Maine: Any Tax is a Bad Tax?

A few years ago, Maine had grand visions of providing affordable health insurance for all its uninsured residents by 2009. But five years after the creation of its Dirigo health care program, funding remains so low that even the first year’s goal of providing insurance for roughly a quarter of uninsured Mainers is very far off. The program is quite popular, especially among small businesses, but Maine simply refuses to raise taxes broadly in order to pay for it. Instead, enrollment has been capped in order to keep costs down while thousands of uninsured Mainers on the waiting list hope for an acceptable source of funding to be found.

Faced with the self-conflicting demand for better health coverage without significant tax hikes, Maine legislators earlier this year considered a fifty cent cigarette tax increase as a way to modestly expand its health program. Broad, progressive, and sustainable tax increases were still out of the question given the political climate in the state, but legislators realized they may be able to raise a smaller and less important tax. Despite being starkly regressive, cigarette taxes have become an extremely popular revenue source among states since they tend to be less controversial than hikes in income, property, or general sales taxes. But having already doubled its cigarette tax in 2005, Maine policymakers soon had to back down from this idea.

The legislature, to its credit, didn’t give up completely in its effort to find funding with which to expand health care coverage. The debate then turned toward another relatively minor tax - alcohol and soda taxes. The argument was made that these products should be taxed more heavily because of their link to higher health care costs, but the more salient reason for the proposal was undoubtedly its perceived political feasibility. Rather than making the hard decision to raise taxes broadly in order to meet the goal it set for itself five years ago, the legislature tried to take the easy way out.

But in Maine, apparently any tax increase isn’t so easy. In response to the tax hike, the “Fed Up With Taxes” coalition was formed, consisting largely of restaurant owners and other related business interests. The coalition is already collecting signatures at restaurants across the state in hopes of getting a repeal of the tax on the ballot.

Despite proceeding so cautiously in search of a revenue source that wouldn’t get them into too much trouble with the voters, the end result of this legislative session may ultimately be a failure to find any way to secure additional funding for the uninsured.

This sudden challenge to the beverage tax suggests that the blame for the lack of funding for the Dirigo health plan should not be placed on legislators – but that the root cause of this embarrassment is instead a refusal on the part of voters to take responsibility for paying for programs they believe to be worthwhile. Across the country the clear preference has been for lower taxes and better government services. These two demands cannot be reconciled, and their interaction has helped contribute to both the national debt and to the avalanche of fiscal problems at the state level.

Too often, voters unwilling to accept higher taxes point to cutting “wasteful spending” as the source of revenues from which favored programs should be enacted or expanded. While wasteful spending certainly does occur, it’s likely not of the magnitude most believe it to be, and identifying it accurately is not a simple, uncontroversial, or inexpensive process. It’s easy to blame whatever one believes to be “wasteful spending” when revenues start to fall short, but the reality is that there’s no easy solution to funding more government services.

Taxpayers either need to learn to expect less from their government, or they need to take responsibility for chipping in to pay for government services. A failure to do these things is what led to the current situation in Maine where a heated battle appears imminent over a tax hike that in the grand scheme of things is too small to substantially improve upon the health care situation in the state. If voters ever decide that they are willing to pay what is needed for government services, the result will be a climate of debate in which sensible reform of the tax system can be enacted. That situation would certainly be preferable to the current one where minor, disjointed, and often regressive tax increases at the margin have the best chance of gaining approval.

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It is About Credit Markets, Not Just Stimulus

Washington has kicked off a perfectly predictable donnybrook over stimulus. Democrats, who spent the past eight years bashing George Bush for turning a Clinton-era surplus into a big deficit, are now defending what will be nearly  $1 trillion in new tax cuts and spending. Republicans, who presided over decades of deficits, suddenly are worried about the debt we are leaving to our grandchildren.

Yet, this entire squabble may be missing the point. If Washington is going to help dig the economy out of its very deep hole, it must do more than just stimulate demand. It must also restore the health of the credit markets.

That is not to say that designing a good stimulus bill is not important. It is. But we need to recognize the limits of what all this government spending and tax cutting can do.

For now, Washington is falling back on recipes that have been tried many times before with only limited success. On the tax side, proposals such as allowing businesses to write-off capital costs more quickly, or giving cash payments to workers, have been tried repeatedly in past recessions. As a new TPC report card shows, there are no magic bullets here. While some pieces of the tax stimulus working its way through Congress will be better than others at jump-starting the economy, none will have a major impact.

The same goes for spending. A new CBO report concludes it will take years for the proposed new outlays to work through the economy. For instance, CBO figures only about one-third of $30 billion in proposed highway money could be spent within the next 20 months.

My sense is that, at best, the stimulus package will keep things from getting worse. Necessary, as they say, but not sufficient for recovery. The IMF recently published an interesting paper that noted the importance of both stimulus and credit market reform, even as it called for massive efforts to boost demand. Christy Romer, a key adviser to President Obama and a highly respected economic historian, has argued that New Deal fiscal policy did almost nothing to end the Great Depression.   

