[Economic Report of the President (2013)]
[Administration of Barack H. Obama]
[Online through the Government Publishing Office, www.gpo.gov]

 
CHAPTER 3


FISCAL POLICY

The American Taxpayer Relief Act of 2012 (ATRA), which was enacted
on January 2, 2013, permanently extended the 2001 and 2003 Federal
income tax cuts for 98 percent of taxpayers. The tax relief act
reflects the approach supported by the President to reduce the
Federal budget deficit- an approach that balances responsible
reductions in government spending with new revenues and increased
progressivity of the tax code. The new law extended the expansions
of several tax credits enacted in the American Recovery and
Reinvestment Act of 2009 (the Recovery Act) that have proï¿½vided
economic opportunities through tax relief and college expense assisï¿½
tance to 25 million low- and middle-income students and working
families each year. In addition, the new law prevented a substantial
cut in Medicare physician payment rates, extended emergency
unemployment insurance benefits to protect 2 million workers from
losing their benefits in January 2013, and permanently indexed to
inflation the exemption amounts for the Alternative Minimum Tax
(AMT) to provide tax certainty to tens of millions of middle-class
families. The permanent fix to the AMT will protect middle-class
families from being subject to a tax designed to ensure that
wealthy taxpayers pay their fair share in taxes.
Together with the additional Medicare and investment income taxes
for high-income taxpayers in the Affordable Care Act (ACA), ATRA has
made the Federal tax system more progressive. Figure 3-1 shows the
trends in average Federal individual income and employment tax rates
by income class. These average tax rates, defined as the share of
taxpayer income paid in taxes, are measured by holding the
distribution of taxpayer income constant over time (using the 2005
distribution with incomes adjusted for growth in the National Average
Wage Index) to isolate the effects of tax law changes. The tax law
changes in 2013 increased the average tax rate for taxpayers in the
top 1 percent and the top 0.1 percent of the income distribution
by 4.9 and 6.5 percentage points, respectively, while leaving
individual income tax rates unchanged for 98 percent of Americans.

91



Another recent development in government finance is that the
fiscal outlook for State and local governments has improved, although
expenditures remain below pre-recession levels and State and local
investment spending remains notably low. As shown in Figure 3-2, the
continued decline in State and local investment is atypical. In other
recoveries, State and local governments' gross real investment was
typically flat for several quarters following a business-cycle trough
and then increased, but, in this recovery, gross investment has failed
to rebound.
This chapter highlights the declining Federal budget deficit
since 2009 and the additional work needed to achieve medium- and
long-term fiscal health. It then outlines the principles for Federal
income tax reform set forth by President Obama in September 2011 and
describes specific plans proï¿½posed by the Administration to meet these
goals. The enactment of ATRA is a step toward achieving these goals,
but substantial work remains to make the tax code more equitable and
efficient. The chapter also reviews the State and local budget outlook
and the Federal Government's role in mitigating the recent recession's
effect on government finances at these levels. Finally, the chapter
discusses the long-term financial challenge facing State and local
governments from the underfunding of pension plans.


92 |  Chapter 3






The Federal Budget Outlook

The Obama Administration has taken significant steps to restore
the country's fiscal health without disrupting the continuing economic
recovery. In fiscal year (FY) 2009, the Federal budget deficit was
10.1 percent of gross domestic product (GDP). This ratio fell 3.1
percentage points to 7.0 percent in 2012, the largest three-year
reduction in the deficit since 1949. Under current law, the deficit
is projected to fall to 5.3 percent in 2013 (CBO 2013). This decline
in the deficit largely reflects the wind-down of Recovery Act spending,
the reductions in spending set forth in the Budget Control Act of 2011,
new revenues as a result of ATRA, and the improved performance of the
economy.
The Congressional Budget Office (CBO) projects that Federal
receipts will grow by 11 percent to $2.7 trillion, or 16.9 percent of
GDP, in 2013 (Figure 3-3). This is the highest receipts-to-GDP ratio
since 2008, but still below the average of 18.3 percent of GDP
recorded between 1970 and 2000. As a percent of GDP, outlays are
projected to fall from 22.2 percent in 2013 to 21.5 percent in 2017
due in large part to the spending caps put in place by the Budget
Control Act as well as reductions in certain mandatory spending as the
economy continues to improve. After 2017, outlays will rise, relative
to GDP, as interest payments on the national debt increase and as
mandatory

Fiscal Policy |  93



health and retirement spending grows in accordance with the cost of
health care and an aging population. Over the long term, these
factors-rising health costs and changing demographics-are the primary
drivers of fiscal imbalance (CBO 2012).
The Administration's goal of stabilizing the debt-to-GDP ratio
requires reducing the deficit to 3 percent of GDP or lower. Increases
in revenues and decreases in outlays in recent years have brought the
Federal budget deficit-the gap between outlays and receipts-closer to
that target (Figure 3-4). CBO projects that, under current law,
deficits will continue to shrink over the next few years, falling below
3 percent of GDP by 2015, but will then increase steadily to 3.8 percent
of GDP by 2022. Under current law, publicly held Federal debt is
projected to reach 77 percent of GDP in 2023 (Figure 3-5).
Although enacted legislation and overall economic improvements will
help reduce the budget deficit, other structural changes will be needed
to achieve fiscal sustainability. The President has put forward a
balanced deficit-reduction plan to achieve approximately $1.8 trillion
in savings through a combination of reductions in discretionary
spending, savings in entitlement programs, and new revenue raised by
reforming tax expendiï¿½tures and closing tax loopholes. When added to
the more than $2.5 trillion in deficit reduction the President already
signed into law, the total deficit

94 |  Chapter 3











Fiscal Policy | 95



reduction would amount to more than $4 trillion over ten years, a goal
set by the President to stabilize the debt-to-GDP ratio and to put the
country on a sustainable fiscal path over the next decade.

