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Taxes, Part One

Taxes, Part One #1119
Feed Date: June 27, 2003
Glenn Hubbard and Martin Baily

Opening Billboard: Funding for this program is provided by...

(Pfizer) At Pfizer, weíre spending over five billion dollars looking for the cures of the future. We have 12,000 scientists and health experts who firmly believe the only thing incurable is our passion. Pfizer, life is our lifeís work.

Additional funding is provided by the Lynde and Harry Bradley Foundation, the John M. Olin Foundation, the Bernard and Irene Schwartz Foundation, and the Smith Richardson Foundation.

Hello, Iím Ben Wattenberg. Arguing about taxes is as old as the hills. But in todayís struggling economy, taxes are the root issue of American politics. President George W. Bush has made cutting taxes the core of his domestic agenda since his first day on the job. His critics, mostly Democrats, donít like tax cuts, at least not Bushís version. A battle royal has ensued. Will tax cuts help the economy? Who should get them and how much? Can anyone make sense of it all?

To find out Think Tank is joined by Glenn Hubbard, professor of Finance and Economics at Columbia University, former Chairman of the Council of Economic Advisors under President George W. Bush, and one of the principal authors of the current Bush tax plan.

And, Martin Baily, Senior Fellow at the Institute for International Economics and Hubbardís predecessor as Chairman of the Council of Economic Advisors under President Bill Clinton.

The Topic Before the House: Taxes, Part One. This week on Think Tank.

Ben: Okay uh, Glenn Hubbard and Martin Bailey, thank you for joining us on Think Tank. Glenn, you are regarded as one of the principal planners and architects of President Bushís tax cuts and economic plan and that plan is described as a supply side plan and you have described yourself as to me as a supply sider. I wondered if we could this discussion with a very elemental question and that is, what is a supply sider?

Glenn: Thatís a great question because over the years itís meant so many different things to different people. To me, what supply side means is that economic incentives matter. Incentives for me to work harder, to save, for a businessperson to invest that those incentives actually affect economic outcomes. The Presidentís most recent plan was built around the notion that those incentives would affect individual decisions and economic growth and that, to me, is what supply side is about.

Ben: Martin?

Martin: Well, the...the term supply side has been...has come to mean uh, rather exaggerated views of how incentives will affect uh, behavior and I think thatís the concern here. What weíre getting is a tax program or tax package which will give us very large budget deficits at a time when weíre already concerned about deficits and probably not a whole lot in terms of uh, incentives. I donít say itíll do nothing. I...I agree with Glenn that uh, taxes do affect behavior but the question is uh, I donít think weíll get much bang for the buck out of this particular package.

Glenn: I really donít agree with that. I think that the powerful incentive affects of the Presidentís tax plan would probably add at least a half of a percentage point to the level of GDP, the level of income and output in our economy forever. Now the Congress, of course, passed a smaller plan but those are very, very large feedback effects. I think the goal of tax policy has to be to create a level playing field for decisions and to try to promote economic growth.

Martin: I donít think uh...I donít think we can support that. If we look at the objective people who are doing research on this including the Congressional Budget Office which is uh, the Agency of...of Congress to look into this and the people like Goldman Sachs who have estimated weíre gonna get four and half trillion dollars worth of deficits over the next ten years and uh, most of the models the CBO looked at suggested that the ten-year effects on GDP will actually be negative, and thatís because if you have big deficits that increases interest rates...

Glenn: I think itís widely accepted among economists that the tax changes that reduce the tax burden on saving and investment can have very powerful effects that is now firmly entrenched in...in academic literature. Many of the models I think that Martin referred to do not pick up on what has been the current strand of work in economics which focuses much more on incentives. I donít accept the notion that short-term budget deficits will have a large effect on interest rates. When I was in the White House I estimated that the Presidentís plan if it were adopted in its entirety might increase long-term rates by as much as ten basis points. Itís easy to see...

Ben: What...what is the basis point?

Glenn: Well, a hundredth of a...of a percentage point. Itís a very, very small...a tenth of a percent.

Ben: Uh, of...of gross domestic product.

Glenn: No, no. Ten...the interest rates would be...

Ben: Of...of...of interest rates.

