Bill Nelson, U.S. Senator from Florida: Grants

Edward D. Kleinbard

Testimony before the Committee on Finance
Subcommittee on Fiscal Responsibility and Economic Growth

September 13, 2011 (2 p.m.)

Chairman Nelson, Ranking Member Crapo, and distinguished members, thank you for inviting me to testify at this hearing. My name is Edward Kleinbard and I am a Professor of Law at the University of Southern California’s Gould School of Law. From 2007-2009 I was privileged to serve as Chief of Staff of the Congress’s Joint Committee on Taxation.

I. SUMMARY OF TESTIMONY.

There is a broad bipartisan consensus that the long-term fiscal policies of the United States are unsustainable.
In grappling with the enormity of our adverse budget deficit trends, it is extremely helpful to divide our economic and fiscal problems into three time buckets: the short-term (perhaps the next two years), the medium-term (Years 2-10) and the long-term (the next several decades).
The short-term crisis is about jobs; tax reform can do little to help here.
The long-term problem is entitlements spending, particularly spending on healthcare. The United States today spends much more on healthcare per capita than does any other developed economy in the world. If the United States were to expend per capita what Norway (the second place country) does on healthcare, our aggregate healthcare spending (public and private) would immediately decline by some $800 billion/year. Our per capita government share of our total healthcare spending is the second highest in the world.
While long-term entitlement spending reform is critical, we must “boil the frog slowly,” to borrow a phrase from Chairman Baucus. Both our citizens’ expectations and our healthcare delivery institutions are built around current policies. Change must follow a predictable path that starts in the near future, phases in slowly, and comes to rest with new institutions that will serve the needs of Americans for decades to come. The requirement that we boil the frog slowly in turn has important implications for tax revenues.
Tax reform and tax policy are most relevant to the medium-term horizon. This period must serve as the bridge from where we are to the more sustainable package of government spending and taxing that we need to reach.
Current levels of nondefense discretionary spending are modest by world norms. This “spending” includes some items, like infrastructure, that are bona fide investments with long-term economic benefits.
Defense discretionary spending, by contrast, is the other great outlier in U.S. government spending policies. By one estimate, the United States spends as much on its military as do the next 14 countries combined – 42 percent of the entire world’s military expenditures.
This implies that, unless we completely rethink our defense policies, spending cuts cannot by themselves fund all of our deficit reduction requirements in the medium term. Whatever the long-term world we transition to, we will need to finance the costs of getting there, and that in turns means higher tax revenues than those we currently collect.
The United States is an extraordinarily low-taxed country by world norms – the fourth lowest in the OECD. And even by our own standards we are collecting historically low levels of tax – below 15 percent of GDP for 2009-2011. This level of revenues cannot be reconciled with our outsized spending on healthcare and defense.
By all measures, the United States can afford to increase the total taxes it collects as a fraction of GDP. Just a decade ago, the country ran budget surpluses and enjoyed both a robust economy and job growth, while tax collections exceeded 20 percent of GDP.
CBO budget projections show us running deficits (albeit relatively small ones) 10 years from now, even with the assumptions that (i) we enjoy uninterrupted growth over those 10 years and (ii) the “Bush tax cuts” (more neutrally, the “2001-03 temporary individual tax discounts”) will all expire at the end of 2012. By contrast, extending these tax discounts indefinitely will add some $4.6 trillion to our cumulative deficit.
We therefore have no practical choice but to raise the level of tax collections in the medium term to the range of 20 percent of GDP, as implied by the CBO baseline, to finance our gradual transition to more sustainable long-term entitlement policies. Discretionary spending cuts also will be useful, but cannot handle the entire burden if we are to maintain even minimum levels of developed country government services.
The CBO baseline effectively must also serve as the tax reform base case. We should assume the lapse of the 2001-03 temporary tax discounts, and ask, how can we raise about the same amount of revenue, or maybe a little more, but in a smarter way?
This in turn means that we have to abandon our nostalgia for the Tax Reform Act of 1986. That tax reform effort was revenue neutral, because it could afford to be. (It also was preceded and followed by major tax increases.) The fact that we have to raise revenue today means that this tax reform effort will look different, not that it is impossible. We should not hold ourselves prisoners to tax nostalgia.
Specifically, I propose the following as the tax reform “Base Case” – the stalking horse that we can seek to improve, while maintaining the same level of revenues, or a little more:

- In general, allow the 2001-03 individual tax discounts to lapse at the end of 2012.

