"Interview with James Poterba"

This is part of a much longer Minneapolis Fed interview with the new president and CEO of the NBER, James Poterba. Given the discussions about tax simplification that always come up around elections, e.g. the flat tax, the comments toward the end on the problems with "having one tax schedule for everybody" are notable:

Tax Reform

Region: Let me throw you in the deep end. With the presidential election drawing near, tax policy is sure to become a topic of increasing debate. As a tax scholar and a member of the 2005 President's Advisory Panel on Tax Reform, what kind of advice would you offer to an incoming president on tax policy?

Poterba: We are approaching a period when tax reform will likely move out of academic discussion and attract serious attention from Washington policymakers, for two reasons.

One is the Alternative Minimum Tax, a feature of the tax code that was originally designed to affect very-high-income taxpayers but has over time come to affect a larger and larger fraction of the U.S. tax-paying population because the relevant provisions were not indexed for inflation. Congress has been fixing the AMT one year at a time by raising the thresholds at which it affects taxpayers. But the one-year fix strategy is becoming increasingly expensive... It's likely that Congress will have to do something to fix the AMT in a more permanent way—after the next election would be a natural time.

The other factor that will draw tax reform into the middle of the political debate is the scheduled expiration of the tax changes that were enacted in 2001 and 2003. ...

It's difficult to predict where tax reform is likely to go. When the president's tax panel looked at the AMT and other issues in 2005, we recognized that there was no easy solution to the challenge of tax reform. Fixing the AMT is a very expensive proposition. It costs more than a trillion dollars over a medium-term budget window to repeal the AMT, and if you're going to do that in a revenue-neutral way, you have to either change income tax rates or broaden the income tax base. The tax panel pushed toward the base-broadening approach, which I think has a great deal to recommend it.

Of course, supporting base-broadening is hardly novel. It's almost a reflexive action for most public finance economics. Marginal distortions associated with the tax code tend to rise with the square of the tax rate, so that as the tax rate gets into higher and higher territory, the marginal dead-weight losses tend to grow rapidly. Going from a 30 percent to a 40 percent marginal tax rate, for example, doesn't increase the marginal efficiency cost of taxation by a factor of 1.33, but by the ratio of 16 over 9—close to 75 percent.

Region: Thus the appeal of broadening the base.

Poterba: Exactly. Broadening the tax base reduces the need to impose high marginal dead-weight burdens associated with high marginal tax rates. The challenge of broadening the base—which I fear the tax panel members learned the hard way by proposing a lot of base-broadening and then seeing the proposals go nowhere in the political system—is that most of the things that erode the current income tax base are political sacred cows. These include the home mortgage interest deduction, the exclusion of employer-provided health insurance from the tax base for individuals, the deduction for state and local property taxes, and the relief we provide on medical expenditures of various kinds. They all have constituencies that find them very important and very attractive. There isn't a strong constituency at the moment, and probably never will be, for the efficiency gains associated with broadening the tax base and lowering rates.

So you're faced with one of the classic political economy problems of imposing burdens on an identifiable group that can tell they're going to have their oxes gored by the particular reform you've proposed, while generating broadly diffused benefits for the population at large in the form of a more efficient structure for raising revenue. ...

Region: The advisory panel also suggested a simpler code; is that a feasible goal?

Poterba: Absolutely. Simplification may be the easiest dimension of reform. If you look, for example, at the way we currently provide incentives for saving to finance retirement, education, medical expenditures—we have a dizzying array of programs: 401(k)s, IRAs, Roth IRAs, 403(b)s, 457s—all of these are basically ways of offering households what public finance economists call “consumption tax treatment” on their savings. By investing in these special forms, investors can earn the pretax return on their investments. But each of these account types has its own complicated set of rules, and many households don't know what they're eligible for and don't take full advantage of the opportunities that these programs present. Some simplification could surely be achieved by rolling some of those programs into a smaller number of more broadly available saving vehicles.

There probably are other opportunities for moving in the direction of a return-free system for a substantial number of low-income taxpayers who have relatively simple tax returns. If a taxpayer's only income source is wage income or that plus some very easily identifiable capital income, perhaps from a bank, the IRS could easily compute the household's tax liability and send out a bill.