Glenn: Right. Interest rates would rise very, very slightly. Itís easy to see why that is. We have an international capital thatís tens of trillions of dollars, and weíre talking about relatively small movements. Uh, another way to see is the fact that we have seen over the past few years a marked change in fiscal position in the country and we have the lowest nominal interest rates in a generation.

Ben: Will this tax cut uh, generate a diminishment in what is called the marginal tax rate and would one of you explain what...a marginal tax rate is?

Glenn: Martin?

Martin: A marginal tax rate is what you pay on the extra dollar of income that you receive. So, on average I might pay twenty, thirty, whatever it is percent of my income, but if I get an extra dollar by working an extra hour, uh, how much of that do I have to give over to the...the government. Well, let me come back to something that Glenn said that I think is important. He said we are in an international capital market and indeed we are, but what weíre doing is borrowing from the world at a very high rate. In other words, weíre running up huge foreign debts. In order to...so running deficits and then financing those deficits overseas is not something thatís desirable for us even if it does mitigate the rise in interest rates.

Ben: What is dynamic scoring? We...we hear all about that in...in this dialogue. What...what does it mean?

Glenn: Well, dynamic scoring I think has a simple definition and two uses, at least one of which I think is really important. The simple definition of dynamic scoring is to take into account when you have a tax change what the effect would be on economic activity and future revenue, so and if I cut taxes and people work harder or invest more and the economy is larger, the government gets a share of that. Thatís dynamic scoring. Itís used in some quarters to suggest that, well; tax cuts just donít cost very much after all. Thatís not the sense in which I think itís in useful calculation. I think itís useful because if I were a member of Congress, I would want to know whatís the effect of what Iím proposing to do on the economy and to do that you must have dynamic scoring. I think thatís why economists of all stripes have been urging the Congress to think hard about dynamic scoring.

Ben: Did...are you in favor of dynamic scoring?

Martin: If itís done right. Um, the new head of the Congressional Budget Office that I
mentioned earlier, Doug Holseiken, a very strong economist, a very good guy, and uh, he has uh, taken a look at what this package will do and make some estimates of...of it, and he does allow for changes in the economy. He does allow for these feedbacks, this dynamic scoring, the effects of marginal tax...

Ben: And...and thatís not enough as far as youíre concerned?

Glenn: Well, it...not strictly but thatís not the big problem of what Martin is saying. What...what the CBO did was look at the entire budget which is a mixture of some spending programs, a variety of tax changes, some of which frankly are better tax policies changes than others. What I think of as dynamic scoring where I a policymaker voting on this is to know policy by policy whatís the feedback effect. For example, many economists believe that cutting marginal tax rates on work has a feedback of about thirty-three percent, so the government would get back about a third of the estimated of the tax cut. The Presidentís plan to reduce dividend taxes could have a feedback of even forty or even fifty percent. These are things that I think policymakers need to know not so much to think theyíre getting tax cuts on the cheap, but to know what policies work and what policies donít.

Ben: What...what...what does that mean, feedback?

Martin: What does it mean, feedback?

Ben: Yes.

Martin: Uh, it...it...I...well, Glenn used the term, but I think what it means here is that if you have some uh, change in taxes and that changes peopleís behavior then that, in turn, changes the level of economic activity, the level of GDP, and uh, how much money we have in our economy.

Glenn: Well, my...my view is that the current economic situation was one in which business fixed investment was a problem. The recovery of the business investment had been slow, uh, in part because we had too much investment in the past. We were just working through a capital overhang, and in part, because balance sheets were adjusting very slowly. The stock market had declined a great deal, of course, since its peak in...in Two Thousand. So if you ask yourself what change in tax policy could both reduce the cost of capital for business investment and help reflate asset values, thereís only one category of policy, which Iím aware, which would be cutting dividend and capital gains taxes.

Ben: But...but one very wealthy man is going to get six million dollars because of that dividend tax cut. Is that fair?

Glenn: Well, I donít think thatís the issue. Hereís the way I would think of it. If you tax something, you get less of it. If you double tax something, which is the current issue, you get I guess a lot less of it, and the question is whatís the if? I mean...

Ben: Double tax it in...in what respect?