Federal Income Tax Reform

A fair, simple, and efficient tax code lays the foundation for job
creï¿½ation, economic growth, and an equitable society. Recognizing the
crucial role tax reform can play in deficit reduction and economic
growth, President Obama set forth a list of principles in September
2011 for comprehensive tax reform. These principles include lowering
tax rates, cutting inefficient and unfair tax breaks, observing the
"Buffett Rule" to enhance tax fairness, reducing the deficit, and
increasing job creation and growth in the United States (OMB 2011).
Because revenue must be raised to finance essential services
provided by the government, sound tax policy attempts to raise
revenue fairly and effiï¿½ciently. A number of notions of fairness
can help guide tax policy: "horizonï¿½tal equity" demands equal
treatment of equals; the ability-to-pay principle prescribes that
a taxpayer's burden should be related to her ability to pay; the
benefit principle suggests that a taxpayer's burden should be
related to the benefits she receives from government services.
Such notions of fairness are often incomplete, and sometimes they
are in conflict with each other. Still, these principles can
serve as useful guides.
Fairness, however, must be balanced with efficiency. High tax
rates, combined with a complex tax system and a narrow tax base (that
is, with many deductions, exclusions, or exemptions), provide
incentives for tax-payers to shift income between the individual and
corporate tax bases, re-time income, and alter behavior in other ways
to reduce tax liability (Saez, Slemrod, and Giertz 2012). In addition,
although tax subsidies could encourï¿½age socially beneficial activity
or correct market failures, when there are no externalities or other
market failures, tax provisions that favor one activity over another
can lead to an inefficient allocation of resources.
A key feature of the tax code is the schedule of statutory tax
rates on marginal income. To achieve myriad tax, economic, and social
policy goals, the tax code also contains a dizzying web of deductions,
exemptions, excluï¿½sions, credits, and special treatment of certain
income. The fact that taxpayï¿½ers modify their behavior to reap the
benefits of special tax provisions is bittersweet. On one hand, it
means that well-thought-out tax provisions that are designed to
encourage a particular activity are working. On the other hand, a
taxpayer determined to avoid liability can engage in tax avoidance


96 |  Chapter 3




and thereby expend socially unproductive resources navigating the
jungle of tax provisions.\1\

Tax Expenditures

The tax code contains numerous special tax provisions, referred
to as "tax expenditures," which lead the tax system to deviate from
taxing economic income (Box 3-1). Economic income generally follows
the Haig-Simons definition of comprehensive income as consumption plus
changes in net worth. Relative to a tax structure built on a
comprehensive income measure, tax expenditures erode the tax base,
causing the government to forgo revenue, but they provide important
tax benefits to individuals and families. How such benefits are
distributed over the income distribution varies widely across tax
provisions. To assess the distributional effects of a given tax
expenditure, the Treasury Department estimated the tax benefits of
each major individual income tax expenditure under 2013 income tax law
for taxpayers in different income classes.
As illustrated in Figure 3-6, the Earned Income Tax Credit (EITC)
and the Child Tax Credit (including the refundable portion) provide
substantial benefits to taxpayers in the lowest income quintile but
have little impact on the after-tax income of taxpayers in the top
three income quintiles. By contrast, the bottom two income quintiles
receive almost no benefits from tax expenditures like the charitable
giving deduction and deductions for State and local taxes. Almost all
of those tax benefits accrue to taxpayers in the top two income
quintiles. Middle and upper-middle income taxpayers benefit the most
from the exclusion of employer-provided health insurance, whereas
taxpayers in the bottom quintile and those in the top percentile of the
income distribution receive relatively little benefit from the exclusion.
Because the tax value of deductions and exclusions increases with
taxpayers' marginal tax rates, these tax expenditures provide larger
benefits to high-income taxpayers than to low- and middle-income
taxpayers for a given amount of deductions or exclusions. (For various
measures of tax rates, see Economics Application Box 3-1.) In particular,
an additional dollar of deductions or exclusions reduces taxable income
by $1 and consequently reduces the liability of taxpayers in the
39.6-percent bracket and 25-percent bracket, respectively, by 39.6 cents
and 25 cents. In an effort to improve tax fairness, improve efficiency,
and reduce the deficit, the President has proï¿½posed to reduce the tax
value of selected tax expenditures to 28 percent for high-income
taxpayers, a level comparable to the tax value provided by the tax code
for middle-income taxpayers.
__________________
1 Behavior that reduces tax remittances without altering real investment,
savings, or labor decisions is called tax avoidance when it is legal and
tax evasion when it is illegal.


Fiscal Policy    | 97

________________________________________________________________________

Box 3-1: Estimates of Tax Expenditures in the President's Budget

Tax expenditures, commonly viewed as government spending through
the tax code, are defined in the Congressional Budget Act of 1974 as
"revenue losses attributable to provisions of the Federal tax laws
which allow a special exclusion, exemption, or deduction from gross
income or which provide a special credit, a preferential rate of tax,
or a deferral of tax liability."
Each year the Treasury Department estimates the value of tax
expenditures in terms of the Federal income tax loss and reports the
estimates in the annual Budget of the United States Government.\1\
Table 17-1 of the President's fiscal year 2013 Budget lists 173
corporate and individual income tax expenditures in the tax code.
Tax expenditures take many different forms:
 Exclusions and exemptions allow specific types or
sources of income-such as compensation received as medical insurance
or interest from municipal bonds-to be excluded or exempt from income
for tax purposes.

 Deductions permit taxpayers to deduct certain types of
expenses from income to calculate the taxable base. Examples include
itemized deductions (which include deductions for home mortgage
interest, charitable giving, State and local taxes, and medical
expenses) and "above-the-line" deductions (which include deductions
for student loan interest, self-employed retirement and health
insurance contributions, and educators' out-of-pocket expenses).

