The fiscal agreement has very little reform of the basic tax code. Nothing was done about the many undesirable special exemptions called “corporate welfare”. These include, among many, employer deductibility of contributions to health care coverage of its employees; subsides to the oil industry, and subsidies also to alternative sources of energy, such as solar.
Middle income and rich families mainly take advantage of the deduction for interest paid on home mortgages that cost about $90 billion in federal tax revenue in 2012. Although many attempts have been made to provide economic and social justifications for encouraging home ownership, the arguments and evidence have been weak.
Charitable contributions are the other major itemized deduction. That deduction has greater justification because it helps decentralize charitable giving away from the government. Nevertheless, with such large fiscal deficits, that deduction should also be restricted. The fiscal agreement did limit total deductions by couples earning more than $300,000, but it did not distinguish among deductions, and the limit should apply to all personal income tax filers.
The optimal income tax structure-if income rather than consumption remains the basis of taxation- would have a rather flat percentage tax on a very broad definition of income that eliminates the great majority of deductions, and incorporates dividends and capital gains into reported income. The extra tax revenue from increasing marginal tax rates as incomes increase is not worth the social cost in the form of tax avoidance measures and tax evasion. An element of progressivity should be introduced through providing an exemption from income taxes for persons with incomes below a reasonable poverty line.
The tax changes in the fiscal agreement combine higher taxes on the “rich”, including limits on their itemized deductions, with higher taxes on capital gains, dividends, and estates. As Posner indicates, all the changes combined are estimated to bring in only about $600 billion in additional tax revenue over ten years. This increase is a drop in the bucket when federal spending is almost $4 trillion per year. Even the $600 billion figure is a large overestimate of what will be generated in added revenue because it assumes no changes in behavior on the part of businesses and individuals affected by higher tax rates. Corporations are likely to adjust to the higher rates by reducing dividends, taking more of their incomes abroad, and making other changes that reduce their tax burdens. Individuals facing higher marginal tax rates will increase their itemized deductions when this helps reduce their tax obligations, shift their effort and energy from work to untaxed or lower taxed activities, and take increasing advantage over time of loopholes discovered by tax lawyers and accountants.
Virtually nothing was done in the compromise on the spending side-that supposedly is to be taken up in a couple of months. As Posner indicates, they did continue to extend unemployment benefits to a maximum of 99 weeks. This does not involve a lot of spending, but the extension makes no sense when employment is growing each month, and when almost 4 million jobs are going unfilled. Paying compensation for almost two years of unemployment has contributed to the large number of workers who have been unemployed for over a year.
Federal spending has increased from about 18% of GDP in 2000 to over 24% at present. A good part of the increase went to spending on social security, Medicare, and Medicaid, but many other categories of spending increased as fast or even faster than these entitlements. Adjusted for inflation, between 2000 and 2011 Medicare grew by over 100% and Medicaid by 83%, while income security programs grew by over 130%, and defense grew by 86%. Spending on highways and mass transit, energy, and various other programs also grew by a lot. So-called discretionary spending as a whole that includes various domestic programs and defense grew by over 70%. So even if we exclude entitlements, there are many places to cut federal spending to help move the country toward the spending situation at the end of the Clinton presidency. There was no widespread belief then that the federal government was on a starvation diet.
Of course, it is also crucial to try to rein in the growth of Medicare and Medicaid since they are so important. Medicaid and related government health programs are supposed to be for children and parents in poor families, but the definition of “poor” has expanded beyond a reasonable level, and should be scaled back.
A mandate for health care coverage can be justified perhaps as an effort to control free riding, but such a mandate should require only coverage against health catastrophes, and it should only subsidize the premiums of poor families. The Affordable Care Act’s mandate, by contrast, requires extensive coverage, and subsidizes premiums for individuals earning up to 4 times the poverty level.
Medicare can also be reformed in several ways (see the more extensive discussion of Medicare reform in my blog post on 4/10/11). One important change would be to increase the fraction of out of pocket spending by the non-poor elderly receiving medical treatment under Medicare. This fraction is much below that in Switzerland, a country that generally provides excellent medical care. Obamacare does little to increase out of pocket expenses, and instead adds a series of quotas on care and price controls on payments for care.
The over age 65 population is much healthier than when Medicare started over half a century ago. This suggests that extending Medicare eligibility to age 67 or 68 from age 65 would not impose major hardships on persons of these ages, and it would encourage them to make greater use of private insurance. Of course, to allow older persons to prepare for this change in eligibility age, it should not go into effect for say 5 years, and could be phased in after that.
I am not optimistic that the reforms discussed in this piece or other reforms will be enacted in the near future. The President and both sides in Congress have inflexible positions. Nor has the media been of much help in arousing the public since it has concentrated on how to raise taxes on the so-called rich rather than on tax and spending reforms. Still, in trying to change the discussion, it is important to show how to reform the tax code, and the many reasonable ways to cut federal spending.