STEUERLE CRITIQUES DESIGN OF ADMINISTRATION'S TAX PROPOSAL.

SUMMARY:

Commenting on the Fiscal Year 1991 budget is not easy. Many of the major issues likely to be addressed by the Administration and the Congress are probably not even reflected in the budget documents. In a worst case scenario, major domestic policy decisions will mainly be reactionary, often responding to crises or problems after they have festered for too long -- savings and loans, housing, and a poorly designed catastrophic health surtax being among examples from the recent past.

In a best case scenario, the Administration's budget will come to represent a positive baseline from which to begin. The Administration accepts significant reductions in defense and modest increases in revenues, along with modest containment of other expenditure programs, as a means of continuing on a path of deficit reduction. A number of tax proposals are sound and promote fairness and efficiency. While the budget does not require any really hard decisions, it does not close the door on such decisions either.

In addition, I have some hope that the Administration and Congress will begin to address some more difficult issues as the year progresses. On the tax side of the budget, the anticipated release of both Treasury's completed health study and the soon-to-be-completed study of corporate integration would represent a major step in that direction. Even though the trade-offs these studies are likely to suggest will not be easy to achieve politically, they will show us positive ways to enhance efficiency, equity, and growth in the economy.

Still, I cannot help but express my disappointment that more progress is not being sought with respect to the deficit itself. Despite the rhetoric, we were able to pass important deficit-reducing bills in 1982, 1983, 1984, and 1987, along with tax reform in 1986. I find it hard to believe that decisions in the 1990's are more difficult to make than in the 1980's. The failure to achieve more rapid progress deters us from other decisions that need to be made with respect to expenditure and tax programs. Even if we agree, for instance, that education of children should be one of our most important priorities, we seem to be unable to reorient the budget to meet that need.

A FAILURE TO DESIGN PROPOSALS "THE RIGHT WAY"

What is also troubling about this current budget process is that in many cases we are not even willing to put forth the effort to "do things right." Let me explain what I mean. Whether or not we agree on the importance of saving incentives, or capital gains incentives, or subsidies for health insurance, there is a right way and a wrong way to draft these proposals. Politics has come to dominate the budget process so much that many proposals put forward are actually designed in such a way as to defeat their stated purposes.

Since you have asked me to focus on the Administration's tax proposals for Fiscal Year 1991, my examples will be taken from that list. However, I should indicate from the start that I have a similar concern with many of the proposals emanating from Congress.

Here, then, are some examples:

o The budget effectively argues that we should tax individuals on their telephone calls to their grandparents rather than on their pollution of the environment.

(An extension of the telephone excise tax would reduce growth in one of our most efficient and competitive industries.)

o Money aimed at fostering special needs adoptions would be concentrated on those with the least need for assistance and on those who misclaim eligibility for assistance. As a result, there would be a reduction in the number of special needs adoptions that could otherwise take place.

(Treasury's tax reform study argued that the "deduction for special needs adoption expenses [should] be repealed and replaced by a direct expenditure program." It is almost never administratively practical to provide for a special deduction for only a few people on returns and instructions that involve tens of millions of individuals.)

o Enterprise zone incentives, as currently proposed, would create new HUD scandals years from now and concentrate revenue losses on windfall gains to individuals who often participate little in the development of the enterprise zone. In effect, there would be a decrease in the amount of assistance that could be made available to the underclass in depressed areas.

(If we're going to enact enterprise zones, the focus should be on jobs, youth activity, and education rather than on capital gain relief for the person who moves a store across the street into a qualified zone.)

o Proposals to provide credits for low income housing are designed in such a way that the value of housing made available would be significantly less than the amount spent, some of the subsidy would be spent on developers and local officials rather than on individuals in need, and low income individuals would be deterred from moving to locations where jobs, better schools, and family support for child-care are available. Hence, there would be a relative increase in the number of individuals who are effectively left in conditions of need and poverty.

