Agency compiles possibilities, but makes no recommendations

With all options on the table as a result of the unprecedented amount of new federal spending, tax policy has taken on critical importance.

In its just-released second volume of Budget Options, the Congressional Budget Office has provided Congress with a laundry list of options for altering federal spending and revenues. The options in the report stem from a variety of sources, such as legislative proposals, the president's budget, congressional and CBO staff, other government agencies, and private groups, and are intended to reflect a range of possibilities.

Among the tax changes the report considers are an increase in individual income tax rates; replacing multiple tax rates on long-term capital gains with a deduction of 45 percent of net realized gains; relief from the individual Alternative Minimum Tax; using an alternative measure of inflation to index some portions of the Tax Code; reducing the mortgage interest deduction or replacing it with a tax credit; limiting or eliminating the deduction for state and local taxes; limiting the tax benefit of itemized deductions to 15 percent; and limiting deductions for charitable gifts of appreciated assets to the gifts' tax basis.

Current law contains six statutory rates on taxable income earned by individuals through 2010, with a reversion to five rates after 2010. The report states that boosting all statutory tax rates on ordinary income by 1 percentage point would increase revenues by a total of $196 billion over the five-year period from 2010 to 2014. It notes that if rates for the AMT remained the same, the revenue impact of raising all of the ordinary tax rates would diminish over time relative to the size of the economy as more taxpayers became subject to the AMT.

However, by raising the AMT rates along with all of the regular rates by 1 percentage point, revenue during the five-year period would increase by $259 billion, according to the report. And by boosting the separate tax rates on capital gains and dividends as well, federal revenues would increase by a total of $267 billion over the next five years.

REVENUE RAISERS

The CBO pointed out that as a way to raise revenues, a step up in tax rates would have administrative advantages over other types of tax increases because it would require only relatively minor changes to the current tax-collection system. Its drawbacks are that it would reduce the incentive to work and save. In addition, higher rates would encourage taxpayers to shift income from taxable to nontaxable forms and to increase spending on tax-deductible items, such as home mortgage interest.

The CBO said that these estimates incorporate the assumption that taxpayers would respond to higher rates by shifting taxable income to nontaxable or tax-deferred forms. Such a shift might involve substituting tax-exempt bonds for other investments or opting for more tax-free fringe benefits, instead of cash compensation.

However, the estimates do not incorporate potential changes in how much people would work or save in response to higher statutory tax rates. Such changes are difficult to predict, according to the CBO.

DYNAMIC VS. STATIC

Critics of raising taxes point to the difference in using dynamic scoring as opposed to static scoring in predicting the revenue effects of tax legislation. Dynamic scoring takes into account the changes in behavior induced by changes in tax rates.

"The CBO uses dynamic scoring in some of its estimates, but for the most part it thinks in terms of static scoring," said Dr. Merrill Matthews, resident scholar at the Institute for Policy Innovation. "They don't take into consideration the way people change in response to the implications of tax legislation. They almost always underestimate the cost of legislation and overestimate the revenues they will get by raising taxes."

Andrew Quinlan, president of the Center for Freedom and Prosperity Foundation, agreed. "Politicians need to know that even if they raise tax rates, you don't get the tax revenue you're looking for, because there is an optimal rate which gives you the biggest bang for the buck," he said. "As soon as you go above it, you bring in less than you thought and eventually you bring in less taxes, period."

Both the CBO and the Joint Committee on Taxation tend to use static scoring with respect to macroeconomic variables, according to Rudolph G. Penner, institute fellow with the Urban Institute. "That is, they don't look at the impact on the gross domestic product or on things like the inflation rate, but they do consider what I would call microeconomic responses to tax changes," he said. "For example, where they score the revenue effect of reducing the values of itemized deductions, they would take into account that some people would shift more to the standard deduction."

"The reason for the distinction is if you assume that an income tax increase reduces labor effort and overall economic activity, theoretically you should consider the effect of lowered GDP on every other tax in the system," he added. "It would be difficult to be logically consistent, as well as extremely time-consuming - Congress likes to have these estimates in 12 hours."

However, the CBO does work at informing Congress as to what various dynamic effects might be, according to Penner. "They take into account the dynamics using a great variety of models."

"There are huge differences among economists on these issues, and the differences are largely ideological," he said. "When estimates are so uncertain, it's a dangerous area for the CBO to be caught up in political arguments."

The CBO, however, cautioned against assuming that the options that it analyzes are on the fast track to becoming law, noting that they are intended to reflect a range of possibilities, rather than to provide a ranking or a comprehensive list.

"The inclusion or exclusion of a particular policy change does not represent an endorsement or rejection by CBO," it stated. "In keeping with CBO's mandate to provide objective and nonpartisan analysis, the report makes no recommendations."

(c) 2009 Accounting Today and SourceMedia, Inc. All Rights Reserved.

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