In the Nation's Interest

Taxes: House Rules and the State of the Union

Two recent developments have put tax policy in the spotlight in Washington – although there is no indication that the show really will go on.

First, the House of Representatives has changed its rules to require, under certain circumstances, that the budget scoring of pieces of “major legislation…incorporate the budgetary effects of changes in economic output, employment, capital stock, and other macroeconomic variables” – AKA “dynamic scoring.”  “Major legislation” here means a budgetary effect (before dynamic scoring) of 0.25 percent of the GDP, or any bill so designated by the Budget Committee Chairman.

And second, the President, in his State of the Union address last night, put forward an agenda to cut taxes for middle-income taxpayers while raising them for upper-income taxpayers – almost exclusively, the “one percent.”

Thus, the House and the White House seem to be on a collision course – and of course, with the President’s veto, his building truly is the immovable object.  Prospects are for little net movement, but plenty of sparks could fly in the process of repeated collisions over the next two years.

Let’s think about the House rule first.

The usual simplified interpretation of the “scoring” of legislation in Congress by the Congressional Budget Office (CBO, for spending bills) and the Joint Committee on Internal Revenue Taxation (JCT, for tax bills) is that they assume that individual and business behavior does not change, regardless of the content of the legislation.  That actually is not precisely true.  As just one example and focusing on tax issues for the moment, the JCT in the past estimated that liberalizations of individual retirement accounts (IRAs) would result in much more saving in IRAs, and less in fully taxable accounts.  (The same kinds of behavioral estimates are made for spending bills.)  What the JCT and the CBO do not do is reflect effects of legislation in changing the basic economic assumptions – GDP, inflation, employment, interest rates – on which the budget itself is based.

(Incidentally, because the CBO does not “score” tax bills – only the JCT does – the common gossip about the CBO and its Director being a roadblock to dynamic scoring of tax cuts is way off base.  Don’t expect that gossip to end, though – especially as the four-year term of the current CBO Director comes to its end.)

There are reasons why budget scoring stops short of assuming changes in these bedrock economic parameters.  For one thing, it is a big economy out there.  It takes a lot to move the entire GDP by much, as one example; and U.S. interest rates are set in a global market, for another.  Optimistic legislators sometimes say that their proposals will increase work effort, but many Americans are on an institutional 40-hour week, and cannot work more unless their employers request overtime from a significant segment of the entire firm, or else those workers take second jobs.  Work effort by second spouses was on the rise for decades, but has topped out for some years, suggesting that family obligations have reached a hard minimum for the population as a whole.  And so on.  Mere federal legislation often can have only limited impact on such institutional realities.

A second factor is that the entire economy is under a significant measure of control by the Federal Reserve.  If the Fed does not believe that some tax cut can expand the economy and that it therefore will cause inflation, the Federal Open Market Committee will constrain the money supply to forestall the inflation – and in the process will obviate any chance that the legislation can realize its intended effect.

But perhaps the greatest reason for sticking with old-fashioned static scoring is prudence.  Debt is forever.  Once you pile it up, you must service it ever after (unless you pay it off – which doesn’t happen very often in Washington, although I was pleased to be involved in the only such instance in recent decades).  Using “static” scoring doesn’t prevent cutting tax rates; it just puts on more pressure to offset the tax cuts with spending cuts.  If you do so, the chances of favorable economic outcomes are much greater; and when the revenue rolls in, you have plenty of pleasant options for using the extra cash.  (Sophisticated economic analysis makes clear that if even the most effective incentive-creating tax cuts are not paid for, the negative impact of the deficits exceeds the positive effect of the tax cuts, and the net effect is an economic loser.)

But let’s review the track record.  There are several episodes of (admittedly uncontrolled) experiments with tax rate cutting (and increasing) that we should consider.

Substantial tax rate cuts were enacted in 1981.  The folk wisdom is that “we cut tax rates, and revenue went up.”  Well, not really.  At the time of the proposal of the 1981 economic program, the last hard revenue number on the scoreboard was for fiscal year 1980, then estimated at $520.0 billion.  Those 1981 budget program documents estimated revenue for 1984 of $772.1 billion, or 48.5 percent more (with outlays of $771.6 billion, yielding a budget surplus of $0.5 billion).  What actually hit the cash drawer was revenue of $666.4 billion, $105.7 billion or 13.7 percent less than had been projected (with outlays of $851.8 billion, for a $207.8 billion deficit).

According to current figures, revenues were $517.1 billion for 1980; $599.3 billion for 1981; $617.8 billion for 1982; and $600.6 billion for 1983.  Thus, revenues fell between 1982 and 1983, to a level barely (0.2 percent) above the level of 1981.