Think of stimulus as a life preserver. It may keep the economy from drowning, but won’t do much to get us back on a course of sustained economic growth.

It will be up to the Fed and the much-maligned TARP (and its costly progeny) to accomplish that. The problem, of course, is that when it comes to fixing the credit markets, we are sailing in unchartered waters. Do we create a “bad bank” that will offload toxic loans from troubled financial institutions?  Do we nationalize some brand-name banks? In desperation, we find ourselves looking to the experiences of Sweden or Japan for answers that are not obvious.

After a lot of arguing, we’ll enact a nearly $1 trillion stimulus. It will help, though much of the money will inevitably be wasted. But keep your eyes on what the Fed and the Obama Administration do to get the credit markets working again. That, more than tax cuts and spending, will be key to how quickly the economy gets back on track. 

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How Federal tax is calculated for whithholding from paycheck?

Did the Capital Gains Tax Break on Home Sales Help Inflate the Housing Bubble?

No.

The New York Times suddenly discovered a study by Fed economist, Hui Shan, which they think reveals a new cause for the housing bubble. Shan’s study found that a 1997 tax change allowing capital-gains-tax-free sales of homes (up to $500,000 of gains for couples and $250,000 for singles) increased housing sales. The Times concluded that this change might have contributed to the housing bubble by increasing the demand for owner-occupied housing. They tell the story of an investor who repeatedly bought homes, lived in them for the required two years, and then sold them at a tax-free profit, and inferred from this anecdote that this was a significant part of the bubble.

But Hui Shan did not conclude that the 1997 law increased housing prices—only sales of houses that qualified for the gains exclusion—and the capital gains/bubble hypothesis rests on pretty shaky ground.

Let’s recap what the 1997 law did. Pre-1997, homeowners who sold a home and purchased a more expensive one could defer capital gains tax indefinitely. Homeowners age 55 and over who sold a home qualified for a one-time exemption on gains up to $125,000. Homeowners who died in their homes were forgiven capital gains tax altogether (as they were on all other assets because of so-called “step-up in basis”—the provision that spares heirs tax on capital gains earned by decedents).

The consequence of this law is that, before 1997, almost nobody paid capital gains tax on homes. Sally Wallace, David Weiner and I found that in 1993, of $50.5 billion of gains reported on home sales, $48 billion was exempt from tax either because of the rollover provision ($30 billion) or the special break for older owners ($18 billion). We also found that, while the tax collected almost no revenue, it created significant distortions. Look at this chart showing a 20 point increase in the percentage of homeowners who switch to renting when they turned age 55 (and qualified for the gains tax break).

So the old law discouraged down-sizing or renting, especially for those under age 55. That is, they consumed too much housing. How does eliminating that distortion inflate housing prices???

Another revealing measure is to compare tax expenditures on housing capital gains before and after the tax change. In 1996, the JCT estimated that the rollover provision would reduce tax revenues by $18.8 billion in 1998 and the special tax break for taxpayers age 55 and over would be worth $5.1 billion. In 1997, JCT estimated that the tax expenditure for the new provision would be $5.6 billion in 1998. In other words, the tax subsidy for owner-occupied housing declined by $18 billion. And that inflated the bubble?

The other argument that might be made is that even though the prior law raised almost no revenue, it amounted to a huge implicit tax (because it locked people in homes more expensive than they wanted) so eliminating it raised the after-tax return to housing. This assumes that people accounted for this when they decided how big a house to buy or whether to own or rent, which I think is unlikely except for those who wanted to buy homes as short-term investments.

As the NY Times article notes, there are flaws in the implementation of the 1997 law. It shouldn’t apply to people who flip homes every two years. But, on balance, eliminating a tax that encouraged people to consume too much housing while raising virtually no revenue was a good thing. And it certainly is not a significant factor in the housing bubble.

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Great Expectations

I’ve been reading up on the Great Depression (never say those of us at TPC don’t know how to have fun) and am struck by one overriding thought: Even with the benefit of 80 years of hindsight, economists still can’t agree on either what went wrong or how the economy got back on track.

There is an important lesson here. Famously impatient, Americans not only expect government to fix today’s economic crisis, they demand it. Barack Obama, I suspect, will have about a year to turn things around before the public turns on him. Yet, if we still don’t know what happened in 1929, how can we expect policymakers to truly understand—and correctly address—events happening in real time today?

Here is the dirty little secret: Obama doesn’t know how to fix the recession. Nobody does. It is easy (though wrong) to say Herbert Hoover failed to grasp the enormity of the Depression. But in truth, FDR had little better idea of how to respond to the crumbling economy. In fact, Roosevelt was famous for trying one solution after another until something seemed to work.

