Republican Tax Plans: Radically Regressive

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regressive taxes, tax cuts for the rich

The Republican Presidential candidates have proposed radical changes to the US income tax system.  The changes they propose would lead to truly gigantic tax cuts for the rich, historically unprecedented even under Bush or Reagan, and would create a radically more regressive tax structure compared to what we have now.  And with the notable exception of 9-9-9 Plan proposed by Herman Cain, the tax plans would also collect far less revenue than the current system, at a time when the same Republican candidates complain loudly that government deficits will lead the country to ruin.

A reform of the US tax system is clearly important.  The current system is far too complex, with numerous loopholes and special interest provisions, that make it possible for many of the truly super-rich to pay taxes at rates below that of their secretaries, as Warren Buffett has noted.  But instead of tackling this, the Republican proposals would make the problem even worse.

The Tax Policy Center (TPC), a joint program of the Urban Institute and Brookings, has undertaken a careful and consistent analysis of the Republican candidate proposals.  A summary by TPC of each of the Republican plans is available here.  The Tax Policy Center has also prepared detailed simulations of the implications of three of the Republican proposals:  those by Cain, Perry, and Gingrich.  The graph above was drawn from these results, which are available at the TPC web site here.  The numbers are worked out from a Microsimulation model developed by TPC, which is similar in nature to tax models used by the Congressional Budget Office, the US Treasury, and others.  The TPC model is based on actual 2004 individual tax return data, with the figures then projected forward (or “aged”) based on actual and projected economic growth and structural changes.  With this model, TPC can work out the tax implications for individual groups of proposed new tax rates and rules.

TPC has not undertaken such a simulation analysis of the Mitt Romney proposals.  To be fair, the Romney tax proposals are more limited than the radical changes proposed by all of the other candidates.  Romney would extend the Bush tax cuts, would cut the tax rate on corporate profits to 25% from the current 35%, would cut capital gains taxes to zero for all households below $200,000 in annual income, and would eliminate the estate tax (which only impacts the rich).  All the other Republican candidates have proposed far more radical changes.

The Cain proposals are the most radical.  While Cain himself has “suspended” his campaign, his withdrawal from the race was due to multiple and separate charges of sexual harassment by several women coming forward, plus the revelation by another woman of a 13 year long affair with Cain while he was married.  The campaign suspension was not due to his tax proposals, and indeed, all indications are that Cain’s 9-9-9 plan was and remains extremely popular among the Republican faithful.  Cain would replace the entire income tax system (including Social Security and Medicare taxes) with a flat 9% tax on personal incomes, a 9% tax on corporate incomes, and a 9% retail sales tax.

The graph above shows what the resulting average tax rates would be on households, by income category.  Taxes paid as a share of income would go under Cain from the relatively progressive rates shown (in black for what current law would be after 2012, or in blue for what they would be if the Bush tax cuts are renewed rather than allowed to expire in 2012 as per current law), to a fairly flat rate of normally 22 to 24% for those making up to $200,000.  They would then drop to 18% for those making over $500,000.  That is, under Cain’s plan, taxes would go up for the poor and middle class (all those making less than $100,000), and then drop sharply for the very rich.  Close to 90% of the population (the poorest 90%) would end up paying more taxes under Cain’s proposal.  The richest 10% would pay less.

Households at poverty line income (the group earning between $20 and $30,000) pay less than 10% of their income in taxes under current law, but under Cain their taxes would more than double, to 22% of income.  And the rich and super-rich (all those making over $500,000), would see not only a sharp cut in their taxes due, but such a sharp drop that they would end up paying a lower share of their income in taxes than the poor would.  It should be noted that the Tax Policy Center did ask Cain representatives about this, and the representatives indicated there would be some transfers made to fix this glaring issue.  But they could not provide any specifics on what would be done, and hence the calculations here could not factor in what they would be.

But while Cain would move the tax system to a sharply regressive one, even more regressive than Perry and Gingrich propose, at least his system would raise almost as much in taxes as the current system.  That is, Cain is simply and directly proposing a redistribution of the tax burden, with the poor and middle class paying far more so that the rich can pay less.  Total tax revenues would fall by about $200 billion a year in the Cain system, which while not small, is still far less than the $1.28 trillion reduction that would follow under the Gingrich plan, and $1.0 trillion reduction under Perry (see below).  And indeed under Cain, total tax revenues would go up by about $100 billion for all those making less than $1 million dollars a year.  But Cain would then cut taxes by a total of $300 billion on all those making more than $1 million (with an average annual income of about $3 million each among them), leading to the net loss of $200 billion.