The problem with simplicity is that while almost everybody thinks that a simpler tax code is an attractive ideal, in many cases the tax code is not simple because it's trying to deal with the complexity of economic life. You could make the tax code simpler, for example, by  and just saying that married couples and single individuals would file on the same schedule; no need to look up different rates or anything else. But of course that would offend some people's sense of fairness. They would say that a two-person household with a given income should not necessarily face the same tax burden as a five-person household with the same income, or as a single individual with that income. So you say, “Okay, we'll have different tax codes for married couples; we'll allow for some dependency deductions.” Soon you're on the path to making the tax system more complicated. The same thing happens to an even greater degree when you're trying to track the income from investment property. A lot of the complexity really comes from the fact that people do complicated things, and we need to track them appropriately.

While it would be straightforward to simplify the tax code for quite a large number of taxpayers, some of the inherent complexity of the tax code that's associated with the measurement of capital income, with the tracking of business receipts and things like that, would be very difficult to get rid of without ending up with a tax system that many people would find objectionable. ...

Also, if you read this Slate piece, "Debunking the 'Wealth Effect,'":

the idea of a wealth effect doesn't stand up to economic data.

Then you should also read the section of the interview called "Housing and the Wealth Effect":

Poterba: ...Much of the discussion of the wealth effect seems to assume that there's a question of whether it exists. I think that's a misapprehension. The simple logic of budget constraints for multiperiod consumers and households tells you that if you reduce the value of the assets that households own at a given point in time, the present discounted value of their consumption stream must be reduced correspondingly. So the real question is simply, How does a household, or the household sector in aggregate, spread the loss of wealth from a drop in equity values or house values over various consumption in various future periods?

Region: So it's not whether, but when and how big.

Poterba: Right...

Comments

[bakho]

From limited experience in filling out 1040s, it is my impression that the process is complex only because there are tax breaks written into the tax code for all kinds of things. Because of the tax breaks, the tax rates have to be higher. Writing down the income is the simpler part. My FICA taxes certainly don't take a huge form.

It is my impression that Congress collects campaign donations by writing tax breaks into the code, making the process more complex. The GOP penchant for giving tax breaks for everything exacerbates the problem. Why not do away with the tax breaks all together and put everyone on a lower marginal rate? Because Congress would get fewer campaign donations.

[save_the_rustbelt]

"If a taxpayer's only income source is wage income or that plus some very easily identifiable capital income, perhaps from a bank, the IRS could easily compute the household's tax liability and send out a bill."

This guy never has dealt seriously with the IRS or the IRS computer systems.

Bakho pretty much nails the real issue, except that the Democrats create a significant share of the "loopholes."

[swells]

I have a slightly different take on this. Americans want more than they can really afford. Most all of the tax complexity can be blamed on that and from medicare to social security to credit crunches it comes down to trying to find ways to pull rabbits out of hats without having to manufacture hats or feed rabbits.

[ScentOfViolets]

Exactly, bakho. While one can acknowledge that in principle, tax incentives are necessary to encourage or discourage some behviours in an economically 'optimal' way, the system has devolved into little more than a baroque patronage system.

[swells]

ScentOfViolets, I think you are exactly right when you call it a baroque system of patronage. It has become one more example of how an elite extracts resources from the hierarchy in ways that predominately benefit the elite.

[ScentOfViolets]

I notice that the piece debunking the wealth effect has another interpretation, namely that a lot of household spending really is non-discretionary. No, most people are not spending their money on frippery like game boy consoles, high-end furniture, European vacations. Most people, regardless of the worth of their house, have to pay off their college loans, their mortgage, have to pay insurance, etc. I'm guessing that except for the one biggie, the housing deduction for home owners, most people also don't get those tax exemptions.

Pearson's Law strikes again, though probably it's one percent and not twenty.

[robertdfeinman]

Whenever I see a person talk about "dead-weight losses" I stop reading. I know I've entered the twilight zone.

Bankers only look at money. It is this one-sided view of the world that has led to so much one-sided policy. Whenever a wealthy person or firm has to give money to the government it's a bad thing. What the money is used for, and whether this leads to benefits for the overall society are not part of the equation.

Unsurprisingly, the same people can use the opposite arguments when they are looking for handouts from the government. Export subsidies - good idea. Work displacement assistance - let the government pay. Backstopping failed bets by the "investment" banking sector - have the FED bail them out.

