Tax Policy and the Economy, Volume 27

By Jeffrey R. Brown

Taxation policy was a central part of the policy debates over the “fiscal cliff.” Given the importance of fiscal issues, it is vital for rigorous empirical research to inform the policy dialogue.  In keeping with the NBER’s tradition of carrying out rigorous but policy-relevant research, Volume 27 of Tax Policy and the Economy offers insights on a number of key tax policy questions.  This year's volume features six papers by leading scholars who examine the tax treatment of tuition at private K-12 schools, the potential streamlining of the federal rules for post-secondary financial aid and the use of tax return information in this process, the effect of tax and benefit programs on incentives to work, the macroeconomic effects of fiscal adjustments, and the set of factors that contributed to the weakening US fiscal outlook in the last decade.

• Language: English
• Publisher: University of Chicago Press Journals
• Release date: Aug 22, 2013
• ISBN: 9780226097824

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Contents

Copyright

NBER Board of Directors

Relation of the Directors to the Work and Publications of the NBER

Acknowledgments

Introduction

Jeffrey R. Brown

The Deterioration in the US Fiscal Outlook, 2001–2010

Jeffrey B. Liebman

The Design of Fiscal Adjustments

Alberto Alesina and Silvia Ardagna

Recent Marginal Labor Income Tax Rate Changes by Skill and Marital Status

Casey B. Mulligan

How Important Are Perpetual Tax Savings?

James R. Hines Jr.

Donating the Voucher: An Alternative Tax Treatment of Private School Enrollment

Andrew A. Samwick

Simplifying Tax Incentives and Aid for College: Progress and Prospects

Susan Dynarski, Judith Scott-Clayton, and Mark Wiederspan

Copyright

NBER Board of Directors

Relation of the Directors to the Work and Publications of the NBER

Acknowledgments

The job of serving as a conference organizer and volume editor can be either a delight or a strain, depending on the quality of the assistance one receives along the way. Thanks once again to the professionalism of the NBER staff, organizing the Tax Policy and Economy conference and editing the annual volume is a professional joy. The NBER conference department, including Director Carl Beck, Lita Kimble, and especially Rob Shannon, consistently delivers a high-quality product. I am especially grateful for their optimism and can-do attitude at all stages of the process. I am also grateful to Helena Fitz-Patrick for her skill and her patience when guiding the publication process. Above all, I thank Jim Poterba, who, through his roles as former TPE organizer and as current NBER president, shows unwavering support of this annual event.

The authors also deserve special thanks because the conference and this volume are only as good as the research underlying them. I am pleased with the high quality of the contributions this year. I am also grateful to the authors for their willingness to package important economics research in a manner that makes it accessible to a broad policy audience.

Finally, I wish to thank Jan Eberly, who at the time of this conference was serving as the Assistant Secretary for Economic Policy at the US Department of Treasury, for delivering a luncheon address. She began her remarks with a summary of where the United States stood in terms of its economic recovery from the global financial crisis. While striking an overall optimistic note about the near-term conditions for growth, she was also clear about the challenging economic headwinds, including the existing fiscal backdrop. She articulated a view that, given current conditions, it would be difficult for the United States to engage in fiscal consolidation without negative economic consequences. She then turned to education policy: specifically, how to make higher education accessible across the income distribution. Throughout her talk, she underscored the important role that economic analysis has played in informing the decision-making process.

© 2013 by the National Bureau of Economic Research. All rights reserved.

978-0-226-09779-4/2013/2013-0007$10.00

Introduction

Jeffrey R. Brown

University of Illinois at Urbana-Champaign and NBER

The 2012 Tax Policy and Economy conference, which convened less than 7 weeks before the US presidential election, brought empirical clarity to a number of important economic issues that featured prominently in the national political discussion. At the time of the conference, the US economy was still in weak recovery mode following the Great Recession, publicly held US government debt as a fraction of GDP was at a many-decades high, and policy makers, pundits and business leaders were beginning to seriously consider the possibility that our elected officials might lead us over the so-called fiscal cliff. It is precisely at such times, when the economic consequences of fiscal policy are so important, that rigorous empirical economic research on the effects of taxation and government expenditure are vital.

