Examining whether ther is a Role for Tax Reform in Comprehensive Deficit Reduction and Fiscal Policy

Comments for the Record

 United States Senate Committee on Finance

Subcommittee on Fiscal Responsibility and Economic Growth

Examining whether there is a Role for Tax Reform in

Comprehensive Deficit Reduction and U.S. Fiscal Policy

By Michael Bindner

Center for Fiscal Equity

Chairman Nelson and Ranking Member Crapo, thank you for the opportunity to address this topic. The Center for Fiscal Equity believes that tax reform will play a key role in comprehensive deficit reduction. Our comments will address the context of the debate, the role of health care expenses for the long term, our standard tax reform plan, how tax policy can address long term health costs and how to retain some form of vertical equity.

The Context of the Debate

 The key fact of the deficit reduction debate is that the entire exercise is only necessary to fund the extension of the 2001, 2003 and 2010 tax cuts. If these tax cuts were allowed to expire automatically, no further deficit reduction would be required. For the efforts of the Joint Select Committee to succeed, they must not only link cuts to permanent tax reforms, but they must also enact enough cuts and reforms to make extending the Bush cuts a non-issue.

Cutting only $1.5 trillion on top of the previous $900 billion in cuts is inadequate for a master compromise, because no agreement is likely possible on which tax provisions to offset. If cuts are proposed to offset tax savings to preserve the 10%, 25% and 28% rates and the $1000 child tax cut, Republican members will never agree – as this would allow the President to veto any additional tax cut extensions. Democrats will never allow tax cuts at the high end to come to the floor unless low end cuts are enacted first. In order to enact any tax plan, some type of tax simplification is necessary, else gridlock will solve the deficit problem, provided the President refuses to compromise on temporary tax cut extensions.

The Role of Health Costs

Over the long term, rising health care expenses require either budget cuts or increased revenue. Making such revenue increases politically acceptable requires that they be broad based, rather than targeted only to wealthy taxpayers and they should have offsets so that private delivery of health care now funded by the government reduces such targeted taxes.

Health care reform complicates the entire picture more than is generally known or acknowledged. If reform collapses the private insurance market or a subsidized public option is needed to replace the recent reforms and preserve private insurance, fixes to Medicare and Medicaid will seem like an afterthought.

The key issue for the future of health care reform is the impact of pre-existing condition reforms on the market for health insurance. Mandates under the Affordable Care Act (ACA) may be inadequate to keep people from dropping insurance - and will certainly not work if the mandate is rejected altogether for constitutional reasons.

If people start dropping insurance until they get sick – which is rational given the weakness of mandates – then private health insurance will require a bailout into an effective single payer system. The only way to stop this from happening is to enact a subsidized public option for those with pre-existing conditions while repealing mandates and pre-existing condition reforms.

In the event that Congress does nothing and private sector health insurance is lost, the prospects for premium support to replace the current Medicare program is lost as well. Premium support also will not work if the ACA is repealed, since without the ACA, pre-existing condition protections and insurance exchanges eliminate the guarantee to seniors necessary for reform to succeed. Meanwhile, under a public option without pre-existing condition reforms, because seniors would be in the group of those who could not normally get insurance in the private market, the premium support solution would ultimately do nothing to fix Medicare’s funding problem.

Resorting to single-payer catastrophic insurance with health savings accounts would not work as advertised, as health care is not a normal good. People will obtain health care upon doctor recommendations, regardless of their ability to pay. Providers will then shoulder the burden of waiting for health savings account balances to accumulate – further encouraging provider consolidation. Existing trends toward provider consolidation will exacerbate these problems, because patients will lack options once they are in a network, giving funders little option other than paying up as demanded.

Shifting to more public funding of health care in response to future events is neither good nor bad. Rather, the success of such funding depends upon its adequacy and its impact on the quality of care – with inadequate funding and quality being related. For example, Medicare provider cuts under current law have been suspended for over a decade, the consequence of which is adequate care. By way of comparison, Medicaid provider cuts have been strictly enforced, which has caused most providers to no longer see Medicaid patients, driving them to hospital emergency rooms and free clinics with long waiting periods to get care.

Ultimately, fixing health care reform will require more funding, probably some kind of employer payroll or net business receipts tax – which would also fund the shortfall in Medicare and Medicaid (and take over most of their public revenue funding).

Tax Reform Plan

The Center for Fiscal Equity’s Tax Reform plan, which has four major parts:

• Value Added Taxes (VAT) to fund domestic military and civil discretionary spending (in addition to other excises, such as the gasoline tax);
• VAT-like Net Business Receipts Taxes (NBRT) on labor and capital to fund non-pension entitlement spending which replace some payroll and most income taxation at both the individual and corporate levels;
• Old Age and Survivors Insurance (OASI) payroll taxes on employers and employees to fund old age and survivors insurance (retirees only) – with survivors insurance to non-retirees and disability insurance funded by the NBRT (and decoupled from income); and
• Income surtaxes on cash disbursements from all sources, including inheritance to fund overseas military and naval deployments, retirement of debt to the Social Security system and other trust funds, and net interest on the debt and any additional debt retirement.

Funding Health Care

Unlike a VAT, an NBRT would not be visible on receipts and should not be zero rated at the border – nor should it be applied to imports. While both collect from consumers, the unit of analysis for the NBRT should be the business rather than the transaction. As such, its application should be universal – covering both public companies who currently file business income taxes and private companies who currently file their business expenses on individual returns.