 Tax credits reduce tax liability by the amount of the
credit. When the amount of a tax credit exceeds tax liability before
the credit is applied, the credit will erase the tax liability, and,
if the credit is refundable, the government will pay the filer the
excess amount. In the Federal Budget, the portion of a refundable credit
that reduces tax liability is treated as a revenue loss, and the portion
that exceeds tax liability is treated as an outlay.

 Special rates apply a lower tax rate to specific sources
of income than the rate applied to ordinary income. For example,
long-term capital gains and qualified dividends are taxed at lower rates
than ordinary income.

 Deferrals permit taxpayers to delay including certain
income in the taxable base. Such tax expenditures include accelerated
depreciation
____________________
1 The Joint Committee on Taxation also annually publishes a list of
tax expenditures. Tax expenditure estimates do not equal the amount of
revenue that would be generated if the expenditure were eliminated for
two reasons: first, eliminating a tax expenditure would result in
behavioral effects that could offset the revenue gain; second,
removing multiple tax expenditures simultaneously creates interaction
effects that depend on the particular expenditures.
________________________________________________________________________

98 | Chapter 3



________________________________________________________________________
or immediate expensing of business investment as well as tax incentives
for retirement saving.
Table 17-3 of the FY 2013 Budget ranks tax expenditures by pro-
jected revenue effect. The 10 largest tax expenditures by the projected
revenue effect for 2013-2017 are:\2\
 Exclusion of employer contributions for medical insurance
premiums and medical care ($1,012 billion)
 Deductibility of mortgage interest on owner-occupied homes
($606 billion)
 401(k)-type plans ($429 billion)
 Accelerated depreciation of machinery and equipment ($375
billion)
 Exclusion of net imputed rental income on owner-occupied
housing ($337 billion)
 Special rates for capital gains ($321 billion)
 Defined benefit pension plans ($298 billion)
 Deductibility of State and local taxes other than on
owner-occupied homes ($295 billion)
 Deductibility of charitable contributions, other than
education and health ($239 billion)
 Exclusion of interest on public purpose State and local
bonds ($228 billion).
_________________
2 The estimates do not include effects on Federal outlays. Refundable
tax credits, such as the Earned Income Tax Credit and the Child Tax
Credit, can carry significant outlay effects.
________________________________________________________________________

The preferential rate on capital gains and dividends gives rise to
tax benefits because these sources of income are taxed at a lower rate
than ordiï¿½nary income.2 Of the selected tax expenditures in Figure 3-6,
the benefits of the preferential tax rate on capital gains and dividends
are most skewed to the upper end of the income distribution. The
underlying tax data for Figure 3-6 suggest that taxpayers in the top
0.1 percent of the income distribution receive 41 percent of the total
positive capital gains realizations and qualified dividends. Because of
this unequal distribution of capital gains realizations and qualified
dividends, the preferential rate provides substantially more benefit
to the top 0.1 percent of taxpayers than to taxpayers in any other
income class.
__________________
2 One argument for the preferential rate is that corporations already
pay income taxes so individual income taxes on capital gains and
dividends result in double taxation. However, evidence shows that not
all of the long-term capital gains are attributable to corporate stocks
or mutual funds, and therefore some capital gains are never taxed at
the corporate level (Wilson and Liddell 2010; Burman 2012).

Fiscal Policy | 99






Vertical Equity

Vertical equity holds that individuals who have a greater ability
to pay should contribute more in taxes than those who are less able to
pay (for a discussion of tax fairness, see Economics Application Box
3-1). The President has called one specific formulation of this idea,
the Buffett Rule, a basic principle of tax fairness. The Buffett Rule
states that no household making over $1 million should pay a smaller
share of income in taxes than middle-class families pay. Several
studies have shown that the curï¿½rent tax system violates the Buffett
Rule; many high-income families pay a smaller share of income in
Federal taxes than do middle-income families (Hungerford 2011; CEA
2012; Cronin, DeFilippes, and Lin 2012). Thus, implementing the Buffett
Rule, or adopting the rule as a guiding principle for tax reform, would
improve tax fairness.
While the current Federal tax system is progressive, its
progressivity has significantly declined since the 1960s. Figure 3-1
above shows that average tax rates for middle-income taxpayers rose
slightly in the 1960s and the 1970s and then remained relatively stable
since the 1980s. By contrast, Federal tax burdens for the wealthiest
taxpayers have dropped dramatically since 1960 as a result of changes in
tax laws. The share of income the top 0.1 percent paid in Federal
individual income and employment taxes fell to 24.1 percent in 2012,
about half of what this group paid in 1960.

100 | Chapter 3

________________________________________________________________________

Economics Application Box 3-1: Marginal Tax Rates
and Average Tax Rates on Individual Income

Marginal and average tax rates are two tax rates commonly used to
describe a tax system and to measure the fraction of income people pay
in taxes. A statutory marginal tax rate for an income tax is the tax
rate specified by law and applied to one additional dollar of taxable
income. A tax system may consist of multiple statutory rates, with
each applying to a range of taxable income to form a tax bracket. A
taxpayer's statutory marginal tax rate thus depends on the tax bracket
in which her taxable income falls. An effective marginal tax rate is
the fraction of an additional dollar of income a taxpayer actually pays
to the government. The effective marginal tax rate is determined by the
statutory rate as well as by other tax provisions, such as phase-ins
or phase-outs of tax credits. An average, or effective, tax rate is
the fraction of a taxpayer's total income that is owed as tax liability.
The share of total income paid in taxes indicates the tax burden faced
by a taxpayer.
One criterion for evaluating tax systems is fairness. Economics
provides useful tools to help evaluate a tax system's fairness. Two
important concepts are horizontal and vertical equity. Horizontal equity
means equal treatment of equals, which is commonly interpreted as equal
treatment of those with an equal ability to pay; vertical equity holds
that those who have a greater ability to pay should contribute more in
taxes than those who are less able to pay. To evaluate vertical equity,
a tax can be classified as being proportional, regressive, or
progressive. A tax is proportional if average tax rates are equal
for taxpayers at all income levels. A tax is regressive if average tax
rates fall with income, and a tax is progressive if average tax rates
increase with income. Under a progressive tax system, high-income
taxpayers face a larger tax burden than low-income taxpayers. This
notion is long ingrained in economics. In fact, endorsing progressive
taxes, Adam Smith wrote in The Wealth of Nations that "it is not
very unreasonable that the rich should contribute to the public
expense, not only in proportion to their revenue, but someï¿½thing more
than in that proportion."
________________________________________________________________________
Figure 3-7 depicts the trends in effective marginal tax rates on
wage income. As shown, effective marginal tax rates faced by middle-
income taxï¿½payers have been relatively constant during the past five
decades, in contrast with the dramatic decline in the effective marginal
tax rates faced by the top 1 percent or 0.1 percent of taxpayers. In
other words, taxpayers at the top of the income distribution have always
faced higher marginal tax rates on wage income than middle-income
taxpayers, but the spread between their marginal tax rates has narrowed
significantly since 1960. Before ATRA was

