Financing S-CHIP

Let’s re-pass S-CHIP, with a new financing mechanism: either a surtax on incomes over $500,000 per year, or a tax on private jet travel.

Having come up 13 votes short on the S-CHIP bill, Congressional Democrats need to think about next steps. I think the right strategy is obvious: pass the damned thing again, and keep passing it, making the Republicans vote against health care for middle-class children from now until Election Day. It looks to me like a no-lose: either the bill passes, and we have an accomplishment to claim, or it doesn’t pass, and we have an issue for 2008 that (1) is salient (2) is easy to understand and (3) where 75% of the voters, including almost all the swing voters, are on our side.

But passing exactly the same bill looks too much like a gimmick. And the bill that just crashed and burned did have one substantial flaw: it was to be financed with higher cigarette taxes, with fairly bad consequences for a substantial number of poor elderly nicotine addicts, who really haven’t done anything to deserve it. As Jon Caulkins once remarked, “Their decision to damage their lungs is no reason to make them pay through the nose.”

So let’s pass a new S-CHIP bill, identical to the previous one except for the financing mechanism. And since the second over-ride might also fail, we should have additional backups.

Where should the money come from? Obviously, from people who have more than they need. There are two basic ways of doing that: higher taxes on the highest incomes (let’s say, $500,000 per year) or taxes on things that rich people consume.

The policy analyst in me says “Income taxes good; sumptuary taxes bad.” So my first choice would probably be to create an additional tax bracket at the $500,000-per-year level (indexed for inflation).

But politically there’s an advantage in taxing “wicked waste.” And fortunately, we now have a symbol of wicked waste that’s actually A Bad Thing: travel by private jet. It ought to be discouraged on global-warming grounds alone, in addition to the contribution of private jet travel to airport crowding. (Landing a plane ties up a runway for the same amount of time no matter how small it is.) Since all aircraft file flight plans with the FAA, administering a per-hour or per-takeoff-and-landing tax on private and corporate jet aircraft would be trivially easy. If it made some of the wingnuts feel better to think they were “taxing Al Gore’s private jet,” that’s fine with me.

So all we need to turn these concepts into proposals is the numbers. What marginal rate at the $500,000 bracket, and what tax per hour in the air or per operation for private jets, would be needed to raise $7B/yr.?

Update A reader points out that figure is $35 billion over 5 years, not $35 billion a year as the post originally stated. A quick calculation suggests that the requisite private-jet tax would be too high to be practicable. On the other hand, a reader with the data at his fingertips estimates that it would take only a 0.7% surtax on incomes over $500k per year to raise $7B per year. “Of course,” he adds, “that would completely destroy their incentive to work and save.”

Even More Tax Reform…

Below, Mike O’Hare raises some issues with Mike Graetz’s proposal for tax reform, as interpreted through my abbreviated discussion of it. We agree on one issue, and disagree on on the other.

First, I agree that we ought to axe the mortgage interest deduction entirely. The Oakeshottean in me is queasy with the unpredictable effects of such a change, given that the deduction is so woven through our society in ways that are hard to specify. But the negative effects of the deduction are so large, as Mike describes, that I’d probably be willing to swallow hard and get rid of it. That said, I think Mike may miss the point of Graetz’s design. Graetz doesn’t get rid of the mortgage interest deduction because, as I recall, he doesn’t get rid of ANY deductions. He simply eliminates them entirely for families under $100,000, because the income tax doesn’t start until then. So a pure policy analyst would say, “hey, why not get rid of all those deductions for higher earners? Why say you’re doing tax reform and preserve all the deductions?” To which I (channeling Graetz) would say, we now have plenty of evidence that doing comprehensive tax reform via eliminating broad based deductions to lower rates doesn’t work. We had a laboratory experiment, and the code just went back to what it was pre-reform. Graetz’s gamble is that when you eliminate the income tax entirely for middle-earners, that the coalition for deductions starts to become very vulnerable (since you can’t say any more than they’re really there to help hard-working average Americans, who will now no longer pay income tax). It then becomes politically feasible to eliminate deductions, especially if the alternative is either raising rates on upper earners or raising VAT on everyone else. So, to Mike, I’d say that Graetz’s proposal is the most likely thing out there that I can think of that might actually get what we both want where the mortgage interest deduction is concerned, and do so durably (I would note that much of my thinking on the politics of this has been influenced by Eric Patashnik of UVA, whose upcoming book on policy durability is going to be a blockbuster).