And all of these numbers are in nominal dollars.  This was in a period of very rapid inflation.  In real dollars, revenues in 1984 were 1.5 percent below what they had been in 1980.

There was another round of tax rate cuts in 2001, again heralded by advocates of dynamic scoring.  In fiscal year 2000, just before the tax cuts, revenues were $2.025 trillion.  In the succeeding years they plunged to $1.991 trillion in 2001; $1.853 trillion in 2002; and $1.782 trillion in 2003, a drop of 12.0 percent in three years.  Revenues regained their 2000 level only in 2005.

In 1993, tax rates were increased.  There were predictions of doom.  However, revenues soared, and by 1998 they were 57.8 percent above their 1992 level, and the budget was balanced for the first time in 29 years.

Tax rates should no more be raised without limit than they should be cut without limit.  Every episode is unique.  Pointing out that unique circumstances in 1981, or 1993, or 2001 helped to determine each particular outcome is merely to say that such outside forces are numerous and powerful enough to overrule changes in tax policy.  That is why budget forecasting is perilous in the best of times.  But using potentially optimistic assumptions to justify tax cuts risks adverse and irreversible consequences – because added debt is almost certainly irreversible.

The need here is prudence.  Pay for tax cuts and spending increases, and you will be much less likely to regret it later.

But meanwhile, as the House changes its rules to encourage dynamic scoring, the President proposes changes in tax law contrary to that spirit.  It is a further indication of the extreme partisan divide in which we find ourselves trapped.  Some might have thought that the new House dynamic scoring rule was a thumb in the eye of the President.  Others might discount the significance of the rule, and say that the President’s State of the Union tax proposals put injury on top of mere insult.  But it doesn’t really matter who hit whom first; all that counts is that we now have a full-scale brawl under way everywhere from the Library of Congress to the White House china room.

We don’t yet have the fine print on the President’ proposals – that will come with the Budget – but the rhetorical fact sheet includes (1) an increase in the tax rates on capital gains and dividends for couples with incomes over $500,000; (2) capital gains taxation of as-yet-untaxed accrued gains on inherited assets (what has been called “carryover of basis”); (3) a seven-basis-point fee on the liabilities of financial institutions with assets over $50 billion; and (4) tax cuts for child-care expenses, second earners in families, and others that would spend more than half of the proceeds of the tax increases enumerated above.

Before I focus on the two capital gains tax items on this list, let me talk for a moment about the overall configuration of the President’s proposal in budget terms.  Until we see the entire budget two weeks from now, we won’t know the whole fiscal picture.  But it is troubling to see so much emphasis on the uses of what little money the President proposes to raise.  The budget has barely escaped the zone where the deficit is so large that the debt is growing faster than the economy; and even with today’s budget outlook – much rosier than we saw two or three years ago – a return to spiraling deficits and debt is just a matter of time.  And now the President proposes to burn up scarce revenue-raising policy opportunities and spend most of the proceeds.  It is like an obese person, overjoyed at for the first time seeing his weight decline by two pounds, therefore rewarding himself with an ice cream sundae.  We are far from out of the woods, and the debt remains enormous.  Our situation calls for caution, not celebration.

Now looking at the individual policies, it is worth noting that “carryover basis,” for all its substantive charms – because of random accidents of longevity and mortality, some accrued capital gains are realized and taxed, and others are not – has a worse than checkered history.

Carryover basis was enacted into law in 1976 with an effective date of 1977.  However, it was repealed before it affected a single taxpayer.  Concerns about it were numerous.  (I will focus on the 1976 episode, when the provision was enacted in isolation.  But carryover basis also was enacted as a palliative to accompany the proposed repeal of the estate tax effective in 2010, and there was much relief in the tax preparation and administration community when that repeal was voided – because it forestalled the return of carryover basis.)

How would carryover basis work?  Suppose that Grandpop bought a share of stock for $2 with his first paycheck from his first job at age 20, and then upon expiring at age 90 left it to his then 68-year-old son, Junior, at a value of $100.  Under current law, Junior could sell the stock the next day for $100, having acquired (that is, inherited) it the day before at that value, with a taxable capital gain of zero (the $100 sale price minus Junior’s $100 acquisition price) and pay no tax.  Under the President’s proposal, the taxable capital gain would be $98 (the $100 sale price minus Grandpop’s $2 acquisition price – Grandpop’s basis would be “carried over”) – assuming that all of the other conditions in the President’s proposal, including a minimum level of total income and a minimum amount of total capital gain, were met.

Why was carryover basis stillborn that first time?  One frequently heard argument was that it could be impossible for Junior to know precisely what Grandpop paid for the stock – two years before Junior was born – if Grandpop did not leave clear records.

