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THE HAMILTON Achieving Progressive Tax Reform PROJECT in an Increasingly Global Economy STRATEGY PAPER JUNE 2007 Jason Furman, Lawrence H. Summers, and Jason Bordoff The Brookings Institution The Hamilton Project seeks to advance America’s promise of opportunity, prosperity, and growth. The Project’s economic strategy reflects a judgment that long-term prosperity is best achieved by making economic growth broad-based, by enhancing individual economic security, and by embracing a role for effective government in making needed public investments. Our strategy—strikingly different from the theories driving economic policy in recent years—calls for fiscal discipline and for increased public investment in key growth- enhancing areas. The Project will put forward innovative policy ideas from leading economic thinkers throughout the United States—ideas based on experience and evidence, not ideology and doctrine—to introduce new, sometimes controversial, policy options into the national debate with the goal of improving our country’s economic policy. The Project is named after Alexander Hamilton, the nation’s first treasury secretary, who laid the foundation for the modern American economy. Consistent with the guiding principles of the Project, Hamilton stood for sound fiscal policy, believed that broad-based opportunity for advancement would drive American economic growth, and recognized that “prudent aids and encouragements on the part of government” are necessary to enhance and guide market forces. THE Advancing Opportunity, HAMILTON Prosperity and Growth PROJECT Printed on recycled paper. THE HAMILTON PROJECT Achieving Progressive Tax Reform in an Increasingly Global Economy Jason Furman Lawrence H. Summers Jason Bordoff The Brookings Institution JUNE 2007 The views expressed in this strategy paper are those of the authors and are not necessarily those of The Hamilton Project Advisory Council or the trustees, officers, or staff members of the Brookings Institution. Copyright © 2007 The Brookings Institution Introduction he progressive tax system, and the nation’s fiscal scant encouragement to saving by low- and moderate- system more broadly, have historically played an income Americans, many of whom face the prospect Timportant role in expanding opportunities for of an insecure retirement. America’s factories and cars all Americans while reducing inequality. But the same continue to emit vast amounts of the carbon dioxide dynamic forces of technological change, financial in- that drives climate change, a problem that would be novation, and globalization that have contributed to remedied, in part, if the tax code imposed a cost for rising income inequality also present new challenges burning carbon-emitting fossil fuels. for progressive taxation. Financial engineering, for example, has made it easier for the financially sophis- There is broad agreement about many of the shortcom- ticated—typically the wealthy—to take advantage of ings of our current tax system, but little consensus about new financial instruments that shelter their gains from the solution. To make progress, lawmakers will, at a min- tax. And as capital is able to move ever more quickly imum, have to come together in good faith and agree and easily across borders, corporate income becomes on a broad approach. In an effort to define a common increasingly elusive of taxation. These forces, together approach, this strategy paper offers six broad principles with deliberate policy changes, have led to an erosion of that reflect the new challenges facing our tax system progressivity—the principle that higher incomes should in the twenty-first century. We believe these principles face higher rates of taxation—and a dramatic reduction should command wide assent as policymakers consider in the average tax rate facing very high-income house- tax reforms, whether incremental or far-reaching: holds. More than half of that decline is the result of declining effective corporate tax rates, as high-income 1. Fiscal responsibility requires addressing both taxes households own disproportionate amounts of capital. and spending. 2. Rising inequality strengthens the case for progressiv- The tax code is not only a means of raising revenue ity. to pay for government services. It also impacts an as- 3. The tax system should collect the taxes that are tonishing array of economic and social activities, from owed. homeownership to education and child care to support 4. Tax reform should strengthen taxation at the busi- for low-income workers. Taxes contribute, as part of the ness level. problem or as part of the solution, to many of the chal- 5. Taxes for individuals should be simplified. lenges our nation faces. The present tax treatment of 6. Social policy can and should often be advanced health insurance, for example, pushes health spending through the tax code—and it must be well designed. upward while offering many of the uninsured little help in getting coverage. The tax treatment of retirement The remainder of the paper will discuss