Why Tyler Cowen is Wrong About a VAT
Tyler Cowen from Marginal Revolution wrote a much-discussed piece this week ("Is There a Case for a VAT?") about a value-added tax (VAT). I would read that first before continuing to read this, which should be considered ATR's rebuttal.
- If there's a fiscal boogeyman, it's not taxes. Federal taxes have averaged about 18 percent of GDP since 1960. According to the Obama budget, they will equal 19.6 percent in the tenth year of his budget policy. In other words, taxes are not too low. A case can be made that taxes under the Obama budget (or current law) are already too high. Even under a "full extension" tax plan (Bush tax cuts, AMT patch indexed, extenders) taxes only revert back to their historical average of 18 percent of GDP
- The fiscal boogeyman is spending. Spending as a percent of GDP has averaged about 21 percent of GDP since 1960, creating a structural deficit average of 3 percent of GDP (21 minus 18). Yet, the Obama budget calls for a year-10 spending level of 23.7 percent of GDP. Spending is the source of the long-term budget imbalance, not taxes. If spending was to end up at its historical levels, we'd be pretty close to a balanced budget by the end of this decade
- Cutting spending as a percent of the economy is very realistic. Cowen points out that it is too politically-difficult to cut spending. I agree. Congress isn't set up to do that. However, the 1992-2000 period shows us how limiting spending to less than the rate of nominal GDP growth can have profoundly free-market results. When the first President Bush left office, federal spending was 22.1 percent of GDP. Republicans stymied the Clinton agenda, took over Congress, and stopped the big-spending Clinton agenda in its tracks (Clinton's presence avoided the unchecked spending excesses of the Republican-only era of this decade). Spending fell all the way to 18.2 percent of GDP in 2000 and 2001. This was a monumental achievement for less government. How did it happen? Simple--the government grew at a slightly slower rate than the economy grew. We can do that again, probably with a GOP House and a Democrat President. This is not ancient history. It's the 1990s. This is the model to shrink Washington. Boil the lobster slowly.
- There is no "credible bipartisan deal" for a VAT and spending restraint. This is a fantasy of politically-disconnected policy wonks and the mainstream media. Every time tax increases have been on the table with spending restraint (TEFRA 1982, the 1990 "Read My Lips" Andrews Air Force Base deal, etc.) the spending cuts didn't materialize. The tax hikes sure did. This "deal" would be no different. We'd end up with phony spending cuts and a VAT. And, as Dan Mitchell from Cato has amply pointed out, a VAT killed Europe's economy in the second half of the last century.
So, there's our rebuttal. Higher taxes are not needed (in fact, scheduled tax hikes need to be scrapped, and pro-growth tax cuts put in place to make sure we get enough GDP growth). On the spending side, don't spend the rest of the stimulus bill. Don't re-spend TARP. Back out some of the waste from the Bush-Obama-Pelosi-Reid spending spree. But mostly rely on the 1990s divided government strategy. Grow the government, but less than you grow the economy. We can all take a deep breath and move on with our lives.
UPDATE: Tyler Cowen emailed me to clarify that his first preference is spending cuts, and he does not endorse a VAT. This is made abundantly-clear in his post, which should be read prior to reading this rebuttal.
Quick Analysis of Tax Provisions in<br> So-Called "Jobs" Bill
Language (though not yet a score) is out for the Senate "jobs bill" which will be considered after the President's Day recess. The cheesy DC acronym is the "HIRE Act" (which stands for "Hiring Incentives to Restore Employment"). The major tax provisions are:
- Forgiving the employer half of Social Security taxes for the rest of the year for any employee hired from the unemployment line
- Giving employers a $1000 tax credit for retaining a worker the whole year, and for not cutting his wages more than 20% in the second half of the year
- One-year extensions of energy, personal, and business extenders (including small business expensing)
- Disclosure of bank account information from foreign countries--a probable precursor to seizing those funds in tax disputes
- Codification of the "economic substance doctrine" which empowers the IRS to disallow a legal tax deduction or other mechanism if the IRS deems the transaction to lack "economic substance." In other words, even if something is allowed under tax law, it will be disallowed if the IRS doesn't think it "smells right." This gives way too much power to the IRS to decide what passes their smell test
All told, this is likely to be a net tax cut (the JCT and CBO scoring won't be out until next week, in all liklihood).
However, this latest tax bill continues a troubling trend: "paying for" present-law tax relief (for one more year) by permanently-enacting new tax hikes. If that trend continues, there will be a new series of tax hikes every year just to "pay for" what we already have in the way of tax relief.