For more than a quarter century, the NBER has used the annual TPE conference to facilitate a two-way conversation between academic researchers and the Washington, DC, policy community to evaluate and analyze tax and spending policy. This year’s conference featured six papers by leading scholars who brought their considerable expertise to bear on issues related to education funding, labor supply, taxation, fiscal adjustments, and the overall US fiscal outlook. In keeping with the policy and practices of the NBER, the papers in this volume provide analysis that can inform policy debates but do not offer specific policy recommendations.

The first two papers in this volume go directly at the heart of the discussion about the overall fiscal situation facing the United States and other developed nations. Jeffrey Liebman’s paper, The Deterioration of the US Fiscal Outlook, traces the United States’ shift over the past dozen years from running surpluses equal to 2% of GDP to projections of persistent deficits exceeding 5% of GDP even after recovery from the Great Recession. He notes that more than half of this decline occurred prior to the recession as a result of an increase in discretionary outlays (primarily defense and homeland security), increased Medicare spending due to rising health care costs and the introduction of Medicare Part D, an expansion of refundable tax credits, and revenue declines from the tax cuts of 2001 and 2003. Looking to the future, he reports that rising Medicare, Medicaid, and Social Security costs and rising interest payments on debt are the primary contributors of continued high deficits relative to GDP. He also examines the longer-run fiscal pressure that results from continued demographic change and rising health care costs and discusses the political economy of reform. Overall, this paper underscores the economic and political difficulties associated with stabilizing the debt-to-GDP ratio in the coming decades.

Stabilizing a nation’s fiscal stance can be done through revenue increases, spending reductions, or a combination of the two. In their paper, The Design of Fiscal Adjustments, Alberto Alesina and Silvia Ardagna provide new empirical evidence on the mix of tax increases and spending cuts that, historically, have had the most long-lasting effect on reducing the debt-to-GDP ratio. Using data on 21 OECD countries from 1970 to 2010, they find that fiscal adjustments more heavily weighted toward spending reductions are less likely to be subsequently reversed than fiscal adjustments that rely on tax increases. Importantly, they also examine the output and employment effects of fiscal adjustments and find that spending-based fiscal adjustments are associated with smaller recessions than tax-based adjustments. Indeed, their estimates suggest that it is possible for spending reductions to be expansionary, that is, to be associated with economic growth rather than a recession. This evidence is especially salient in light of ongoing policy discussions in the United States and elsewhere about the economic impact of fiscal adjustments at a time of overall economic fragility.

Labor markets were especially hard hit during the 2008–9 recession and the subsequent slow recovery: indeed, as of late 2012, labor market activity is still well below prerecession levels. In the third paper in this volume, Recent Marginal Labor Income Tax Rate Changes by Skill and Marital Status, Casey Mulligan provides evidence that much of the decline in employment and work hours—especially the disproportionate decline among the less skilled and the unmarried—is driven by implicit tax rates on labor supply. Specifically, he calculates the effective marginal tax rates that are implicit in the design of several government programs, such as unemployment insurance, SNAP (previously known as food stamps), and Medicaid. He examines the change in the tax rates associated with expansions in these programs over the 2007–9 period and notes that large shares of the skill distribution saw their marginal tax rates on labor income increase by more than 5 percentage points in this short time period. He documents that the pattern of changes in implicit taxes of these programs exhibit important cross-sectional variation due to differing eligibility rules. Most importantly, he then shows a striking correspondence between the 2007–12 changes in worker hours per capita and the changes to work incentives that result from these programs, patterns that are hard to reconcile with alternative explanations. An implication of these findings is that the labor market is unlikely to recover as long as there remain important disincentives to work.

The estate tax has been an important part of fiscal policy discussions over at least the past decade. One of the incentives created by the presence of an estate tax is for wealthy families to transfer resources to distant generations in order to avoid having the wealth become subject to multiple rounds of estate taxation. In How Important Are Perpetual Tax Savings, Jim Hines examines the economic, legal, and policy issues surrounding the ability of wealthy families to effectively create perpetual trusts. He notes that, until recently, it was not possible to create perpetual trusts because of legal restrictions inherited from English common law. However, he notes that the rules against perpetuities are established by state, not federal, law and that a number of states have repealed or relaxed these restrictions in recent years. He uses this variation to study whether there has been an increase in the creation of perpetual trusts. Although he documents modest tax benefits of creating such vehicles, the effect of repeal of laws against perpetuities is statistically insignificant as a predictor. He does find that state population and income have very large and significant effects, which is consistent with a hypothesis that most trusts are formed where settlors live rather than in other states with more attractive tax and/or legal environments.

