Mercatus Site Feed

Reforming Social Security to Better Promote Retirement Security

Jason J. Fichtner — Thu, 23 May 2013 12:58:41 -0400

Publication

Good morning, Chairman Johnson, Ranking Member Becerra, and Members of the Committee. Thank you for inviting me to testify today.

My name is Jason Fichtner, and I’m a senior research fellow at the Mercatus Center at George Mason University where I research fiscal and budgetary issues, including Social Security. I am also an adjunct professor at Georgetown University, Johns Hopkins University, and Virginia Tech, where I teach courses in economics and public policy. All opinions I express today are my own and do not necessarily reflect the views of my employers.

I’d like to begin by thanking Chairman Johnson and Congressman Becerra for the leadership you provide this committee in ensuring that important public policy issues involving Social Security and retirement security get the attention and debate they deserve, and also for ensuring that ideas and viewpoints from all sides are aired in a collegial and respectful manner. It is truly a privilege for me to be here testifying before you today.

My testimony focuses on the Social Security program’s incentives—specifically, how the current structure provides disincentives to work and save. I will also discuss how Social Security reform, if done correctly, can increase US savings, labor force participation, economic growth, and federal revenues.

The Economy's Effects on When People Claim Social Security Benefits

The financial crisis that began in 2008 resulted in a great and unanticipated loss of wealth for millions of Americans. The US stock market, as measured by the broad S&P 500 index, fell nearly 57 percent from a peak on October 10, 2007, to a bottom on March 9, 2009.[1] Housing prices plummeted and unemployment rose quickly to double digits. Survey research suggests financial wealth declined by 15 percent for the median household as a result of the 2008 financial crisis.[2] General confidence in the financial system was greatly weakened.

The widespread economic crisis affected a range of ages and income levels. According to data from the Health and Retirement Study (HRS),[3] about 28 percent of surveyed households reported that they had been affected “a lot” by the financial crisis, 46 percent responded they had been affected “a little,” and only 26 percent reported not having been affected.[4]

Though the broad stock market has recovered much of its losses and reached new highs, and housing prices have started to recover, unemployment is still too high. Unemployment rates for workers ages 55–64 averaged 7 percent for the years 2009–10 compared to 3 percent for the period 2005–8.[5] As of April 2013, the unemployment rate for workers ages 55–64 was 5.1 percent—still far above the 3 percent average between 2005 and 2008.[6]

A sudden and unplanned drop in wealth and income can have significant effects on retirement behavior. Research I’ve done with coauthors John Phillips and Barbara Smith finds that more people will elect to begin taking Social Security retirement benefits as soon as eligible, due to financial shocks, increases in unemployment because of the global financial crisis,[7] and an arrested economic recovery.[8]

A study by Michael Hurd and Susann Rohwedder after the 2008 crisis finds that 3.5 percent more individuals expected to work past the age of 62 than previously, while an additional 4.3 percent planned to work past the age of 65.[9] A financial shock, such as steep drops in the value of stock prices, investment portfolios, and housing assets might cause a delay in people’s retirement plans,[10] with workers remaining in the workforce longer than originally planned to rebuild retirement savings.[11] Those near or post-retirement are more limited in their ability to attain or maintain a secure retirement. For current retirees, sudden declines in wealth from housing assets and financial portfolios might force immediate changes in consumption.

The loss of a job has particularly pronounced effects on workers above the age of 55 and on the decision to retire. According to a special study in 2010 from the US Bureau of Labor Statistics,[12] older workers who lose their jobs are likely to have longer durations of unemployment than younger workers. A Congressional Research Service study finds that older workers who are unemployed have a higher incidence of withdrawing from the labor market than younger workers.[13] When they do retire, they replace earnings with available sources of income, such as pensions and Social Security benefits. Workers who retire early may experience lower lifetime benefits from Social Security, and their removal from the workforce slows economic growth.

Though the decision to start receiving Social Security benefits can be concurrent with retirement, electing to receive benefits is not necessarily a predictor of leaving the workforce.[14] In fact, the decision whether to stop working can be completely independent from the decision whether to begin collecting Social Security benefits. For example, a worker might choose to stop working but delay receipt of Social Security benefits to take advantage of higher monthly benefit amounts that accrue the later one waits to claim (up to age 70). Or a worker might decide to elect retirement benefits as early as age 62, receiving a permanently reduced monthly benefit,[15] yet continue to work full- or part-time for continued income support.[16] In some cases, a worker might opt to select Social Security benefits and then return to work.[17]

Researchers have long recognized the role Social Security benefits play in a secure retirement.[18] Social Security retirement benefits provide income security for millions of Americans, with 65 percent of all aged recipients[19] relying on Social Security for 50 percent or more of their income, and 36 percent relying on Social Security for 90 percent or more of their income.[20] Because low-income households use Social Security benefits for a larger portion of annual income, the financial crisis has affected these retirees less.[21] As a result, the structure of Social Security has its most significant economic and behavioral effects on the middle class.