(Portable vouchers are a superior means of subsidizing housing.)

o Monies to be spent on subsidizing the purchase of health insurance would be spent in a way that provides assistance to those who often have the least needs. Consequently, there would be a relative increase in the number of uninsured persons in society.

(The self-employed do deserve a deduction for health insurance if other employed persons receive a deduction. Extending the 25 percent deduction for the self-employed, however, is less efficient than extending a general credit to all persons without health insurance.)

o Saving incentive proposals would concentrate most revenue loss on those individuals who simply switch monies from one account to another and on those who do no saving at all, but simply borrow the funds necessary to make deposits in tax-preferred accounts. In addition, because of the effect on the budget, these proposals would almost certainly reduce national saving.

(Almost all proposals on the table are also extraordinarily complex, making it very difficult for the taxpayer to know when withdrawals are taxable. If anything, the myriad of existing incentives needs to be simplified.)

o Capital gains proposals would assist various sectors and segments of society on political, not economic, grounds. For instance, extension of capital gains proposals to include real estate would expand the tax break to a large number of partnerships and individuals who pay negative taxes on much of their income and who borrow, rather than save, to finance much of their investment. Extension of the tax break to existing gains, rather than new gains, would lower the cost of consumption out of those gains and reduce, not increase, saving. In effect, these additions to the capital gains proposal deter investment in the most productive assets, reduce growth, and promote consumption, not saving.

(As an aside, it is quite clear that it is possible to design a capital gains tax rate reduction that would increase long- term revenues under either the Joint Committee on Taxation or the Treasury method of revenue estimation. These estimates are less far apart than many realize.)

Again, I should indicate that many problems with these proposals rest not with one side of the aisle or the other, but with a budget process where politics dominates policy to such an unreasonable extent that we can not even get well-designed proposals on the table initially. For instance, much in the Administration's package of proposals is really nothing more than a response to a bidding war. If some existing provisions for, say, low-income housing are expected to be extended in any case, why not get there first? If yet another saving incentive is expected to be added to a whole slew of saving incentives that are not currently understood nor used fully by the vast majority of Americans, why not take credit?

A BASE OF PROPOSALS WHICH PROMOTE FAIRNESS AND EFFICIENCY

By the same token, several of the Administration's proposals are clearly worth consideration and adoption. In particular:

o Extending Medicare Hospital Insurance (HI) to certain State and local employees is justified on grounds of both fairness and efficiency. Many of these individuals receive substantial health benefits at only a fraction of the cost imposed on other workers.

o Extending Social Security retirement coverage to State and local employees not participating in Public Employee Retirement also represents sound tax and retirement policy. Many of these individuals will later receive Social Security benefits, and they should be put in the same type of tax/benefit structure as private employees. In some cases, failure to include these workers later increases the number of persons with inadequate retirement income.

o Under principles of public finance, it is entirely appropriate for users of the nation's air transportation system to pay for the use of that system. The existing Airport and Airway Trust Fund has never covered total FAA outlays. The current structure of the trust fund is designed mainly to divert expenditures toward capital outlays. When those outlays are not forthcoming, the trust fund builds up even though total expenditures exceed tax revenues. A rationalization of the trust fund has long been in order.

o Modest expansions of the IRS budget for tax law enforcement is a reasonable way to insure that honest taxpayers do not continue to shoulder an unfair share of the total tax burden. Let me add the caveat, however, that new IRS resources should be concentrated at this point on improving computer systems and upgrading the quality of staff rather than simple increases in number of staff.

These four proposals, along with some of the proposals labeled as miscellaneous in the President's budget -- e.g., extending Social Security and Medicare Hospital Insurance to D.C. employees and increasing fees on shippers to cover costs of harbor maintenance dredging -- represent a solid base on which to build a tax component to deficit reduction. In my view, it would be a mistake for Congress once again to label as "dead on arrival" those very proposals that can be justified as sound on the basis of public finance principles of equity and efficiency. If the experience of the past couple of years is any indication, substitutes would be less likely to be based upon principles and often would detract from, rather than add to, the efficiency and fairness of the tax Code.