- Restore the estate and gift taxes to their 2009 levels, preferably as of January 1, 2012. (This actually has a roughly $260 billion cost relative to the CBO baseline.)

- Maintain current policy’s prescription that corporate dividends should be taxed at the same rates as long-term capital gain. (This proposal loses revenue relative to the CBO baseline but has strong policy justification.)

- Add a new top marginal tax rate of, say, 42 -44 percent for incomes above $2 million. (The idea would be to find the income level that would raise revenues sufficient to fund the dividend tax reduction.)
We can do better than this Base Case. The straightforward goals of an incremental reform of the personal income tax (which includes the 1986 Tax Reform Act) should be (1) to raise the targeted level of revenues with (2) the desired distributional consequences while (3) keeping marginal tax rates – the tax imposed on your last dollar of income – as low as possible. Raising average tax rates without raising marginal rates (beyond the expiration of the 2001-03 tax discounts) requires broadening the tax base. Unlike in1986, when the tax system overflowed with unintended tax shelters that could be cleaned up and traded off against lower rates, this means directly tackling some of the deliberate Congressional subsidy programs baked into the tax code, which is to say, tax expenditures.
Of all current law’s tax expenditures, the most important to address in tax reform are the personal itemized deductions, such as the deductions for home mortgage interest, charitable contributions and state and local taxes. They are extraordinarily costly subsidies – about $250 billion/year in forgone tax revenues. They are inefficient, in that they lead to major misallocations of economic resources, particularly with respect to housing. They are poorly targeted, in that the government subsidies go to individuals who would have behaved the same without the subsidies. And they are unfair, in that they are “upside down” subsidies – they subsidize high-income Americans more than low-income ones.
Tax Policy Center has estimated that eliminating the subsidies for personal itemized deductions would increase tax revenues in the neighborhood of 1.5 percent of GDP, over and above the lapse of the 2001-03 temporary tax discounts. This is an enormous revenue pickup; it could be used for deficit reduction or to mitigate the tax rates implicit in the Base Case. The elimination of these subsidies also would simplify the tax code greatly and increase its progressivity. Moreover, their elimination would large remove the need for an AMT “patch,” because it is these deductions that drive most taxpayers into the AMT in the first place.
I fully recognize that the home mortgage interest deduction and other personal itemized deductions invariably are described as “sacred cows.” But they are sacred cows that we can no longer afford to maintain. Either we eliminate these sacred cows, or we allow them to stampede over us.
The elimination of personal itemized deductions must be phased in. For example, the deductions could be removed ratably over the 5-year period 2013-17, ideally by turning them into tax credits where the credit amount declines to zero over that time.
Tax reform also should address the corporate income tax. Its 35 percent rate is much too high by current world norms. At the same time, U.S. multinationals have become extremely adept at gaming the current U.S. system, and those of other high-tax countries around the world, through the production of what I call “stateless income” – income that is taxed essentially nowhere. The U.S. corporate tax base is being systematically eroded through these stateless income tax planning strategies.
A revenue-neutral tax reform package should be fashioned along the following lines:

- Eliminate business tax expenditures, all of which represent Congressional meddling in matters best left to the markets.

- Reduce the corporate tax rate to something in the range of 25-27 percent.

- Tax multinationals on their worldwide income.
The resulting corporate tax system would represent a huge competitive boost for American domestic firms, would attract inward investment, and would provide a fair tax environment for U.S.-based multinationals.