each of these savings provides a windfall for high-income Americans principles in detail. who would likely have saved anyway, while offering THE HAMILTON PROJECT n the broo K in G S institution Principle #1: Fiscal Responsibility Requires Addressing Both Spending and Taxes he nation’s fiscal books remain seriously unbal- Whatever other ends it serves, the fundamental pur- anced, and the problem will soon become much pose of the tax system is to raise the money govern- Tworse. The only real solution is some combina- ment needs to pay for the spending it has chosen to tion of reduced spending and increased revenue. The undertake. Indeed, government spending is actually a long-term challenges from such trends as rising health better indicator of the ultimate tax burden than is rev- care spending per capita are simply too great to solve if enue collected at any given point in time. That is what we limit changes to just one side of the budget. the late Nobel laureate in economics Milton Friedman meant when he said, “To spend is to tax” (quoted in Restoring a culture of fiscal responsibility can help poli- Ebenstein 2007). Whenever government spends a dol- cymakers address both taxes and spending. A familiar lar, it commits itself to raising a dollar in revenue—the argument views cutting taxes as a way of “starving the only question is when. To the extent the government beast,” in the belief that only large deficits will force funds spending with borrowing, it has merely deferred spending restraint. But recent history suggests the op- the taxes that future generations will have to pay. posite dynamic is often at work. In the 1990s, policy- makers made the tough choices to balance the budget N. Gregory Mankiw, the former chairman of President and invest in key priorities by raising taxes on the most Bush’s Council of Economic Advisers, recently wrote, fortunate, while at the same time reducing spending on “Everyone hates taxes, but the government needs to Medicare and other government programs. In recent fund its operations…” (Mankiw 2006). In recent years years, in contrast, policymakers have passed large tax the tax system has fallen far short of this goal. In 2000 cuts without regard for their budgetary cost. This reck- the federal government had a $236 billion unified bud- lessness shattered the ethic of fiscal responsibility and get surplus, which was projected to rise to $573 billion mutual restraint, facilitating sizable increases in govern- in 2007. (The unified budget includes the balance in ment spending as well. Social Security.) Instead the latest projection is for a $177 billion deficit in 2007—a $750 billion reversal. TABLE 1 Sources of the Change in the Projected UnifiedB udget Baseline, January 2001 to March 2007 Billions of dollars Percent of total change Tax cuts $297 0% Defense and homeland security outlays $234 1% Other outlays $162 22% Economic and technical projection errors $56 7% Total fiscal deterioration $750 100% Source: Auerbach, Furman, and Gale (2007). ACHIEVING PROGRESSIVE TAX REFORM IN AN INCREASINGLY GLOBAL ECONOMY FIGURE 1 National Saving and Borrowing from Abroad as a Percent of GDP, 1929-2006 20% 15% Net national saving 10% 5% 0% Borrowing from abroad -5% -10% 1929 1940 1951 1962 1973 1984 1995 2006 Source: Bureau of Economic Analysis (2007). And as table 1 shows, the single largest source of this this in perspective, achieving long-run fiscal balance deterioration is the tax cuts enacted in 2001 and since.1 would require an immediate and permanent 34 percent In their absence the federal government would have run cut in all government spending, including Social Se- a sizable unified budget surplus in 2007—money that curity, Medicare, and defense. Delaying these changes, could have been used to pay down the national debt to or exempting some areas of government spending from prepare for the looming challenges in Social Security cuts, would mean substantially larger reductions later to and Medicare. restore fiscal balance. Although the budget deficit in 2007 is not unusually In these circumstances an optimal fiscal policy today large by historical standards, it still represents a seri- would not aim for average deficits, or even the more ous long-term problem for budget policy—and for eco- modest target of a stable debt-to-GDP ratio, but in- nomic performance—for several reasons. First, major stead would aim to balance the budget or, better yet, fiscal obligations are just around the corner, driven pri- to achieve surpluses for a period of years—especially marily by rapidly escalating health spending, and sec- during economic expansions—to prevent unnecessarily ondarily by the demographic changes associated with large future tax increases (Barro 1979) or abrupt ben- falling fertility rates and the aging of the baby-boom efit cuts. The more quickly policymakers address this generation. Over the next seventy-five years, the fed- looming problem, the less painful the adjustments will eral government faces a fiscal shortfall of at least 6.3 need to be.

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