Glenn: In other words, the...the proposal to reduce or eliminate dividend taxes is saying, look, this income is already taxed once at the corporate level. Should we tax it again at the investor level and make American companies less competitive? If you double tax something, you get a lot less of it and whatís the 'it'? The 'it' here is productive capital. What the double tax had done is diminish capital accumulation ultimately reducing the level of productivity and wages going forward. Who bears the burden of this tax is not the guy writing the check to the IRS, which was your question, but ultimately, all of us in terms of our wages. This isnít about people who get dividends and capital gains. Itís about all of us.

Ben: Sir, why donít you give us a nice uh, um, full...full-bodied response to that idea of a dividend tax cut?

Martin: Well, Iím in favor of improving the efficiency in the way we tax cap...uh, tax capital. I think that could improve the performance of the economy. I donít think itíll make a huge difference um, but I think it would be uh, a helpful thing to do, but letís...letís be...straighten out a couple of things. First of all, a lot of that...thereís not a lot of double taxation, a lot of profits uh, thereís depreciation allowances and various things that corporations do. A lot of the dividends get paid out to uh, retirement funds and foundations and groups like that that are not uh, paying taxes, so thereís some double taxation, but itís...it...it shouldnít be exaggerated how much uh, that is, and the...the question is if you take the tax off dividends, will you get a lot more investment on a lot more wages, and...and you get a little bit but itís a stretch, and it...it really is suggesting that weíre getting a big price in terms of big deficits which is taxes weíre gonna have to pay in the future as Glenn said, this is a fairly expensive measure thatís likely to have pretty small effects on investment and then through investment, pretty small effects on uh, on wages, so if you want to...if you want an efficiency enhancing policy, uh, this do a little bit for you but at a big price in terms of the deficit, there are better things to do I think.

Glenn: Well, let me suggest that thatís...thatís not the case at all. I think if you ask public finance economists, people who study the tax code in economics, eliminating or significantly reducing capital income taxes would be the top of their list. Theyíre the most distorting taxes. Theyíre the highest costs in our economy. Ten years the Treasury Department outside any current policy debate took a hard look at across a lot of models and a lot of economistís views at eliminating dividend taxes and in...concluded that you would have very large gains in output and in wages for doing so. And I would dispute the point about double taxation. The...the fact that a lot of investors are not now paying taxes. Theyíre foreigners or they are tax exempt uh, institutions, does not mean that the costs of capital and asset prices arenít affected as long as the person an economist would say at the margin, the last one in the tray, it is someone who pays taxes.

Martin: Let me just chip in something here, ícause I think if we had tax reform, some kind of revenue neutral tax reform, I think maybe Glenn and I could reach some agreement on how you would go about improving the way we tax capital and I think we both agree that maybe it would do something uh, to...positive for the economy, but in a situation where uh, spending is rising. Glenn mentioned itís the size government. At the moment spending is rising, deficits are rising.

Ben: Is...is...is it...is it...itís...spending...spending is rising in addition to the military spend up and build up. Is that correct?

Martin: Um, itís...well, what...I think itís...itís primarily because of the military build up but thatís gonna continue and then further down the road weíve got these entitlement programs which are gonna rise because we just got more people retiring. So the prospects for trying to keep spending under control is tough. Itís gonna be a tough, tough sledding. Basically the budget process at the moment has just gotten out of control. It took a long time to go from the deficits of the Eighties to get the budget process back under control. It was a bi-partisan effort. Bush, Sr., the Congress, President Clinton, everybody got that thing under control and we ended up with surpluses. That process has now gotten out of control and thatís why I object so much to these taxes...tax cuts, not because itís uh, a bad idea to improve the way we...we tax capital but because the budget process has gotten out of control.

Glenn: I think itís worth reminding ourselves where these surpluses came from the Nineteen Nineties. Overwhelmingly it was because of the success of the private economy, the fact that we had very good news about future profitability and productivity in our economy. Much of that good news still persists to this day. We also had meaningful spending restraint. Those were the two hallmarks of that...of that era, and I agree with Martin, it is important to have spending restrained, and I think that as a country weíre gonna have to look very, very hard at ways to control spending. I think the notion of raising taxes to offset the spending pressure as...as opposed to cutting spending is not one thatís gonna promote economic growth.