Obama Budget's Tax Hikes on<br> Families Making Less Than $250,000
On the day that President Obama announced his "agnosticism" about raising taxes on middle-income families, it seems prudent to go through his latest budget with a fine-toothed comb. After all, there are probably more than a few such tax hikes in there. Note that this is on top of the middle-class tax hikes he supported in his first year. It should also be noted that these tax hikes are limited to the ones directly imposed on working families. All of the tax hikes (e.g., the bank tax) will eventually be passed along to everyone in the form of higher prices and lower wages indirectly.
I'll proceed line by line through Summary Table S-8. The sub-section is entitled "other revenue changes and loophole closers."
- Make unemployment payroll surtax permanent. Under current rules, there is a 0.2% surtax on top of the 6 percent unemployment tax rate. This surtax is always about to expire, and Congress always moves the expiration date forward. President Obama chooses to make this "temporary" surtax permanent. It's important to note that the federal unemployment tax (FUTA) only applies to the first $7000 of wages
- Information reporting. The budget increases information reporting on 1099-MISC forms for small business owners and landlords. This would increase an already-burdensome tax compliance deadweight cost. There is no exception noted for very small businesses
- Independent contractor rules. This change would make it harder for someone doing services with a business to be classified as an independent contractor (who cannot be unionized and merely receives a 1099-MISC), and would instead categorize millions of people as employees (who can be unionized and for whom quarterly filing and withholding must be done). There is no carve-out either for sub-$250,000 contractors or very small business owners dealing with them
- Economic substance doctrine. This would give the IRS the power to determine whether a legal financial transaction was merely to reduce tax liability, or in fact had "economic substance," If the IRS determines that it is non-substantive, the deduction can be denied (even if legal). This is a naked money grab, and there's no carve out for smaller taxpayers at all.
Crisis of Faith:<br> Obama "Agnostic" About <$250k Tax Hikes
You might have seen today that President Obama is now officially "agnostic" about whether a bi-partisan tax increase/deficit commission should raise taxes on families making less than $250,000 per year. A few things here:
- This would directly contravene his campaign promise (repeated again and again throughout the campaign and during his first year in office) to not raise "any form" of taxes on these families, "not one dime." ATR has maintained a full database of this tax promise
- As Jim Pethokoukis of Reuters has pointed out, this could be a subtle signal that Obama is paving the way for a value-added tax (VAT). ATR maintains an Anti-VAT Congressional Caucus
- An agnostic is someone who lacks the conviction of either an atheist, or a believer. It seems pretty clear that President Obama is actually rather zealous in his faith that higher taxes across the board (including for non-affluent households) is the correct public policy goal.
The Hidden Tax Hikes in the Obama Budget
Over the past week, ATR has been breaking open the Obama budget to examine all the new tax hikes (on international income, small business, and more to come). Today, we wanted to take a quick look at the "tax gap" and "tax compliance" tax hikes in the budget.
People often make the mistake of skimming over tax compliance measures, but that would be a big mistake. Over the 10-year budget window, the Obama budget projects that these compliance "reforms" will raise $13.8 billion to close the so-called "tax gap," $7.4 billion to "improve compliance by businesses," $4.4 billion to "strengthen tax administration," $36 million in increased penalties, and $23.7 billion in backdoor death tax hikes. You can view the scores here (Table S-8). Add these together, and you get a $49.4 billion total tax hike. That's more than double the amount raised by taxing carried interest as ordinary income, so this is a lot of money.
There are a couple of dozen individual proposals, so we'll focus on just the most damaging ones for small business owners and those who work for small businesses:
- Corporate Information Reporting ($9.2 billion). Under current law, small business owners and others need to issue "1099-MISC" statements to individuals and partnerships to whom they pay at least $600 for goods and services. This expands that to also include corporations. This could dramatically-increase the number of these forms that are issued, which will increase headaches for small business owners every January.
- Landlord Information Reporting ($3.1 billion). This further expands the above reporting requirement to owners of rental properties. Those to whom rent is paid would need to receive a 1099-MISC.
- Independent Contractor Discrimination ($7.3 billion). This would permit the IRS to more easily re-classify independent contractors (who only need to receive a 1099-MISC in January) as employees (which requires hiring a payroll company, quarterly filing and tax payments, and a W-2 in January). The real reason behind this is to make it easier to unionize people who are currently not employees.