The Gingrich and Perry plans are broadly similar in nature to each other, but the Perry plan less extreme.  Both Gingrich and Perry would give taxpayers the option of paying taxes due under the “present” system  (defined as the current law by Perry, but defined by Gingrich as the rates that would apply with the Bush tax cuts extended), or paying a flat rate of 20% (Perry) or 15% (Gingrich).  Both would cut taxes on capital gains to zero and repeal the AMT for those choosing the flat taxes, would cut taxes on corporate profits (to 12.5% for Gingrich and 20% for Perry, from the current 35%), and would end the estate tax.  It is interesting that under Perry, taxes would actually be higher for the poor and lower middle class (all those households making up to $50,000) than they would be if the Bush tax cuts are extended.  But taxes under Perry would be cut drastically for the rich.

The result would be a radical reduction in tax rates, for all under Gingrich, and for especially the very rich under both Perry and Gingrich.  They would fall so far under Gingrich that millionaires as a group (and not simply some individual millionaires who can take advantage of special loopholes) would pay a lower average tax rate than those earning $40,000 a year.  For Perry, millionaires would on average pay the same rate as those earning $40 to 50,000.  That is, middle income households earning between $50,000 and $500,000 a year would pay a higher rate of taxes than millionaires.  The US tax system has never been regressive in this way.

Furthermore, the Gingrich and Perry tax plans would collect far less in revenue than the current system:  $1.28 trillion less in 2015 under Gingrich, and $1.0 trillion less under Perry, as noted above.  Republicans might argue that these reduced revenues should simply be matched by cuts in government spending, so that the deficit does not rise as a result.  But the most recent projection by the Congressional Budget Office indicates that total federal government discretionary spending in 2015 (including all military spending) would only be $1.26 billion.  Even Republicans would agree that one cannot eliminate the entire military budget.

This is simply not serious.  Yet these are the presidential contenders of the principal opposition party in the US.

Home Prices Stagnate, at Levels Similar to Those of 2003

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US home prices, Case-Shiller 10-City index, 1987 to 2011

US home prices continue to stagnate, at levels well below the peak reached in 2006 during the housing bubble. They fell sharply in 2007 and 2008 during the last two years of the Bush Administration and then stabilized under Obama, first rising a bit and then falling back a bit, but with no overall trend so far.  Based on the 10-city composite home price index of S&P / Case-Shiller, the prices of single-family homes in September 2011 were 33% below the peak reached in April 2006.

It is useful to view this in the longer term context, as presented in the graph above.  While home prices are fully a third off their peak, they are still higher than they ever were prior to 2003.  The sharp fall in prices is a reflection of the sharp rise in the middle of the decade, as a bubble built up and policy makers decided not to try to do anything to moderate it.  Indeed, many politicians, as well as many existing homeowners, felt quite good about the rapidly rising prices.

Then the bubble burst, and the consequences for the economy have been clear, as the economy collapsed in the sharpest downturn since the Great Depression.  This was then followed by an anemic recovery, with still high unemployment.  Recovery from such “balance sheet recessions” are normally slow, as the entities with the over-extended balance sheets (mortgage holders in the US; the corporate sector in Japan in the 1990s) seek to hunker down and save their way out of their predicament.  Asset prices recover only slowly at best.

If nothing is done, US home prices are likely to continue to stagnate, and may well fall further.  As indicated above, while prices after the bubble burst fell by a third, they are still only at the level seen in 2003.  Yet between 1997 and 2003 they had already doubled.  That home prices have not now fallen further than simply to 2003 levels is therefore even a bit of a surprise.  They could fall more.  And as seen prior to 1997, there can be long periods when prices are basically just flat.

Those households with negative equity in their homes (commonly referred to as “underwater”) face major difficulties, even if they can afford to make continued payments on their homes.  They cannot refinance at the current low rates for mortgages, unless they can come up with extra cash to bring the mortgage down to 80% (generally) of their current lower home value.  And they cannot sell their house to someone else, perhaps to move elsewhere for a new job, without bringing extra cash to the closing to pay off the remaining mortgage balance.  The housing market remains frozen, and with that, the economy remains in the doldrums.

Unless something major is done, this weak housing market will likely keep the economy in the doldrums.  And there is no reason to believe that there will be a jump in housing prices to levels similar to those at the peak of the bubble, with this then curing the problem of the underwater mortgages.   Rather, a comprehensive program, led by government, will be necessary to restructure these mortgages, to unfreeze this market and allow the economy to recover.