Negative Effects of Labor Force Participation

Most analyses of Social Security have concluded that its current design offers substantially negative incentives for work, especially for younger seniors and for secondary household earners. Research by Gayle Reznik, David Weaver, and Andrew Biggs has found that Social Security’s return on payroll tax contributions by those aged 62–65 is −49.5 percent,[22] meaning that the program literally pays back just pennies in additional benefits for each additional dollar contributed. Barbara Butrica and her coauthors have found that the broader array of federal laws strongly inhibits continued work by seniors, with disincentives growing stronger as they age: “The implicit tax rate on work increases rapidly with age, rising for our representative worker from 14 percent at age 55 to 50 percent at age 70.”[23]

Notably, labor force participation did not immediately decline for those younger than 65 (and thus originally ineligible for Social Security benefits) until Social Security’s early eligibility age (EEA) of 62 was established.[24] After the creation of the EEA, labor-force participation by males aged 55–64 also began to trend downward, from 87.3 percent in 1960 to 67.7 percent by 1990. As the Bureau of Labor Statistics notes, “Labor force par- ticipation decreases started in the 1960s for those 55 to 64. Since this time, some of the 20-percentage points decrease for men in this age group has to be attributed to the availability of Social Security benefits to men 62 years of age.”[25] The Bureau of Labor Statistics report also notes the new availability of Social Security’s disability benefits and suggests that they further dampened middle-aged labor-force participation.

How Does Social Security Penalize Work?

The basic Social Security benefit formula is itself designed to impose net incremental income losses on those who extend their working careers.[26] Previous studies by Charles Blahous;[27] Gopi Shah Goda, John B. Shoven, and Sita Nataraj Slavov;[28] and others have explained how returns on contributions generally diminish the longer one works and why they become even more sharply negative once a worker has contributed for 35 years.

The primary reasons for the work disincentives are the facts that the Social Security benefit formula is progressive, while also based on a worker’s top 35 years of earnings on average. Thus, the longer one works, the more “zero earnings years” in one’s wage history are replaced with positive earnings years and the more one’s “average earnings” rise (so that one is gradually considered a relatively higher-wage earner), and thus the worse one’s returns under the program’s progressive benefit formula.[29]

This worsening becomes particularly pronounced after 35 years of earnings,30 when the best a worker can hope for is to replace a previous year in the highest 35 years of one’s wage history with a higher earnings year. That is to say, after 35 years of work, one’s benefit can only rise in proportion to the differential between two previous earnings years, despite paying a full additional year of payroll taxes. Indeed, someone who takes a part-time “transition job” on the way to full retirement may well pay a full year’s worth of additional taxes while receiving no additional benefit credits whatsoever. This embodies a substantial work disincentive at precisely the time when a worker is likely to make a retirement decision.

Penalities Against Seniors and 55-65-Year-Olds

Though this sustained trend toward early retirement has bottomed out and begun to reverse somewhat in recent years, Social Security on balance clearly remains a substantial barrier to labor participation by Americans in their late middle age. For example, seniors who continue to work after claiming Social Security benefits at 62 (but before normal retirement age [NRA] of 66) are subject to an earnings limitation under which they are required to temporarily give up as much as $1 in benefits for every $2 earned above a $15,120 threshold.[31] This rule is but one of the program’s facets that nudge individuals into early retirement.

Social Security’s EEA of 62 is, in fact, the most common age of benefit-claiming.[32] Over 70 percent of beneficiaries take advantage of the opportunity to claim Social Security retirement benefits before NRA, despite receiving lower monthly benefits by doing so.[33] Not long ago, Social Security Administration (SSA) field offices often encouraged early retirement under the mistaken belief that it leaves beneficiaries better off. Early retirement is only certain to make beneficiaries better off in the short run, however. The reduction in monthly benefits that accompanies early claims also results in net lifetime benefit reductions for those who live to especially advanced ages—often a time in life when beneficiaries are most likely to rely on Social Security benefits to pay their expenses. Fortunately, the SSA has more recently adopted policies recognizing that individual circum- stances must be carefully considered when determining one’s optimal age for claiming benefits.[34]