- Economic Substance Doctrine ($4.2 billion). This would give the IRS the power to determine that a transaction used to lower a tax bill "lacks economic substance." This is an arbitrary standard, and would subject every small business decision to the whims of an IRS auditor
The Obama Budget and Small Business
President Obama today is touting all the advantages his budget has for small businesses. In particular, he's talking about using TARP funding (supposedly temporary, to be paid back to taxpayers) for small business lending.
Even if you limit yourself to the tax side of things, though, there are some pro-small business crumbs in the Obama budget: small business expensing is extended, a new jobs credit is created, and small business stock is exempted from capital gains. Good things, all, to one degree or another.
But there is one bad--very bad--tax increase on the small business sector in the Obama budget. Under his plan, the top two income tax rates increase from 33 and 35 percent to 36 and 39.6 percent. We've documented before that two-thirds of small business profits pay taxes in these bracket levels. Small businesses pass their profits through to their owners, who pay income tax on them. To raise taxes on "the rich" is a laser-beam tax hike aimed at small employers.
Small business owners also have to pay the Medicare portion of the self-employment tax at the high margin. Furthermore, they will face a phaseout of their itemized deductions (Pease) and personal exemptions (PEP) under the Obama budget, unlike 2010 law.
What does that mean for the marginal tax rate on small business activity? Assuming a 5 percent state income tax rate, the calculation is the following for a sole proprietor or general partner (S-corporation owners don't have to pay Medicare tax, so it will be slightly smaller for them):
|PEP and Pease||2.34%|
So, the top marginal tax rate on small business income will rise to 49.19 percent by my reckoning, up from about 41 percent today. This is a huge increase in the tax rate on most small business profits. I wonder if President Obama will be sharing this with entrepreneurs today?
Initial Thoughts on the New Obama Budget
A few early thoughts on the FY 2011 Obama budget:
- It's important to keep the 30,000 feet view in mind. The top-line estimate for taxes, spending, and debt over the next decade can be found in Table S-1:
Taxes are scheduled to rise from 14.8 percent of GDP in 2009 to 19.6 percent by 2020 (the historical average is 18 percent).
Spending is scheduled to fall from 24.7 percent of GDP in 2009 to a still-high 23.7 percent of GDP in 2020 (considering the historical average is 21 percent, this is actually a very significant and permanent increase in the size of government). When Bill Clinton left office, for instance, federal spending was 18.2 percent of GDP and falling.
The national debt is scheduled to rise from 53 percent of GDP in 2009 to 77.2 percent of GDP in 2020. As a percentage of the economy, the national debt hasn't been that high since 1950.
- So, taxes are scheduled to be higher than their historical average. Spending is scheduled to be higher than its historical average. If you have a problem with the deficit, it's not because taxes are too low--it's because spending is too high. The culprit is clearly spending, not taxes. The deficit is signaling to policymakers that they are spending far more money than they should be.
- In the terminations and reductions section (page 4), the budget includes some energy tax hikes along with actual spending cuts. Tax increases ARE NOT spending cuts.
- In the coming days, ATR will be breaking out different analyses of the budget, including the international tax hikes, the energy tax hikes, the small business tax hikes, the tax hikes disguised as "compliance," and the tax increases on families making less than $250,000. We'll also be looking at the various spending questions via our Center for Fiscal Accountability.
State of the Union Myth/Fact:<br> Government-Run Healthcare
MYTH: “[My health plan] would give small businesses and uninsured Americans a chance to choose an affordable health care plan in a competitive market.”
FACT: The Obama-Reid-Pelosi plan would actually increase health premium costs for the uninsured. The average individual health insurance premium today is $2985 for singles and $6328 for families. According to the non-partisan Congressional Budget Office, the average premium will increase to $5800 for singles and $15,200 for families under the Obama plan by 2016. This is 10 to 13 percent higher than they would be under current law. Only those individuals earning less than about $40,000 and families earning less than about $85,000 would receive any tax or spending benefits to even partially-offset this increased cost. Those earning more than this get no help whatsoever.
For small businesses (“small group plans”), today’s average premium is $4155 for singles and $10,956 for families. Under the Obama-Reid-Pelosi plan, this increases to $7800 for singles and $19,200 for families by 2016, a 1-2 percent increase over current law. Only about 12 percent of people receiving coverage from their small business employer would benefit from the small business health tax credit.
MYTH: “[My plan] would require every insurance plan to cover preventive care.”
FACT: Under current law, someone can’t wait until they are sick and then sign up for health insurance. That’s called “gaming the system.” Insurance only works if healthy people are paying premiums each month, so that when you get sick or go to the doctor, money is there for you. If healthy people can wait to buy coverage, the entire insurance model falls apart very quickly. Put simply, “guaranteed issue” would be the death of insurance.