Ben: What...what is the difference between the so-called Keynesian Tax Cut and a Supply Side Tax Cut? They both cut taxes donít they? John Kennedy supported it. Ronald Reagan supported it. George W. Bush supported it. Whatís the difference?

Martin: Well, right at the moment we have an economy where the demand for goods and prod...services, how much people want to go out and buy is less than the capacity of our economy to produce or supply it, so...so weíre in a demand uh, weak uh, recession at the moment or downturn at the moment, period of slow growth. So the thing to do to get this economy going is to use policies that will stimulate demand. Weíre doing that. Monetary policies is setting interest rates very low and may lower them uh, even further, so itís doing itís uh, part, and itís reasonable to say that we should have some kind of uh, fiscal stimulus to contribute to that, and in this package thatís being proposed, there would be a...a fiscal stimulus from it. Iím...I wouldnít say thereís no fiscal stimulus, but at the price of...of uh, these long run concerns that I have. There are other things that we could do. I think give a bit more aide to the states which at the moment are having to lay-off uh, policeman and fireman ícause they donít have enough money. Some of that is their own fault, but I think we should still do a bit more to help them than is being proposed.

Ben: Um, what about a flat tax. The former chairman of the Ways and Means Committee, Bill Archer, used to purposely do his own taxes with...without an accountant every year just to show it could be done. The tax system has gotten so complicated. I mean, how...how high is it? I mean miles high, the actual code? Um, what would be wrong with going to a...I mean, Steve Forbes popularized it I guess, but...but whatís the dish on...on the flat tax?

Glenn: Well, I think youíve really raised two questions.

Ben: I mean, he says you could...you could fill out your taxes with a postcard.

Glenn: But I...I think youíve really raised two questions. They are for most Americans the tax system really isnít that complicated. Uh, for many high income Americans and increasingly because of the alternative minimum tax it is complicated, but the problem of complexity can be addressed even outside of talking about a flat tax. It could be addressed by...

Ben: Could...could you just do a little byway here and tell us what the alternative minimum tax is?

Glenn: The alternative minimum tax is this strange parallel tax system that says if we file our regular tax what we would all fill out on our Form Ten-Forty before April Fifteenth and we have too many preferences. That is, departures from the standard tax policy. We might get kicked onto an alternative minimum tax so that we all pay a certain level of tax. It was designed to make sure that very high income tax payers did not escape the tax system by using tax avoidance devices. Increasingly, itís ensnared a lot of us who frankly arenít that well to do and itís a real problem. We could fix complexity without even going to a flat tax. We could change dividend and capital gain tax treatments. In the business area we could clean up the way we tax international companies and so on. I think the interest in the flat tax has come about partly for simplification but partly because of the interest in lowering marginal tax rates, and to me as an economist whatís important is not so much that a tax literally be flat but that we try to have as low a marginal tax rate was we can, the tax rate on that extra dollar that I earned and a broad base.

Ben: The uh...the tax rate on the alternative minimum tax was supposed to be fifteen, sixteen, seventeen percent, much lower than what...what relatively uh...I mean, upper middle-class Americans are...are paying.

Glenn: Well, of course, that rate has...has gone up substantially over...over time. I think the question is to try to get a very broad base and a relatively low rate and to make sure that we have a tax system that provides benefits for people who are at the very bottom of the income scale.

Martin: Well, a flat tax in principle has a lot of attractions to it. Let me explain, I think, why we donít have one in practice. Well, number one, if it applies to people at the very bottom of the income distribution, then it would be more aggressive in the current system. As Glenn said, a lot of people currently donít pay...have to pay taxes, so if it was flat all the way to the people at the bottom uh, then I...I would not like it, because it would uh, penalize people who are currently not paying uh, federal taxes. Then as you go up into uh, higher income individuals, if you had a flat tax, I could imagine a flat tax that I might be willing to support but the question is would the American people, would they be willing for example to get rid of some of their deductions like mortgage interest or uh, medical care. If youíre gonna have a flat tax and keep it at a fairly moderate rate, you would have to get rid of a lot of things that uh, I think would be very hard politically to get rid of. Even if you look on the corporate side, thereís a reason why we have such a complicated tax system. We have a whole set of tax lobbyists uh, out there. Uh, we have a lot of individual circumstances that require very difficult judgment about what constitutes income and...and what doesnít. What constitutes expenses and what doesnít? So I think itís an illusion to think that we could all of a sudden change our whole political system and get rid of all that uh, complexity. Itíd be nice if it happened.