Penalties for Two-Earner Couples

Social Security specifically provides a disincentive to taxpaying work by more than one earner per household. Incremental returns on taxes paid by women have been estimated at −32.0 percent relative to what they would receive by staying out of the paid workforce altogether and instead often collecting the nonworking spouse benefit.[35] As a general rule, Social Security aggressively redistributes income from two-earner married couples to one-earner married couples, thus penalizing a household decision to have both spouses work and contribute payroll taxes. For example, a medium-wage two-earner couple, both born in 1955, can expect to receive back only 80 cents from Social Security on each dollar contributed (in present value), whereas a one-earner couple can expect to receive $1.39.[36] Today 61 percent of married women participate in the labor force, compared to only 32 percent in 1960—and there are more women than men in the modern-day workplace.[37] Much of the original welfare system was designed to support single-earner families.[38] As a result of changing demography, Social Security needs to reflect the evolving workplace and not penalize two-earner couples.

One reason for this income redistribution and these negative labor participation incentives is the structure of Social Security’s nonworking spouse benefit. Individuals without any history of paid employment can be entitled to receive a benefit equal to 50 percent of their spouse’s earned benefit. Consequently, an individual who is married to a high-wage earner may receive a benefit well exceeding what another individual might earn based on an entire working career of payroll tax contributions.

Despite the complexities involved in determining one’s net effective tax rate on Social Security–covered work, there is evidence that individuals and two-earner couples do respond rationally to these disincentives. As Jeffrey B. Liebman, Erzo F. P. Luttner, and David G. Seif point out in a 2008 study, “Our estimates conclusively reject the notion that labor supply is completely unresponsive to the incentives generated by the Social Security benefit rules. We find reasonably robust and statistically significant evidence that individuals are more likely to retire when the effective marginal Social Security tax is high.”[39] For most seniors, these effective marginal tax rates are indeed enormously high.

These various features of Social Security—from the technical details of its benefit formula, to the earnings limitation, to the benefit eligibility at age 62, to the nonworking spouse benefit, to others—all act as a drag on labor-force participation and thus interfere with the goal of maximizing future economic growth.

The Fiscal Importance of Labor-Force Participation

The financial unsustainability of current federal entitlement programs is substantially attributable to insufficient projected growth in the US labor force. This conclusion can be substantiated by some simple math. Social Security’s initial benefit formula, for example, increases along with growth in the national Average Wage Index.[40] Because program payroll tax revenues also automatically grow with national wages, this benefit formula would be financially sustainable within a stable tax rate if the worker-to-beneficiary ratio never declined—or in other words, if gains in longevity and health were always matched by proportional increases in the duration of workers’ taxpaying careers.[41] This proportionality, however, is not being maintained. Worker– beneficiary ratios are projected to become much more unfavorable going forward.

Though press attention rightly focuses on how the Baby Boomers’ Social Security and Medicare benefit claims will increase federal spending, the other side of the coin is the corresponding reduction in labor force growth rates as the Boomers cease working. Whereas from 1963 through 1990 inclusive annual labor-force growth rates never once dropped below 1.2 percent despite periodic recessions, from 2019 onward labor force growth rates are projected never to exceed even half that rate (0.6 percent).[42] Thus, to the extent that Baby Boomers and subsequent generations perceive greater rewards for extending their working lives, the picture of our national economic future will brighten enormously.

It bears emphasis that workforce participation trends among those in their 60s are not driven primarily by issues of physical incapacity. Labor-force participation among males over 65 was much higher in the mid-20th century than it is now despite substantial gains in national health and longevity since then. Incentives have played a much greater role. Beyond the fact that it is generally more attractive to enjoy additional years of leisure rather than to continue work, our federal entitlement policies have made the decision to retire virtually irresistible financially as well. Given these incentives, it is unsurprising that our future economic growth outlook is depressed by current projections for labor-force participation, relative to what would be the case if more of our national gains in longevity and health were converted into longer periods of taxpaying work.

The economic benefits of longer working careers well exceed, however, what is shown in federal scorekeepers’ analyses of program finances. Repeal of the Social Security earnings limitation, for example, is scored under current SSA methodology as actuarially neutral, although it would almost certainly incentivize longer working careers, both generating additional government tax revenue and benefiting the economy as a whole. Similarly, proposals to raise Social Security’s EEA of 62 are not scored by the Social Security actuaries as producing direct financial gains for the program, though the change would better incentivize taxpaying work by those in their early 60s.

