Macroblog

May 19, 2011

The long and short (runs) of tax reform

In an earlier part of my career, I spent a fair amount of time thinking about fiscal policy issues. The evolution of my responsibilities eventually moved my attentions in a somewhat different direction, but you never really forget your first research love. With questions of debt, government spending, and taxes at the top of the news, it isn't hard for my old fondness for the topic to reemerge.

So, in that context, I had a somewhat nostalgic response to an item at Angry Bear, written by contributor Dan Crawford. In essence, the Crawford post formally (through statistical analysis) asks the question "How is GDP growth related to marginal tax rates (that is, the tax rate applied to your last dollar of income)?" More specifically, Crawford analyzes how gross domestic product (GDP) growth next year is related to the marginal tax rate faced by the average individual and the marginal tax rate faced by the highest-income taxpayers.

I don't intend to quibble with the specifics of that experiment per se but rather highlight an aspect of taxation and tax reform that I think should not be forgotten. That is, the short run is no place for a decent discussion of tax policy to be hanging out. To say that more formally, the largest effects of tax policy accrue over time, and it is probably not a good idea to be too focused on the immediate—say, next year's—effects of any given policy or change in policy.

The following chart is based on tax reform experiments in a paper I co-authored over a decade ago with Alan Auerbach, Larry Kotlikoff, Kent Smetters, and Jan Walliser. (Note that the chart does not appear in the paper, but I created it using data from the paper—a publicly available version of the paper can be found here.) The chart depicts the cumulative percentage increases in national income that would be realized (in our model) in the years following three different tax reforms.

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The three experiments depicted in this chart were as follows:

"[The clean income tax] replaces the progressive taxation of wage income with a single rate that is also applied to capital income. In addition, the clean income tax eliminates the major federal tax-base reductions including the standard deduction, personal and dependent exemptions, itemized deductions, the deductibility of state income taxes at the federal level, and preferential tax treatment of fringe benefits...

"Our flat tax experiment modifies the clean consumption tax by including a standard deduction of $9500. In addition, housing wealth, which equals about half of the capital stock, is entirely exempt from taxation."

Parenthetically, the "clean consumption tax"

"...differs from the clean income tax by including full expensing of investment expenditures. This produces a consumption-tax structure. Formally, we specify the system as a combination of a labor-income tax and a business cash-flow tax."

Finally,

"Our [flat tax with transition relief] experiment adds transition relief to the flat tax by extending pre-reform depreciation rules for capital in place at the time of the tax reform."

Here's what I want to emphasize in all of this. If the change in policy you might be considering involves a reduction in effective marginal tax rates (implemented via a combination of changes in statutory rates and adjustments in deductions and exemptions), the approach taken by Crawford in his Angry Bear piece is probably acceptable. The clean income tax reform is in the spirit of Crawford's calculations, and in our results the long-run impact on output is realized almost immediately. If, however, the tax reform involves changing the tax base in a fundamental way (in both versions of our flat tax experiments the base shifts from income to consumption), then the ultimate effects are felt only gradually. In our flat tax experiments, the longer-run effects on income are in the neighborhood of three times as large as the near-term effects.

All of the experiments described were done under the assumption of revenue neutrality, so questions of the right policy for budget balancing exercises weren't explicitly addressed. (Nor is it the nature of the experiment contemplated in the Angry Bear post.) Nonetheless, they do suggest that deficit reduction exercises that involve changes in tax rates and the tax base will have differential effects over time, and realizing the full benefits of tax reform may require a modicum of patience.

Note: A user-friendly description of the paper that the chart above is based on appeared in an Economic Commentary article published by the Cleveland Fed.

Update: Though the item at Angry Bear was posted by Dan Crawford, Mike Kimel actually wrote it. I apologize for the mistake and draw your attention to Kimel's follow-up post.

By Dave Altig
senior vice president and research director at the Atlanta Fed

• May 19, 2011 in
  • Deficits
  • Fiscal Policy
  • Taxes
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October 27, 2010

Real estate and municipal revenue

In September, the Federal Reserve Bank of Atlanta's Center for Real Estate Analytics sponsored a conference to examine the impact the real estate downturn is having on public sector finances.

