Joel Slemrod: ‘We shouldn’t kid ourselves that cutting a few credits will solve this.’

November 11, 2012

Joel Slemrod is the Paul W. McCracken Collegiate Professor of Business Economics and Public Policy and the chair of the Department of Economics at the University of Michigan. He is an expert on tax policy, known for his empirical studies of the effects of changes in the tax code. His new book, coauthored with Syracuse's Len Burman, is Taxes in America: What Everyone Needs to Know. We spoke on the phone Sunday afternoon; an edited transcript follows.

Dylan Matthews: So it looks like the first big fight of President Obama's second term will be over extending the Bush tax cuts. You and Matthew Shapiro did some empirical work on those cuts. What did you find?

Joel Slemrod: So that work is about the short-term impact of changes in disposable income, via changes in the tax code. In that work, which is based on surveying people, we found that, when the taxes were cut, not a whole lot of folks said that they're going to take that extra disposable income and spend it. From 20-25 percent said they'd mainly spend it, which is associated with an marginal propensity to consume [the amount that consumers spend out of the next dollar they earn - Dylan] of about a third.

If you reverse that and look at if we go off the fiscal cliff and raise taxes substantially, that suggests there would be a depressing effect on the economy, but it wouldn't be as big as you might think. Spending might drop by a third of the size of the cuts. Of course it's a different time, and it's a different side because we were looking at rebates, not increases. But hat's what our research suggests: it wouldn't affect consumption, at least not as much as previous research which suggests a higher marginal propensity to consume.

DM: Then again, that suggests that they're saving two thirds of it, which increases investment and could spur growth later on, no?

JS: It sounds like we're ready to change to the long-term! It changes with that question. Myself, I believe that it would be good for the economy if we deal with the long-term fiscal imbalance sooner rather than later, so I would be in favor, at some point, of a package which has a substantial amount of tax increases in it. The policy question, though, is, "When is that moment?"

The recovery is still fairly fragile, I think, but there's a lot of consensus that in the long term, you need a debt plan that involves raising taxes nontrivially. But it may be the wrong time to do it. My sense is we should postpone falling fully off the fiscal cliff, while thinking about a credible plan for the debt.

DM: Another component of the fiscal cliff is the payroll tax cut expiring. Your research suggests that might not be as big a deal as some think.

JS: Looking at a payroll tax cut versus the sort of rebate programs we studied, our research suggests the effect on consumption is about at the same order of magnitude. The increased spending from the payroll tax cut was a little bit smaller than from the rebates. If we're talking about the same dollars for those things, I don't think there's a big difference in what the macroeconomic impact would be.

DM: A lot of the deficit-reducing tax plans in D.C. involve broadening the tax base but, if anything, lowering tax rates. Do you think that makes sense, economically or fiscally?

JS: There's two distinct issues there. The first is, "Would the tax system be more efficient or more consistent with growth if we broadened the tax rates and lowered the rates?" The answer is yes. There are dumb base broadeners and smart ones, but in principle you can raise a given amount of revenue with less deleterious effects with a broad base and lower rates.

Back to the long term, can we raise enough revenue to deal with the long-term fiscal balance by only broadening or broadening and lowering rates? I think the answer to that is no. If tax rates are part of how we deal with the long-term fiscal balances, broadening isn't going to be enough. It's not nothing, but we shouldn't kid ourselves that cutting a few credits will solve this. And the cuts where the money is are very politically sensitive.

DM: What do you make of plans like Martin Feldstein's to cap tax expenditures, either at a certain percentage of income or at a dollar amount?

JS: I think it's definitely an idea worth considering. It certainly would raise revenue by itself. But for the people whose deductions exceed the cap, all of the subsidies go away at the margin. If I'm at the cap, there's no incentive to give to charity. We're back at the discussion of whether we're throwing out the baby with the bathwater. If you think the charitable deduction is a good thing, then a cap is going to nontrivially reduce that subsidy, and it's going to reduce charitable deductions among people subject to the cap.

DM: What about replacing deductions with credits? Same problem?

JS: Not really. If it's not capped, and everyone gets a credit of 15 percent of their charitable contributions, it does reduce the subsidy for people above the 15 percent bracket, but for people not itemizing or at the 10 percent bracket, it increases the incentive. So it's hard to say.

DM: This is probably not politically viable, but do you think adding a value-added tax to the picture would help?

JS: I think if we start to seriously consider increasing revenue substantially, then introducing a value-added tax might be a very good way to do it, because it doesn't add pressure on our creeky income tax. If you add one, it probably raises that money with less cost to economic growth.

But the problem, as you know, is that it raises revenue in a much more regressive way than the way we've talked about raising revenue. Comparing to raising rates on top earners, it's going to be so much more regressive, so much more on low-income people. Michael Graetz at Columbia Law School has one interesting idea, which is you add a VAT, but you increase substantially the exemption level of the income tax, so it takes low-income people off the income tax rolls, which helps with simplicity. You could also have some increased refundable credits at the low-income range. I think that would be part of the problem with designing an additional add-on VAT.

DM: What do you make of proposals for a progressive consumption tax, like Robert Frank's personal expenditure tax or the X tax

JS: I don't think a personal expenditure tax is viable, mostly due to the complexity issues. Also, I just don't think Americans are ready yet for a tax system where withdrawals from their bank account, or transactions on their credit card have taxable implications. I just don't think that's going to happen.

I think the X tax is an elegant and beautiful solution for how to levy a consumption tax while maintaining progressivity. I doubt that it's politically viable because only payroll and not capital income is taxed. As much as we argue that the capital income is already taxed at the corporate level, we can't convince everyone.

DM: To pivot slightly, another problem with the code is the high marginal rates on low-income people, as they transition off of means-tested programs like food stamps or the Earned Income Tax Credit. Do you think there's a good way to address that?

JS: No I don't have a solution to the problem of how to target assistance to low-income people without raising implicit marginal tax rates. If you have a solution, do tell me.

DM: Milton Friedman's negative income tax (where all taxpayers are given a lump sum of money that is then taxed with the rest of their income) comes to mind, but I don't think Americans will agree to just give money away in my lifetime.

JS: And you're pretty young!

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