Allow the IRS to Fill In Our Tax Forms For Us – It Can and It Should

A.  Introduction

Having recently completed and filed this year’s income tax forms, it is timely to examine what impact the Republican tax bill, pushed quickly through Congress in December 2017 along largely party-line votes, has had on the taxes we pay and on the process by which we figure out what they are.  I will refer to the bill as the Trump/GOP tax bill as the new law reflected both what the Republican leadership in Congress wanted and what the Trump administration pushed for.

We already know well that the cuts went largely to the very well-off.  The chart above is one more confirmation of this.  It was calculated from figures in a recent report by the staff of the Joint Committee on Taxation of the US Congress, released on March 25, 2019 (report #JCX-10-19).  While those earning more than $1 million in 2019 will, on average, see their taxes cut by $64,428 per tax filing unit (i.e. generally households), those earning $10,000 or less will see a reduction of just $21.  And on the scale of the chart, it is indeed difficult to impossible even to see the bars depicting the reductions in taxes for those earning less than $50,000 or so.

The sharp bias in favor of the rich was discussed in a previous post on this blog, based there on estimates from a different group (the Tax Policy Center, a non-partisan think tank) but with similar results.  And while it is of course true that those who are richer will have more in taxes that can be cut (one could hardly cut $64,428 from a taxpayer earning less than $10,000), it is not simply the absolute amounts but also the share of taxes which were cut much further for the rich than for the poor.  According to the Joint Committee on Taxation report cited above, those earning $30,000 or less will only see their taxes cut by 0.5% of their incomes, while those earning between $0.5 million and $1.0 million will see a cut of 3.1%.  That is more than six times as much as a share of incomes.  That is perverse.

And the overall average reduction in individual income taxes will only be a bit less than 10% of the tax revenues being paid before.  This is in stark contrast to the more than 50% reduction in corporate income taxes that we have already observed in what was paid by corporations in 2018.

Furthermore, while taxes for households in some income category may have on average gone down, the numerous changes made to the tax code on the Trump/GOP bill meant that for many it did not.  Estimates provided in the Joint Committee on Taxation report cited above (see Table 2 of the report) indicate that for 2019 a bit less than two-thirds of tax filing units (households) will see a reduction in their taxes of $100 or more, but more than one-third will see either no significant change (less than $100) or a tax increase.  The impacts vary widely, even for those with the same income, depending on a household’s particular situation.

But the Trump/GOP tax bill promised not just a reduction in taxes, but also a reduction in tax complexity, by eliminating loopholes and from other such measures.  The claim was that most Americans would then be able to fill in their tax returns “on a postcard”.  But as is obvious to anyone who has filed their forms this year, it is hardly that.  This blog post will discuss why this is so and why filling in one’s tax returns remains such a headache.  The fundamental reason is simple:  The tax system is not less complex than before, but more.

There is, however, a way to address this, and not solely by ending the complexity (although that would in itself be desirable).  Even with the tax code as complicated as it now is (and more so after the Trump/GOP bill), the IRS could complete for each of us a draft of what our filing would look like based on the information that the IRS already collects.  Those draft forms would match what would be due for perhaps 80 to 85% of us (basically almost all of those who take the standard deduction).  For that 80 to 85% one would simply sign the forms and return them along with a payment if taxes are due or a request for a refund if a refund is due.  Most remaining taxpayers would also be able to use these initial draft forms from the IRS, but for them as the base for what they would need to file.  In their cases, additions or subtractions would be made to reflect items such as itemized deductions (mostly) and certain special tax factors (for some) where the information necessary to complete such calculations would not have been provided in the normal flow of reports to the IRS.  And a small number of filers might continue to fill in all their forms as now.  That small number would be no worse than now, while life would be much simpler for the 95% or more (perhaps 99% or more) who could use the pre-filled in forms from the IRS either in their entirety or as a base to start from.

The IRS receives most of the information required to do this already for each of us (and all that is required for most of us).  But what would be different is that instead of the IRS using such information to check what we filed after the fact, and then impose a fine (or worse) if we made a mistake, the IRS would now use that same information to fill in the forms for us.  We would then review and check them, and if necessary or advantageous to our situation we could then adjust them.  We will discuss how such a tax filing system could work below.

B.  Our Tax Forms are Now Even More Complex Than Before

Trump and the Republican leaders in Congress promised that with the Trump/GOP tax bill, the tax forms we would need to file could, for most of us, fit just on a postcard.  And Treasury Secretary Steven Mnuchin then asserted that the IRS (part of Treasury) did just that.  But this is simply nonsense, as anyone who has had to struggle with the new Form 1040s (or even just looked at them) could clearly see.

Specifically:

a)  Form 1040 is not a postcard, but a sheet of paper (front and back), to which one must attach up to six separate schedules.  This previously all fit on one sheet of paper, but now one has to complete and file up to seven just for the 1040 itself.

b)  Furthermore, there are no longer the forms 1040-EZ or 1040-A which were used by those with less complex tax situations.  Now everyone needs to work from a fully comprehensive Form 1040, and try to figure out what may or may not apply in their particular circumstances.

c)  The number of labeled lines on the old 1040 came to 79.  On the new forms (including the attached schedules) they come to 75.  But this is misleading, as what used to be counted as lines 1 through 6 on the old 1040 are now no longer counted (even though they are still there and are needed).  Including these, the total number of numbered lines comes to 81, or basically the same as before (and indeed more).

d)  Spreading out the old Form 1040 from one sheet of paper to seven does, however, lead to a good deal of extra white space.  This was likely done to give it (the first sheet) the “appearance” of a postcard.  But the forms would have been much easier to fill in, with less likelihood of error, if some of that white space had been used instead for sub-totals and other such entries so that all the steps needed to calculate one’s taxes were clear.

e)  Specifically, with the six new schedules, one has to carry over computations or totals from five of them (all but the last) to various lines on the 1040 itself.  But this was done, confusingly, in several different ways:  1)  The total from Schedule 4 was carried over to its own line (line 14) on the 1040.  It would have been best if all of them had been done this way, but they weren’t.  Instead, 2) The total from Schedule 2 was added to a number of other items on line 11 of the 1040, with the total of those separate items then shown on line 11.  And 3) The total from Schedule 1 was added to the sum of what is shown on the lines above it (lines1 through 5b of the 1040) and then recorded on line 6 of the 1040.

If this looks confusing, it is because it is.  I made numerous mistakes on this when completing my own returns (yes – I do these myself, as I really want to know how they are done).  I hope my final returns were done correctly.  And it is not simply me.  Early indications (as of early March) were that errors on this year’s tax forms were up by 200% over last year’s (i.e. they tripled).

f)  There is also the long-standing issue that the actual forms that one has to fill out are in fact substantially greater than those that one files, as one has to fill in numerous worksheets in order to calculate certain of the figures.  These worksheets should be considered part of the returns, and not hidden in the directions, in order to provide an honest picture of what is involved.  And they don’t fit on a postcard.

g)  But possibly what is most misleading about what is involved in filling out the returns is not simply what is on the 1040 itself, but also the need to include on the 1040 figures from numerous additional forms (for those that may apply).  Few if any of them are applicable to one’s particular tax situation, but to know whether they do or not one has to review each of those forms and make such a determination.  How does one know whether some form applies when there is a statement on the 1040 such as “Enter the amount, if any, from Form xxxx”?  The only way to know is to look up the form (fortunately now this can be done on the internet), read through it along with the directions, and then determine whether it may apply to you.  Furthermore, in at least a few cases one can only know if the form applies to your situation is by filling it in and then comparing the result found to some other item to see whether filing that particular form applies to you.

There are more than a few such forms.  By my count, one has just on the Form 1040 plus its Schedules 1 through 5 amounts that might need to be entered from Forms 8814, 4972, 8812, 8863, 4797, 8889, 2106, 3903, SE, 6251, 8962, 2441, 8863, 8880, 5695, 3800, 8801,1116, 4137, 8919, 5329, 5405, 8959, 8960, 965-A, 8962, 4136, 2439, and 8885.  Each of these forms may apply to certain taxpayers, but mostly only a tiny fraction of them.  But all taxpayers will need to know whether they might apply to their particular situation.  They can often guess that they probably won’t (and it likely would be a good guess, as most of these forms only apply to a tiny sliver of Americans), but the only way to know for sure is to check each one out.

Filling out one’s individual income tax forms has, sadly, never been easy.  But it has now become worse.  And while the new look of the Form 1040 appears to be a result of a political decision by the Trump administration (“make it look like it could fit on a postcard”), the IRS should mostly not be blamed for the complexity.  That complexity is a consequence of tax law, as written by Congress, which finds it politically advantageous to reward what might be a tiny number of supporters (and campaign contributors) with some special tax break.  And when Congress does this, the IRS must then design a new form to reflect that new law, and incorporate it into the Form 1040 and now the new attached schedules.  And then everyone, not simply the tiny number of tax filers to whom it might in fact apply, must then determine whether or not it applies to them.

There are, of course, also more fundamental causes of the complexity in the tax code, which must then be reflected in the forms.  The most important is the decision by our Congress to tax different forms of income differently, where wages earned will in general be taxed at the highest rates (up to 37%) while capital gains (including dividends on stocks held for more than 60 days) are taxed at rates of just 20% or less.  And there are a number of other forms of income that are taxed at various rates (including now, under the Trump/GOP tax bill, an effectively lower tax rate for certain company owners on the incomes they receive from their companies, as well as new special provisions of benefit to real estate developers).  As discussed in an earlier post on this blog, there is no good rationale, economic or moral, to justify this.  It leads to complex tax calculations as the different forms of income must each be identified and then taxed at rates that interact with each other.  And it leads to tremendous incentives to try to shift your type of income, when you are in a position to do so, from wages, say, to a type taxed at a lower rate (such as stock options that will later be taxed only at the long-term capital gains rate).

Given this complexity, it is no surprise that most Americans turn either to professional tax preparers (accountants and others) to fill in their tax forms for them, or to special tax preparation software such as TurboTax.  Based on statistics for the 2018 tax filing season (for 2017 taxes), 72.1 million tax filers hired professionals to prepare their tax forms, or 51% of the 141.5 million tax returns filed.  The cost varies by what needs to be filed, but even assuming an average fee of just $500 per return, this implies a total of over $36 billion is being paid by taxpayers for just this service.

Most of the remaining 49% of tax filers use tax preparation software for their returns (a bit over three-quarters of them).  But these are problematic as well.  There is also a cost (other than for extremely simple returns), but the software itself may not be that good.  A recent review by Consumer Reports found problems with each of the four major tax preparation software packages it tested (TurboTax, H&R Block, TaxSlayer, and TaxAct), and concluded they are not to be trusted.