A recent Congressional Budget Office (CBO) analysis of raising the EEA acknowledges this effect conceptually but does not attempt to quantify it: “This option also would probably lead workers to remain employed longer, which would increase the size of the workforce and boost federal revenues from income and payroll taxes. Moreover, the additional work would result in higher future Social Security benefits, although the increase in benefits would be smaller than the increase in revenues.” But “the 10-year estimates for this option do not include those two effects.”[43] Other CBO analyses, including those of the Diamond-Orszag and the Bush Com- mission’s proposals, quantify some potential advantages of reforming Social Security benefits for promoting economic growth. CBO found that the Bush Commission plan to constrain the growth of benefits beyond price inflation would increase national GNP relative to the budget baseline, whereas the Diamond-Orszag proposal to raise Social Security taxes would reduce it. These findings in turn reflected analyses that the Bush Com- mission proposal “could cause some people to work longer or harder,”[44] whereas under the Diamond-Orszag proposal, “households would choose more leisure.”[45]

Extended workforce participation would pay dividends for individual seniors as well as for the economy as a whole. As Butrica and her coauthors noted in 2004, “Working longer increases the net output and productiv- ity of the economy, generates additional payroll and income tax revenue, and reduces the number of years that individuals receive retirement benefits. . . . [P]eople could increase their annual consumption at older ages by more than 25 percent simply by retiring at age 67 instead of age 62. The increased tax revenues generated by this work could be used to support a wide range of government services, including public support for the aged.”[46]

For these and many other reasons, Social Security reform as well as broader entitlement reform should be undertaken with an eye toward rewarding those in late middle age who decide to extend their working careers.

Social Security Reforms to Improve Work Incentives

Bowles-Simpson and the Bipartisan Policy center Plans

The impact of Bowles-Simpson and the Social Security reforms of the Bipartisan Policy Center (BPC) on work incentives vary depending on the specific provision examined. While some reforms encourage greater participation in economic activity, others limit the desirability of work and could incentivize even earlier retirement. Some proposals would encourage significant behavioral shifts while others would encourage only marginal changes.

Both plans include the following policy recommendations that would encourage greater labor force participation: adjusting the cost-of-living adjustment (COLA) to be indexed according to a Chained-CPI-U, to account for substitution effects as consumers change what goods they purchase in response to changes in prices; reducing the growth of benefits for the highest-earning beneficiaries; and indexing the benefit formula for longevity. Of these three reforms, indexing the COLA to Chained-CPI-U would most increase the desirability of individual saving. President Obama has also proposed indexing the COLA to the Chained-CPI-U in his FY 2014 budget.

The proposed CPI-U price index accounts for living expenses for around 87 percent of the US population. It is a measure of inflation facing all urban consumers. The current CPI-W index, however, measures the higher rate of inflation experienced by all urban workers, roughly 32 percent of the population.[47] Because the W index represents a subset of the U population, many Social Security recipients experience inflation-adjusted wages that exceed their actual cost-of-living increases. Adjusted wages in excess of inflation incentivizes less individual saving and lower labor-force participation in exchange for greater reliance on Social Security.

The two other benefit reductions considered by the Bowles-Simpson and BPC plans are designed to make the benefit structure more progressive and to slow the growth of benefits for higher-income workers. The first would marginally reduce the growth of benefits for approximately the top 25 percent of beneficiaries. The proposal by BPC would slowly reduce the top bend point in the primary insurance amount (PIA) formula applied to a person’s average indexed monthly earnings from 15 percent to 10 percent over a 30-year period.48 For someone eligible for benefits in 2013, this percentage would apply to additional monthly covered earnings in excess of $4,768. The Bowles-Simpson plan would also adopt a more progressive benefit formula that slows the growth of benefits for higher-income earners by expanding the amount of earnings at the bottom end that are covered by the 90 percent replacement rate and would subject higher-income earners to a new and lower top-end replacement rate of 5 percent. While this reform should encourage the top 25 percent of beneficiaries to work longer and save more, a more progressive benefit formula that gives a higher benefit amount to lower-income workers could have the opposite effect and would not encourage additional saving or longer labor-force participation.

The second benefit change considered by both Bowles-Simpson and BPC is to adjust benefits for expected increases in longevity. As Americans live longer, the financial commitment of Social Security increases as well. Lifetime benefits for Social Security recipients are greater than ever and will continue to increase. BPC would reduce benefits beginning in 2023 (after the full retirement age increases to 67 under current law) by 0.3 percent each year in order to offset part of the additional costs of estimated longevity increases. Bowles-Simpson would gradually increase both the early eligibility age and normal retirement age to account for increases in longevity. Adjusting Social Security to reflect increases in longevity would encourage greater labor-force participation and saving.