MYTH: “Our approach would preserve the right of Americans who have insurance to keep their doctor and their plan.”
FACT: The Obama-Reid-Pelosi plan taxes your current health insurance, if it’s deemed to be a “Cadillac plan.” It also puts in place minimum coverage requirements in order to remain “qualifying,” which probably will alter your plan. It probably will make it impossible to design health insurance plans which are HSA-compatible. Clearly, you simply can’t keep your current plan under this bill.
MYTH: “According to the Congressional Budget Office – the independent organization that both parties have cited as the official scorekeeper for Congress – our approach would bring down the deficit by as much as $1 trillion over the next two decades.”
FACT: According to CBO, these cost estimates only pan out if Congress is willing to cut Medicare provider reimbursements, something everyone knows will never happen. Budget savings based on phony, never-going-to-happen spending cuts are bogus. This creates an unfunded liability in the program.
MYTH: “I know that with all the lobbying and horse-trading, this process left most Americans wondering what's in it for them.”
FACT: When the American people don’t want a massive plan of this size, margins can get a little tight on Capitol Hill. That’s why Obama-Reid-Pelosi had to buy off members with the Louisiana Purchase, the Cornhusker Kickback, the Cadillac Compromise, and untold other backroom, closed-door deals. Back in the campaign, candidate Obama said he would put negotiations on C-SPAN so this could not happen.
MYTH: “There's a reason why many doctors, nurses, and health care experts who know our system best consider this approach a vast improvement over the status quo.”
FACT: One word: money. The American Medical Association, nursing groups, hospitals, and others are receiving billions in taxpayer subsidies under this bill.
MYTH: “If anyone from either party has a better approach that will bring down premiums, bring down the deficit, cover the uninsured, strengthen Medicare for seniors, and stop insurance company abuses, let me know.”
FACT: It’s worth pointing out that even President Obama’s own plan will increase premiums, increase the deficit (at least in the real world) even while raising taxes, cover only some of the uninsured (theoretically), cut Medicare, and drive insurance companies totally out of business. So one might first turn the question back on him.
Can President Obama, Speaker Pelosi, and/or Leader Reid use the Internet? Can their staffs? It appears not, since this is a common refrain easily refuted. The fact is, there are dozens of good ideas and several comprehensive plans which have been proposed. The House Republicans have even aggregated all of them. Their list doesn’t include the DeMint plan, nor does it include the comprehensive “American Roadmap” government reform plan (including healthcare) of Congressman Paul Ryan (R-Wisc.)
State of the Union Myth/Fact:<br> Obama's New Taxes on Your 401(k)
MYTH: “To recover the rest [of TARP], I have proposed a fee on the biggest banks. I know Wall Street isn't keen on this idea, but if these firms can afford to hand out big bonuses again, they can afford a modest fee to pay back the taxpayers who rescued them in their time of need.”
FACT: The President himself pointed out that most of the money from the bailout has been recovered from the banks. This new “bank tax” has nothing to do with TARP—it is being assessed on banks which never accepted TARP funds (or have since paid them back with interest), and is not being assessed on TARP recipients who still owe the taxpayers money (like Government Motors). It’s a money grab.
In fact, this new “bank tax” will be passed along by the banks to ordinary Americans. It will be paid in the form of higher 401(k) fees, higher bank fees, higher mortgage and credit card interest rates, and lower interest rates on savings.
MYTH: “We cut taxes for 95 percent of working families…we haven’t raised income taxes by a single dime on a single person. Not a single dime.”
FACT: It’s mathematically impossible to cut taxes for 95 percent of working families. According to the IRS, fully one-third of all tax returns owed no income tax last year. Nearly 20 percent of returns had neither an income nor a payroll tax liability. These people cannot see their taxes cut any further. Anything given to them is pure spending.
Obama, Pelosi, and Reid may not have raised income taxes last year, but they surely tried to. Last year’s administration budget submission had dozens of tax hikes. The health care legislation they are still pushing has 18 separate tax hikes. All told, ATR has calculated that President Obama proposed or supported $2.1 trillion in tax hikes in 2009. And let’s not forget that he signed into law a $65 billion tax hike on cigarette smokers 16 days into his administration. The median income of a smoker is $36,000.
MYTH: “To encourage these and other businesses to stay within our borders, it's time to finally slash the tax breaks for companies that ship our jobs overseas and give those tax breaks to companies that create jobs in the United States of America.”
