My Weekend Tax policy with and Nick and Adamother willful misunderstandings

by Leonard Burman and Joel Slemrod

The following is an imaginary debate between partisans in the modern tax policy wars. The goal is to try to tease out econo- mists’ honest differences and maybe find some common ground. Although we’ve heard real people make every one of the argu- ments expressed here, our characters are fictional. — LB and JS

I’m an economist and a tax expert, but you’ll never see me on the CBS Evening News. For I am a two-handed economist (“on the one hand … on the other hand … ”), the kind that Harry Truman hated and TV news Ishow bookers avoid like SARS. I see two sides of almost every policy issue. In short, I am not constituted to enlighten in 30 seconds or less. But I’m the exception; one-handed economists abound. I (naturally) have mixed feelings about these folks. As an economist and a teacher, I am always thrilled to see economics explained to the innocent. Yet, those insights seem to take the true believers places even Captain Kirk has never been before. Thus, it is odd that I ended up spending a January weekend alone

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Third Quarter 2003 51 misunderstandings your solution is to borrow more money to with two one-handers. Nick, the son of Rus- pay for tax cuts for the rich! How can you sian immigrants, is almost religiously com- look your children in the face?” mitted to free markets and has a visceral aver- “No problem,” Nick sneered. “You liberals sion to government. Adam, a native of Brook- are interested in fiscal responsibility only lyn and the son of labor organizers, believes when it comes to tax cuts. If the President had government is there to help the oppressed. proposed going into debt to finance national Ironically, these guys have been friends since health insurance, subsidies for child care or grad school. The fact they’ve never changed more college scholarships, you would be lead- each other’s mind on a single issue hasn’t ing the parade. And that would leave our kids dampened their ardor for debate. in the poorhouse.” Let me explain how this weekend came “Whoa!” I protested. “You guys sound like about. I teach at a small college. Every Janu- you’re not even from the same species, never ary, I join other professional colleagues at the mind the same profession. If economics is a economists’ annual conference, which this science, how can you two reach opposite con- year was in Pittsburgh. I ran into Nick and clusions about almost everything?” Adam at the airport. But they were fighting Serious economists across the ideological tooth and nail, and I didn’t want to interrupt spectrum really do agree about many of the their fun. basics. For example, we agree that tax policy Two hours into the flight, the pilot an- plays a crucial role in economic policy and in nounced that a nasty storm had made Pitts- government operations more generally. burgh an impossible dream. We ended up in Or do we? Nashville, to find the airport packed and no “The impact on incentives is always over- room at the inn. As I was denouncing my fate, rated by right wingers like Nick,” Adam Adam waved me over. Seems he had arranged explained. “As Charlie Schultze, Jimmy Car- to borrow his cousin’s nearby cabin , and Nick ter’s chief economic adviser, likes to say, had scrounged the last rental car available. ‘There’s nothing wrong with supply-side eco- The little car from Seoul or Jakarta or nomics that dividing by 10 wouldn’t cure.’” someplace was too small for the three of us, “Come on! There are two centuries of evi- and the roads were slick. But even more dis- dence that people respond to incentives,”par- concerting, my companions were soon at ried Nick. each other’s throats over the latest tax bill I asked my traveling companions if they from the Bush administration. agreed that, in raising revenue, it would be “You people are shameless,”accused Adam. best to level the playing field – that is, not “Our country is facing a fiscal emergency, and penalize one activity more than another or favor one sector over another. That is, to let the market decide. LEONARD BURMAN is a senior fellow at the Urban In- “Ah, the market!” Nick rhapsodized. “The stitute, co-director of the Tax Policy Center and research invisible hand will always do better than the professor at Georgetown University. From 1998 to 2000, he was deputy assistant secretary of the U.S. Treasury for bureaucratic, arm of government.” tax policy analysis. JOEL SLEMROD isthePaulW. “Sure, markets are amazing under certain McCracken professor of business economics and public pol- icy at the University of Michigan and director of the conditions,” Adam conceded. “But those con- Business School’s Office of Tax Policy Research. ditions are violated again and again in the real

