything that reduces the burden of taxes is welcome. But they are not the type of tax cuts that spur economic growth.

    Why are low marginal tax rates important to economic growth? First, high marginal tax rates discourage people from producing. As people get to keep less and less of what they produce after they pay higher tax rates, many decide to produce less. Some stop producing anything.

    Second, high marginal tax rates encourage people to invest in economically unproductive investments like tax shelters simply to avoid tax, without regard to the underlying wisdom of the investment. Or, people decide that since government takes so much of the money they earn, they might as well spend it on tax-deductible expenses that they might not buy otherwise. A company might hold an engineering conference at an expensive luxury resort instead of a modestly-priced facility — or instead of holding it electronically.

    Who responds most positively to reductions in marginal tax rates? First, with about half of American households paying no federal income tax at all — although they do pay payroll taxes — the idea of marginal tax rates doesn’t apply to them. That leaves high-income workers, or as Jeffrey A. Miron explains, the most economically productive members of society that are positively affected by marginal income tax rates:

    The Bush cuts provided lower taxes on ordinary income, especially for taxpayers at the high end of the income distribution. These are some of the most energetic and productive people in society; raising tax rates would discourage their effort and entrepreneurship. High-income taxpayers also have multiple ways of avoiding high tax rates, so any revenue gain from raising rates would be modest. The Bush cuts also lowered taxes on dividend and capital gains income; maintaining these lower rates is even more important for economic performance. Capital is mobile: when it is taxed heavily here, it flees somewhere else, meaning lower investment and employment in the United States. And because capital income taxes discourage investment or drive it overseas, they generate little if any tax revenue. (Jeffrey A. Miron, “Why the Bush Tax Cuts Worked”)

    It is these “energetic and productive” people that are responsible for a great deal of economic activity and job creation. When these people take steps to avoid taxes it means less productive economic activity and more unproductive tax shelters.

    In Slaying Leviathan: The Moral Case for Tax Reform, author Leslie Carbone explains the harm of high marginal taxes, especially progressive taxes, where rates become higher as more income is earned:

    The discouragement of earning money by working, saving, or investing inherent in any income tax is exacerbated by progressivity. While any high tax rates are economically destructive, high marginal rates are even worse, because high marginal rates particularly discourage productivity and inhibit economic growth. … By lowering potential pay off, high investment taxes especially discourage risky investment. Discouragement of risky investment squelches technological advancement, because new technologies are the most risky. This means our progressive tax system actually reduces progress and inhibits improve quality of life.”

    If the goal of the Obama Administration is to create private sector economic growth instead of growth in government, it needs to keep the Bush tax cuts in place and avoid increases in marginal tax rates for everyone, especially the most productive members of society. A better strategy would be to reduce these tax rates farther to create even more economic growth.

  • Huffington Post says ‘tax it all.’ Seriously.

    Yesterday the Huffington Post’s Jeffrey Sachs criticized a recent Wall Street Journal editorial, claiming that the Journal “distorts the truth about taxes.”

    In the Journal piece, the claim is made that even if we taxed all the income of the top one percent of taxpayers, that would not raise enough funds to close the deficit. Sachs takes issue with the numbers, he claiming that taxing “total income of the top 1% would close the budget deficit entirely.” He sees an error in the numbers the Journal uses, and I think he might be right. I can’t figure out the arithmetic the Journal uses.

    But while Sachs takes great relish in showing — at least in his mind — that the Journal is wrong in its numbers, Sachs himself can’t be taken seriously. After all, he is proposing to tax 100 percent of the adjusted gross income income of the top one percent of earners.

    While liberals might want to take all the income of our country’s high-earning people, this is a plan that can’t be taken seriously, especially by a purportedly serious person as Sachs. It could possibly work for one year — if you could pull off a surprise and make the 100 percent tax rate retroactive, after everyone has already earned the money for the taxable year. Any other plan will fail. That’s because we know that when marginal tax rates rise, people takes steps to have less income. Some decide to work and risk less, so they have less income. Others seek to shelter income from taxes, and since almost all such tax shelters are an economically unproductive use of funds, we are all poorer as a result. And some people lie and cheat in order to avoid taxes. But we can be sure that people will takes steps to have less taxable income as tax rates rise.

    Try as we might, raising tax rates won’t generate higher revenues (as a percentage of gross domestic product), due to Hauser’s law. W. Kurt Hauser explains in The Wall Street Journal: “Even amoebas learn by trial and error, but some economists and politicians do not. The Obama administration’s budget projections claim that raising taxes on the top 2% of taxpayers, those individuals earning more than $200,000 and couples earning $250,000 or more, will increase revenues to the U.S. Treasury. The empirical evidence suggests otherwise. None of the personal income tax or capital gains tax increases enacted in the post-World War II period has raised the projected tax revenues. Over the past six decades, tax revenues as a percentage of GDP have averaged just under 19% regardless of the top marginal personal income tax rate. The top marginal rate has been as high as 92% (1952-53) and as low as 28% (1988-90). This observation was first reported in an op-ed I wrote for this newspaper in March 1993. A wit later dubbed this ‘Hauser’s Law.’”

    People react to changes in tax law. As tax rates rise, people seek to reduce their taxable income and make investments in unproductive tax shelters. There is less incentive to work and invest. These are some of the reasons why tax hikes usually don’t generate the promised revenue.

    Any plan to reduce the deficit by raising tax rates will have to overcome this tax-avoiding behavior. Hauser’s law says this is not likely to happen.

    The subtitle to Hauser’s article is “Tax revenues as a share of GDP have averaged just under 19%, whether tax rates are cut or raised. Better to cut rates and get 19% of a larger pie.”

    Hauser's LawHauser’s Law illustrated. No matter what the top marginal tax rate, taxes collected remain an almost constant percentage of GDP.