FACT: Obama is no doubt referring to his tax hikes from last year’s budget. ATR has compiled a series of one-pagers detailing his $210 billion in proposed tax hikes on American companies who have overseas income. How raising taxes on American companies will incent them to remain in the United States is a mystery. The reason these tax breaks are in place is to avoid double taxation of international corporate income. To take away these tax breaks is to tell an American company that they will potentially have to pay taxes twice on the same income. The best solution is to transition the U.S. tax code toward a territorial system (which most of the developed world has done), but getting rid of these tax breaks without doing that reform is foolish. There’s no reason that an American company with an Irish subsidiary cannot become an Irish company with an American subsidiary. America has a 39 percent “all-in” corporate rate. Ireland’s is 12.5 percent.
MYTH: “[We’re] making it easier to save for retirement by giving every worker access to a retirement account and expanding the tax credit for those who start a nest egg.”
FACT: Candidate Obama campaigned on a “forced IRA” plan for small businesses, and President Obama continues to support it. It would force every small business in America which doesn’t have a qualified retirement plan like a 401(k) or a SIMPLE IRA to open a salary-deferral IRA for their employees. Some versions of this plan would also require the employer to start making salary deferrals into this IRA unless the employee opts out. But suppose neither the business owner nor the employee wants to save in the IRA? It would still have to be set up, at the business’ expense. Retirement savings is a good thing, but not at the barrel of a gun. The best solution here is personal Social Security savings accounts for younger workers, who often don’t have the after-tax income to save adequately.
MYTH: “To help working families, we will extend our middle-class tax cuts. But at a time of record deficits, we will not continue tax cuts for oil companies, investment fund managers, and those making over $250,000 a year. We just can't afford it.”
FACT: Let’s lay out exactly what tax increases he is proposing here (leaving aside the fact that “we” are the ones who can’t afford his taxes, not the other way around):
The top two tax rates (which two-thirds of small business profits face) would rise from 33 and 35 percent today to 36 and 39.6 percent in 2010. The return of the itemized deduction and personal exemption phase-outs would take the mathematical effective top marginal tax rate to 41.6 percent.
The top capital gains rate would rise from 15 to 20 percent. The top dividends rate would skyrocket from 15 to 39.6 percent. This would be a body blow to everyone’s IRA and 401(k) as the stock market priced in this new tax wedge.
Obama-Pelosi-Reid wants to raise the capital gains tax rate for managers of investment partnerships from 15 percent to 39.6 percent. This will leave universities, charities, and pension plans holding the bag as partnership managers understandably demand a greater profit share to make them whole after-tax.
Finally, Obama is referring to repealing the “Section 199” domestic production activities deduction—but only for energy companies. This is a targeted tax hike on one industry. It will result in higher energy costs for all of us (companies don’t pay higher taxes—they pass them along to us as higher prices). It’s shortsighted and counter-productive.
Updated: How Much Does It Cost To Hire a New Federal Employee?
When politicians claim that they will save money by “in-sourcing” federal functions from contractors, or will respond to some new need by expanding the federal workforce, that has a cost to taxpayers. How much is that cost?
In order to determine the cost of hiring a new federal bureaucrat, ATR has calculated the “all-in” cost of hiring a new employee. We include salary as well as benefits, pension contributions, and payroll taxes. We assume a 40-year federal career. The numbers presented are both nominal and inflation-adjusted. A COLA is assumed which is equal to the average level in the Washington, DC area for the past five years.
Here are the results for a low-cost, medium-cost, and high-cost employee:
|Low Cost (GS-7)||Intermediate Cost (GS-11)||High Cost (GS-15)|
|Nominal||$4.73 million||$7 million||$13.86 million|
|$2.73 million||$4.04 million||$8 million|
- The federal general pay schedule for the Washington, DC area is used
- There are separate estimates for low-cost (GS-7), intermediate-cost (GS-11) and high-cost (GS-15) employees. This was recommended as appropriate levels by former administration officials to give a sense of scope
- The employee is assigned a “Step 5” in the GS table for a 40-year career. As employees move up the GS-scale, their steps bounce up and down.
- The five-year moving average for this locality’s COLA is 3.55%, so that is assumed to be the COLA rate going forward
- In order to account for benefits, pension contributions, and payroll taxes, the GS dollar levels are increased by 33 percent, which was standard budgeting practice in the Department of Labor in the Bush Administration
- The dollar value is expressed in nominal terms and after-inflation (2.5%)