The good policy analyst that he is, Mike has identified the most important dislocation that any broad-scale tax reform would involve, and that’s the change to our system of non-profit finance. I agree with Mike that this is a big problem, albeit one that effects any change that reduces rates (because every reduction in rates reduces the value of deductions). So, instead of telling Mike he’s all mixed up (which he’s not), I’ll reply by asking him what change in Graetz’s plan would preserve the most of the benefits of the charitable deduction without unwinding the structure of the rest of the plan? Is there a way to ensure a flow of funds both from the wealthy and the non-wealthy? My temptation is to think that the problem among the $100k+ people is not that severe–how sensitive are charitable donations to shifts in marginal rates anyways? So my instinct is that the real problem is among the under-$100k folks. Comments and suggestions from our skilled readers are especially welcome. Any non-crock proposals will be passed along to Graetz.

Two more notes on tax reform

Steve skewers extending the mortgage income tax deduction down the income scale and applying it to payroll taxes in his recent post, and admires a package with a 25% income tax only on income above $100,000 per family.

I wish first to take another poke at the first idea. Why do we subsidize housing at all? There’s a romantic view that homeownership confers all sorts of moral standing and responsibility; in my view this is a lot of nonsense. Renting doesn’t seem to have made Mark craven and dissolute (while he rides out the LA housing bubble); he was a house guest a few weeks ago and we still have all the sterling. And there’s plenty of evidence, especially now, that there’s a lot wrong with inducing people to put almost their entire portfolio into one kind of asset at one address on one street.

Housing as a consumption good seems to me to have only negative externalities; the bigger your house and lot are, on the average, the bigger your carbon footprint on my planet, and the harder you make it for me to have efficient transit and a pedestrian community. The mortgage interest deduction is pushing in exactly the wrong direction; we need fewer people living in houses with three-car garages and five bedrooms for three people, not more. Basics apply: housing (and gasoline) are too cheap, not too expensive.

The Graetz proposal has a hole below the waterline Steve doesn’t mention: it throws a bomb into the system of charitable non-profit enterprise that, with all its defects, is a virtue of how Americans have organized our society. It removes the implicit subsidy (deduction of gifts from income) for giving to charities, churches, education, and the arts from everyone below the $100K cutoff, and reduces it for everyone else from the current top rate of about 40% (including state deductions) to 25%. In other words, the price of a gift of $1000 from middle-class people will go from (say) $800 to $1000, and for rich people it will rise 25%, from $600 to $750. The overall result will be a severe contraction of charitable giving and hence of the services provided by nonprofits, so if we want those services, they will have to be provided the way Europeans do, by government. Without some assurance that this will happen – and the politics of such an expansion of the public sector are quite daunting – and a lot of assurance that we will really be happy if a large fraction of, for example, higher education and the arts are nationalized and become provided by a bureaucracy, a scheme like Graetz’s, despite its appeal on some grounds, needs to be dealt with very gingerly.

Wrongheaded Tax Policy

At the American Prospect, Michael Lind has a long piece proposing that we allow people who, because their income is too low, to take some of the largest tax deductions (like the mortgage interest deduction) against their payroll taxes. Before explaining why I think this is precisely the wrong direction for tax policy to go in, I should note that I have enormous respect for Lind. His book The Next American Nation had a big impact on me when it came out, and I think he is one of the most creative thinkers in the DC think tank world. Our national discourse would be much worse without him.

That said, this is a crummy idea. Our tax code has three great problems. First, it is outrageously complicated, producing huge dead weight losses by distorting economic behavior and requiring large outlays for tax preparation. Large-scale tax simplification is probably the simplest thing we could do to improve the efficiency of the economy, and probably also the perceived legitimacy of our government, and this goes in the opposite direction–spreading that complexity to the payroll tax. If anything, it would be great if we made the income tax look more like the payroll tax–which is a kind of flat tax on earnings–while reforming the payroll tax by removing the cap on taxable income, creating a standard payroll earnings deduction, expanding the payroll tax to investment income and maybe even taxing earnings at progressive rates.

The second problem is that the tax code doesn’t produce as much revenue as we need. To get more income, we need to substantially increase effective tax rates at the top. That can be done somewhat by raising the top rate, but the most effective way to do that would be to cut back drastically on the opportunities for high-earners to shield income. Lind’s suggestions don’t help with this, and by increasing the coalition to preserve our tax subsidy regime, probably hurts it.

