USC Gould School of Law

1. USC Gould School of Law June 3, 2011 FIVE STEPS TO FISCAL RECTITUDE Edward D. Kleinbard Professor of Law ekleinbard@law.usc.edu

2. Getting a Grip on the Deficit Problem • Where did our enormous budget deficit spring from? • What are the long-term spending and revenue trends? • Which is the more effective tool? -- Raise taxes? -- Cut spending? • It is important to divide time horizons for solutions • Very short term: address underperforming economy • Long term: implement phased-in entitlements reforms and/or new financing for existing levels of entitlements • Medium term: move towards long-term! • This presentation focuses on the medium term

3. 5-Step Path to Budget Enlightenment • Understand the actual depressing deficit facts • Understand that, while entitlements programs are a big part of the problem, slashing spending is an improbable short or medium-term solution • Accept that revenue increases are feasible and would not burden economic growth unduly, based on historic experience • Concentrate on progressive tax increases that raise average rates on high-income taxpayers without raising marginal rates unduly • Which in turn leads to eliminating personal itemized deductions as the key to budget nirvana

4. PART I DEPRESSING DEFICIT FACTS

5. THE BUDGET CRISIS IS REAL • Long-term “Fiscal Gap” is in the range of $60 to $100 trillion, give or take a penny • Measures projected revenues minus projected spending for several decades, using current policies applied to changing demographics and economic growth • Deficit for FY 2010 = $1.3 trillion (8.9% of GDP) • Proj. deficit for FY 2011 = $1.5 trillion (9.8% of GDP) • Deficits beyond 3% of GDP are not sustainable • Most economists would prefer deficits to be under 2% of GDP • And here 2% or lower deficits needed to pay back cost of Great Recession (see below)

6. Projected Deficit as % of GDP Source: CBO March 2011

7. Footnote on “Baselines” CBO and JCT are nonpartisan, have large professional staffs, and (with Treasury) have access to best data But their presentations unless noted rely on “baseline” projections of the future. This means that temporary legislation is assumed to expire In particular, baseline revenue projections assume expiration of all Bush tax cuts Spending policies by contrast are presumed to continue

8. Revenues and Outlays 1971-2021 Source: CBO January 2011

9. President’s Budget vs Baseline

10. COMPONENTS OF THE DEFICIT

11. ARRA and TARP WORKED OUT CBO May 2011 on ARRA: Raised real (inflation-adjusted) gross domestic product (GDP) by between 1.1 percent and 3.1 percent, Lowered the unemployment rate by between 0.6 percentage points and 1.8 percentage points, Increased the number of people employed by between 1.2 million and 3.3 million, and Increased the number of full-time-equivalent jobs by 1.6 million to 4.6 million compared with what would have occurred otherwise CBO March 2011 on TARP: CBO estimates that the cost to the federal government of the TARP’s transactions (also referred to as the subsidy cost), including grants for mortgage programs that have not been made yet, will amount to $19 billion. That cost stems largely from assistance to American International Group (AIG), aid to the automotive industry, and grant programs aimed at avoiding foreclosures.

12. OBSERVATIONS ON DEFICIT • Previous table leaves out Medicare Part D costs • Tough to estimate, but likely hundreds of billions • Extraordinary contribution of Bush tax cuts • $5.4 trillion (including interest costs and AMT interaction) for 2009 -19 • Their expiration by itself brings deficit to near 3% of GDP • Very large and continuing contribution of Great Recession • $3.5+ trillion for 2009-19 • Relatively small contribution of ARRA/TARP • Plus long-term secular trends in entitlements (below)

13. PART II SPENDING CUTS ARE NOT THE MEDIUM TERM SOLUTION

14. MANDATORY AND DISCRETIONARY SPENDING

15. DISCRETIONARY SPENDING BREAKDOWN

16. DON’T BLAME DISCRETIONARY SPENDING Too much!

17. INCOME SECURITY AND GREAT RECESSION

18. MANDATORY SPENDING IS A PROBLEM

19. ENTITLEMENTS VS CURRENT TAX POLICY Big 3 entitlements + defense + interest alone swallow up more than current tax policies bring in

20. OBSERVATIONS ON SPENDING • Mandatory spending (entitlements) reforms are critical for the long term health of the country • But any reforms MUST in practice phase in gradually. In the meantime, the resulting deficits must be financed • Nondefense discretionary spending is a small part of the budget (especially after veterans’ benefits etc. are removed), but those programs are a critical part of the economic security safety net, and deliver value to many Americans • Air traffic control to national parks • President’s budget would cut 11 percent from budget for CDC – and House Republican budget even more. Is it really desirable to defund the country’s front line defense against pandemics? • Important distributional consequences of discretionary spending, not just taxes!