The final two papers in this volume are focused on tax incentives for education. Andrew Samwick, in Donating the Voucher: An Alternative Tax Treatment of Private School Enrollment, examines the tax cost of allowing families who send their children to private schools to take a tax deduction equal to the per-pupil expenditure in their public school district. Using the NBER Taxsim model and the Public Use Microdata Sample of the American Community Survey, he calculates that treating the decision to forgo public schooling as the equivalent of a charitable contribution would cost the federal government an average of $7.75 billion per year over the 2006–10 period. Because rates of private school attendance are higher among higher-income families, the distributional effects of such a policy would be concentrated among higher-income households.

Susan Dynarski, Judith Scott-Clayton, and Mark Wiederspan’s paper, Simplifying Tax Incentives and Aid for College: Progress and Prospects, shifts the focus to federal aid for college. One way to view this paper is as a retrospective of what has occurred with regard to financial aid simplification in the 5 years since two of these authors wrote a prior TPE paper analyzing the complexity of the aid process. The authors note that, since their initial paper, the aid process has been simplified (as measured by a reduction in the number of questions on FAFSA, the federal application form), but only modestly. They note that the application still contains 116 questions, making it longer than the tax return filed by most US households. After reviewing the array of government programs targeted at college financial aid and the existing evidence on program effectiveness, the authors examine the prospects for further simplification of the aid process. They document that the vast majority of questions on the financial aid form have little impact on eligibility, suggesting that the distribution of aid would not be significantly affected if these questions were removed. For example, they find that if assets were dropped from the calculation of eligibility for Pell Grants, the share of FAFSA applications eligible for a Pell would be unchanged at 52%. They also find that such a change would leave the amount of aid unchanged for 95% of recipients. This work is important for helping to quantify both the costs and benefits of potential simplification of the aid application process.

As our nation moves forward in its effort to reduce the long-term gap between revenues and expenditures, rigorous research on the effects of fiscal policy on behavior is critical to the policy making process. The papers in this volume are important contributions to this effort.

© 2013 by the National Bureau of Economic Research. All rights reserved.

978-0-226-09779-4/2013/2013-0000$10.00

The Deterioration in the US Fiscal Outlook, 2001–2010

Jeffrey B. Liebman

Harvard University and NBER

Executive Summary

From 1999 to 2001, US budget surpluses averaged 2% of GDP. By 2011, the Congressional Budget Office was projecting persistent current policy budget deficits exceeding 6% of GDP, even after the economy recovered from the recession. This paper reviews the remarkable deterioration in the US fiscal outlook. It shows that more than half of the deterioration occurred before the 2007–9 recession, as a combination of tax cuts, increased spending, and worse than expected economic performance shifted the budget from surplus to deficit. The further deterioration since 2007 has two main components. Spending on Medicare, Medicaid, and Social Security is projected to increase by almost 3% of GDP over the first 10 years of baby boomer retirements, and interest costs are rising both because of the underlying fiscal imbalance and also as a result of the recession. The paper also discusses proposals for reducing the deficit, longer-term fiscal challenges, and the political economy of fiscal reform.

I. Introduction

For more than 35 years, it has been evident that the 2011–20 period would be one of fiscal stress in the United States as the first baby boomers began receiving retirement benefits. The federal government has been making 75-year projections of its health and retirement programs for many years, and as early as 1974, these projections showed spending increases similar to the ones that are, in fact, occurring.¹

In 1983, the United States instituted policy changes designed to prepare for this fiscal challenge, setting revenues for the OASDI program significantly above spending—with the explicit purpose of reaching our current point in history with a lower debt-to-GDP level than would otherwise have occurred. Facing large deficits in the early 1990s, the United States adopted a formal pay-as-you-go budget policy to prevent further fiscal deterioration in advance of the retirement of the baby boomers. This policy required that any tax cuts or permanent new spending be offset so as to be deficit neutral or deficit reducing. When budget surpluses emerged in the late 1990s, President Clinton articulated a save Social Security first policy of dedicating the budget surpluses to debt reduction in advance of the baby boomers’ retirement. The US House of Representatives endorsed this general approach in 2000, voting 381–3 to use the portion of the budget surplus attributable to Social Security and Medicare for debt reduction. Between 1993 and 2001, federal debt as a share of GDP fell from 49% to 33%.

