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Taxes, Part One

THINK TANK WITH BEN WATTENBERG
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, we’re 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 life’s 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, I’m Ben Wattenberg. Arguing about taxes is as old as the hills. But in today’s 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, don’t like tax cuts, at least not Bush’s 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 Hubbard’s 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 Bush’s 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: That’s a great question because over the years it’s 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 President’s 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 that’s the concern here. What we’re getting is a tax program or tax package which will give us very large budget deficits at a time when we’re already concerned about deficits and probably not a whole lot in terms of uh, incentives. I don’t say it’ll do nothing. I...I agree with Glenn that uh, taxes do affect behavior but the question is uh, I don’t think we’ll get much bang for the buck out of this particular package.

Glenn: I really don’t agree with that. I think that the powerful incentive affects of the President’s 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 don’t think uh...I don’t 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 we’re 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 that’s because if you have big deficits that increases interest rates...

Glenn: I think it’s 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 don’t 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 President’s plan if it were adopted in its entirety might increase long-term rates by as much as ten basis points. It’s easy to see...

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

Glenn: Well, a hundredth of a...of a percentage point. It’s 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. It’s easy to see why that is. We have an international capital that’s tens of trillions of dollars, and we’re 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 we’re doing is borrowing from the world at a very high rate. In other words, we’re running up huge foreign debts. In order to...so running deficits and then financing those deficits overseas is not something that’s 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. That’s dynamic scoring. It’s used in some quarters to suggest that, well; tax cuts just don’t cost very much after all. That’s not the sense in which I think it’s in useful calculation. I think it’s useful because if I were a member of Congress, I would want to know what’s the effect of what I’m proposing to do on the economy and to do that you must have dynamic scoring. I think that’s 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 it’s 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 that’s not enough as far as you’re concerned?

Glenn: Well, it...not strictly but that’s 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 what’s 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 President’s 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 they’re getting tax cuts on the cheap, but to know what policies work and what policies don’t.

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 people’s 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, there’s only one category of policy, which I’m 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 don’t think that’s the issue. Here’s 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 what’s 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 what’s 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 isn’t about people who get dividends and capital gains. It’s about all of us.

Ben: Sir, why don’t you give us a nice uh, um, full...full-bodied response to that idea of a dividend tax cut?

Martin: Well, I’m 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 don’t think it’ll make a huge difference um, but I think it would be uh, a helpful thing to do, but let’s...let’s be...straighten out a couple of things. First of all, a lot of that...there’s not a lot of double taxation, a lot of profits uh, there’s 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 there’s some double taxation, but it’s...it...it shouldn’t 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 it’s a stretch, and it...it really is suggesting that we’re getting a big price in terms of big deficits which is taxes we’re gonna have to pay in the future as Glenn said, this is a fairly expensive measure that’s 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 that’s...that’s 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. They’re the most distorting taxes. They’re 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 economist’s 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. They’re foreigners or they are tax exempt uh, institutions, does not mean that the costs of capital and asset prices aren’t 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, ’cause 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 it’s the size government. At the moment spending is rising, deficits are rising.

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

Martin: Um, it’s...well, what...I think it’s...it’s primarily because of the military build up but that’s gonna continue and then further down the road we’ve 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. It’s 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 that’s why I object so much to these taxes...tax cuts, not because it’s 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 it’s 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 we’re 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 that’s 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 don’t they? John Kennedy supported it. Ronald Reagan supported it. George W. Bush supported it. What’s 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 we’re 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. We’re doing that. Monetary policies is setting interest rates very low and may lower them uh, even further, so it’s doing it’s uh, part, and it’s reasonable to say that we should have some kind of uh, fiscal stimulus to contribute to that, and in this package that’s being proposed, there would be a...a fiscal stimulus from it. I’m...I wouldn’t say there’s 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 ’cause they don’t 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 what’s the dish on...on the flat tax?

Glenn: Well, I think you’ve 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 you’ve really raised two questions. They are for most Americans the tax system really isn’t 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, it’s ensnared a lot of us who frankly aren’t that well to do and it’s 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 what’s 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 don’t 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 don’t 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 you’re 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, there’s 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 doesn’t. What constitutes expenses and what doesn’t? So I think it’s an illusion to think that we could all of a sudden change our whole political system and get rid of all that uh, complexity. It’d be nice if it happened.

I think the Nineteen Eighty-six Tax Reform was certainly uh, helpful. Uh, we’ve ended up with a lot of that complexity back in the system, so...and there’s a sense in which it didn’t stick. But the main thing to say about that it was tax reform that was revenue neutral, and in other words it said, we’re gonna raise a certain amount of revenue which is the amount that we think we need. What’s 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 wouldn’t uh, be at all surprised, and I think those cuts are in the step toward tax reform.

Ben: There...there...there’s 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, we’ll give you more. We’ll 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 don’t 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 you’re rich anyway, then we won’t give you uh, quite as much. Oh well, that’s...that’s 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 what’s likely to come in over the next seventy-five years is about fourteen trillion dollars. That’s about a hundred and forty percent of our country’s 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 let’s 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. It’s what makes our program better. For Think Tank, I’m Ben Wattenberg.

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Funding for this program is provided by...
(Pfizer) At Pfizer, we’re 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 life’s 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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