Can we stop pretending that there is any coherent theory behind capitalism and "free trade" advocates? There is a coherent goal - more for me. The theory is: whatever it takes to achieve the goal.

Discussions of changes in tax policy are just a side show.

[a]

"Broadening the tax base reduces the need to impose high marginal dead-weight burdens associated with high marginal tax rates."

"Dead-weight burdens"? WTF? Hardly a value-free characterization of the issue. So basically the guy doesn't want to tax the rich, but he can't come out and say so directly because then we will know he is yet another economist who is beholden to wealthy interests.

[Donald A. Coffin]

Broadening the tax base makes immense sense. As Poterba points out, some efforts to do t hat run into huge political problems. But I think he under-appreciates the practical issues in, for example, ending the mortgage interest deduction. Millions of households have mortgages and deduct the interest. Part of the decision to take on mortgages with specific interest rates relied on the presence of interest deductibility. So the (nominal) interest rates people pay are higher because of deductibility. Ending deductibility amounts to a large increase in effective interest rates on long-term debt. The only practical way around this is to end deductibility for newly-taken-out mortgages, allowing the market adjustment to occur gradually, rather than all-at-once.

[Maynard]

I thought the reason to question the existence of a wealth effect is that a large number of households are short in housing. If I'm a 25 year old renter saving to buy a house, an increase in house prices reduces my wealth. If I'm a 35 year old who owns a two bedroom house, planning on buying a bigger house as my family grows, an increase in house prices reduces my wealth. Mechanically, if I'm saving to buy a house and the price of the house rises, I have to increase my saving, i.e. decrease my consumption. So whether or not the wealth effect as commonly described exists depends on the number of people who are long in housing versus the number of people who are short in housing.

[peterbob]

Poterba makes sense. Reduce the loopholes.

I don't think that everyone pays their fair share of taxes, and I'd like to see the IRS release simple average tax rates for individuals. Specifically, take line 63 divided by line 22 on the 1040 form. I think that people would be shocked by what a small percent some people pay in taxes, due to ridiculous tax loopholes. Maybe looking at the gross inequities of the tax structure (two people with the same income treated very differently) will be helpful to move tax reform along politically.

The California LAO calculated about six months ago that the biggest tax loophole is the Mortgage Interest Deduction, which costs California over $1bil per year. Given all that we know about the MID (that it doesn't encourage new ownership, but rather larger homes, and benefits mostly the wealthy), and given the housing bubble collapse, perhaps there will be political will to get rid of it.

[Michael McKinlay]

Simple,

A new progressive tax system that treats all income, individual, business, capital gains, dividends and estate, the same.

[JeffF]

For me over the last couple years by far the most complicated part of filling out my taxes has been short and long term capital gains and qualified and regular dividends. If those were taxed like regular wage income the time it takes me to fill out my taxes would be cut in half mainly because the capital gains figuring wouldn't require me to find exactly when I bought whatever I sold that year, or calculate an average cost basis for those cases where the investment firm doesn't do it for me.

[Don]

I love how he keeps euphemistically referring to "broadening the tax base" (i.e. taxing more of the less well off to pay for tax cuts for the more well off).

I'm all for reducing complexity and making taxes easier to calculate and figure (Every dollar that goes to the tax preparer doesn't go to the needs of society and is still a lost dollar for the individual), but I have no patience for snow jobs.

[jamzo]

lots of words, lots of obfuscation

but at the end of the day we are talking about the income taxes of 5-10% of the population

[baileyman]

Poterba's brilliant. Though as he says, "if you reduce the value of the assets that households own at a given point in time" misses a bit.

These assets he's talking about had an expected value which was distorted by apparent market values. People thought they had value that would be permanent merely because they could observe market transactions that seemed to confirm those values. But they were wrong.

A correct reading of these would have established an expected value different from and lower than the market values, and the expected consumption stream would have been lower as well.

It's not "spreading the loss of wealth", it's adjusting to the loss of expected wealth.

[JeffF]

"or calculate an average cost basis for those cases where the investment firm doesn't do it for me."

Well, ok I might still have to do the average basis, but it would be much simpler without the differing rates.

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