It's no secret that state and local governments are currently experiencing substantial revenue declines. One popular explanation is that deteriorating local real estate conditions are responsible for a portion of that decline, but it turns out that this explanation is not the main cause, at least not yet. One of the sessions in the conference featured attempts by three economists from the Federal Reserve Board of Governors (Lutz, Molloy, and Shan) and two from Florida State University (Doerner and Ihlanfeldt) to estimate the direct impact of the decline in real estate values on local tax revenues. Both papers examined the multiple channels of influence between the decline in real estate values and local revenues.

The largest channel, of course, is the decline in property tax income related to declining assessed property values. Of course, property owners don't pay property taxes based on the current value of their home. They pay based on an assessment that is at least a year old. Thus, the decline in property values takes considerable time to work its way through the assessment process and into property tax revenues. Consequently, declines in property values have only more recently started to be reflected in lower property tax revenues. Experts expect the decline in those revenues to continue for another couple of years, with the worst shortfall two or three years out. Some of the assessments are fairly gloomy.

To illustrate that point, I've pulled a few charts from the Lutz, Molloy, and Shan paper. The first chart illustrates the decline in revenues led by individual and sales taxes. Notably, property tax collections grew at an increasing rate in 2009 over 2008.

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The next chart directly depicts the relationship (or the short-run lack thereof) between housing price growth changes and property tax revenue. Lags in changes in assessments and the ability of local governments to change property tax rates can go a long way in explaining why overall property tax revenue continues to grow.

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Finally, Lutz, Molloy, and Shan broke down the data by some states, and I include the case of Georgia below. (The Ihlanfeldt and Doerner paper does something similar—and in great detail for the state of Florida.) The Georgia case clearly shows the effect of the lags: property values rose through the first part of the last decade and, even though tax rates were falling, overall tax revenue rose. Post-2007, however, market values of homes declined while the aggregate assessed values continued to rise through 2009 (along with property tax revenue).

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It is hard to imagine the trend of aggregate increased assessed valuation continuing. If the assessed values begin to track the market values, pressures will emerge on the government entities that depend on property taxes. The picture suggests that tax rates and/or spending on programs are likely to change notably during the coming few years.

By Tom Cunningham, vice president and associate director of research and acting director of the Center for Real Estate Analytics at the Federal Reserve Bank of Atlanta

• October 27, 2010 in
  • Economic Growth and Development
  • Fiscal Policy
  • Taxes
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March 11, 2009

Another side of the administration’s tax plan

While discussions of the Obama administration's tax plan focus on the expected impact on consumer spending and the federal deficit, not much attention has been given to the incentives of the plan for work effort. Different tax rates, deductions, and rebates provide varying degrees of incentives to work less or work more, and those incentives differ across income groups. Here I want to focus on just one of the proposed changes: the reinstatement of the 39.6 percent marginal tax rate for the wealthy.

Supply side economists tout low tax rates across the board as a way to provide incentives for people to work harder and thus for the economy to grow faster; with this thinking, people work harder because they get to keep more of the money they're working for.

Results in a recent working paper, with coauthor Robert Moore, confirm these predictions by finding that work effort increased across all income levels when tax rates were cut (among other things) in the 2001 Bush administration tax reform. But work effort increased much less among the more educated (higher income) families.

The administration's current budget plan includes a reversion of the marginal tax rate among the wealthiest to the pre-Bush tax rates—an increase from 35 to 39.6 percent. This tax rate increase is equivalent to reducing a worker's wage by 7 percent. The chart shows what the impact on work effort would be across education/income groups if wages were decreased for both groups by 7 percent; education and income are very highly correlated. The analysis found that husbands with a high school degree only would reduce their hours worked by about 63 hours per year (about 2.9 percent), whereas husbands with a college degree or more would reduce their work hours by only 42 hours per year (about 1.8 percent). Working wives in these families would also reduce their hours of work.