There is broad agreement on what government should not do, such as run a tight monetary policy or restrict trade. But there is much less consensus on what it should do. How much will pulling fiscal levers boost demand? Is massive new government spending really such a good idea? Will tax cuts get people and businesses spending again?

When credit markets collapsed earlier this year, George Bush turned to his group of wise men for advice. They included Fed Chairman Ben Bernanke, a highly-regarded student of the Depression. President-elect Obama has now chosen his team, including Christy Romer, another expert on that era. They are very smart, and have access to far better data than their counterparts had in the 30s.

But today’s data are not that good. And there is no magic bullet. For instance, Treasury Secretary Hank Paulson has been roundly criticized for his on-again-off-again use of the TARP. First, he insisted on using the $700 billion to acquire bad assets, then he decided to pump liquidity into financial institutions, and now he is giving $13 billion to the auto companies. This seems incoherent because it is. But trial-and-error is as inevitable in economics as in medicine—another field based more on art than science.

Obama’s stimulus plan, which by some accounts will cost $850 billion or more, will include its share of bad ideas. Some initiatives may at first seem to make perfect sense but will inevitably have dreadful unintended consequences. And there will be good ideas that should be in the plan but fail to make the cut.

Those of us who kibbitz from the sidelines will identify mistakes and demand better alternatives. But we should have no illusions. Getting a huge, complex, and still poorly understood economy back on track is not going to be simple and it will take time. Obama, despite the stratospheric expectations he’s raised, is going to make errors. We will, and should, call him on those poor choices. But we’d be fools to expect perfect diagnosis and treatment from the incoming Administration.

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A Way to Boost Demand and Reduce Long-term Budget Problems

Policy makers are rightly focused on boosting demand as a way to pull us out of the current recession. The proposals offered so far will help, but none directly target the price of goods and services that people buy and all will add to our alarming budget deficits. So here’s a simple suggestion. Why don’t we promise future price increases so consumers will have an incentive to spend more now.

Enact a value-added tax (VAT) that phases in starting in 2010. (A VAT, common throughout the rest of the world, is basically a sales tax that is collected in stages from producers and retailers.) If the VAT started at a 5-percent rate, that would push retail prices up by 5 percent (assuming the Fed lets the money supply grow), providing an incentive for consumers to make purchases in 2009 rather than postpone them.

This would reduce the risk of deflation—actual declines in prices—which would tend to exacerbate the economic decline. If consumers expect prices to fall, they have an incentive to postpone purchases, which weakens demand further and depresses prices more.

The VAT revenues could eventually constitute a significant part of overall federal tax revenues, which would help pay off the debt that we are piling up in our efforts to avert economic collapse. When fully phased in, revenues could be used to pay for all or a portion of federal health care costs, allowing for cuts in income and payroll taxes while moving federal finances to a more secure footing. The VAT would hit lower-income people especially hard, but the tax’s regressivity could be offset through income tax credits or by pairing the tax with health insurance subsidies targeted at low- and middle-income households. And, since a VAT taxes consumer spending, but not saving, it could help reverse the alarming decline in personal savings in the United States, making the next recession a little less painful.

Moreover, once on the books, the VAT would be a powerful tool to help manage fiscal policy. The rate could be increased to help keep the economy from overheating during booms and cut to spur demand during future recessions.

I’m not underestimating the political and practical problems inherent in enacting a VAT in the United States, but the fact is that there are no painless or perfect solutions to our current economic problems. And this option has the unique advantage of actually diminishing the likelihood of the future budget catastrophe that many of us fear much more than the current economic downturn.

Postscript:  After I posted this, I learned that Princeton economist, Alan Krueger, had been thinking along very similar lines.  See his excellent post, “A Future Consumption Tax to Fix Today’s Economy,” on the NY Times Economix blog.  Most interesting, one of his commentators noted that the UK has temporarily cut their VAT to boost demand.  And, while we’re acknowledging antecedents, I first broached this idea on the National Journal expert’s blog back on January 5 as part of a series of “neglected stimulus ideas.”

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AIG: Ben Blinked

Just when we thought the bailouts were over, just when Fed Chairman Ben Bernanke and Treasury Secretary Hank Paulson insisted failing financial institutions would, like Lehman Brothers, sink or swim on their own, along comes AIG.

Make no mistake, the Wall Street financiers called Bernanke and Paulson’s bluff. After the two men said Washington would not throw taxpayer money into the AIG pot, the big money guys went all in, insisting they would not rescue the rapidly-sinking financial services giant without cash from Washington.

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The Next Financial Bailout

My sources at the Federal Reserve and in the financial markets increasingly expect that Washington is going to have to put up hundreds of billions of dollars more to directly recapitalize troubled banks.

Such a step would be in addition to the $700 billion authorized by Congress last week and could require new congressional appropriations. It would put even greater pressure on the short-term budget deficit and add to uncertainty over the total cost of cleaning up the financial system mess. It could also require new federal legislation, setting up yet another bruising battle on Capitol Hill.

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