52 The Milken Institute Review world. Yes, a market can efficiently allocate, By morning, it was clear that there would be say, rights to pollute – but only after govern- no way back up the driveway, let alone to the ment establishes those rights and creates a economists’ convention. way to enforce them. Left to its own devices, So I set about playing mediator for my the free market would allow cowboy capital- companions. Over breakfast, I began,“Do you ists to make the earth uninhabitable. Nor can agree there are three criteria for judging tax the market guarantee that hard-working peo- policy: equity, efficiency and simplicity?” ple will be able to afford basic needs – decent Adam nodded. “The burden of taxes health care, housing, retirement security.” should be shared equitably according to soci- We were lost (literally), and I was starting ety’s standards. Americans want this burden to worry that I would be found dead – to be higher for those of greater means and wedged into a tiny rental car with two guys want those with more income to pay a larger who would no doubt be frozen for posterity percentage in tax than those with less.” in mid-epithet. I resolved that, if we survived “There are three goals, Adam – not one,” the night, I was going to find some common Nick rejoined. “You liberals don’t give a damn ground for my old classmates. about efficiency or simplicity. You are willing Miraculously, we found our bearings – and to make everyone worse off just so the most the cabin. More miraculously, the cabin had productive people don’t get to keep much central heating and food to last the weekend. more than the slackers. And your ‘refundable’

Third Quarter 2003 53 misunderstandings we should pay for it. tax credits – spending programs in drag – “That’s part of it,” Adam concurred. “The complicate taxes horrendously. It’s not just Republicans are trying to starve government that you want the tax system to be progres- so that we will have to slash funding for wel- sive; every single provision must be targeted fare, education, Social Security and Medicare.” to people with lower incomes! That’s ideolo- “Maybe,” responded Nick, “but we could gy, not principle.” get a lot of the savings by eliminating waste, Adam bristled. “Lots of differences in fraud and abuse.” earning capacity have to do with luck rather Adam sighed theatrically. “You’re not than skill or hard work. If you didn’t know going to eliminate these massive deficits by you were going to be one of the lucky few, you trimming fat. You’re going to have to cut deep would surely want to live in a society with a into the muscle. Your real political problem is safety net. And don’t tar me as the ideologue that most people like the programs conserva- around here! You claim high tax rates dis- tives want to slash.” courage work and saving, but your motive “People like free services and monthly could just as well be pure greed.” checks in the mail,” Nick responded. “But “I prefer to think of it as the laudable people don’t realize the true cost – not just in desire to provide for one’s family,” Nick terms of higher taxes, but in lower productiv- replied. “I do admit, though, that I am not as ity. And slower growth will hurt our kids a lot troubled as you are by inequality, as long as more than deficits.” the game is not rigged – and I don’t think “There’s no compelling evidence that taxes government should be in the business of sec- at the level we pay – just about the lowest in ond-guessing outcomes.” the industrialized world – have much effect on Adam responded that Nick really opposed work, savings or investment,”Adam said.“Be- all taxes; indeed, all government. sides, why assume away the positive role that “Not true!” laughed Nick. “I’m happy that government can play in fostering economic the government operates the military, courts, growth? Think of all the government dollars federal prisons and maybe interstate high- shelled out to protect property rights, provide ways. We could probably pay for all that with infrastructure and support education.” a flat 5 percent income tax.” I found my chance to intercede. “Why is it “Now we’re getting to the heart of the mat- that so many liberals believe the effect of taxes ter,” Adam exhorted. “Folks like you above all on incentives is small, while their conservative want smaller government. But you don’t counterparts believe that taxes create huge believe that you can achieve that goal directly, distortions? Since this is an empirical ques- so you seek to ‘starve the beast,’ as Reagan’s tion, you’d expect the conclusions to be inde- budget director, David Stockman, put it.” pendent of one’s politics.” “Bingo!” Nick said as he jumped up from “Not necessarily,” Nick responded. “Some his chair.“If we hadn’t cut taxes in the last two conservatives are skeptical about government years, you Democrats would have piddled the because we view the costs of paying for it as surplus away on spotted owl reserves.” very high.” I wondered out loud whether the argu- “Do any Republicans believe that taxes ment wasn’t really as much about the appro- don’t affect behavior much?” I asked. “Do any priate size of government as it was about how Democrats believe that taxes are costly?”