And on top of this, there is the time the taxpayer must spend to organize all the records that will be needed in order to complete the tax returns – whether by a hired professional tax preparer, or by software, or by one’s own hand.  A 2010 report by a presidential commission examing options for tax reform estimated that Americans spend about 2.5 billion hours a year to do what is necessary to file their individual income tax returns, equivalent to $62.5 billion at an average time cost of $25 per hour.

Finally there are the headaches.  Figuring one’s taxes, even if a professional is hired to fill in the forms, is not something anyone wants to spend time on.

There is a better way.  With the information that is already provided to the IRS each year, the IRS could complete and provide to each of us a draft set of tax forms which would suffice (i.e. reflect exactly what our tax obligation is) for probably 80% or more of households.  And most of the remainder could use such draft forms as a base and then provide some simple additions or subtractions to arrive at what their tax obligation is.  The next section will discuss how this could be done.

C.  Have the IRS Prepare Draft Tax Returns for Each of Us

The IRS already receives, from employers, financial institutions, and others, information on the incomes provided to each of us during the tax year.  And these institutions then tell us each January what they provided to the IRS.  Employers tell us on W-2 forms what wages were paid to us, and financial institutions will tell us through various 1099 forms what was paid to us in interest, in dividends, in realized capital gains, in earnings from retirement plans, and from other such sources of returns on our investments.  Reports are also filed with the IRS for major transactions such as from the sale of a home or other real estate.

The IRS thus has very good information on our income each year.  Our family situation is also generally stable from year to year, although it can vary sometimes (such as when a child is born).  But basing an initial draft estimate on the household situation of the previous year will generally be correct, and can be amended when needed.  One could also easily set up an online system through which tax filers could notify the IRS when such events occur, to allow the IRS to incorporate those changes into the draft tax forms they next produce.

For most of those who take the standard deduction, the IRS could then fill in our tax forms exactly.  And most Americans take the standard deduction. Prior to the Trump/GOP tax bill, about 70% of tax filers did, and it is now estimated that with the changes resulting from the new tax bill, about 90% will.  Under the Trump/GOP tax bill, the basic standard deduction was doubled (while personal exemptions were eliminated, so not all those taking the standard deduction ended up better off).  And perhaps of equal importance, the deduction that could be taken on state and local taxes was capped at $10,000 while how much could be deducted on mortgage interest was also narrowed, so itemization was no longer advantageous for many (with these new limitations primarily affecting those living in states that vote for Democrats – not likely a coincidence).

The IRS could thus prepare filled in tax forms for each of us, based on information contained in what we had filed in earlier years and assuming the standard deduction is going to be taken.  But they would just be drafts.  They would be sent to us for our review, and if everything is fine (and for most of the 90% taking the standard deduction they would be) we would simply sign the forms and return them (along with a check if some additional tax is due, or information on where to deposit a refund if a tax refund is due).

But for the 10% where itemized deductions are advantageous, and for a few others who are in some special tax situation, one could either start with the draft forms and make additions or subtractions to reflect simple adjustments, or, if one wished, prepare a new set of forms reflecting one’s tax situation.  There would likely not be many of the latter, but it would be an option, and no worse than what is currently required of everyone.

For those making adjustments, the changes could simply be made at the end.  For example (and likely the most common such situation), suppose it was advantageous to take itemized deductions rather than the standard deduction.  One would fill in the regular Schedule A (as now), but then rather than recomputing all of the forms, one could subtract from the taxes due an amount based on what the excess was of the itemized deductions over the standard deduction, and one’s tax rate.  Suppose the excess of the itemized deductions over the standard deduction for the filer came to $1,000.  Then for the very rich (households earning over $600,000 a year after deductions), one would reduce the taxes due by 37%, or $370.  Those earning $400,000 to $600,000, in the 35% bracket, would subtract $350.  And so on down to the lower brackets, where those in the 12% bracket (those earning $19,050 to $77,400) would subtract $120 (and those earning less than $19,050 are unlikely to itemize).

[Side Note:  Why do the rich receive what is in effect a larger subsidy from the government than the poor do for what they itemize, such as for contributions to charities?  That is, why do the rich effectively pay just $630 for their contribution to a charity ($1,000 minus $370), while the poor pay $880 ($1,000 minus $120) for their contribution to possibly the exact same charity?  There really is no economic, much less moral, reason for this, but that is in fact how the US tax code is currently written.  As discussed in an earlier post on this blog, the government subsidy for such deductions could instead be set to be the same for all, at say a rate of 20% or so.  There is no reason why the rich should receive a bigger subsidy than the poor receive for the contributions they make.]

Another area where the information the IRS would not have complete information to compute taxes due would be where the tax filer had sold a capital asset which had been purchased before 2010.  The IRS only started in 2010 to require that financial institutions report the cost basis for assets sold, and this cost basis is needed to compute capital gains (or losses).  But as time passes, a smaller and smaller share of assets sold will have been purchased before 2010.  The most important, for most people, will likely be the cost of the home they bought if before 2010, but such a sale will happen only once (unless they owned multiple real estate assets in 2010).

But a simple adjustment could be made to reflect the cost basis of such assets, similar to the adjustment for itemized deductions.  The draft tax forms filled in by the IRS would leave as blank (zero) the cost basis of the assets sold in the year for which it did not have a figure reported.  The tax filer would then determine what the cost basis of all such assets should be (as they do now), add them up, and then subtract 20% of that total cost basis from the taxes due (for those in the 20% bracket for long term capital gains, as most people with capital gains are, or use 15% or 0% if those tax brackets apply in their particular cases).

There will still be a few tax filers with more complex situations where the IRS draft computations are not helpful, who will want to do their own forms.  This is fine – there would always be that option.  But such individuals would still be no worse off than what is required now.  And their number is likely to be very small.  While a guess, I would say that what the IRS could provide to tax filers would be fully sufficient and accurate for 80 to 85% of Americans, and that simple additions or subtractions to the draft forms (as described above) would work for most of the rest.  Probably less than 5% of filers would need to complete a full set of forms themselves, and possibly less than 1%.

D. Final Remarks

Such an approach would be new for the US.  But there is nothing revolutionary about it.  Indeed, it is common elsewhere in the world.  Much of Western Europe already follows such an approach or some variant of it, in particular all of the Scandinavian countries as well as Germany, Spain, and the UK, and also Japan.  Small countries, such as Chile and Estonia, have it, as do large ones.

It has also often been proposed for the US.  Indeed, President Reagan proposed it as part of his tax reduction and simplification bill in 1985, then candidate Barack Obama proposed it in 2007 in a speech on middle class tax fairness, a presidential commission in 2010 included it as one of the proposals in its report on simplifying the tax system, and numerous academics and others have also argued in its favor.

It would also likely save money at the IRS.  The IRS collects already most of the information needed.  But that information is not then sent back to us in fully or partially filled in tax forms, but rather is used by the IRS after we file to check to see whether we got anything wrong.  And if we did, we then face a fine or possibly worse.  Completing our tax returns should not be a game of “gotcha” with the IRS, but rather an effort to ensure we have them right.

Such a reform has, however, been staunchly opposed by narrow interests who benefit from the current frustrating system.  Intuit, the seller of TurboTax software, has been particularly aggressive through its congressional lobbying and campaign contributions in using Congress to block the IRS from pursuing this, as has H&R Block.  They of course realize that if tax filing were easy, with the IRS completing most or all of the forms for us, there would be no need to spend what comes to billions of dollars for software from Intuit and others.  But the morality of a business using its lobbying and campaign contributions to ensure life is made particularly burdensome for the citizenry, so that it can then sell a product to make it easier, is something to be questioned.

One can, however, understand the narrow commercial interests of Intuit and the tax software companies.  One can also, sadly, understand the opposition of a number of conservative political activists, with Grover Norquist the most prominent and in the lead. They have also aggressively lobbied Congress to block the IRS from making tax filing simpler.  They are ideologically opposed to taxes, and see the burden and difficulty in figuring out one’s taxes as a positive, not as a negative.  The hope is that with more people complaining about how difficult it is to fill in their tax forms, the more people will be in favor of cutting taxes.  While that view on how people see taxes might well be accurate, what many may not realize is that the tax cuts of recent decades have led to greater complexity and difficulty, not less.  With new loopholes for certain narrow interests, and with income taxed differently depending on the source of that income (with income from wealth taxed at a much lower rate than income from labor), the system has become more complex while generating less revenue overall.

But it is perverse that Congress should legislate in favor of making life more difficult.  The tax system is indeed necessary and crucial, as Reagan correctly noted in his 1985 speech on tax reform, but as he also noted in that speech, there is no need to make them difficult.  Most Americans, Reagan argued, should be able, and would be able under his proposals, to use what he called a “return-free” system, with the IRS working out the taxes due.

The system as proposed above would do this.  It would also be voluntary.  If one disagreed with the pre-filled in forms sent by the IRS, and could not make the simple adjustments (up or down) to the taxes due through the measures as discussed above, one could always fill in the entire set of forms oneself.  But for that small number of such cases this would just be the same as is now required for all.  Furthermore, if one really was concerned about the IRS filling in one’s forms for some reason (it is not clear what that might be), one could easily have a system of opting-out, where one would notify the IRS that one did not want the service.

The tax code itself should still be simplified.  There are many reforms that can and should be implemented, if there was the political will.  The 2010 presidential commission presented numerous options for what could be done.  But even with the current complex system, or rather especially because of the current complex system, there is no valid reason why figuring out and filing our taxes should be so difficult.  Let the IRS do it for us.

Taxes on Corporate Profits Have Continued to Collapse

 

The Bureau of Economic Analysis (BEA) released earlier today its second estimate of GDP growth in the fourth quarter ot 2018.  (Confusingly, it was officially called the “third” estimate, but was only the second as what would have been the first, due in January, was never done due to Trump shutting down most agencies of the federal government in December and January due to his border wall dispute.)  Most public attention was rightly focussed on the downward revision in the estimate of real GDP growth in the fourth quarter, from a 2.6% annual rate estimated last month, to 2.2% now.  And current estimates are that growth in the first quarter of 2019 will be substantially less than that.

But there is much more in the BEA figures than just GDP growth.  The second report of the BEA also includes initial estimates of corporate profits and the taxes they pay (as well as much else).  The purpose of this note is to update an earlier post on this blog that examined what happened to corporate profit tax revenues following the Trump / GOP tax cuts of late 2017.  That earlier post was based on figures for just the first half of 2018.