In 2002, the pay-as-you-go law was permitted to lapse, and what followed was a period of rising deficits. Tax cuts of roughly 2% of GDP were enacted without offsetting spending reductions. A significant new social insurance program, subsidizing the purchase of prescription drugs for the elderly and costing approximately 0.4% of GDP per year, was introduced, also without offsetting financing. In addition, spending increased for the security and war-fighting expenses of the post-9/11 period, with no new revenue collected for this purpose. In total, the fiscal balance worsened by about 4% of GDP, from surpluses that averaged 1.7% of GDP from 1999 to 2001 to deficits averaging 2.5% of GDP during the post-9/11, prerecession years of 2003–7.

With combined spending on Medicare, Medicaid, and Social Security projected to increase by almost 3% of GDP during the first decade of baby boomer retirements and with interest costs rising as a result of a variety of factors including the fiscal impact of the deep 2007–9 recession, there was a further deterioration in the fiscal outlook between 2007 and 2010. By January 2011, the Congressional Budget Office (CBO) was projecting that if current policies continued, the United States would experience persistent budget deficits exceeding 6% of GDP, even after the economy recovered from the recession—a remarkable deterioration from the budget surpluses of 2% of GDP that had existed just 10 years before.

During the past 3 years, Congress and the president have taken significant steps to bring down the budget deficit. In August 2011, discretionary spending caps and automatic enforcement procedures were enacted in the Budget Control Act of 2011 (BCA 2011), reducing projected out-year budget deficits by about 1.5% of GDP. In January 2013, changes were made to the tax code in the Taxpayer Relief Act of 2012 (TRA 2012) that are projected to reduce the annual deficit by about 0.4% of GDP. Current projections are that deficits will average about 3.5% of GDP during the coming decade and that the debt-to-GDP ratio will stabilize at approximately its current level of 75%.

Putting the debt-to-GDP ratio on a downward trajectory and preparing for future increases in government-funded health care costs would require additional adjustments. While there is a broad consensus around the menu of policy changes that could be used to reduce the long-term fiscal imbalances, there is no clear path to the political deal that will be necessary to enact the changes.

This paper begins by reviewing the deterioration in the US fiscal outlook over the 2001–10 period and the improvements that have occurred more recently. Next it discusses the outlook for additional deficit reduction over the coming decade and then turns to longer-term issues. It concludes with a discussion of the political economy of fiscal consolidation in the United States and the implications of fiscal rebalancing for economic growth.

II. The Deterioration in the Fiscal Outlook

In 2000, the United States was running federal budget surpluses equal to 2% of GDP, and projections showed surpluses persisting far into the future. Debt-to-GDP had fallen from 49% in 1993 to 33% in 2000, nearly undoing the increase in the debt from 26% to 49% that had occurred between 1981 and 1993. Policy makers were actively debating the implications of the United States paying down all its publicly held debt, raising questions such as whether financial markets could tolerate a world without US Treasury bonds and whether the US government should use surpluses to acquire private-sector assets so that it could continue to issue debt to the public.²

By 2011, CBO was projecting persistent deficits exceeding 6% of GDP, even after economic recovery from the 2007–9 recession. Figure 1 shows the CBO’s 10-year budget projections made in January 2001, the actual path of the deficit during that decade, and the 2011 CBO current policy projection of deficits in the coming decade.³ The figure reveals that the United States was on a trajectory to experience a worsening of the budget balance of more than 8% of GDP over a period of 20 years. The figure also contains an update based on CBO’s May 2013 projections that incorporates the 2011 discretionary budget caps and automatic enforcement provisions, the January 2013 tax legislation, and other more technical changes in the budget outlook.⁴ These recent changes have improved the budget