May 27, 2010
Early last week, I wrote that CBO is providing basic budget and economic analysis for the National Commission on Fiscal Responsibility and Reform. That blog posting summarized the presentations that Assistant Director Peter Fontaine and Deputy Director Robert Sunshine had made to some members of the commission regarding discretionary spending (that is, spending that is governed by the annual appropriation process) and mandatory spending (that is, spending for programs like Social Security and Medicare that are not governed by the appropriation process ).
Last Wednesday was my turn. Following a presentation by Thomas Barthold, the chief of staff for the Joint Committee on Taxation, I discussed three aspects of tax policy:
- The effect of taxes on economic activity through effects on labor supply, saving, the allocation of capital, the composition of spending, and other decisions;
- The burden of taxation and who bears that burden; and
- The revenue collected through taxes.
I used the picture shown here to illustrate the daunting magnitude of the imbalance between federal revenues and federal spending that CBO projects for 2020. Under current law, spending would be more than 10 percent bigger than revenues, as depicted in the two bars on the left. Alternatively, if the 2001 and 2003 tax cuts were extended, the alternative minimum tax (AMT) was indexed to inflation, and no other changes were made to the federal budget, spending would be nearly one-third bigger than revenues. Under this alternative scenario, the budget could be balanced in 2020 by raising revenues by about one-third and leaving the path of spending unchanged, by cutting spending by about one-quarter and leaving the path of revenues unchanged, or by making less dramatic changes in both revenues and spending.
Federal Spending and Revenues in 2020
In thinking about possible changes to the tax system and how they might affect the nation’s economy, it is important to consider not only how much revenue is raised, but also how it is raised. Among the questions one might consider, here are five key ones:
- How broad should the base be for the personal income tax?
- What should the personal income tax rates be?
- What should payroll tax rates be, and how much income should be subject those taxes?
- How broad should the base be for the corporate income tax?
- Should the government impose taxes on things that are not taxed today—in place of or in addition to other taxes?
In addressing those questions, policymakers will need to consider that, in collecting resources for the government’s activities, taxes affect the behavior of people and businesses. A tax essentially raises the price of doing something and thereby lowers the relative price of doing something else; for example, the income tax raises the price of working relative to taking leisure, and it raises the price of saving relative to current spending. Higher marginal tax rates change prices by more than lower marginal tax rates, and thereby affect behavior more. Also, households generally bear the economic cost or burden of the taxes that they pay directly (such as individual income taxes and the employees’ share of payroll taxes); they also ultimately bear the burden of taxes paid by businesses (such as the corporate profits tax and the employers’ share of payroll taxes).