The Eurozone Crisis: The Much Praised “Convergence” as a Cause

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Eurozone crisis, Eurozone and UK Government borrowing rates, 10 year yields, January 1993 to October 2011

The Eurozone crisis is complicated, and a mess.  Europe as a whole is probably already in an economic recession.  But one of the seeds for this crisis (there are several) can be found in what was seen then as the remarkable, and at the time much praised, “convergence” in government borrowing rates among the Eurozone members from the introduction of the Euro on January 1, 1999 (and Greece from its entry on January 1, 2001), until the Lehman Brothers collapse in September, 2008.

The graph shows how markets drove interest rates on government bonds to equality for Eurozone members, until the Lehman collapse in 2008.  It is really quite remarkable that the markets acted this way.  They treated the Government of Greece as if the probability it would default or otherwise reduce the value of the loans made to it (e.g. by an involuntary restructuring), were the same for it as for Germany (or any other Eurozone member).  Even if the markets thought that Germany would in the end always bail out any member otherwise unable to repay its debt, one would have thought that the markets would have at least viewed this as not 100% certain, and that they would in any case ultimately face some degree of loss even with a German bailout.  That the markets did not act this way shows how unbridled faith in markets acting rationally and fully informed is dogma, and is not supported by history.

The graph also shows the 10 year borrowing rate by the Government of the UK.  The UK has its own currency, and it must have been painful for it to see that the markets treated Eurozone members such as Greece and Ireland as better risks than the UK in the middle of the last decade.  I have included the UK in the above graph in part to show how tightly bound the borrowing rates were for the Eurozone members during this period. And despite a UK fiscal deficit which is now higher than all Eurozone members other than Greece (and in fact close to that of Greece, where the Greek fiscal deficit is projected to be 9.1% of GDP in 2011, vs. 8.8% projected for the UK), and public debt ratios similar to the EU average (and a third higher than that of Spain, for example), the UK 10-year borrowing rate is now almost the same as Germany’s (as of this writing on December 12, the 10 year UK rate was 2.10%, vs. 2.02% for Germany).  An independent currency helps.

The Eurozone crisis has reached the point that it has, threatening a renewed world-wide downturn and a possible break-up of the euro itself, because the traditional tools to manage a crisis are not there, due to the euro and the rules under which it was established.  The European Central Bank says it is not permitted to be a lender of last resort to Euro member governments, thus forgoing an important mechanism normally available to countries with a sovereign currency.  And as a member of the Eurozone, individual countries cannot devalue, where a devaluation could improve competitiveness and spur growth.  Many conservative economists have argued that putting nations is such straightjackets is the way to prosperity.  The Eurozone crisis shows that is simply not correct.

There are no good alternatives in what to do now.  The time for corrective actions should have come much earlier, including from the launch of the euro when the convergence in government borrowing rates was observed, despite the clear differences in capacity to service public debt among the Eurozone members.  But in coming up with a resolution to this crisis, one element will need to be that losses are taken by the lenders who had earlier treated all Eurozone governments as the same.  It was this failure of the market to differentiate across the Eurozone members that supported both profligate governments (such as Greece) and profligate private borrowers (such as banks in Spain and Ireland that  drove real estate bubbles), and more broadly financed at too low a price the trade imbalances that developed among the member countries.

Ensuring the lenders suffer such losses is not only morally justifiable (that is, all the costs should not be imposed Greece, Italy, Spain, and others, even if this would suffice, and it won’t), but also important to ensure another such crisis does not develop again in a few years.  Angela Merkel and Germany are trying instead to impose strict fiscal rules on public sector deficits and the accumulation of public debts, but it is unlikely that such blunt rules will suffice to cover the complexities of any real world situation the countries find themselves in.  Furthermore, such fiscal rules, if seriously applied, will limit the ability of governments to respond as they should to economic downturns, even recognizing that the rules in principle allow for some flexibility in such circumstances.

And by Germany insisting that banks and other lenders not take losses on the loans they made to the riskier countries (other than Greece), where such loans were made at rates that reflected an assumption of no risk, lenders might well feel that in other than extreme cases (like Greece) they will in the future again be bailed out.  While one should hesitate in relying solely on the markets, given their poor track record, the markets would function better if lenders were forced to take losses on their bad lending decisions.  That would then act as a check on excessive government borrowing in circumstances when such borrowing truly was excessive rather than a reasonable response to the real world situation the countries might find themselves in at some point in the future.  And such market discipline would function better than crude, one size fits all, fiscal rules that limit a government’s ability to respond appropriately to downturns.