21. PART III THE CASE FOR HIGHER TAX REVENUES

22. THE USA IS A LOW-TAX COUNTRY • The USA today is a low-tax country • At the bottom of the OECD list of total tax as % of GDP • But we rely on high salience taxes (income tax) much more than other countries • And even by our standards we are collecting historically low levels of tax • 14.8% Of GDP in 2011, vs 18.4% historic norm

23. OECD DATA ON TAX RATES

24. OECD on Composition of Taxes

25. U.S. Tax at Historic Low Levels If 2011 collections = 18.4% (historic average), rather than 14.8%, deficit would be $ 538 billion smaller!

26. THE POOR PAY TAXES TOO

27. PART IV GETTING A GRIP ON THE DEFICIT PROBLEM

28. Thinking About Time Horizons • Entitlement reform and/or higher taxes to finance existing programs are key to the long term, but meanwhile deficits from existing policies must be financed • Markets demand medium-term efforts and a firm plan to getting to long-term stasis • The medium term is the key to muddling through. • Addresses market concerns • Reorients public thinking to accept fundamentally different environment • Demonstrates Congressional commitment to making hard choices • Serves as fiscal bridge to longer-term plans

29. What Can We Do in The Medium Term? • Spending Cuts? • U.S. government is not a big spender by world norms • Except in defense spending! • In normal times, only about 20% of federal budget (<4% of GDP) goes to nondefense discretionary items (~ $600 billion/year) • Cutting nondefense discretionary items to zero would not solve the problem even in medium term (Slide 19) • New Taxes (e.g. VAT)? • Certainly possible, but feasible in current polarized environment?

30. What Are the Medium Term Goals? • OECD 10/2010 Report recommendations: • Bring deficit down to 3% of GDP by 2015 • Bring deficit to 0 by 2020 • Get there by: • Spending constraint, but also • Tax increases • “The focus should be on [tax] base-broadening rather than rate increases, and on reducing the most detrimental distortions.” Report: Patrick Lenain, Robert Hagemann and David Carey, RESTORING FISCAL SUSTAINABILITY IN THE UNITED STATES: OECD ECONOMICS DEPARTMENT WORKING PAPER No. 806 (Oct. 25 2010)

31. More Revenue = Personal Tax Hikes • Corporate income tax is a small fraction of total tax collections (10 – 15% in good years) • Corporate statutory rates are now out of step with world norms • Corporate tax base can be broadened, but the revenue pickup should be earmarked to lower statutory rates. • So unlike 1986, medium-term tax “reform” logically would mean: • Revenue neutral business tax reform • Significant tax hikes on individuals

32. PART V TAX EXPENDITURE SACRED COWS: IT’S THEM OR US

33. Tax Expenditures Hold the Key • Tax expenditures are government spending by another name • Total exceeds revenues collected from personal income tax (roughly $1.2 trillion/year)! • 90% personal, 10% business • Personal tax expenditures are highly regressive • So where’s the big money in tax expenditures? • Employer-sponsored health insurance • But we just went through agony on this subject • JCT estimate is $659 billion over next five years in forgone revenues • Personal Itemized deductions!

34. Personal Itemized Deductions by the Numbers • Home Tax Expenditures: $691 billion/5 years • Home mortgage interest + real property taxes + cap gains exclusion • Charitable Contributions: $246 billion/5 years • State + Local taxes: $237 billion/5 years • These 3 itemized deductions = $1.2 trillion over next five years in forgone revenues • These all may be political sacred cows, but it’s come down to their survival, or ours http://www.huffingtonpost.com/edward-d-kleinbard/sacred-tax-cows-its-them_b_677514.html (Estimates from JCT annual tax expenditure estimates for 2010-2014)

35. Effect of Expiration of 2001/03 Tax Cuts + Elimination of Itemized Deductions on Deficit 2013-17

36. Tax Expenditures Are Regressive Source: Tax Policy Center May 2011

37. The USA is a Tax Expenditure Junkie • Only Canada is in our league: • S source: OECD 10/2010 Report

38. Concluding Tax Expenditure Thoughts • Boil that frog slowly! • Of course it is too disruptive to eliminate itemized personal deductions all at once • But there’s plenty of money there to enable budget goals to be met with long phase-ins • Tax expenditure process reform is critical • Congress likes to spend • Tax expenditures already are its favorite way to spend • If Congress clamps down on explicit spending but leaves “tax reductions” unpoliced (as contemplated by House Republican new “Cut-go” rule), the result will be massive migration of remaining discretionary spending into new tax expenditures