Fiscal Policy | 101






enacted, the top effective marginal rate on wage income was close to
its lowest level in the past five decades; there was only a short period
in the late 1980s and early 1990s when the top effective marginal tax
rate was lower than the rate in 2012.
As noted, the preferential rate on long-term capital gains is
particularly regressive, and evidence suggests that capital gains
realizations have become more concentrated over time. The portion of
total capital gains realized by the 0.1 percent of taxpayers who
reported the most capital gains income increased from 25 percent in
1987 to over 40 percent in 2010 (Lurie and Pearce 2012). Relative to
the increased income concentration, the top effective marginal tax rate
on long-term capital gains declined during the period (Figure 3-8). The
rate ranged between 20 percent and 30 percent from the 1980s to the
early 2000s, fell to 16 percent in 2003, and fell further to 15 percent
in 2010 because of the scheduled elimination of the phase-out of
itemized deductions under the 2001 tax cut. The rate rose to 25 percent
in 2013.
In addition to individual income and employment taxes, the Federal
Government collects corporate income taxes and estate taxes. Piketty and
Saez (2007) examined the combined effect on vertical equity of Federal
individual, employment, corporate, and estate taxes from 1960 to 2004.
They argued that corporate and estate taxes substantially contributed to a

102 | Chapter 3





more progressive tax system in 1960 than in 2004. Because the
wealthiest taxpayers own a disproportionately large share of the
nation's capital income and wealth, they bear the largest burden of
the corporate income and estate taxes.3 The Federal Government, however,
has shifted away from relying on these two Federal taxes as revenue
sources, leaving taxpayers at the top of the income distribution with
a much lower tax burden in 2004 than in 1960. As shown in Figure 3-9,
corporate tax revenues as a percent of total Federal receipts declined
from 23.2 percent in 1960 to 10.1 percent in 2004. The share for estate
and gift taxes declined modestly from 1.7 percent in 1960 to
1.3 percent in 2004 (OMB 2012b).

Efficiency and Simplification

From the current point of a complex tax code with many special
provisions, simultaneously eliminating special provisions and lowering
tax rates could make the tax code both simpler and more efficient.
Cutting unfair and
_________________
3 Piketty and Saez (2007) assume the burden of the corporate income tax
falls on owners of capital income. Several tax policy groups, including
the Treasury Department's Office of Tax Analysis, the Congressional
Budget Office, and the Tax Policy Center, assume in their current tax
models that the majority of the corporate tax burden-about 80 percent--
is borne by capital income, whereas the remainder is borne by labor.
Cronin et al. (2013) provide details of the different corporate tax
incidence assumptions.

Fiscal Policy | 103





inefficient tax breaks and simplifying the tax system with lower tax
rates are among the principles the President set forth for tax reform.
High tax rates, coupled with a narrow tax base, cause taxpayers to
adopt economically inefficient behavior. When examining the efficiency
gains from tax reform, it is important to identify the behavioral
margins that are in response to changes in tax policy and the resulting
economic effects. In theory, lowerï¿½ing tax rates can lead to an
increase in labor supply (or a decrease in labor supply if the income
effect dominates the substitution effect), but evidence suggests that,
when tax rates change, labor supply effects are small compared with
tax avoidance effects (Saez, Slemrod, and Giertz 2012). One such effect
occurs when investors delay realizing capital gains and hold onto assets
only to avoid capital gains tax. Despite this inefficient "lock-in"
effect, negative associations between top individual income tax rates
on capital gains and private saving, investment, or changes in real GDP
are not supported by U.S. experience (Hungerford 2012; Burman 2012).
When taxpayers make decisions in response to special provisions in
the tax code, they engage in more of the tax-preferred activity than
they would otherwise, thereby steering resources away from other more
productive uses.\4\ One major unfair and inefficient tax break is the
tax treatment of partners' profits interests, also known as carried
interests, in an investment partnership. Carried interests, despite
being derived from performance of labor services, receive capital gains
treatment. This preferential tax treatï¿½ment provided for income derived
from performing a specific activity induces a behavioral distortion and
is economically inefficient. To improve fairness and efficiency of the
tax code, the Administration has proposed to tax carried interests as
ordinary income and subject that income to self-employment taxes.
In addition, the Administration has proposed to improve the tax
code's efficiency by closing business loopholes and broadening the
business tax base. For example, corporations currently use life insurance
as a form of tax shelter because of its favorable tax treatment.
Investment returns on life insurance products are allowed to accumulate
tax free until policies are cashed in. As a result, businesses can
take interest deductions for investment-oriented life insurance policies
that cover their officers and employees before any gain is realized-and
taxed-on the policies. The Administration's recent Budget would close
this loophole and encourage businesses to make more efficient investment
decisions by limiting the interest deductions alloï¿½cable to investment
in certain life insurance policies.
__________________
4 If the tax-preferred activity is underconsumed or underproduced because
of market failures or externalities, then a favorable treatment could
increase quantity and result in more efficient allocations of resources.