The key difference between the two taxes is that the NBRT should be the vehicle for distributing tax benefits for families, particularly the Child Tax Credit, the Dependent Care Credit and the Health Insurance Exclusion, as well as any recently enacted credits or subsidies under the ACA. In the event the ACA is reformed, any additional subsidies or taxes should be taken against this tax (to pay for a public option or provide for catastrophic care and Health Savings Accounts and/or Flexible Spending Accounts).

To incentivize cost savings under an NBRT, allow companies to offer services privately to both employees and retirees in exchange for a substantial tax benefit. Employers who fund catastrophic care would get an even higher benefit, with the proviso that any care so provided be superior to the care available through Medicaid. Making employers responsible for most costs and for all cost savings allows them to use some market power to get lower rates, but no so much that the free market is destroyed. The ability to exercise market power, with a requirement that services provided in lieu of public services be superior, will improve the quality of patient care.

This proposal is probably the most promising way to decrease health care costs from their current upward spiral – as employers who would be financially responsible for this care through taxes would have a real incentive to limit spending in a way that individual taxpayers simply do not have the means or incentive to exercise. While not all employers would participate, those who do would dramatically alter the market. In addition, a kind of beneficiary exchange could be established so that participating employers might trade credits for the funding of former employees who retired elsewhere, so that no one must pay unduly for the medical costs of workers who spent the majority of their careers in the service of other employers.

Employer provided health care will also reverse the trend toward market consolidation among providers. The extent to which firms hire doctors as staff and seek provider relationships with providers of hospital and specialty care is the extent to which the forces of consolidation are overcome by buyers with enough market power to insist on alternatives, with better care among the criteria for provider selection.

The NBRT would replace disability insurance, hospital insurance, the corporate income tax, business income taxation through the personal income tax and the mid range of personal income tax collection, effectively lowering personal income taxes by 25% in most brackets. Note that collection of this tax would lead to a reduction of gross wages, but not necessarily net wages – although larger families would receive a large wage bump, while wealthier families and childless families would likely receive a somewhat lower net wage due to loss of some tax subsidies and because reductions in income to make up for an increased tax benefit for families will likely be skewed to higher incomes. For this reason, a higher minimum wage is necessary so that lower wage workers are compensated with more than just their child tax benefits.

The Center calculates an NBRT rate of 27% before offsets for the Child Tax Credit and Health Insurance Exclusion, or 33% after the exclusions are included. This is a “balanced budget” rate. It could be set lower if the spending categories funded receive a supplement from income taxes.

Conceivably, NBRT offsets could exceed revenue. In this case, employers would receive a VAT credit.

Retaining Vertical Equity

In order to preserve vertical equity in a given tax year in a consumption tax environment, some form of progressive income and inheritance taxation is essential, otherwise the debt crisis cannot be avoided as consumption taxes will never be adequate to replace the lost revenue. The Center suggests retaining surtaxes on high income earners and heirs. These would replace the Inheritance or Death Tax by instead taxing only cash or in-kind distributions from inheritances but not asset transfers, with distributions remaining tax free they are the result of a sale to a qualified Employee Stock Ownership Plan.

In testimony before the Senate Budget Committee, Lawrence B. Lindsey explored the possibility of including high income taxation as a component of a Net Business Receipts Tax. The tax form could have a line on it to report income to highly paid employees and investors and pay a surtax on that income. We considered and rejected a similar option in a plan submitted to President Bush’s Tax Reform Task Force, largely because you could not guarantee that the right people pay taxes. If only large dividend payments are reported, then diversified investment income might be under-taxed, as would employment income from individuals with high investment income. Under collection could, of course, be overcome by forcing high income individuals to disclose their income to their employers and investment sources – however this may make some inheritors unemployable if the employer is in charge of paying a higher tax rate. For the sake of privacy, it is preferable to leave filing responsibilities with high income individuals.

Identifying deficit reduction with this tax recognizes that attempting to reduce the debt through either higher taxes on or lower benefits to lower income individuals will have a contracting effect on consumer spending, but no such effect when progressive income taxes are used. Indeed, if progressive income taxes lead to debt reduction and lower interest costs, economic growth will occur as a consequence.

Using this tax to fund deficit reduction explicitly shows which economic strata owe the national debt. Only income taxes have the ability to back the national debt with any efficiency. Payroll taxes are designed to create obligation rather than being useful for discharging them. Other taxes are transaction based or obligations to fictitious individuals. Only the personal income tax burden is potentially allocable and only taxes on dividends, capital gains and inheritance are unavoidable in the long run because the income is unavoidable, unlike income from wages.

Even without progressive rate structures, using an income tax to pay the national debt firmly shows that attempts to cut income taxes on the wealthiest taxpayers do not burden the next generation at large. Instead, they burden only those children who will have the ability to pay high income taxes. In an increasingly stratified society, this means that those who demand tax cuts for the wealthy are burdening the children of the top 20% of earners, as well as their children, with the obligation to repay these cuts. That realization should have a healthy impact on the debate on raising income taxes.

Thank you for the opportunity to address the committee. We are, of course, available for direct testimony or to answer questions by members and staff.