I think the Nineteen Eighty-six Tax Reform was certainly uh, helpful. Uh, weíve ended up with a lot of that complexity back in the system, so...and thereís a sense in which it didnít stick. But the main thing to say about that it was tax reform that was revenue neutral, and in other words it said, weíre gonna raise a certain amount of revenue which is the amount that we think we need. Whatís the most efficient way of doing that? If we started with that premise, I think many of us could get on board with tax reform.

Glenn: My guess is the administration would continue to push to make the current tax cuts permanent... so in that sense I wouldnít uh, be at all surprised, and I think those cuts are in the step toward tax reform.

Ben: There...there...thereís this great issue about the aging of the society and people wanting uh, reaching retirement age and what the Congress and the President has come up with is say, oh, weíll give you more. Weíll give you a prescription uh, a prescription benefit, and the numbers go into the scores of trillions. I mean why...I mean and yet it was said that the touching Social Security was the third rail of American politics. In Nineteen Eighty-two, the Greenspan/Moynihan Commission proposed a...an increase albeit in the future of...of tax rates and nobody got electrocuted.

Glenn: Well and President Bush campaigned on Social Security reform. I...I donít think Social Security is...is the third rail.

Martin: Well, let me...let me comment on that. First of all on Social Security uh, I think we can do something to reform Social Security, but the Social Security plan we have at the moment is not a terribly generous one. We do not give our retirees a whole lot of money uh, to live on, so we may be able to do some things and we may be able to say, okay, well if youíre rich anyway, then we wonít give you uh, quite as much. Oh well, thatís...thatís tricky to do also. Where we probably can do something is on Medicare but as you point out correctly uh, at the moment Medicare does not give prescription drugs. The...the President has proposed doing that. I actually supported his plan to encourage uh, seniors to go into managed care if they were gonna get uh, prescription drug plan. That would be actually heresy to many uh, many democrats uh, but I think we need to do things like that to uh, try to slow the growth of the healthcare spending. But even if we do, everything that I think is politically feasible or even desirable, the costs of those programs are gonna be enormous and we should be thinking now about how to pay for them.

Glenn: Yeah. Well, let me put a numbers face on that if I might. The unfunded liability of Medicare, that is the...are excess promises over whatís likely to come in over the next seventy-five years is about fourteen trillion dollars. Thatís about a hundred and forty percent of our countryís GDP.

Ben: Trillion with a T.

Glenn: Trillion with a T. If we add a drug benefit not of the form the President proposed which I agree with Martin would have been the better way to go but one which goes as well into conventional Medicare with no competition reforms. Over seventy-five years, we could add as much debt as is the entire stock of public debt today, about another three and half trillion dollars.

Ben: Again, with uh...with a tree. With a...with a T.

Glenn: With...with a T.

Ben: With a T-R.

Glenn: These are huge, huge changes. So I find it deeply ironic that we had so much discussion of growth tax policy that mentions the deficit work repeatedly yet waiving through a policy, which is probably the biggest single fiscal change I can remember.

Ben: Okay, on...on that note letís just uh, pause for a moment. Uh, Glenn Hubbard, thank you. Martin Bailey, thank you. Uh, thank you all for joining us. Please remember to uh, write us via e-mail. Itís what makes our program better. For Think Tank, Iím Ben Wattenberg.

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Funding for this program is provided by...
(Pfizer) At Pfizer, weíre spending over five billion dollars looking for the cures of the future. We have 12,000 scientists and health experts who firmly believe the only thing incurable is our passion. Pfizer, life is our lifeís work.

Additional funding is provided by the Lynde and Harry Bradley Foundation, the John M. Olin Foundation, the Bernard and Irene Schwartz Foundation, and the Smith Richardson Foundation.

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