We now have figures for the full year, and they confirm what had earlier been found – corporate profit tax revenues have indeed plummeted.  As seen in the chart at the top of this post, corporate profit taxes were in the range of only $150 to $160 billion (at annual rates) in the four quarters of 2018.  This was less than half the $300 to $350 billion range in the years before 2018.  And there is no sign that this collapse in revenues was due to special circumstances of one quarter or another.  We see it in all four quarters.

The collapse shows through even more clearly when one examines what they were as a share of corporate profits:

 

The rate fell from a range of generally 15 to 16%, and sometimes 17%, in the earlier years, to just 7.0% in 2018.  And it was an unusually steady rate of 7.0% throughout the year.  Note that under the Trump / GOP tax bill, the standard rate for corporate profit tax was cut from 35% previously to a new headline rate of 21%.  But the actual rate paid turned out (on average over all firms) to come to just 7.0%, or only one-third as much.  The tax bill proponents claimed that while the headline rate was being cut, they would close loopholes so the amount collected would not go down.  But instead loopholes were not only kept, but expanded, and revenues collected fell by more than half.

If the average corporate profit tax rate paid in 2018 had been not 7.0%, but rather at the rate it was on average over the three prior fiscal years (FY2015 to 2017) of 15.5%, an extra $192.2 billion in revenues would have been collected.

There was also a reduction in personal income taxes collected.  While the proportional fall was less, a much higher share of federal income taxes are now borne by individuals than by corporations.  (They were more evenly balanced decades ago, when the corporate profit tax rates were much higher – they reached over 50% in terms of the amount actually collected in the early 1950s.)  Federal personal income tax as a share of personal income was 9.2% in 2018, and again quite steady at that rate over each of the four quarters.  Over the three prior fiscal years of FY2015 to 2017, this rate averaged 9.6%.  Had it remained at that 9.6%, an extra $77.3 billion would have been collected in 2018.

The total reduction in tax revenues from these two sources in 2018 was therefore $270 billion.  While it is admittedly simplistic to extrapolate this out over ten years, if one nevertheless does (assuming, conservatively, real growth of 1% a year and price growth of 2%, for a total growth of about 3% a year), the total revenue loss would sum to $3.1 trillion.  And if one adds to this, as one should, the extra interest expense on what would now be a higher public debt (and assuming an average interest rate for government borrowing of 2.6%), the total loss grows to $3.5 trillion.

This is huge.  To give a sense of the magnitude, an earlier post on this blog found that revenues equal to the original forecast loss under the Trump / GOP tax plan (summing to $1.5 trillion over the next decade, and then continuing) would suffice to ensure the Social Security Trust Fund would be fully funded forever.  As things are now, if nothing is done the Trust Fund will run out in about 2034.  And Republicans insist that the gap is so large that nothing can be done, and that the system will have to crash unless retired seniors accept a sharp reduction in what are already low benefits.

But with losses under the Trump / GOP tax bill of $3.1 trillion over ten years, less than half of those losses would suffice to ensure Social Security could survive at contracted benefit levels.  One cannot argue that we can afford such a huge tax cut, but cannot afford what is needed to ensure Social Security remains solvent.

In the nearer term, the tax cuts have led to a large growth in the fiscal deficit.  Even the US Treasury itself is currently forecasting that the federal budget deficit will reach $1.1 trillion in FY2019 (5.2% of GDP), up from $779 billion in FY2018.  It is unprecedented to have such high fiscal deficits at a time of full employment, other than during World War II.  Proper fiscal management would call for something closer to a balanced budget, or even a surplus, in those periods when the economy is at full employment, while deficits should be expected (and indeed called for) during times of economic downturns, when unemployment is high.  But instead we are doing the opposite.  This will put the economy in a precarious position when the next economic downturn comes.  And eventually it will, as it always has.

Taxes on Corporate Profits Have Collapsed

A.  Introduction:  The Plunge in Corporate Profit Tax Revenues

Corporate profit tax revenues have collapsed following the passage by Congress last December of the Trump-endorsed Republican tax plan.  And this is not because corporate profits have decreased:  They have kept going up.  The initial figures, for the first half of 2018, show federal corporate profit taxes (also referred to as corporate income taxes) collected have fallen to an annual rate of roughly just $150 billion.  This is only half, or less, of the $300 to $350 billion collected (at annual rates) over the past several years.  See the chart above.

The estimates on corporate profit taxes actually being paid through the first half of 2018 come from the National Income and Product Accounts (NIPA, and commonly also referred to as the GDP accounts) produced by the Bureau of Economic Analysis.  The figures are collected as part of the process of producing the GDP accounts, but for various reasons the figures on corporate profit taxes are not released with the initial GDP estimates (which come out at the end of the month that follows the end of each quarter), but rather one month later (i.e. on August 29 this time, for the estimates for the April to June quarter).  The quarterly estimates are seasonally adjusted (which is important, as tax payments have a strong seasonality to them), and are then shown at annual rates.  While we already saw such a collapse in corporate tax revenues in the figures for the first quarter of 2018 (first published in May), it is always best with the estimates of GDP and its components to wait until a second quarter’s figures are available to see whether any change is confirmed.  And it was.

This initial data on what is actually now being collected in taxes following the passage of the Republican tax plan last December suggests that the revenue losses will be substantially higher than the $1.5 trillion over ten years that the staff at the Joint Committee on Taxation (the official arbiters for Congress on such matters) forecast.  Indeed, the plunge in corporate profit tax collections alone looks likely to well exceed this.  On top of this, there were also sharp cuts in non-corporate business taxes and in income taxes for those in higher income groups.

This blog post will look at what the initial figures are revealing on the tax revenues being collected, as estimated in the GDP accounts.  The focus will be on corporate income taxes, although in looking at the total tax revenue losses we will also look briefly at what the initial data is indicating on reductions in individual income taxes being paid.

The chart above shows what the reduction has been in corporate profit taxes in dollar terms.  In the next section below we will look at this in terms of the taxes as a share of corporate profits.  That implicit average actual tax rate is more meaningful for comparisons over time, and it has also plunged.  And the implicit actual rate now being paid, of only about 7% for the taxes at the federal government level, shows how misleading it is to focus on the headline rate of tax on corporate profits of 21% (down from 35% before the new law).  The actual rate being paid is only one-third of this, as a consequence of the numerous loopholes built into the law.  The Republican proponents of the bill had argued that while they were cutting the headline rate from 35% to 21%, they were also (they asserted) ending many of the loopholes which allowed corporations to pay less.  But in fact numerous loopholes were added or expanded.

The next section of the post will then look at this in the longer term context, with figures on the implicit corporate profit tax rate going back to 1950.  The implicit rate has fallen steadily over time, from a rate that reached over 50% in the early 1950s, to just 7% now.  While Trump and his Republican colleagues argued the cut in corporate taxes was necessary in order for the economy to grow, the economy in fact grew at a faster pace in the 1950s and 1960s, when the rate paid varied between 30 and 50%, than it has in recent decades despite the now far lower rates corporations face.

But this is for the federal tax on corporate profits alone.  There are also taxes on corporate profits imposed at the state and local level, as well as by foreign governments (although such foreign taxes are then generally deductible from the taxes due domestically).  This overall tax burden is more meaningful for understanding whether the overall burden is too high.  But, as we shall see below, that rate has also fallen steadily over time.  There is again no evidence that lower rates lead to higher growth.

The final substantive section of the post will then look more closely at the magnitude of the revenue losses from the December bill.  They are massive, and based on the initial evidence could very well total over $2 trillion over ten years for the losses on the corporate profit tax alone.  The losses from the other tax cuts in the new law, primarily for the wealthy and for non-corporate business, will add to this.  A very rough estimate is that the losses in individual income tax revenues may total an additional $1 trillion, bringing the total to over $3 trillion.  This is double the $1.5 trillion loss in revenues originally forecast.

But first, an analysis of what we see from the initial evidence on what is being paid.

B.  Profit Taxes as a Share of Corporate Profits

The chart at the top of this post shows what has been collected, by quarter (but shown at an annual rate), by the federal tax on corporate profits over the last several years.  Those figures are in dollars, and show a fall in the first half of 2018 of a half or more compared to what was collected in recent years.  But for comparisons over time, it is more meaningful to look at the implicit corporate tax rate, as corporate profits change over time (and generally grow over time).  And this can be done as the National Income and Product Accounts include an estimate of what corporate profits have been, as part of its assessment of how national income is distributed among the major functional groups.

That share since 2013 has been:

Between 2013 and 2016, the implicit rate (quarter by quarter) varied between about 15 and 17%.  It came down to about 14% for most of 2017 for some reason (possibly tied to the change in administration in Washington, with its new interpretation of regulatory and tax rules), but one cannot know from the aggregate figures alone.  But the rate then fell sharply, by half, to just 7% after the new tax law entered into effect.

A point to note is that the corporate profit figures provided here are corporate profits as estimated in the National Income and Product Accounts.  They are a measure of what corporate profits actually are, in an economic sense, and will in general differ from what corporate profits are as defined for tax purposes.  Thus, for example, accelerated depreciation allowed for tax purposes will reduce taxable corporate profits.  But the BEA estimates for the NIPA accounts will reflect not the accelerated depreciation allowed for tax purposes, but rather an estimate of what depreciation actually was.  Thus the figures as shown in the chart above will be a measure of what the true average corporate tax rate actually was, before the adjustments made (as permitted under tax law) to arrive at taxable corporate profits.

That average rate is now just 7%.  That is only one-third of the headline rate under the new law of 21%.  Provisions in the tax code allow corporations to pay far less in tax than what the headline rate would suggest.  This is not new (the headline rate previously was 35%, but the actual average rate paid was just 15 to 17% between 2013 and 2016, and 14% in most of 2017).  But Trump administration officials had asserted that many of the loopholes allowing for lower taxes would be ended under the new tax law, so that the actual rate paid would be closer to the headline rate.  But this clearly did not happen.  As many independent analysts pointed out before the bill was passed, the new tax law had numerous provisions which would allow the system to be gamed.  And we now see the result of that in the figures.

C.  Corporate Taxes in a Longer Term Context

The cuts in corporate profit taxes are not new.  Taxes on corporate profits in the US used to be far higher:

In the early 1950s, the federal tax on corporate profits (actually paid, not the headline rate) reached over 50%.  While it then fell, it kept to a rate of between about 30% and 50% through the 1950s and 60s.  And this was a period of good economic growth in the US – substantially faster than it has been since.  A high tax rate on corporate profits did not block growth.  Indeed, if one looked just at the simple correlation, one might conclude that a higher tax on corporate profits acts as a spur to growth.  But this would be too simplistic, and I would not argue that.  But what one can safely conclude is that a high rate of tax on corporate profits does not act as a block to more rapid growth.