104 | Chapter 3





The President has also proposed making the Federal subsidy for
State and local governments' borrowing costs more efficient by extending
Build America Bonds (BABs), in which the Federal Government makes
direct payments to State and local governments. Traditional tax-exempt
bonds provide a Federal subsidy through a Federal tax exemption to
investors for interest income received from the bonds. One study finds
that as much as 20 percent of the tax revenue the Federal Government
forgoes from tax-exempt bonds accrues to investors, leaving only 80
percent of the subsidy to benefit State and local governments (CBO/JCT
2009).
Complexity is another source of inefficiency in the tax code
because it increases the amount of time and money taxpayers spend to
comply with the law and creates opportunities for them to engage in the
unproductive activity of tax avoidance. It is estimated that complying
with the Federal income tax cost businesses at least $100 billion for
tax year 2009 (Contos et al., forthcoming) and individuals over $50
billion for tax year 2010,5 with the total costs amounting to
approximately 1 percent of GDP. Estimating the time and monetary
costs incurred by taxpayers for preparing individual income tax returns,
an analysis by the Internal Revenue Service (IRS) shows
_______________
5 The IRS estimates of the business and individual income tax compliance
costs include outï¿½of-pocket costs and the monetized burden associated
with the time spent on preparing the returns.

Fiscal Policy | 105



sources of individual income tax compliance costs by reporting activity
(Figure 3-10).6 More than half-55 percent-of compliance costs arise
from keeping track of and reporting income, and the remaining compliance
costs arise mostly from calculations for tax deductions and credits.
Thus, tax simplification-such as having fewer deductions and credits or
streamlining income reporting-has the potential to reduce compliance
burdens. Tax simplification could also enhance taxpayer compliance by
reducing the opportunities for tax evasion and decreasing inadvertent
taxpayer errors in calculating tax liabilities (Kopczuk 2006).\7\

Reforming the International Corporate Tax

The international provisions of the corporate tax code create
opportunities for U.S. companies to reduce their taxes by locating
their operations and profits abroad. The tax system is subject to
gaming, as corporations manipulate complex tax rules to minimize taxes
and, in some cases, shift profit that is attributable to activity
performed in the United States or elseï¿½where to low-tax jurisdictions.
The current U.S. tax system subjects foreign subsidiaries of U.S.-
based multinationals to taxes on their overseas income while allowing a
tax credit for foreign taxes paid. However, corporations often do not
need to pay taxes to the Federal Government on that income until they
repatriate it to the United States, a rule called deferral (because it
defers taxation of the income). Many companies reinvest, rather than
repatriate, a significant portion of their income overseas and, as a
result, may never face U.S. taxes on much of that income. The U.S. tax
system is often described as "worldï¿½wide" because it taxes U.S. companies
on profits earned abroad. For many companies, however, opportunities for
deferral can make it effectively much closer to a territorial system-a
system in which taxes are never paid on foreign income. By contrast,
although most other developed countries have taken a territorial
approach, some countries, including Japan and the United Kingdom,
have implemented tax "triggers" that effectively apply worldwide
taxation if a multinational is operating in a low-tax country.
U.S. multinational corporations have a significant opportunity to
reduce overall taxes paid by shifting profits to low-tax jurisdictions-
either by moving their operations and jobs there or by relying on
accounting tools and transfer pricing principles to shift profits.
Studies show that U.S.
________________
6 Under current law, the IRS is authorized access to Federal tax
information for tax administration purposes. Certain Federal agencies
have limited access to tax data for governmental statistical use. See
Data Watch 3-1. 7 For example, studies have shown that complexity may
have affected EITC compliance and kept eligible taxpayers from claiming
the tax credit (Holtzblatt and McCubbin 2004; Kopczuk and Pop-Eleches
2007).


106 |   Chapter 3





multinationals' decisions about the choice of where to invest are
sensitive to effective tax rates in foreign jurisdictions (OECD 2008).
Evidence also sugï¿½gests that U.S. firms' reported profits in a foreign
country increase when the country's tax rate declines relative to the
U.S. rate, after taking into account other factors that would have
influenced the level of income earned by U.S. firms in that foreign
country (Clausing 2009; Grubert 2012).
The incentive to shift profits to low-tax jurisdictions can lead
to inefficient overinvestment abroad and underinvestment in the United
States. It can also erode the U.S. tax base, requiring higher tax rates
on income that remains taxable in the United States to collect the same
amount of revenue. Finally, the international tax system is very
complex, which not only burï¿½dens companies with complicated accounting
and tax requirements but also benefits companies that avoid paying taxes
by manipulating intricate rules.
Business tax reform should be a foundation to maximize investment,
growth, and jobs in the United States. It should properly balance the
need to reduce tax incentives for U.S. companies to locate overseas with
the need for them to be able to compete overseas; some overseas
investments and operations are necessary to serve and expand into
foreign markets in ways that benefit U.S. jobs and economic growth.
The President has proposed to protect the U.S. tax base, strengthen
the international corporate tax system, and encourage domestic
investment by establishing a new minimum tax on


Fiscal Policy |  107



________________________________________________________________________

Data Watch 3-1: Federal Tax Information and
Synchronization of Interagency Business Data