A second argument is that the first argument would be far more powerful if the asset were not a simple share of stock, but rather a family-owned business.  Untangling basis of decades ago could be very difficult, even understanding that businesses are supposed to keep such records, because basis might be immaterial to the tax liability of a going concern and only rear its ugly head as an issue at the worst possible moment, that is, upon the unexpected death of the founder – the only person who might know where the relevant records were figuratively buried.

And then practical issues could intervene.  Suppose that Junior was the oldest of 10 children, and the only one with a desire to run the business.  His siblings collectively want 90 percent of the value – in cash, right away – and Junior is required to pay perhaps 28 percent in tax.  Sure, the other siblings can share that carryover-basis capital gains tax liability, too.  But suppose that the business has insufficient liquid assets to pay the tax and maintain the business itself.  It could be messy.  This might be a stronger argument against large families than it is against carryover basis.  All of these problems can be finessed at least to some extent with borrowing and understanding implementation.  So, for example, the 1976 law included a “fresh start” provision that allowed all heirs a 1976 date as of which to establish basis.  There can be low-interest installment periods to pay tax due.  The President’s proposal apparently delays tax until family businesses actually are sold, rather than upon inheritance itself.  But there is a new taxpayer circumstance to confound every proposed remedy, and these are the kinds of problems that make a proposal very hard to sell in the legislative process.

And then there is one more potential layer of complexity.  The President’s carryover basis proposal has been described in the popular press as though it were an estate tax issue.  It really isn’t.  The tax that would be newly due is an additional income tax, not an estate tax.  However, Grandpop’s business could be subject to the estate tax in addition to the income tax.  The last time we slid down this black hole, taxpayers complained that the combination – what would now be a 40 percent estate tax and a 28 percent capital gains tax – even if the base for the latter were adjusted for the former, would be excessive.  It would seem even more onerous if taken in one blow – and on top of that, on the occasion of a death.

Let me postpone a couple of conclusions about carryover basis until I discuss also the President’s proposed increases on the maximum tax rates on capital gains and dividends.

I have an opinion on this one, as does everyone, and no other individual may agree.  On a purely abstract basis, I have a hard time with a lower tax rate for capital gains than for labor.  I do not understand why one individual who lives on a portfolio of inherited wealth should pay less income tax than another who works for the same income.  I do not understand why the incentive to turn over a portfolio is more important to economic growth than the incentive to work.  I do not understand why one person who runs a business that is salable should pay less tax than another who earns the same income running a business that cannot be sold.  And I do not understand why an entrepreneur who believes that he or she has a killer idea will work any less if after taxes the fabulous return to that idea will be just a little less fabulous.

But all of that is arguable.  I do believe that the President’s handling of this proposal is counterproductive in a much bigger sense.  A wide swath of the business and policy communities believes that fundamental tax reform is vital.  The last time we managed that trick, in 1986, the stickiest wicket in the process was capital gains.  The policy change that made both the politics and the numbers work was taxation of capital gains at ordinary rates – very much reduced ordinary rates.

If the President is willing to take on the capital gains issue, he should have – in my view – offered it as one part of a comprehensive reform in the manner of 1986, including repeal of most tax preferences and reductions in tax rates – the corporate rate along with the top-bracket individual rate.  In fact, the President should have offered to combine that tax reform – raising more revenue, to reduce the projected long-term deficits and debt – with a true market-based reform of the healthcare system, including Medicare.  At that point he would have had the major ingredients of a budgetary “grand bargain” to end our worries about the unsustainability of the public finances.  That would free the private sector from the anxiety that many believe has inhibited long-term planning and investment for far too long.  It also would give the President a chance at a lasting legacy, and truly bridging the partisan divide that makes Washington dysfunctional.

Falling so far short of that comprehensive, bipartisan proposal makes the President’s tax program look like a mere partisan tactic.  Instead of trying to solve a problem, the President seems to aggravate it for political advantage.  Carryover basis will not happen, especially not in this Congress.  Increasing the tax rate on capital gains was acceptable to Ronald Reagan in the context of true tax reform; it will not be acceptable to this Congress as a rifle-shot revenue raiser.  So the President’s tax proposals, despite their merit in some respects, seem only to provide budget-scoring cover for equally unlikely spending and tax-cutting programs that appeal only to the same already-committed political base.

So today I feel like Mikey in the old breakfast cereal commercials: I don’t like anything.  I fear that we are going nowhere, spinning our wheels – and in the process, splattering everyone with mud.  Personally, I was pleased to hear the President’s rhetoric about one United States of America.  I just hope that we get there some day.