There have also been important distributional consequences, however.  Corporate wealth is primarily owned by the wealthy (duh), and the sharp decline in taxes paid on corporate profits means that a larger share of the overall tax burden has been shifted to taxes on individual incomes, which are primarily borne by the middle classes.  Based on figures in the NIPA accounts, in 1950 taxes on individual incomes (including Social Security taxes) accounted for 47% of total federal taxes, while taxes on corporate profits accounted for 35% (with the rest primarily various excise taxes such as on fuels, liquor, tobacco, etc., plus import duties).  By 2017, however, the share of taxes on individual incomes had grown to 87.4%, while the share on corporate profits had declined to just 8.6%.  There was a gigantic shift away from taxes on wealth to taxes on individual incomes – taxes that are borne primarily by the middle class.  And that share will now fall further in 2018, by about half.

The chart above is for federal corporate profit taxes alone.  It could be argued that what matters to growth is not just the corporate profit taxes paid at the federal level, but all such taxes, including those paid at the state and local level, as well as to foreign governments (although the taxes paid abroad are generally deductible on their domestic taxes, so that will be a wash).

That chart looks like:

This follows the same path as the chart for federal corporate profit taxes alone, with a similar decline.  With the federal share of such taxes averaging 84% over the period (up to 2017), this is not surprising.  The federal share will now fall sharply in 2018, due to the new tax law.  But over the 1950 to 2017 period, the chart covering all taxes on corporate profits is basically a close to proportionate increase over what the tax has been at the federal level alone.

So the same pattern holds, and the total of the taxes on corporate profits varied between 33% to over 50% in the 1950s and 60s, to between 15 and 20% in recent years before the plunge in the first half of 2018 to just 10%.  But the relatively high taxes in the 1950s and 60s did not lead to slow growth in those years, nor did the low taxes in recent decades lead to more rapid growth.  Rather, one had the reverse.

D.  An Estimate of the Revenue Losses Due to the Tax Bill

These initial figures on the taxes actually being paid following the passage of the Republican tax bill allow us to make an estimate of what the revenue losses will turn out to be.  These will be very rough estimates, as we only have data for half a year, and one should be cautious in extrapolating this to what the losses will be over a decade.  But they can give us a sense of the magnitude.  And it is large.  As we will see below, based on the evidence so far the revenue losses (from the cuts in both corporate taxes and in personal income taxes) might be over $3 trillion over ten years, or about double the $1.5 trillion loss estimate originally forecast.

First, for the federal taxes on corporate profits, as the largest changes are there:  As was discussed before (and seen in the charts above), corporate profit taxes paid as a share of corporate profits were relatively flat between 2013 and 2016, varying between 15 and 17% each quarter, before falling to 14% for most of 2017.  For the full 2013 to 2017 period, the simple average was 15.3%.  The implicit rate then fell to just 7.0% in the first half of 2018.  Had the rate instead remained at 15.3%, corporate profit taxes collected in 2018 would have been $184 billion higher (on an annual basis).

This is not small, and is twice as high as the estimate of the staff of the Joint Committee on Taxation of revenue losses of $91 billion in FY2019 (the first full year under the new tax regime) from all the tax measures affecting businesses (including non-corporate businesses, and covering both domestic business and overseas business).  It is three times as high as the estimated loss of $60 billion in FY18, but the new tax law did not affect the first quarter of FY2018 (October to December).

One should be cautious with any extrapolation of this loss estimate going forward, as not only is the time period of actual experience under the new tax regime short (only a half year), but the law is also a complicated one, with certain provisions changing over time.  But a simple extrapolation over ten years, based on the assumption that corporate profits grow at just a modest 3% a year in nominal terms (meaning 1% a year in real terms if inflation is 2% a year), and that the tax rate on corporate profits will be 7.0% a year (as seen so far in 2018) rather than the 15.3% of recent years, implies that the reduction in corporate profit tax revenues will sum to about $2.1 trillion.

Note that the losses would be greater (everything else equal) if the assumed growth rate of corporate profits is higher.  But the results are not very sensitive to this.  The total losses over ten years would be $2.2 trillion, for example, at an assumed nominal growth rate of 4% (i.e. with inflation still at 2%, then with corporate profits growing at 2% a year in real terms, or double the 1% rate of the base scenario).  Note this also counters the argument of some that such tax cuts will lead to such a large spurt in growth that total tax collections will rise despite the cut in the rates.  As will be discussed below, there is no evidence that this has ever been the case in the US.  But even assuming there were, the argument is undermined by the basic arithmetic.  In the example here, a doubling of the assumed growth rate of profits (from 1% in real terms to 2%) would imply taxes on corporate profits would still fall by $2.0 trillion over the next ten years.  This is not far from the $2.1 trillion loss if there is no rise at all in the growth of corporate profits.  And a doubling of the real growth rate is far above what anyone would reasonably assume could follow from such a cut in the tax rate.

Second, there were also substantial cuts in individual income taxes, although primarily for the wealthy.  While far less in proportional terms, the substantially higher taxes that are now paid by individuals than by corporations means that this is also significant for the totals.

Specifically, individual (federal) income taxes as a share of GDP in the NIPA accounts were quite steady in the quarterly GDP accounts for the period from 2015Q1 to 2017Q4, varying only between 8.22% and 8.44%.  The average was 8.31%.  But then this fell to an average of 7.89% in the first half of 2018 (7.90% in the first quarter, and 7.87% in the second quarter).  Had the rate remained at 8.31%, then $86 billion more in revenues (at an annual rate) would have been collected.

Extrapolating this out for ten years, assuming again just a modest rate of growth for GDP of 3% a year in nominal terms (i.e. just 1% a year in real terms if inflation is 2% a year), the total loss would be $1.0 trillion.  With a higher rate of growth, and everything else the same, the losses would again be larger.  This extrapolation is, however, particularly fraught, as the Republicans wrote into their bill that the cuts in individual taxes would be reversed in 2026.  They did this to keep the forecast cost of the tax bill to the $1.5 trillion envelope they had set, and an effort is already underway to make this permanent (Speaker Paul Ryan has said he will schedule a vote on this in September).  But even if we left out the tax revenue losses in the final two years of the period, the losses in individual taxes would still reach about $0.8 trillion.

Adding the lower revenues from the taxes on corporate profits and the taxes on individual incomes, the total revenue losses would come, over the ten years, to about $3 trillion.  This is double the $1.5 trillion loss that had been forecast.  It is not a small difference.

To give a sense of the magnitude, the loss in 2018 alone (a total of $270 billion) would allow a doubling of the entire budgets (based on FY2017 actual outlays) of the Departments of Education, Housing and Urban Development, and Labor; the Environmental Protection Agency; all international assistance programs (foreign aid); NASA; the National Science Foundation; the Army Corps of Engineers (civil works); and the Small Business Administration.  Note I am not arguing that all of their budgets should necessarily be doubled (although many should, indeed, be significantly increased).  Rather, the point is simply to give readers a sense of the size of the revenues lost as a consequence of the tax cut bill.

As another comparison to give a sense of the magnitude, just half of the lost revenue (now and into the future) would suffice to fund fully the Social Security Trust Fund for the foreseeable future.  If nothing is done, the Social Security Trust Fund will run out at some point around 2034.  Republicans have asserted that nothing can be done for Social Security except to scale back (already low) Social Security pensions.  This is not true.  Just half of the revenues that will be lost under the tax cut bill would suffice to ensure the pensions can be paid in full for at least 75 years (the forecast period used by the Social Security trustees).

But as noted above, proponents of the tax cuts argue that the lower taxes will spur growth.  This has been discussed in earlier posts on this blog, where we have seen that there is no evidence that this will follow.  There are not only basic conceptual problems with this argument (a misreading of basic economics), but also no indication in what we have in fact observed for the economy that this has ever been the case (whether in the years immediately following the major tax cuts of Reagan or Bush, nor if one focuses on the longer term).

Administration officials have not surprisingly argued that the relatively rapid pace of growth in the second quarter of 2018 (of 4.2% at an annual rate in the end-August BEA estimates) is evidence of the tax cut working as intended.  But it is not.  Not only should one not place much weight on one quarter’s figures (the quarterly figures bounce around), but this followed first-quarter figures which were modest at best (with GDP growth of an estimated 2.2% at an annual rate).

But more fundamentally, one should dig into the GDP figures to see what is going on.  The argument that tax cuts (especially cuts in corporate profit taxes) will spur growth is based on the presumption that such cuts will spur business investment.  More such investment, especially in equipment, could lead to higher productivity and hence higher growth.  But growth in business investment in equipment has slowed in the first half of 2018.  Such investment grew at the rates of 9.1%, 9.7%, 9.8%, and 9.9% through the four quarters of 2017 (all at annual rates).  It then decelerated to a pace of 8.5% in the first quarter of 2018 and to a pace of 4.4% in the second quarter.  While still early (these figures too bounce around a good deal), the evidence so far is the exact opposite of what proponents have argued the tax cut bill would do.

So what might be going on?  As noted before, there is first of all a good deal of volatility in the quarterly figures for GDP growth.  But to the extent growth has accelerated this year, a more likely explanation is simple Keynesian stimulus.  Taxes were cut, and while most of the cuts went to the rich, some did go to the lower and middle classes.  In addition, government spending is now rising, while it been kept flat or falling for most of the Obama years (since 2010).  It is not surprising that such stimulus would spur growth in the short run.

The problem is that with the economy now running at or close to full capacity, such stimulus will not last for long.  And when it was needed, in the years from 2010 until 2016, as the economy recovered from the 2008/09 downturn (but slowly), such stimulus measures were repeatedly blocked by a Republican-controlled Congress.  This sequence for fiscal policy is the exact opposite of the path that should have been followed.  Contractionary policies were followed after 2010 when unemployment was still high, while expansionary fiscal policies are being followed now, when unemployment is low.  The result is that the fiscal deficit is rising soon to exceed $1 trillion in a year (5% of GDP), which is unprecedented for a period with the economy at full employment.

E.  Conclusion

We now have initial figures on what is being collected in taxes following the tax cut bill of last December.  While still early, the figures for the first two quarters of 2018 are nonetheless clear for corporate profit taxes:  They have fallen by half.  Corporate profit taxes paid would be an estimated $184 billion higher in 2018 had the tax rate remained at the level it had been over the last several years.