Each year, the Internal Revenue Service (IRS) collects tax data
from hundreds of millions of taxpayers. During fiscal year 2011, more
than 200 million individual income, employment, corporate income, and
estate tax returns and 1.8 billion third-party information returns, such
as W-2 and 1099 forms, were filed with the IRS (IRS 2012). Successful
tax administration builds on taxpayers' willingness to share personal
information with the tax authority and voluntarily comply with tax
law (Greenia and Mazur 2006). To ensure taxpayer confidence in the tax
system, the tax code contains provisions to safeguard taxpayer confiden-
tiality by requiring each access to Federal tax information (FTI) to be
authorized by law.
Under current law, access to FTI is authorized within the IRS for
tax administration purposes; in other limited cases, disclosures of FTI
are allowed only for specified information to specific parties for
specific tasks. When considering whether to amend the law to authorize a
disclosure of FTI, Congress should evaluate several factors, includï¿½ing
the potential benefits resulting from the data usage and the risk of
compromising taxpayer confidentiality or affecting their willingness
to voluntarily comply with tax law.
Tax law currently authorizes disclosure of business FTI for govern-
ment statistical use. It authorizes disclosure of business FTI--either
for corporate or noncorporate businesses-to the Census Bureau but
permits disclosure of business FTI to the Bureau of Economic Analysis
(BEA) only for corporate businesses. Another Federal statistical agency,
the Bureau of Labor Statistics (BLS), currently does not have access to
any business FTI. The Census Bureau uses business FTI to construct its
business list, and therefore many Census data products are considered
to be "comingled" with tax information (Pilot 2011). Because of the
access limits on BEA and BLS, the Census Bureau cannot share many of
its products with these two agencies, a situation that prevents the
three Federal statistical agencies from synchronizing their business
data.
Business data are the fundamental elements for measuring national
and local economic activity. National and local statistics on income,
output, productivity, payroll, and employment are all based on business
data collected by these Federal statistical agencies. Policymakers and
businesses rely on these statistics to guide their decisionmaking.
Thus, improving the accuracy, consistency, and reliability of national
and local economic statistics can yield tremendous benefits because
policy formation and business decisionmaking will be based on better
quality economic statistics.
________________________________________________________________________

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________________________________________________________________________
Greater synchronization of interagency business data could advance the
quality of economic statistics. For example, BLS and the Census Bureau
currently have different coverage and classifications in their business
data. BEA's National Income and Product Accounts (NIPA) produce two
measures of national economic activity: gross domestic product (GDP,
which uses Census Bureau data as its primary source data) and gross
domestic income (GDI, part of which uses BLS data). The two measures of
national economic activity differ in part because of discrepancies in
the underlying business data. Allowing Federal statistical agencies to
share and coordinate business data would help to reconcile these
discrepancies and thereby result in a better measurement of economic
activity.
________________________________________________________________________
income earned by subsidiaries of U.S. corporations operating abroad
(White House/Treasury 2012). That requirement would stop the tax system
from rewarding companies for moving profits offshore. Thus, foreign income
in a low-tax jurisdiction would be subject to immediate U.S. taxation up to
the minimum tax rate, with a foreign tax credit allowed for income taxes on
that income paid to the host country. At the same time, this minimum tax
would be designed to keep U.S. companies on a level playing field with
competitors when engaged in activities that, by necessity, must occur in a
foreign country.

The State and Local Budget Outlook

State and local government expenditures have continued to rebound
from the challenges created by the Great Recession, although many State
and local governments have yet to return to their pre-recession spending
and investment levels. State general fund spending grew by 1.6 percent
in real terms in FY 2012, after a small 0.6 percent drop in FY 2011
(NASBO 2012a). In the two previous fiscal years, State general fund
spending shrunk dramatically, falling by 2.6 percent in FY 2009 and
8.0 percent in FY 2010 (Figure 3-11); the real gain since 1979 has
averaged 1.6 percent a year.
As local economic conditions have rebounded, fiscal distress faced
by States has abated, although challenges remain. One such indicator of
fiscal distress is the need to institute midyear budget cuts in response
to lowerï¿½than-expected revenues or higher-than-expected outlays. In FY
2012, just 8 States made midyear budget cuts ($1.7 billion total), down
from 23 States in FY 2011 ($7.8 billion), 39 States in FY 2010 ($18.3
billion), and 41 States in FY 2009 ($31.3 billion).


Fiscal Policy | 109




Like State spending, local government expenditures fell sharply dur-
ing the recession. Constrained by lower revenues, cities cut back on
spending more than they have in 25 years (National League of Cities
2012). General fund expenditures dropped at least 4 percent in both FY
2010 and FY 2011, almost twice as much as they did following the recession
in FY 2001. Asked how they plan to change expenditures in FY 2012,
local government budget officers most often said they would reduce the
size of the municipal workforce, followed by delays or cancellations of
capital infrastructure projï¿½ects. The National League of Cities
projected that expenditures will finally increase in FY 2012, but only
by 0.3 percent, because local government revï¿½enues have yet to grow since
the recession (National League of Cities 2012).
On the revenue side, State general fund tax revenues are poised to
increase by $26.1 billion in FY 2013 after increasing by $16.6 billion
in FY 2012. In nominal terms, general fund revenues are set to surpass
pre-recession levels for the first time in FY 2013. The reason for this
jump several years after the onset of the national recovery is that
State revenues follow a cyclical pattern with macroeconomic growth but
often do so with a lag.
Local government tax receipts were also decimated by the recession
and have yet to rebound. A projected decrease in city general fund
revenues for FY 2012 will mark the sixth consecutive year of year-over-
year decreases in revenues, and city budget officers will continue to
face lingering


110 | Chapter 3

challenges. Each of the primary tax streams used by local governments-
property taxes, sales taxes, and income taxes-was affected by the
economic downturn. Sales tax revenues dropped sharply and first, as
consumers cut back on purchases. In 2011 and 2012, however, city sales
tax receipts started to rebound, with sales tax revenues increasing
year-over-year in both years (Figure 3-12). Because home values fell,
cities-many of which rely heavily on property taxes-faced another area
of shrinking revenue. The decline in property tax collections came with
a lag, however, probably because of the time needed for lower prices
to translate into lower assessed values. Property tax receipts fell in
2010 and 2011 and will continue to pose challenges for strapped local
governments. Home prices have started to recover, but slowly. Finally,
local governments also face lower income tax receipts as unemployï¿½ment
challenges persist.