So, based on my research, if a need to raise some revenue means tax rates have to be increased for someone, raising them on the wealthiest will result in a smaller reduction in work effort than raising tax rates on the middle class.

The calculations here use results obtained from estimating a joint labor supply model for dual-earner families with different levels of education for the year 2000. A complete analysis of the work effort implications from the administration's tax plan would require accounting for all the changes to marginal tax rates, phase-outs of deductions, and tax credits simultaneously, as well as considering the impact on decisions of family members to enter or exit the labor market in response to the tax changes.

An additional relevant question remains: What is the implication of changing work effort for GDP growth? The relationship between work effort and value of output is not necessarily the same across income levels. In other words, one hour of high-income (higher education) labor is expected to yield a higher value of output in the economy than one hour of labor from a middle-income (lower education) worker. A complete analysis of the aggregate impact of the administration's tax plan would have to also take this into account.

By Julie Hotchkiss, research economist and policy adviser at the Atlanta Fed

• March 11, 2009 in
  • Labor Markets
  • Taxes
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February 5, 2009

There is no accounting for priorities

Just in case you are desperately seeking some refuge from the pervasive blogland commentary on the fiscal stimulus proposal winding through the Senate (which already made its way through the House of Representatives), be forewarned: You won't find it here, but you will find an update to the old adage, There's no accounting for taste (de gustibus non est disputandum), which is to say that when it comes to the fiscal stimulus package, there's no accounting for priorities.

The Senate bill is not yet a done deal, of course, but a couple of clear differences between it and the House bill have emerged. According to the Congressional Budget Office—or CBO, from whom all figures in this post spring—the Senate bill is slightly bigger ($884.5 billion versus $819.5 billion) and would implement the stimulus at a faster pace. The current Senate bill would introduce about 79 percent of the expenditures and tax cuts in 2009 and 2010. The corresponding figure in the plan that came out of the House is 64 percent.

Perhaps more interesting—and maybe more confusing—are the priorities reflected in the separate bills:

The share of the stimulus devoted to discretionary spending—the place where, for example, infrastructure and education spending reside—is pretty similar in both stimulus plans (about 28 percent in the House version, about 26 percent in the Senate version). What is clearly different is the much greater reliance on tax cuts in the Senate bill, compared with the House bill's emphasis on "direct spending."

In a sense, this distinction is as much an issue of labeling as anything. The majority of the items in this category of direct spending are "provisions that would increase direct spending for unemployment insurance, health care, fiscal relief for states through the Medicaid program, and other programs," according to the CBO. In the language of economists and national income accountants these are "transfer payments," or funds that are transferred to individuals. Formally, they are subsidies for certain types of economic behavior—job seeking and purchasing health care, for example—and hence are really just a negative tax.

There is a certain arbitrariness to the distinction between increases in transfer payments and reductions in tax payments. This arbitrariness is illustrated by a change the CBO made between its initial assessment of the draft House bill and its (largely unchanged) summary of the bill that passed:

"The Congressional Budget Office, in consultation with JCT [Joint Committee on Taxation], has concluded that the subsidy for health insurance assistance for the unemployed should be treated as an increase in outlays rather than a decrease in revenues. Although this treatment is different from that in the table provided in our estimate for H.R. 1 as introduced on January 26, the overall effect on the budget remains the same for each year. JCT has also adjusted its estimates of the mix of revenue losses and outlay increases associated with certain refundable tax credits; that change also has no effect on the budget totals for each year."

Still, if you are likely to be on the receiving end of one of these programs, the distinction is probably not so arbitrary. From this end-user perspective, there is an important economic distinction between approaches taken in the competing plans. So then, which approach to "tax cuts" is better? At this point, I will send you to the aforementioned pervasive blogland commentary. You will find no shortage of opinions.

By David Altig, senior vice president and research director at the Atlanta Fed

• February 5, 2009 in
  • Federal Debt and Deficits
  • Fiscal Policy
  • Taxes
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