While this post has not focused on personal income taxes, they too were cut.  The reduction here was more modest – only by about 5% overall (although certain groups got far more, while others less).  But with their greater importance in overall federal tax collections, this 5% reduction is leading to an estimated $86 billion reduction in revenues (in 2018) from this source.

Based on what has been observed in the first two quarters of 2018, the two taxes together (corporate and individual) will see a combined reduction in taxes paid of about $270 billion in 2018.  Extrapolating over ten years, the combined losses may be on the order of $3 trillion.

These losses are huge.  And they are double what had been earlier forecast for the tax bill.  Just half of what is being lost would suffice to ensure Social Security would be fully funded for the foreseeable future.  And the rest could fund programs to rebuild and strengthen the physical infrastructure and human capital on which growth ultimately depends.  Or some could be used to reduce the deficit and pay down the public debt.  But instead, massive tax cuts are going to the rich.

The Mismanagement of Fiscal Policy Under Trump: Deficits When There Should be Surpluses

A.  Introduction

Since World War II, the US has never run such high fiscal deficits in times of full employment as it will now.  With the tax cuts pushed through by the Republican Congress and signed into law by Trump in December, and to a lesser extent the budget passed in March, it is expected that the US will soon be running a fiscal deficit of over $1.0 trillion a year, exceeding 5% of GDP.  This is unprecedented.

We now have good estimates of how high the deficits will grow under current policy and in a scenario which assumes (optimistically) that the economy will remain at full employment, with no downturn.  The Congressional Budget Office (CBO) published on April 9 its regular report on “The Budget and Economic Outlook”, this year covering fiscal years 2018 to 2028.  In this report to Congress and to the public, the CBO assesses the implications of federal budget and tax policy, as set out under current law.  The report normally comes out in January or February of each year but was delayed this year in order to reflect the tax bill approved in December and also the FY18 budget, which was only approved in March (even though the fiscal year began last October).

The forecast is that the deficits will now balloon.  This should not be a surprise given the magnitude of the tax cuts pushed through Congress in December and then signed into law by Trump, but recall that the Republicans pushing through the tax bill asserted deficits would not increase as a result.  The budget approved in March also provides for significant increases in legislated spending – especially for the military but also for certain domestic programs.  But as will be discussed below, government spending (other than on interest) over the next decade is in fact now forecast by the CBO to be less than what it had forecast last June.

The CBO assessment is the first set of official estimates of what the overall impact will be.  And they are big.  The CBO forecasts that even though the economy is now at full employment (and assumed to remain there for the purposes of the scenario used), deficits are forecast to grow to just short of $1 trillion in FY2019, and then continue to increase, reaching over $1.5 trillion by FY2028.  In dollar terms, it has never been that high – not even in 2009 at the worst point in the recession following the 2008 collapse of the economy.

That is terrible fiscal policy.  While high fiscal deficits are to be expected during times of high unemployment (as tax revenues are down, while government spending is the only stabilizing element for the economy when both households and corporations are cutting back on spending due to the downturn), standard policy would be to limit deficits in times of full employment in order to bring down the public debt to GDP ratio.  But with the tax cuts and spending plans this is not going to happen under Trump, even should the economy remain at full employment.  And it will be far worse when the economy once again dips into a recession, as always happens eventually.

This blog post will first discuss the numbers in the new CBO forecasts, then the policy one should follow over the course of the business cycle in order to keep the public debt to GDP under control, and finally will look at the historical relationship between unemployment and the fiscal deficit, and how the choices made on the deficit by Trump and the Republican-controlled Congress are unprecedented and far from the historical norms.

B.  The CBO Forecast of the Fiscal Deficits

The forecasts made by the CBO of the fiscal accounts that would follow under current policies are always eagerly awaited by those concerned with what Congress is doing.  Ten-year budget forecasts are provided by the CBO at least annually, and typically twice or even three times a year, depending on the decisions being made by Congress.

The CBO itself is non-partisan, with a large professional staff and a director who is appointed to a four-year term (with no limits on its renewal) by the then leaders in Congress.  The current director, Keith Hall, took over on April 1, 2015, when both the House and the Senate were under Republican control.  He replaced Doug Elmensdorf, who was widely respected as both capable and impartial, but who had come to the end of a term.  Many advocated that he be reappointed, but Elmensdorf had first taken the position when Democrats controlled the House and the Senate.  Hall is a Republican, having served in senior positions in the George W. Bush administration, and there was concern that his appointment signaled an intent to politicize the position.

But as much as his party background, a key consideration appeared to have been Hall’s support for the view that tax cuts would, through their impact on incentives, lead to more rapid growth, with that more rapid growth then generating more tax revenue which would partially or even fully offset the losses from the lower tax rates.  I do not agree.  An earlier post on this blog discussed that that argument is incomplete, and does not take into account that there are income as well as substitution effects (as well as much more), which limit or offset what the impact might be from substitution effects alone.  And another post on this blog looked at the historical experience after the Reagan and Bush tax cuts, in comparison to the experience after the (more modest) increases in tax rates on higher income groups under Clinton and Obama.  It found no evidence in support of the argument that growth will be faster after tax cuts than when taxes are raised.  What the data suggest, rather, is that there was little to no impact on growth in one direction or the other.  Where there was a clear impact, however, was on the fiscal deficits, which rose with the tax cuts and fell with the tax increases.

Given Hall’s views on taxes, it was thus of interest to see whether the CBO would now forecast that an acceleration in GDP growth would follow from the new tax cuts sufficient to offset the lower tax revenues following from the lower tax rates.  The answer is no.  While the CBO did forecast that GDP would be modestly higher as a result of the tax cuts (peaking at 1.0% higher than would otherwise be the case in 2022 before then diminishing over time, and keep in mind that these are for the forecast levels of GDP, not of its growth), this modestly higher GDP would not suffice to offset the lower tax revenues following from the lower tax rates.

Taking account of all the legislative changes in tax law since its prior forecasts issued in June 2017, the CBO estimated that fiscal revenues collected over the ten years FY2018 to FY2027 would fall by $1.7 trillion from what it would have been under previous law.  However, after taking into account its forecast of the resulting macroeconomic effects (as well as certain technical changes it made in its forecasts), the net impact would be a $1.0 trillion loss in revenues.  This is almost exactly the same loss as had been estimated by the staff of the Joint Committee on Taxation for the December tax bill, which also factored in an estimate of a (modest) impact on growth from the lower tax rates.

Fiscal spending projections were also provided, and the CBO estimated that legislative changes alone (since its previous estimates in June 2017) would raise spending (excluding interest) by $450 billion over the ten year period.  However, after taking into account certain macro feedbacks as well as technical changes in the forecasts, the CBO is now forecasting government spending will in fact be $100 billion less over the ten years than it had forecast last June.  The higher deficits over those earlier forecast are not coming from higher spending but rather totally from the tax cuts.

Finally, the higher deficits will have to be funded by higher government borrowing, and this will lead to higher interest costs.  Interest costs will also be higher as the expansionary fiscal policy at a time when the economy is already at full employment will lead to higher interest rates, and those higher interest rates will apply to the entire public debt, not just to the increment in debt resulting from the higher deficits.  The CBO forecasts that higher interest costs will add $650 billion to the deficits over the ten years.

The total effect of all this will thus be to increase the fiscal deficit by $1.6 trillion over the ten years, over what it would otherwise have been.  The resulting annual fiscal deficits, in billions of dollars, would be as shown in the chart at top of this post.  Under the assumed scenario that the economy will remain at full employment over the entire period, the fiscal deficit will still rise to reach almost $1 trillion in FY19, and then to over $1.5 trillion in FY28.  Such deficits are unprecedented for when the economy is at full employment.

The deficits forecast would then translate into these shares of GDP, given the GDP forecasts:

The CBO is forecasting that fiscal deficits will rise to a range of 4 1/2 to 5 1/2% of GDP from FY2019 onwards.  Again, this is unprecedented for the US economy in times of full employment.

C.  Fiscal Policy Over the Course of the Business Cycle

As noted above, fiscal policy has an important role to play during economic downturns to stabilize conditions and to launch a recovery.  When something causes an economic downturn (such as the decision during the Bush II administration not to regulate banks properly in the lead up to the 2008 collapse, believing “the markets” would do this best), both households and corporations will reduce their spending.  With unemployment increasing and wages often falling even for those fortunate enough to remain employed, as well as with the heightened general concerns on the economy, households will cut back on their spending.  Similarly, corporations will seek to conserve cash in the downturns, and will cut back on their spending both for the inputs they would use for current production (they cannot sell all of their product anyway) and for capital investments (their production facilities are not being fully used, so why add to capacity).

Only government can sustain the economy in such times, stopping the downward spiral through its spending.  Fiscal stimulus is needed, and the Obama stimulus program passed early in his first year succeeded in pulling the economy out of the freefall it was in at the time of his inauguration.  GDP fell at an astounding 8.2% annual rate in the fourth quarter of 2008 and was still crashing in early 2009 as Obama was being sworn in.  It then stabilized in the second quarter of 2009 and started to rise in the third quarter.  The stimulus program, as well as aggressive action by the Federal Reserve, accounts for this turnaround.

But fiscal deficits will be high during such economic downturns.  While any stimulus programs will add to this, most of the increase in the deficits in such periods occur automatically, primarily due to lower tax revenues in the downturn.  Incomes and employment are lower, so taxes due will be lower.  There is also, but to a much smaller extent, some automatic increase in government spending during the downturns, as funds are paid out in unemployment insurance or for food stamps for the increased number of the poor.  The deficits will then add to the public debt, and the public debt to GDP ratio will rise sharply (exacerbated in the short run by the lower GDP as well).

One confusion, sometimes seen in news reports, should be clarified.  While fiscal deficits will be high in a downturn, for the reasons noted above, and any stimulus program will add further to those deficits, one should not equate the size of the fiscal deficit with the size of the stimulus.  They are two different things.  For example, normally the greatest stimulus, for any dollar of expenditures, will come from employing directly blue-collar workers in some government funded program (such as to build or maintain roads and other such infrastructure).  A tax cut focused on the poor and middle classes, who will spend any extra dollar they receive, will also normally lead to significant stimulus (although probably less than via directly employing a worker).  But a tax cut focused on the rich will provide only limited stimulus as any extra dollar they receive will mostly simply be saved (or used to pay down debt, which is economically the same thing).  The rich are not constrained in how much they can spend on consumption by their income, as their income is high enough to allow them to consume as much as they wish.