The Cyclicality of State and Local Government Expenditures

Particular types of State and local government spending are
more sensitive to cyclical factors than others. For example, when
economic conditions deteriorate, spending on "automatic stabilizers"--
programs like Medicaid that provide means-tested benefits-increases.
While automatic stabilizers are widely recognized as being
countercyclical, less attention has




Fiscal Policy | 111




been paid to the cyclical behavior of public investment spending. One
study by the Government Accountability Office (GAO 2011) examined
trends in State and local government spending across the business cycle
and found that capital expenditures-primarily spending on land,
buildings, and equipment-are more procyclical than other types of
spending (Table 3-1). The GAO found that spending on health and public
welfare is countercycliï¿½cal, while current expenditures on elementary
and secondary education, current expenditures on highways, and capital
outlays are the most procycliï¿½cal categories of State and local
government spending. The GAO noted that trends in capital outlays and
current expenditures tend to lag the business cycle by one to two years,
although there is substantial variation in the lag for current
expenditures by type.
Private economists have reached similar conclusions. Echoing the
GAO finding, Wang, Hou, and Duncombe (2007) studied the determinants of
capital spending, noting that capital expenditures tend to be more
procyï¿½clical than current expenditures. The authors cited evidence
that States' and municipalities' financing decisions are affected by
the business cycle, but the study did not draw conclusions about the
impact of the business cycle on the level of capital spending.
Similarly, McGranahan (1999) found that capital spending is more
procyclical than current expenditures. On average, McGranahan found
that each percentage point increase in the unemployment rate leads to
a $6.94 fall in per capita capital outlays (average per capita spending
is $239.85); this drop is split evenly between construction spending
($3.57) and other capital outlays ($3.37). Moreover, McGranahan found
that even though State operating budgets do not include capital
expenditures, States tend to reduce budgetary pressure by reducing
capital spending durï¿½ing downturns. Hines, Hoynes, and Krueger (2001)
found that all compoï¿½nents of State and local government spending are
procyclical, with capital spending (on highways, parks, and
recreation, for example) generally more procyclical than current
spending (on health and education, for example).
Bureau of Economic Analysis (BEA) data on State and local
expenditures show that the most recent recession was somewhat atypical,
with gross investment failing to rebound as in other recoveries (see
Figure 3-2 above). Ideally, State and local governments would increase
investment spending during recessions, both as a means of employing
capital and labor, thereby helping to drive the economy out of the
recession, and also as a mechanism for strengthening the economy in
the future. Moreover, lower labor costs during recessions make capital
projects relatively cheap, meaning that investment during recessions
can provide taxpayers with a higher return on investment; historically
low interest rates in recent years have further lowered the cost of
capital projects. Greater investment by State and local


112 |  Chapter 3






governments in the most recent recession would have both contributed to
the recovery and built a stronger economy in future years at a
relatively low cost.
Despite the downturn in investment spending relative to past reces-
sions, the procyclical nature of State and local fiscal policy means that
Federal policies can prove particularly effective at mitigating the
economic effects of a downturn. State and local governments serve a vital
role in proï¿½viding services to their residents, and the Federal
Government contributes to that role by aiding State and local
governments through grants, loans, and implicit support through the tax
system.
Federal grants-in-aid-which include both cash grants and grants
in-kind--have been expanding over time.\8\ In constant dollars (FY 2005),
Federal grants to State and local governments increased from $45.3
billion in 1960 to an estimated $504.4 billion in 2012 (Figure 3-13).
The composition of Federal grants to State and local governments has
changed dramatically as well. In 1960, 35.3 percent of Federal grants
were for payments to individuï¿½als, 47.3 percent were for physical
capital, and 17.4 percent were for other uses. As projected, in 2012,
the share of grants for payments to individuals grew to 60.2 percent,
while the share for physical capital fell to 15.7 percent, and the share
for other uses grew to 24.1 percent. Thus, over the past five decades,
the share of Federal grants for physical capital has plummeted while the
share devoted to individual payments has skyrocketed.
________________
8 Federal grants generally fall into one of two broad categories:
categorical grants or block grants. In addition, these grants may have
characteristics of one or more other types of grants: formula grants,
project grants, and matching grants. Categorical grants have a narrowly
defined purpose and may be awarded on a formula basis or as a project
grant.


Fiscal Policy   |  113





Federal Grants to States Through the Recovery Act

The Federal Government used the existing grants structure to
provide swift fiscal relief during the recent recession-a time when
states faced severe and unforeseen economic conditions. It did so
through the Recovery Act, which provided enhanced grant funding in the
areas of education, Medicaid, transportation, energy, water, and other
programs.\9\ Most provisions of the Recovery Act expired in 2010, but
some were extended in August 2010 by Public Law 111-226, an act
providing education and Medicaid assistance to the States. The
temporary fiscal relief provided by the Recovery Act accounts for most
of the $141.1 billion increase in Federal outlays for grants-in-aid to
States from 2008 to 2010. In 2011, Federal grant outlays were $606.8
billion; this was a $1.6 billion decrease from 2010, reflecting the
expiration of the temporary increase in the Federal share of State
Medicaid costs and other provisions of the Recovery Act. Grant outlays
for 2012 are estimated to increase by $5.7 billion to $612.4 billion.
However, outlays from grants funded through annual appropriations
are estimated to decrease by $24.9 billion in 2012 from the previous
year and to decrease again by $20.5 billion in 2013. These decreases
reflect the
__________________
9 In addition to grant funding to States, the Recovery Act created
Build America Bonds, which provided State and local governments a
lower-cost borrowing tool to finance public capital projects. Authority
to issue Build America Bonds expired at the end of 2010.


114 | Chapter 3





winding down of discretionary grant spending on Recovery Act programs
such as the State Fiscal Stabilization Fund as well as the enactment of
caps on discretionary spending in the Budget Control Act of 2011,
which constrains appropriations of new discretionary budget authority,
including appropriaï¿½tions for grants.
By transferring aid to State and local governments, the Recovery Act
helped stabilize programs that would have been cut and kept States and
localities from having to institute tax increases. Had the Recovery Act
not provided grants-in-aid to State and local governments, these
governments would have been forced either to make deeper cuts in funding
for important public programs, including critical education and health
programs (and the associated jobs to support those programs), or to
raise taxes to compensate for the shortfall. Either option would have
been detrimental to the economic recovery. The billions of dollars
provided to State and local governments were one of the reasons the
Recovery Act was able to dampen the recession and put the country on a
faster track to recovery.