54 The Milken Institute Review Nick and Adam agreed there must be “The fiscal discipline of the 1990s was a direct some, but couldn’t name any. In science, there consequence of the deficits of the 1980s. are truths. In economics, at least as practiced Congress passed Gramm-Rudman-Hollings in Washington, there are advocates who claim and the Budget Enforcement Act – both to be custodians of ideologically convenient signed by Republican presidents – which ulti- truth. mately got spending under control. The I asked again if we could agree that the Stockman Effect worked.” debate about taxes is largely about the size of “If deficits don’t constrain spending,” I government. My fellow campers agreed. Then asked Adam, “why do you always bring up I asked if starving the beast works. Social Security, Medicare and homeland secu- “Absolutely,” Nick was quick to reply. rity as programs that would be underfunded “Larger deficits lead to trimmer government.” during times of deficit?” “Not always,” Adam said just as quickly in “Well, if deficits got big enough – ’’ rejoinder. “In the 1980s, Reagan slashed taxes, “I get it now,” I volunteered. “Republicans but never reined in spending.” favor tax cuts because they think cuts con- “That was the fault of the Democratic Con- strain spending. Democrats oppose them be- gress!” Nick countered. cause they fear that the Republicans are “But Reagan never came close to propos- right.” ing a balanced budget. So we got monster de- We helped Nick make lunch with treasures ficits and a huge run-up in debt. The process unearthed in our host’s pantry – fettuccine was reversed in the 1990s, when two tax in- tossed with sun-dried tomatoes, porcini creases were paired with spending restraint. mushrooms and estate-bottled olive oil. “Not That, in combination with the strong econo- all Republicans,” I allowed, “rely on barefoot my, vanquished the Reagan deficits,” Adam wives for food.” said. Alas, my feeble attempt at humor quickly “I’m surprised there’s no patriotic music segued to a heated discussion about the wel- playing in the background,” sneered Nick. fare state and the cycle of dependency –

Third Quarter 2003 55 misunderstandings “Can I interject here?” I interjected. “I’ve whether the 1996 welfare reforms were a suc- taught Economics 101 for many years, and cess or a failure, and whether the Democrats even been around the block a few times with or Republicans deserved the credit (if it was, Econ 201. Most economists think monetary indeed, a success). I washed dishes and tried policy works better for short-term stabiliza- to visualize world peace. It didn’t work. tion than either tax cuts or spending, because I asked Nick if he was troubled about sad- it can be better timed.” dling future generations with debt. Running “You’re right, as far as it goes,” said Adam, deficits is a way to put off burdens without “but voters expect more than easier credit.” specifying who will bear them, I noted. And if “I asked an economics question, and you low taxes and high deficits unleash greater gave me a political answer. Maybe it’s time to economic activity now, won’t the higher taxes fess up that we really don’t have a clue about needed to cover the interest payments squash how to micromanage fiscal policy. economic activity in the future? “And why are you suddenly so quiet, Nick? “We’ll take that chance,” said Nick, while How can a supporter of limited government sipping espresso.“When the time comes, we’ll be for government intervention to prop up be arguing for less government spending, the economy? Are you all Keynesians now?” rather than higher income taxes. And for pri- “I guess we are,”admitted Nick,“but most- vatizing Social Security and Medicare rather ly because it serves our larger purpose of cut- than shoring it up with higher payroll taxes.” ting taxes and, ultimately, downsizing govern- I crept away for a nap. When I woke up, ment. You may have noticed that the Bush tax Adam and Nick were having at it about the cut proposal of 2001 was first made in De- “jobs and growth” tax cuts just passed by cember 1999, well before anyone smelled re- Congress. Adam was gleefully rattling off sta- cession in the air. Once the economy began to tistics about the numbers of jobs lost since slip, we changed the rationale without chang- President Bush took office. ing the proposal. Some wag called it the ‘tax “Can we talk about what should be done cut for all reasons.’” now?” I asked. “Are tax cuts the right policy?” “Hey, don’t forget that it was the Demo- Nick swung hard at this soft pitch. “Yes, a crats who insisted that the tax cut begin with thousand times, yes. For one thing, tax cuts those tax rebate checks, targeted at middle- put more money in people’s hands, and when income families,” Adam bragged. “Giving they have more, they spend more. That raises money to people who are short on cash is demand, so companies hire more workers, much more effective stimulus than tax breaks and so forth. For another, lower marginal tax for zillionaires. Lower-income folks are more rates give people more incentive to seek the likely to spend their tax rebates than the cor- jobs that are out there, and give businesses porate CEOs and coupon clippers.” more incentive to invest.” “Actually,” said Nick, “evidence from the “Everyone who ever passed Economics 101 2001 tax rebate shows no such thing. Low- knows that government spending is probably income families were no more likely to spend more effective at stimulating the economy the rebates than other families. Truth is, than tax cuts,” interjected Adam. Democrats know that, once enacted, tax “But only tax cuts can reduce marginal tax ‘expenditures’ are difficult to reverse. Tax cuts rates,” said Nick. targeted toward low-income people serve