Each of these three examples will add equally to the fiscal deficit, whether the dollar is used to employ workers directly, to provide a tax cut to the poor and middle classes, or to provide a tax cut to the rich.  But the degree of stimulus per dollar added to the deficit can be dramatically different.  One cannot equate the size of the deficit to the amount of stimulus.

Deficits are thus to be expected, and indeed warranted, in a downturn.  But while the resulting increase in public debt is to be expected in such conditions, there must also come a time for the fiscal deficits to be reduced to a level where at least the debt to GDP ratio, if not the absolute level of the debt itself, will be reduced.  Debt cannot be allowed to grow without limit.  And the time to do this is when the economy is at full employment.  It was thus the height of fiscal malpractice for the tax bills and budget passed by Congress and signed into law by Trump not to provide for this, but rather for the precise opposite.  The CBO estimates show that deficits will rise rather than fall, even under a scenario where the economy is assumed to remain at full employment.

It should also be noted that the deficit need not be reduced all the way to zero for the debt to GDP ratio to fall.  With a growing GDP and other factors (interest rates, the rate of inflation, and the debt to GDP ratio) similar to what they are now, a good rule of thumb is that the public debt to GDP ratio will fall as long as the fiscal deficit is around 3% of GDP or less.  But the budget and tax bills of Trump and the Congress will instead lead to deficits of around 5% of GDP.  Hence the debt to GDP ratio will rise.

[Technical note for those interested:  The arithmetic of the relationship between the fiscal deficit and the debt to GDP ratio is simple.  A reasonable forecast, given stated Fed targets, is for an interest rate on long-term public debt of 4% and an inflation rate of 2%.  This implies a real interest rate of 2%.  With real GDP also assumed to grow in the CBO forecast at 2% a year (from 2017 to 2028), the public debt to GDP ratio will be constant if what is called the “primary balance” is zero (as the numerator, public debt, will then grow at the same rate as the denominator, GDP, each at either 2% a year in real terms or 4% a year in nominal terms) .  The primary balance is the fiscal deficit excluding what is paid in interest on the debt.  The public debt to GDP ratio, as of the end of FY17, was 76.5%.  With a nominal interest rate of 4%, this would lead to interest payments on the debt of 3% of GDP.  A primary balance of zero would then imply an overall fiscal deficit of 3% of GDP.  Hence a fiscal deficit of 3% or less, with the public debt to GDP ratio roughly where it is now, will lead to a steady debt to GDP ratio.

More generally, the debt to GDP ratio will be constant whenever the rate of growth of real GDP matches the real interest rate, and the primary balance is zero.  In the case here, the growth in the numerator of debt (4% in nominal terms, or 2% in real terms when inflation is 2%) matches the growth in the denominator of GDP (2% in real terms, or 4% in nominal terms), and the ratio will thus be constant.]

Putting this in a longer-term context:

Federal government debt rose to over 100% of GDP during World War II.  The war spending was necessary.  But it did not then doom the US to perpetual economic stagnation or worse.  Rather, fiscal deficits were kept modest, the economy grew well, and over the next several decades the debt to GDP ratio fell.

For the fiscal balances over this period (with fiscal deficits as negative and fiscal surpluses as positive):

Fiscal balances were mostly but modestly in deficit (and occasionally in surplus) through the 1950s, 60s, and 70s.  The 3% fiscal deficit rule of thumb worked well, and one can see that as long as the fiscal deficit remained below 3% of GDP, the public debt to GDP ratio fell, to a low of 23% of GDP in FY1974.  It then stabilized at around this level for a few years, but reversed and started heading in FY1982 after Reagan took office.  And it kept going up even after the economy had recovered from the 1982 recession and the country was back to full employment, as deficits remained high following the Reagan tax cuts.

The new Clinton budgets, along with the tax increase passed in 1993, then stabilized the accounts, and the economy grew strongly.  The public debt to GDP ratio, which had close to doubled under Reagan and Bush I (from 25% of GDP to 48%), was reduced to 31% of GDP by the year Clinton left office.   But it then started to rise again following the tax cuts of Bush II (plus with the first of the two recessions under Bush II).  And it exploded in 2008/2009, at the end of Bush II and the start of Obama, as the economy plunged into the worst economic downturn since the Great Depression.

The debt to GDP ratio did stabilize, however, in the second Obama term, and actually fell slightly in FY2015 (when the deficit was 2.4% of GDP).  But with the deficits now forecast to rise to the vicinity of 5% of GDP (and to this level even with the assumption that there will not be an economic downturn at some point), the public debt to GDP ratio will soon be approaching 100% of GDP.

This does not have to happen.  As noted above, one need not bring the fiscal deficits all the way down to zero.  A fiscal deficit kept at around 3% of GDP would suffice to stabilize the public debt to GDP ratio, while something less than 3% would bring it down.

D.  Historical Norms

What stands out in these forecasts is how much the deficits anticipated now differ from the historical norms.  The CBO report has data on the deficits going back to FY1968 (fifty years), and these can be used to examine the relationship with unemployment.  As discussed above, one should expect higher deficits during an economic downturn when unemployment is high.  But these deficits then need to be balanced with lower deficits when unemployment is lower (and sufficiently low when the economy is at or near full employment that the public debt to GDP ratio will fall).

A simple scatter-plot of the fiscal balance (where fiscal deficits are a negative balance) versus the unemployment rate, for the period from FY1968 to now and then the CBO forecasts to FY2028, shows:

While there is much going on in the economy that affects the fiscal balance, this scatter plot shows a surprisingly consistent relationship between the fiscal balance and the rate of unemployment.  The red line shows what the simple regression line would be for the historical years of FY1968 to FY2016.  The scatter around it is surprisingly tight.  [Technical Note:  The t-statistic is 10.0, where anything greater than 2.0 is traditionally considered significant, and the R-squared is 0.68, which is high for such a scatter plot.]

An interesting finding is that the high deficits in the early Obama years are actually very close to what one would expect given the historical norm, given the unemployment rates Obama faced on taking office and in his first few years in office.  That is, the Obama stimulus programs did not cause the fiscal deficits to grow beyond what would have been expected given what the US has had in the past.  The deficits were high because unemployment was high following the 2008 collapse.

At the other end of the line, one has the fiscal surpluses in the years FY1998 to 2000 at the end of the Clinton presidency.  As noted above, the public debt to GDP ratio stabilized soon after Clinton took office (in part due to the tax increases passed in 1993), with the fiscal deficits reduced to less than 3% of GDP.  Unemployment fell to below 5% by mid-1997 and to a low of 3.8% in mid-2000, as the economy grew well.  By FY1998 the fiscal accounts were in surplus.  And as seen in the scatter plot above, the relationship between unemployment and the fiscal balance was close in those years (FY1998 to 2000) to what one would expect given the historical norms for the US.

But the tax cuts and budget passed by Congress and signed by Trump will now lead the fiscal accounts to a path far from the historical norms.  Instead of a budget surplus (as in the later Clinton years, when the unemployment rate was similar to what the CBO assumes will hold for its scenario), or even a deficit kept to 3% of GDP or less (which would suffice to stabilize the debt to GDP ratio), deficits of 4 1/2 to 5 1/2 % of GDP are foreseen.  The scatter of points for the fiscal deficit vs. unemployment relationship for 2018 to 2028 is in a bunch by itself, down and well to the left of the regression line.  One has not had such deficits in times of full employment since World War II.

E.  Conclusion

Fiscal policy is being mismanaged.  The economy reached full employment by the end of the Obama administration, fiscal deficits had come down, and the public debt to GDP ratio had stabilized.  There was certainly more to be done to bring down the deficit further, and with the aging of the population (retiring baby boomers), government expenditures (for Social Security and especially for Medicare and other health programs) will need to increase in the coming years.  Tax revenues to meet such needs will need to rise.

But the Republican-controlled Congress and Trump pushed through measures that will do the opposite.  Taxes have been cut dramatically (especially for corporations and rich households), while the budget passed in March will raise government spending (especially for the military).  Even assuming the economy will remain at full employment with no downturn over the next decade (which would be unprecedented), fiscal deficits will rise to around 5% of GDP.  As a consequence, the public debt to GDP ratio will rise steadily.

This is unprecedented.  With the economy at full employment, deficits should be reduced, not increased.  They need not go all the way to zero, even though Clinton was able to achieve that.  A fiscal deficit of 3% of GDP (where it was in the latter years of the Obama administration) would stabilize the debt to GDP ratio.  But Congress and Trump pushed through measures to raise the deficit rather than reduce it.

This leaves the economy vulnerable.  There will eventually be another economic downturn.  There always is one, eventually.  The deficit will then soar, as it did in 2008/2009, and remain high until the economy fully recovers.  But there will then be pressure not to allow the debt to rise even further.  This is what happened following the 2010 elections, when the Republicans gained control of the House.  With control over the budget, they were able to cut government spending even though unemployment was still high.  Because of this, the pace of the recovery was slower than it need have been.  While the economy did eventually return to full employment by the end of Obama’s second term, unemployment remained higher than should have been the case for several years as a consequence of the cuts.

At the next downturn, the fiscal accounts will be in a poor position to respond as they need to in a crisis.  Public debt, already high, will soar to unprecedented levels, and there will be arguments from conservatives not to allow the debt to rise even further.  Recovery will then be even more difficult, and many will suffer as a result.

What a Real Tax Reform Could Look Like – III: A Carbon Tax to Address Climate Change

Source:  James Hansen, Global Temperatures, update of December 18, 2017

 

A.  Introduction

The final element of a comprehensive tax reform would be a tax to address climate change.  Previous posts have looked at what a true reform of corporate and individual income taxes could look like, plus what could be done to ensure Social Security benefits can continue to be paid in accord with current formulae, and indeed enhanced.  This post will look at a tax on greenhouse gas emissions (commonly called a carbon tax, as carbon dioxide is the primary contributor) to address global warming.

There is no doubt the planet is warming –  the chart above shows the most recent estimates.  And this is primarily due to our economies pouring into the air carbon dioxide and certain other gases (such as methane) that lead to heat being retained by the atmosphere.  These greenhouse gases have warmed the planet, leading to an increased frequency of extreme weather events such as the series of remarkably intense hurricanes that hit the US this August and September.  The cost, already being incurred, has been staggering.  Early estimates of the cost of just Hurricanes Harvey (which hit Texas) and Irma (which hit Florida) reach $290 billion.  Hurricane Maria (which hit Puerto Rico) may have cost Puerto Rico as much as $95 billion according to an early estimate (and this excludes the cost to other Caribbean nations it hit).