These proposals could be combined with limits on the growth of tax expenditures that are similar in size to limits being imposed on direct expenditures. Together this would represent a solid package of tax changes to help achieve deficit reduction.

TAX REFORM AND THE IMPORTANCE OF PRINCIPLES

As the Economic Coordinator of Treasury's tax reform effort in the mid-1980s, I cannot refrain from arguing that further tax changes be based solidly upon principles such as efficiency, fairness, growth, and simplicity. This does not mean that tax reform succeeded in meeting all of these goals, in particular, with respect to simplification in the calculation of business income. It also does not imply that the tax Code can be "left alone," at least as long as so much of economic policy is influenced by taxation. The alternative to a policy based upon principles, however, is a policy based only on political pressure. Such a development almost inevitably would reduce fairness, efficiency, and growth, as well as add to complexity. Let me illustrate again with proposals for saving incentives and capital gains relief.

Saving incentive proposals from both Congress and the Administration simply do not work. They are likely to reduce saving and increase complexity in tax filing. They also are designed to increase long-term deficits far more than apparent in five-year revenue estimates. In its consideration of reform of the budget process, I hope that the budget committees will consider reforms that prevent policy makers from pushing costs of both expenditure and tax programs just beyond a period of accountability. This would be one of the most important of all possible budget reforms.

Capital gains proposals also need to be considered on the basis of principles. A good case can be made that relief should be provided both from taxes on income due to inflation and from the double taxation of corporate source income. A case cannot be made that relief should apply mainly to those with the largest windfall gains, often due to good luck or leveraging up of others' inventions, saving, and hard work. My own studies have shown that many of the wealthiest people in society pay little individual tax on much of their capital income because they recognize a much smaller share of their capital income than do average taxpayers.

Removing arbitrary differentials in the taxation of capital income follows from principles of tax reform. A principled approach to taxation offers a reprieve neither to those who want to tax capital gains without regard to merit, nor to those who want to provide an incentive without regard to merit.

RESEARCH AND DEVELOPMENT

Two proposals contained in the Administration's budget are concerned with research and development tax credits and with the allocations of research and experimentation (R & E) between U.S. and foreign-source income. Although I have some misgivings about our ability to subsidize R & E, I believe that R & E, along with education, are perhaps the best mechanisms by which to invest in the long-term growth of our economy.

Having made that claim, let me add that the both declines in defense expenditures and growing international competitiveness require a comprehensive strategy with respect to government promotion of research and development. Any subsidy given by the government is likely to be shared with suppliers -- both capital owners and workers -- in the form of higher profits and wages, rather than increased R & E. Serious attention, therefore, needs to be given as to how to get the most bang out of our research dollars and which programs on both the tax and expenditure side of the budget are likely to be most effective.

SOCIAL SECURITY RATE REDUCTION

Finally, let me comment on recent proposals to reduce Social Security tax rates. For several decades now, the principal means by which the government has financed shifts in the budget has been to increase tax rates on workers, mainly workers at moderate income levels. As Paul Wilson and I have shown, moderate to low income workers saw their tax burdens increase from almost nothing to over one-fifth of income. This trend should be stopped, perhaps even reversed.

Recent proposals to reduce Social Security tax rates should be considered analogous to proposals to increase the personal exemption in the early- to mid-1980s rather than to tax reductions in 1981. In the former case, it was possible to create a fairer and more efficient tax Code without increasing the deficit. To be successful, Social Security tax rate reduction must be developed similarly to tax reform: it should be part of a package that takes into account both short-run deficit concerns and long-run Social Security and Medicare concerns.

Some package of changes in Social Security is both desirable and, to some extent, inevitable. Not only is the system insolvent over the long-run, but individuals with equal incomes pay very different taxes; the system discriminates against working women, the working elderly, and other groups; parts of the system are becoming less progressive as the basic principles behind its establishment are being disregarded; and more and more of total costs are simply subsidizing suppliers of medical care.