56 The Milken Institute Review their core constituency.” responded that Adam’s ticket would cost “You make it sound like helping poor peo- three times as much if airlines were still under ple during hard times is somehow sinister,” the government’s thumb. I tuned out the en- complained Adam. “We’re proud that the tax tirely predictable argument that followed. rebate was not just abstract macroeconomic On the way back to the airport, I made one ‘stimulus.’ It helped struggling families to pay last attempt to find common ground. “Surely their bills. Single mothers clearly needed the we can agree that everything possible should boost more than did the BMW crowd – be done to make tax-paying simple and though the latter drove away with the loot.” straightforward.” “Actually, the same study suggested that “Actually, I’m not sure about that,” said most people didn’t spend their rebate checks Nick. “It may seem hypocritical to rail against at all, but saved the money or paid down inefficient government, and then turn around debts,” I interjected. “So the tax cut didn’t and oppose the IRS’s efforts to become more provide much stimulus at all.” efficient. But I have to admit I want taxpayers I avoided the line of fire by making dinner. to feel the pain of taxes – I don’t want the bur- Later, I fell asleep and dreamed of moderates den hidden. That’s why conservatives op- driving snowplows. The next morning the posed income tax withholding when it was weather had much improved and I was able to first introduced during World War II and why book a flight to Denver. Adam tussled with our first flat-tax proposals would have elimi- the airline about the $100 rebooking fee, nated employer withholding. I guess I’m will- complaining that this never happened before ing to accept an inefficient tax collector if the airlines were deregulated (in the 1970s). Nick end result is less government.”

Third Quarter 2003 57 misunderstandings eligible for this credit – something no other “I’m glad that you have mixed feelings group must do.” about that,”I said,“because I find it very trou- “The EITC is welfare paid out through the bling to think of sabotaging the tax system to tax system, mostly to people who owe no in- achieve other government objectives. An come taxes,” Nick complained. “If we can’t archconservative, one closely aligned with the move welfare out of the tax code, at least we Bush administration, told me that he favored can cut down on its rampant abuse.” the pointlessly complex alternative minimum “The EITC is basically a work incentive tax because it made people hate the income that is the antithesis of welfare,” Adam re- tax. sponded. “It’s a Republican idea – Milton “Let’s try another tack,” I suggested. Friedman suggested it 30 years ago, before “Maybe because of the return of deficits, and Republicans got mean.” the pressure to support our troops under fire, An argument about the Republican agen- tax evasion is back in the news. What do you da and compassionate conservatism ensued. I think about the ‘tax gap,’ which the IRS esti- was relieved to arrive at the airport and say mates to be about $200 billion per year? I’d farewell to my argumentative friends. think you’d both be able to support a crack- On the flight home, I tried to make sense down on tax cheats.” out of what I had heard and learned about Adam agreed. “Tax evaders are stealing our profession. Here it is, unvarnished; I hope from honest taxpayers and our children. Hell, it doesn’t sound two-handed: Nick has always supported the death penalty Economists agree that taxes should be fair, for drug dealers and murderers, two groups simple and promote efficiency, but we can’t apparently immune from its deterrent effect. agree about how to balance these sometimes- But if we fried a couple of tax cheats, that conflicting objectives. Deep disagreements would create a very cost-effective deterrent.” about how taxes affect economic behavior, “You’re not serious,” I said, taking the bait. uninformed by the empirical evidence, are “No,” he answered, “but I do think we the rule. should come down hard on people and busi- To complicate the debate further, conserv- nesses who cheat on their taxes.” atives and liberals usually seek enlightenment Nick agreed, but with reservations. “Let’s in the evidence most consistent with their re- not forget that the main reason for cheating is spective positions. Conservatives argue that high tax rates.” taxes exact huge costs in terms of lost produc- “Why is it that in your eyes draft evasion is tivity; liberals deny it. The rest of us admit tantamount to treason, but tax evasion is our ignorance. practically the duty of every American?” re- In large part, the tax debate is not about joined Adam. “OK, I take that back, but it who should pay or about how to kick start the infuriates me that the IRS seems to spend as economy, but about the size and scope of gov- much of its energy tracking down abuses of ernment. No economist believes that running the earned income tax credit for the working large and growing deficits is sustainable poli- poor as it does to shut down tax haven scams cy. But conservatives are willing to run worth billions more. Indeed, the IRS is plan- deficits for a while if doing so will starve the ning to spend millions making some low- metaphoric beast. Liberals say that starvation income people prove in advance that they are doesn’t work, but they fear that it will. M

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