As I am writing this (January 3, 2018), record-breaking cold has swept over much of the eastern half of the US.  And it is forecast to get worse over the next few days.  Trump has, not surprisingly, tweeted that this cold shows that global warming is not true.  But this illustrates well his ignorance.  First, there is more to the world than the eastern US.  There is also today unseasonably warm weather in the western US (especially Alaska, relative to what is normal there), as well as in Europe, Russia, and especially Siberia.  Overall, the average global surface temperature today is 0.5 degrees Celsius above the 1979 to 2000 average for this time of year, and 0.9 degrees Celsius above that average in the Northern Hemisphere.  But second, that blast of cold hitting the eastern US should not be taken as a surprising outcome of global warming.  Warming leads to greater volatility in atmospheric currents, including in the jet streams that allow (or block) cold air to come down from the Arctic.

One cannot, of course, attribute with certainty any particular severe weather event (whether hurricanes, extreme hot or cold temperatures, drought or floods, and more) to climate change.  We had severe weather events before global warming became significant.  But the same is true of lung cancer and smoking:  One cannot attribute any individual’s death from lung cancer to his or her smoking.  People died of lung cancer before smoking became common.  The issue, rather, is that smoking increases the likelihood of getting lung cancer.  Similarly, global warming increases the likelihood and hence frequency of severe weather events.

And that is precisely what we have seen.  Severe weather events have increased in number in recent years as the planet has warmed and as climate change models have predicted.  A database maintained by the National Oceanic and Atmospheric Administration (NOAA, the home of the National Weather Service) has kept track since 1980 of the number of weather and climate disasters in the US which each cost $1 billion or more (in 2017 prices).  Over that close to 37 year period the 7 worst years (in terms of the number of such disasters) have all come in the last 10 years (including 2017, which as of end September already had tied the worst full year so far, and will exceed it once fourth quarter data is included).

Global warming, arising from man-made emissions of carbon dioxide (CO2), methane (natural gas), and certain other gases (together, greenhouse gases or GHGs, for the greenhouse effect they cause), is thus imposing a huge cost already on society, and one which will get worse as the planet warms further.  It is thus a mark of confusion to say, as Trump and many Republican politicians have, that we cannot “afford” to address the causes of the warming planet.  We are already bearing the costs, and those costs will get far worse if nothing is done.  The question is whether steps will be taken to reduce those costs by addressing the underlying causes.

The issue is that the costs such GHG emissions cause are not being borne by those who emit those gases.  The emitters of GHGs are in effect being subsidized, and encouraged to burn fossil fuels rather than make use of a cleaner alternative.  And when a producer is not bearing the full cost of what he is producing, it will be badly done.  The key is to charge a tax or fee on such production equal to the cost being imposed on others, so that the producer faces the full cost of what he is making.  The producer will then have a reason to make suitable choices on how the product can be made at the least cost to all.  And consumers, facing the full costs of what they are buying, can then make suitable choices on whether to buy one product or another.

A suitable tax on greenhouse gas emissions would bring prices in line with the total costs being incurred.  A comprehensive tax reform should include this.  And it would be straightforward to implement.  There is indeed a well worked out plan being promoted by a group of traditional Republican conservatives, the Climate Leadership Council, with the active involvement and endorsements of several Treasury Secretaries in past Republican administrations (Hank Paulson, James Baker, and George Schultz); as well as of individuals such as Michael Bloomberg and liberal and conservative economists such as Larry Summers, Martin Feldstein, and Gregory Mankiw; companies such as ExxonMobil, General Motors, and Shell; and environmental organizations such as The Nature Conservancy and Conservation International.

It is a good plan, and I would suggest basically just copying it.  The proposal will be explained below.  A one-page summary of the Climate Leadership Council’s specific proposal is available here, while a more complete description is available here.  A very similar proposal has also been assessed by the US Treasury, with a brief summary of the Treasury analysis available on the Climate Leadership Council website here, while the complete Treasury analysis is available here on the Treasury website (assuming the Trump administration has not taken it down).  The Treasury assessment is excellent, as it reviews precisely how one could implement such a tax, including the practicalities, and arrives at specific quantitative estimates of the impact on different income groups.  The analysis below will basically follow the variant of the plan as assessed by the Treasury.

This post will first provide a description of that plan, how it could be implemented, and what the impact on prices might be.  Importantly, clean alternatives exist for many of the processes which emit GHGs, particularly from the burning of fossil fuels, which thus can be substituted for processes emitting those gases.  This would limit the price impact and smooth the way to sharp reductions in GHG emissions.  Furthermore, a key feature of this plan is that the revenues that would be collected by the carbon tax would all be rebated to the American population.  The final section will discuss this and the distributional implications.  The plan would be revenue neutral – the aim is to change prices so that they fully reflect the costs being incurred, not to raise revenues.  And the rebates would be distributionally positive, with the bottom seven deciles of the population (the bottom 70%) coming out ahead after the rebates.  Only the top three deciles (top 30%) would see a net loss, as a direct consequence of their disproportionate share in consumption of goods that cause the GHG emissions in the first place.

B.  A Carbon Tax to Address Climate Change

In brief, under this proposal a tax would be charged for each unit of GHG pollution emitted.  The Climate Leadership Council would set the tax to start at $40 per ton of CO2, with the taxes on other GHGs set in proportion based on their global warming impact per ton relative to that of CO2.  This is often called simply a carbon tax, although it is in fact a tax on CO2 (carbon dioxide) emissions and on other GHGs in proportion to their global warming impact.  The tax would then rise in real terms over time.  The start date would presumably have been 2018, although this was not explicit (the proposal came out in early 2017).  The Treasury variant examined a price of $49 per ton of CO2-equivalent starting in 2019 (with some phasing in of the goods to which it would apply until 2021), and then increasing at a rate of 2% a year in real terms from 2019.

Importantly, all revenues collected would be returned directly to the American population.  The impact on the federal budget thus would be revenue neutral.  There would also be border adjustments for imports and exports (discussed below).  The Treasury estimates that at $49 per ton, the carbon tax would lead to a rebate in the first year (2019) of $583 per person, or $2,332 for a family of four.  Scaling this in proportion, a $40 per ton carbon tax would lead to a rebate of $476 per person, or $1,904 for a family of four.  And the tax would be highly progressive.  The Treasury estimated that there would on average be net income gains for the bottom 70% of the population.  That is, their rebates would be greater than the higher amounts they would need to spend on goods and services to reflect the cost of the carbon tax.

In more detail, under this plan a price (whether $40 or $49 to start) would be charged which reflects the cost to society of the GHGs being emitted as part of the production process for the good or service being produced.  This is called the “social cost of carbon”, and while the concept is clear, it is difficult in practice to estimate precisely.  Its value will depend on factors which are difficult to know at this point in time, including the full cost to our economies (starting now and extending many decades into the future) as a consequence of climate change, the cost of technologies to limit GHG emissions (again starting now, and then for decades into the future), and the appropriate values for parameters such as the proper discount rate to use to put the costs and benefits over this range of time all into the prices of today.  A fundamental difficulty of GHG emissions is that their impact is not just in the near term, but can extend for centuries.  They remain in the atmosphere for a very long time.

Thus while starting at a reasonable cost of carbon (whether $40 or $49) is important, probably more important is how this price should be adjusted over time to reflect actual experience.  Some predictability in the path is also valuable, so firms can make their investment decisions accordingly.  Thus the Climate Leadership Council plan would have the price rise in real terms over time at some unspecified pace, while the Treasury assessment assumed concretely a rise of 2% a year in real terms.  Such a 2% real increase is reasonable.

One should, however, also recognize the inherent uncertainty, as the proper price on carbon is difficult to know before we have any experience with such a plan.  Thus one should allow for reassessment and adjustment, perhaps every five years or so, with the pace of price adjustment increased or decreased depending on the observed response.  The pace would be raised if we find that GHG emissions are not falling at the pace needed, or reduced if we find GHGs are falling at a more rapid pace than anticipated and needed.  Past experience with market mechanisms to reduce pollution (in particular the use of trading schemes to reduce sulfur dioxide and nitrogen oxides pollution) worked surprisingly well, with costs well below what had been anticipated and what would have been incurred through traditional regulatory regimes.  The same would be likely, in my view, if we would start to price GHG emissions.

Pricing GHG emissions is also relatively straightforward administratively for the bulk of GHG sources.  Fully 76% of GHG emissions in the US come from the burning of fossil fuels.  This rises to 83% if one adds in the emission of GHGs in the production of the fossil fuels themselves (at the mine or well-head) plus from the non-energy use of fossil fuels.  The carbon tax thus could be applied at the level of the limited number of power plants that still burn coal; at the level of petroleum refineries where substantially all crude oil must be processed; and at the level of gas pipelines as substantially all natural gas is transported via pipelines.  A limited number of industrial plants then account for a significant share of the remainder.  These include from the use of coking coals in the production of iron and steel; from the production of petrochemicals such as plastics; and GHGs resulting from the production of cement, glass, limestone, and similar products.  For these, it would be straightforward to apply a carbon tax at the factory or plant level.  There would remain GHG emissions from a range of resources, including in particular in agriculture (accounting for about 8% of GHG emissions in the US), and the Treasury analysis assumes the carbon tax would not apply to those sources.  But they are a small share of the total, and an issue one could address in the future.

A key part of the plan is that there would also be a border tax adjustment, where exports would receive a rebate for the carbon taxes paid on their production, while imports would be charged a carbon tax based on the GHGs emitted in their production.  The rebate for exports means that US production would not be disadvantaged by being located here, and there would be no incentive from this source to move such plants abroad.  This addresses the Trump criticism (and confusion) that such carbon taxes will make US industry uncompetitive.  And imports would be charged a carbon tax based on their GHG emissions to the extent such imports do not already reflect such charges (which would likely be the case, as they too would likely be given rebates in their home countries on carbon taxes paid, just as US exports would be).

A feature of this border tax adjustment is that revenues for the US would be generated (and rebated to the US population) in the case where other countries are not themselves charging a carbon tax (or the equivalent, such as in a cap and trade system), but also (given the US trade structure) even when they are.  In the first case, where other countries are not at first themselves charging such a tax, imposing the carbon tax on such imports will generate revenues which would be distributed to the US population.  This would provide a strong incentive for those other countries to join the US and start to charge a similar carbon tax.  And such a border adjustment for the carbon tax would be compliant with WTO rules on trade, as the tax would simply be ensuring that imported goods are being taxed the same as their domestic equivalents are (just as is true for a value-added tax).  This is not discrimination against imports, but rather equal treatment.

