Saturday, February 20, 2010

Rudolph Penner points a steep path toward budget salvation: tax reform and health care reform

As Ezra Klein points out, the long-range budget options laid out in a detailed analysis of the nation's fiscal future under the leadership of the Urban Institute's Rudolph Penner, who was director of the CBO under Reagan, are sobering.  The report, Choosing Our Nation's Fiscal Future, was prepared by a committee organized by the National Research Council and the National Academy of Public Administration.

The report lays out four menu options designed to cap the national debt at 60% of GDP by 2020, ranging from freezing taxation at current levels and cutting spending accordingly, to maintaining benefits at current levels and raising taxes accordingly. The consequences of freezing tax rates at current levels are scary. That would require a Paul Ryan-like budget converting Medicare and Medicaid to a system of vouchers of rapidly diminishing value. Maintaining benefits at current levels in its turn generates daunting tax requirements: top marginal tax rates of 50%, a VAT rising to 8%, payroll tax of 15% with a surtax on top.  Imagine Democrats trying to impose those hikes over the decades.

The report suggests that the challenge would be more manageable, however, if structural tax reform is coupled with effective health care cost control. Tax reform would entail elimination of myriad deductions and exemptions to which we've grown addicted. Here's how Penner presented this kind of tax reform to the Atlantic's Derek Thompson:
The other approach was to radically reform the tax system, getting rid of all tax expenditures [such as tax exclusions for employer health care and pension contributions ... see more here] like capping the employer health exclusion. It's really, really remarkable how much money you get back from tax expenditures, especially from capping the health exclusion. We could actually lower rates over time with that solution to the situation, while keeping the overall tax burden the same.
The elimination of "tax expenditures," as described by Penner in his Senate testimony, would be coupled with just a two-tier income tax - 10% starting at an income of $22,475, and 25% starting at $44,950. Fiscal Future claims that  "[t]he economic waste ("deadweight loss") to economic directly related to marginal tax rates. As marginal rates rise, these efficiency losses rise more than proportionally, roughly as the square of marginal tax rates."  The paper also asserts that various targeted tax incentives (tax expenditures) such as retirement savings or mortgage interest deductions distort economic behavior and so allocate resources less efficiently.

Tax expenditures have long been beloved by both parties -- by Republicans, because they are by definition tax cuts, and by Democrats, because in our right-leaning polity they're often the most politically palatable way to provide breaks to lower and middle class voters; Republicans find them difficult to oppose. Hence the number of targeted tax breaks for individuals has more than doubled since 1974.

I imagine that many economists would dispute the claim that all targeted tax breaks create non-beneficial incentives and economic waste.  A reasonable takeaway from this paper, however, would seem to be that eliminating or limiting some major deductions would yield major revenue and greatly reduce the extent of needed across-the-board tax hikes such as a VAT or increased payroll tax. (There seems to be near consensus, for example, that the current form of the mortgage exemption skews incentives.)  Fiscal Future presents along with each of its four future tax scenarios an equivalent alternative under a radically simplified tax structure that eliminates all "tax expenditures" except the child tax credit and the earned income tax credit. The paper acknowledges, though, that "[t]he current tax structure...and the simplified tax structure discussed here represent two 'bookends,' with many possibilities in between."  One can imagine the mammoth political battles that may come regarding which tax carve-outs to eliminate or radically reduce.

The Senate health bill's excise tax on expensive plans provides a foretaste of such battles. Penner's perspective on the health care tax exemption highlights why Obama is hell-bent on preserving the excise tax in the Senate bill, in the face of furious opposition from unions and House Democrats. The excise tax indirectly caps the health insurance deduction for employers. Proponents expect it both to provide significant revenue and to restrain health care cost growth.  It's a modest step toward eliminating the health care tax exemption for employers, as the Wyden-Bennett alternative HCR bill -- which at present remains a Utopian bipartisan dream -- would do.

The Fiscal Future projections are far less daunting if you imagine effective health care reform of the sort that Atul Gawande argues the pending bill has the potential to spark through its myriad pilot programs -- that is, a revolution in efficient care delivery analogous to the revolution in agricultural production spurred in large part by government research and demonstration programs in the early 20th century.  It seems like a long time ago that Peter Orzag was intoning "health care reform is entitlement reform." But that remains the central domestic policy fact of our time.

What is truly scary, as James Fallows highlighted in his detailed assessment of America's future prospects, is that it's very difficult to imagine Congress and the executive branch mustering the political will  to enact rational structural change.  You just can't do it when one of two major parties proudly defines itself as the Party of No, insists on cutting taxes further and claims it can balance the budget strictly by means of draconian spending cuts it will never make -- even as it demagogues the rational controls on Medicare spending in the health care reform bill.  Here is Penner's comment on the current political climate:
I've been watching the political scene for 40 years now and it's never been worse. We could talk for a long time about the reasons for that. Whatever the cause, at this moment we're marching hellbent for fiscal crisis.
And on tax cuts: "The thought of actually cutting the tax burden is really quite implausible."

Health care reform is the fulcrum -- the symbolic and substantive measure of whether Congress and the executive branch are capable of constructively engaging our long-term challenges. If it passes, I suspect that the current resurgence of the fortunes of the Republican party as now constituted will prove to be a dead cat bounce -- a bounce that may carry them through this year's election but not beyond. Republican poll numbers will fall, gradually or swiftly, with the unemployment rate, which is itself 90% of the Democrats' current political problem. Republicans will eventually be driven to a Clintonian move back toward the center; one can at least dream -- with, say, David Frum -- of a chastened party capable of governing when it once again takes its turn.  If Democrats can't muster the nerve to pass the bill, their longer-term credibility with be on a par with the Republicans'; their nerve and their ability to face down death panel demagoguery will be shot. We may then be in for gridlock, demagoguery, feckless legislation and fiscal crisis as far as the eye can see.

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