State and Local Pensions

State and local pension plans are an important part of the nation's
retirement security framework, promising future retirement benefits to
14.5 million workers employed by State and local governments in 2011
(Census Bureau 2012). About 19 percent of total employer contributions
to employee retirement plans were made through State and local pension
plans, and approximately 28 percent of all plan assets were accounted for
by State and local pensions (CBO 2011). Pension plan contributions make
up a significant component of the compensation provided to State and
local government workers, including police officers, firefighters, and
teachers.
Most State and local plans are defined benefit plans, which provide
workers with a designated benefit based on years of service and final
salary.\10\ For example, a worker covered by a defined benefit plan
might earn benefits equal to 2 percent of wages (often measured over the
last several years of employment) multiplied by years of work and
adjusted for inflaï¿½tion. The structure of defined benefit plans means
that employer liability grows as workers earn wages and increase their
tenure with State and local governments; this liability can also grow
with inflation because the value of a defined benefit plan is often
indexed to the cost of living. From this
________________
10 Defined benefit plans are fundamentally different from defined
contribution plans, which allow workers to contribute to an individual
retirement account and often offer some form of an employer match.
Defined contribution plans do not provide workers with a designated
retirement benefit; rather, the individual account balance grows with
new contributions and investment returns.


Fiscal Policy   | 115

perspective, defined benefit plans can be viewed as a form of deferred
compensation, with workers reaching retirement age being owed
compensation earned earlier in their career.
Defined benefit programs offer workers a steady stream of income
for life, thus providing insurance against outliving assets and
investment risk. One drawback to these plans, however, is the problem
of underfundï¿½ing, which presents a serious long-term fiscal challenge
for State and local governments. Underfunding arises when the
accumulated contributions in State and local government pension
accounts are insufficient to cover the expected liabilities owed to
public sector workers. The Pew Center on the States estimated that the
public pension programs of State and local governï¿½ments were underfunded
by $757 billion in FY 2010, carrying $3.07 trillion in liabilities and
$2.31 trillion in assets (Pew Center on the States 2012). Another study
showed that the ratio of State and local pension fund assets to
liabilities declined from 103 percent in 2000 to 75 percent in 2011, due
in large part to market trends and the specific accounting rules adopted
by most plans to value assets (Munnell et al. 2012a). While aggregate
funding levels have decreased over the past decade, funding adequacy
varies considï¿½erably from state to state.
Alternative approaches to calculating pension funding suggest even
lower levels of funding adequacy. Unlike private pension systems, which
are governed by Federal law and regulations, no Federal rules apply to
State and local plans in determining plan liabilities and required
contribuï¿½tions. Most States and local pension plans adhere to
guidelines drafted by the Governmental Accounting Standards Board (GASB)
to report funding adequacy, but the board does not have enforcement
authority, nor can it require States and localities to adopt specific
funding policies. Until June 2012, GASB standards allowed plans to use
discount rates based on the expected rates of return-typically around
8 percent-to determine penï¿½sion liabilities. Under this approach,
pension underfunding was about $700 billion at the end of 2009 (CBO
2011), consistent with the Pew Center's estimate. In sharp contrast,
CBO found that a broader measure of liabilities that uses the fair value
discount rate, an approach often applied in corporate accounting,
produces an underfunding estimate of $2 trillion to $3 trillion.
Low levels of funding threaten the welfare of both taxpayers and
State and local government employees. One concern is that underfunded
pensions will dominate State and local government budgets in upcoming
decades, as an increasingly high share of revenue may be needed to
provide retired government workers with promised benefits. If taxpayers
must devote higher revenue to paying promised benefits to retired
workers, less funding may be available for key programs like
elementary education, health care,


116 | Chapter 3


and infrastructure development. From another perspective, underfunded
pensions may also pose a risk to government employees, who may see
their benefits challenged as a means of achieving cuts in government
spending.
Increased transparency in the budget process is a key step toward
improving the adequacy of State and local pension funding. One
important strategy often proposed to increase transparency is for State
and local govï¿½ernments to adopt discount rates for liabilities that
accurately portray the magnitude of their promised obligations. Critics
of the old GASB discount rate argued that the high discount rate of
around 8 percent ignored the role of asset risks in calculating the
present value of future promised benefits. Economists often argue that
pension liabilities should be discounted by the riskless rate of return
because the payments to retired workers will be made with certainty
(Novy-Marx and Rauh 2011).\11\

Under the new discount method approved by GASB, plans will project
the portion of pension liabilities that are backed by underlying plan
assets (that is, the funded portion) and the portion of liabilities that
need to be covï¿½ered by other resources (that is, the unfunded portion).
The new standards allow States and localities to use a roughly 8 percent
discount rate for funded liabilities but require the use of a riskless
discount rate for pension liabilities that are unfunded (NASBO 2012b).
With the new GASB standards, the estimated funding ratio of State and
local pension plans would have been 57 percent in 2010, markedly lower
than the 76 percent estimated under the previous method (Munnell et al.
2012b).\12\ Once State and local pension underfunding is better
understood through heightened reporting transparï¿½ency, State and
local governments might be more willing to undertake diffiï¿½cult
financial decisions and pension reforms to shore up their pension plans.





____________________
11 In a sample of 77 municipal plans, the discount rate ranged from
7.5 percent to 10.0 percent, with a median of 8.0 percent (Novy-Marx
and Rauh 2011).
12 This rate change incorporates the effects of the new discount
method and other pension accounting reforms approved by GASB.


Fiscal Policy   | 117