In the second case, where trading partners are themselves all charging a similar carbon tax (let’s assume), the US would still come out ahead in carbon tax revenues due to our trade structure.  US imports of goods are about 50% higher than its exports of goods, and it is primarily in the production of goods that GHGs are emitted.  Partially offsetting this in the overall trade balance, US exports of services are about 50% higher than its imports of services.  But services are a smaller share of trade, plus services are not as intensive as goods in the GHGs emitted.  Overall, the US has a current account deficit (more imports of goods and services than exports), matched by capital inflows being invested in the US.  With such a trade structure, the carbon taxes charged on imports will substantially exceed whatever is rebated on exports.  The US population would come out ahead.  Put another way, producers of goods being sold in the US are currently being provided a subsidy by not charging them for the cost we are incurring due to the greenhouse gases being emitted in their production.  Given the US trade structure, a substantial share of this subsidy is going to foreign producers.  A tax on such GHG emissions is simply the removal of this subsidy.

C.  Price Impacts, and the Viability of Clean Alternatives

Applying the carbon tax will lead producers to raise their prices if they do not otherwise adjust their processes.  For transportation fuels, for example, the Treasury analysis estimated that at $49 per ton of CO2 (and its equivalent for other GHGs), the tax would equal 44 cents per gallon for gasoline, or 50 cents per gallon for diesel fuel.  While significant, such increases are not huge.  There have been far greater fluctuations in such fuel prices in recent years in response to the price of crude oil rising or falling, and consumers and the economy have been able to accommodate such changes.

More broadly, and expressed in terms of percentage increases, the Treasury analysts estimated that if the cost increases from the carbon tax were all fully passed along, the price of gasoline would rise by 11.8%, home heating oil by 12.4%, and air transportation by 7.5%.  The price of natural gas would go up by 27.0% and the price of electricity by 16.9%, but note these are the prices of just the energy alone.  The delivered price to our homes also includes distribution and other charges.  For natural gas, for example, the energy component of my bill (in Washington, DC) was just 44% of my total bill over the last 12 months, so a 27% increase in the wholesale cost of natural gas would mean a 15% increase in my overall bill for gas.  There would be no reason for distribution and other such charges to go up by any significant amount, as their costs depend on the volume delivered and not on the wholesale cost of the gas being delivered (and similarly for electricity).  Overall, the Treasury analysis forecasts that prices in general would go up by 2.6% if the new carbon tax (at $49 per ton of CO2) were fully passed forward.

But the higher costs would provide incentives both to producers to change how they make things, and to consumers to take into account the total costs in their decisions on what to buy.  One would see this most importantly (given its share as a source of GHG emissions) in how electricity is produced.  Generating electricity by the burning of fossil fuels is now heavily subsidized, in effect, as nothing is charged for the cost of the damage done (hurricanes and other severe weather events, and more) by the resulting GHG emissions.  But even with such subsidies going to those who burn fossil fuels, solar and wind produced power is now competitive (even without the subsidies going to solar and wind – see below) for newly built power plants, and indeed has been for some years.  See the careful analysis of the relative costs that is undertaken annually by Lazard (see here for their November 2017 report).  Indeed, Lazard found in its 2017 analysis that at current costs, utility-scale solar and wind generation is now often cheaper than just the operating costs of coal or nuclear plants, thus encouraging such substitution even when the capital costs of coal and nuclear plants are treated as a sunk cost.

Furthermore, solar and wind technology is still developing, with costs falling rapidly, while at this point the further reduction in costs in traditional power generation is slow.  Lazard estimates the levelized cost of energy production at a new installation (in terms of dollars of overall costs, including capital costs, per megawatt hour of electricity generated, and excluding explicit subsidies on renewables) fell by 72% between 2009 and 2017 for utility-scale solar installations and by 47% for wind generation (to prices of $50 and $45 per megawatt hour, for solar and wind respectively; this is equivalent to 5 cents and 4.5 cents per kilowatt hour).  In contrast, the cost for power generated by coal fell by just 8% over this period (to $102 per megawatt hour) and by 28% for natural gas (to $60).  And the full levelized cost for nuclear power generation actually rose by 20% over the period (to $148).

There is, of course, wide variability in the cost of solar and wind across the country, depending on local conditions.  Existing coal and nuclear plants are also of various ages and efficiencies, and hence also of varying costs.  Thus overall averages tell only part of the story.  The cost competitiveness (on average) of new installations does not mean that all new installations will be solar or wind, much less that all generation would or could shift immediately.  But the now competitive costs have led to a bit over 50% of all new generation capacity built in the US over the last 10 years (2007 to 2016) to come from installations of solar, wind, or other renewables (with most of the solar coming only in the second half of that period).

No transition will be instantaneous, but should a significant carbon tax be imposed (of $40 or $49, for example), one should see an acceleration in the pace of such substitution of renewables for fossil fuels.  And with such substitution, the impact on higher power prices will be limited in time, and should soon decline.

The other major user of fossil fuels is transportation, and here one sees a similar dynamic.  Electric battery powered cars are now either competitive in cost or close to it (depending on how one values other attributes, such as better performance and inherently easier maintenance), and a carbon tax will accelerate the transition to such vehicles.  And battery-powered vehicles are not just limited to cars.  Tesla has announced plans to produce heavy trucks powered by batteries, with a range of up to 500 miles on a charge.  Costs would be more than competitive with traditional fueled heavy trucks, and a substantial number of pre-orders have indeed already come in from owners of large trucking fleets.  There is an interest at least in trying this.  And with battery-powered heavy trucks possible, the same is true for full-size buses.

Again, starting to charge for the costs borne by society from the CO2 and other GHGs emitted in transportation would accelerate the shift to less polluting vehicles.  It won’t happen overnight.  But that shift will limit the extent and duration of higher costs stemming from charging a carbon tax.

And while such a tax alone will not lead to zero GHG emissions with current technologies available, it would be a giant step in that direction.  It would also provide a strong incentive to develop the technologies that would carry this further and at a lower cost.

D.  Distributional Implications

Finally and importantly, the funds collected by the carbon tax would be fully rebated to all Americans, with the same amount rebated per person.  The Treasury analysis estimated that at $49 per ton of CO2 in 2019, the carbon tax would collect funds sufficient to provide a rebate of $583 per person (for the year), or $2,332 for a family of four.  The rebate could be provided annually or quarterly, or even monthly, and through the IRS or Social Security.

The rebates would also be distributionally positive.  The poor would indeed benefit on a net basis.  Being poor, they do not consume that much, and thus do not account for a high share of GHG emissions.  The rich, in contrast, not only consume more (they are rich, and can afford more), but the products they buy are also more polluting in greenhouse gases (big gas-guzzling cars rather than small fuel-efficient ones; jet travel for vacations but not public transit; large homes kept heated and air-conditioned rather than smaller homes and apartments; etc.).  Thus the rich will receive back less than what is paid in carbon taxes on the goods they consume, while the poor will receive back more.  Furthermore, because the poor are poor, a given dollar amount rebated to them will be a higher percentage of their (low) incomes, than the same dollar amount would be (in percentage terms) for the rich.

The impacts are significant.  The Treasury analysis (based on data they use for their tax simulation models) concluded that the impacts by family income decile would be:

Net Impact on Income from $49 per ton Carbon Tax, with $583 per Person Rebate, by Family Decile

Decile

% of Income

0 to 10

+8.9%

10 to 20

+4.7%

20 to 30

+3.1%

30 to 40

+2.0%

40 to 50

+1.2%

50 to 60

+0.6%

60 to 70

+0.1%

70 to 80

-0.3%

80 to 90

-0.7%

90 to 100

-1.0%

Families are ranked here by income decile, so the first decile (0 to 10%) is made up of the 10% of families (in number) who have the lowest incomes, the second decile (10 to 20%) is made up of the 10% of families with the next lowest incomes, and so on, up to the richest 10% of families (90 to 100%).

The results indicate that on a net basis (i.e. after taking account of the higher prices that would be paid on goods purchased, reflecting the carbon tax at $49 per ton), the lowest income decile families would see an increase in their real incomes of 8.9% following the $583 per person rebate.  This is quite substantial.  And the analysis found there would be a similar, positive, gain for all families up through the 7th decile, although at diminishing shares of their income.  The top 3 deciles would end up paying more on a net basis, due to their greater purchases of goods where greenhouse gases are emitted (both in total amount and in the mix of their goods).  But the net cost reaches just 1% of incomes for the richest decile.  It is only a small share in part because their incomes are of course the highest.  This tax is not unaffordable.

E.  Conclusion

To conclude, imposing a carbon tax is administratively practical, would bring prices and costs in line with the costs being borne by society when greenhouse gases are emitted, and even with current technologies would lead to a significant shift away from processes that are warming our planet.  It is a fundamental confusion to assert, as Trump and others have done, that “we cannot afford it”.  That is nonsense:  We are paying the costs already (in an increased frequency of severe weather events, in droughts in some areas and floods in others, and other such impacts), and they will get far worse if nothing is done.  Furthermore, such a carbon tax would not reduce our competitiveness when applied equally to imported items (and rebated for exports).  Indeed, with our current trade structure, the US would come out ahead financially by starting to charge for GHG emissions.

Such a tax also would be distributionally highly progressive, as the poor would come well ahead on a net basis with the revenues collected being rebated back to the population.  Indeed, it is estimated that the bottom 70% of the population would come out ahead on a net basis.  And while the rich would end up paying more, reflecting their greater consumption and the GHG intensity of the goods they buy, this would come just to 1% of the incomes of the richest 10% of the population.

Such a tax on GHG emissions would be the final component of what a comprehensive tax reform really should have looked like.  As discussed in the preceding posts on this blog, there should have been a reform to simplify corporate and individual income taxes (with all sources of income taxed similarly), plus action taken on Social Security taxes to ensure the system will be sustained for the foreseeable future.  None of this was done.  Nor was any action taken to address climate change, where the subsidy we are implicitly providing fossil fuels and other sources of greenhouse gas emissions (by not charging for the damage being done as a result of those emissions) could have been addressed by a tax on such emissions.

This is not surprising, unfortunately.  There are important vested interests in the fossil fuel industries (coal, oil, and gas) that benefit from not being charged for the damage their fuels are causing.  As a rationalization of this, Trump and much of the Republican Party continue to deny that climate change even exists.  But the result will be that the damage being done, already large, will grow over time.  Plus, once the doubters do finally recognize it, the actions that will then need to be taken will be more costly and disruptive than if action were taken now.

As discussed above, there is no practical or special administrative difficulty to addressing the climate change problem now.  It would be straightforward to implement a tax on GHG emissions.  And the sooner this is done, the better.