The third problem is that our code doesn’t help much in counteracting inequality. That’s presumably part of what Lind is trying to do here, but I don’t think it will succeed. The best way to counteract inequality is by raising more revenue and then spending it on things that the middle and lower classes need, like national health insurance. Even if you let more of the middle and lower classes into the tax subsidy regime, they still won’t get as much out of that regime as upper-class people do, and you’ll only hollow out the taxation capacity of the national government that all expansions of the welfare state require.

I do think that there is one proposal for tax reform that does do all of these things (especially if modified slightly) and that’s Michael Graetz’s very elegant proposal, described here. Mike’s plan, simplifying the details considerably, would do the following things:

a) Eliminate the income tax entirely for families earning up to $100,000, indexed for inflation.

b) Impose a flat rate tax on income above that level, at a rate of 20-25% (I lean strongly toward the upper end of the range).

c) Impose a VAT tax at a 10-14% rate.

d) Lower the corporate tax, aligning it closely to the new, lower income tax rates (while also forcing corporations to use the same accounting standards when they deal with the IRS and the SEC).

e) Mike would deal with the EITC’s elimination by providing a refundable offset to the payroll tax. I think that my suggestions above could do roughly the same thing, or we could establish some compromise between what I want and what Mike wants.

The important point of Mike’s plan is that it valuably diversifies the tax capacity of the American state, by adding a VAT, something that every European welfare state (which all raise more revenue than we do) has, and that we know how to administer (in sharp distinction to the crackpot proposals for a national sales tax, which are designed to completely replace all federal taxes). It also wrecks much of the political support for tax expenditures, by explicitly limiting them only to those actually in the income tax system–a fairly small group. Therefore, even though Mike’s plan doesn’t explicitly get rid of ANY tax subsidies, it makes them much more vulnerable over time, and suggests that if the rates he suggests aren’t enough, that more revenue will be raised by gradually chipping away at these now-vulnerable deductions. It’s probably also the case that by shifting more of the code over to taxation on consumption, that the code will generally be better for encouraging savings and investment.

What’s really smart about Mike’s plan is that it sidesteps almost all of the usual problems with tax reform, the most important being that they all depend on getting rid of deductions by lowering rates–but as we saw in 1986, it didn’t take long for the deductions to grow back, because of the basic political economy of interest group organization. Mike’s plan just sidesteps all of this, at least in the first instance, but in the process makes it much more likely that subsidies will be reduced in future iterations of the tax politics game. And perhaps most important, his plan gives the American welfare state a much sturdier base for future expansion (esp. since the VAT is less transparent than other forms of taxation), especially since there’s room here to add some form of carbon tax, which is necessary for dealing with global warming and would provide even greater revenue going forward. Finally, the politics of his plan are almost irresistible–he actually succeeds in eliminating the income tax entirely for most families, and in the process drains almost all of the basis of Republican tax populism.

This is a proposal that’s economically sensible, progressive (especially over the long term), politically viable and, most important, sustainable. The answer isn’t to expand the tax subsidy regime–it’s to kill it–and this is the most politically feasible way to do it. Any Democrat looking for an ambitous and politically viable signature proposal would be smart to look very closely at Mike’s plan.

[Note: another oar dipped into this issue by Mike here.]

Facing reality, a little bit late

The Republican Governor of Minnesota is reconsidering his opposition to tax increases after the bridge collapse. Too bad he didn’t do so before the collapse. Since he’s not running for President, he can’t just pretend that the money will magically appear. Has someone told Rudy Giuliani?

After sacrificing five victims on the altar of Grover Norquist’s no-tax-increase pledge, the Republican Governor of Minnesota &#8212 who twice vetoed gasoline tax increases &#8212 is having second thoughts.

Pawlenty, unlike Rudy Giuliani, isn’t running for the Republican nomination for President but has to actually run the state. So, unlike Giuliani, Pawlenty can’t just pretend that cutting taxes magically increases revenues. He needs to actually raise the money, and of course in the real world that means raising taxes.

It’s too bad Pawlenty &#8212 not to mention the innocent drivers and their families &#8212 had to learn from his mistakes, instead of from reason.

Poor Richard Says:

Experience keeps a hard school.

But some fools will learn at no other.