The following policy recommendations would penalize the decision to work and encourage earlier retirement: raising the amount of income subject to payroll taxes and increasing the special minimum benefit. Raising the amount of income subject to payroll taxes could have negative implications for investment and saving levels. I won’t elaborate in detail in my testimony on the negative economic effects of raising payroll taxes, as previous witnesses have testified before this committee extensively on the topic.[49] But, in brief, raising Social Security payroll taxes would generally mean that people would work less, because the financial return from work has been decreased; save less, because they now have less after-tax income with which to save; and retire early, because the replacement rate of Social Security benefits will rise.[50]

The final policy recommendation from the BPC and Bowles-Simpson is to increase the special minimum benefit and to provide a “bump up” in benefits for beneficiaries in their 80s. The special minimum benefit was enacted in 1972 to provide minimum financial protection for low-income workers.[51] However, the current minimum benefit is adjusted for changes in prices, not wages. As wages have grown faster than prices, the PIA for most low-wage workers is higher than the special minimum PIA. The BPC plan would propose a special minimum benefit set at 133 percent of the poverty level for retirees with at least 30 years of covered work. The Bowles- Simpson plan would set the special minimum benefit at no less than 125 percent of the poverty level in 2017 and index it to wage growth thereafter. The proposed “bump up” is a small boost in income that retirees would receive between the ages of 81 and 85 (BPC plan), and for those on benefits 20 years after the earliest eligibility age (Bowles-Simpson), as saving levels tend to be significantly reduced once beneficiaries reach this age range.

The goal of the special minimum benefit and “bump up” for those in their 80s should be to reach beneficiaries who would otherwise be unable to provide for themselves rather than to provide a general welfare expansion for all retirees. Social Security’s benefit structure already discourages labor-force participation. So, while we should definitely ensure that our society’s most vulnerable members are protected against poverty, an expansion of the special minimum benefit should reach only those most in need in order to avoid having further negative impacts on the labor-force participation rate.

Raising the Early Eligibility

With age 62 now the most popular age to claim benefits, raising the EEA would necessarily delay many claims and would likely correlate with continued employment.[52] Research has estimated that raising the EEA to 65 would increase long-run GDP by 3–4 percent.[53]

Several key points should be kept in mind with regard to raising the earliest eligibility age. First, an EEA increase of three years, for example, would merely bring the age of earliest eligibility to what it was at the program’s inception; it would not begin to adjust for the substantial health and longevity gains since. Period life expectancy at birth has grown by more than 14 years since 1940, while life expectancy at 65 has grown by more than six years.[54]

Second, raising the EEA to bring it closer to the NRA would likely reduce poverty among seniors, as they would be subject to a smaller early retirement penalty. As previously noted, annual benefits under Social Security law are adjusted downward from full benefit levels in proportion to how early one claims before reaching the NRA. This keeps expected lifetime benefits constant, regardless of the age of claim; some of the risk of old-age poverty resides with seniors who retire early, have “too low” an annual benefit, and then outlive their other savings.

Increase the Delayed Retirement Credit

Another positive work incentive could be created by increasing the program’s actuarial penalty for early retirement as well as its delayed retirement credit (DRC). The current actuarial penalty for early retirement is a 25 percent reduction in annual benefits for those who retire at 62, four years before the current NRA of 66, or about a 6 percent reduction for each year.

On the other hand, the delayed retirement credit is an 8 percent increase in annual benefits for each year (up to age 70) claims are delayed beyond the NRA. For someone delaying claiming benefits until age 70, this credit amounts to a 32 percent increase in the monthly benefit.[55] These current-law adjustments hold expected life- time benefits constant for a typical retiree, and thus do not account for the value of additional payroll taxes likely contributed if an individual delays claiming benefits and continues working. Increasing these adjustments may better reflect the value of additional payroll taxes contributed by working seniors.

Offering the DRC as a lump-sum option could potentially provide an additional incentive to continue work- ing, without adding a financial cost to the system. The current DRC offers an increase in one’s monthly Social Security benefit proportional to the time over which the benefit claim is delayed. However, only a minority (between 5 and 6 percent in 2011) take advantage of this option.[56] It is also worth noting that more than 70 percent of those claiming retirement benefits in 2011 did so before their normal retirement age, thus receiving reduced monthly benefits.[57] An option potentially more attractive to workers would be to allow an individual to receive the entire DRC as a lump sum when claimed, while also receiving the basic monthly benefit as it would have been calculated at NRA. This option could potentially allow claimants to receive a lump sum of tens of thousands dollars on the date of their delayed claim. Recent research by Jingjing Chai and his coauthors confirmed that offering a lump-sum option could boost the average retirement age by 1.5–2 years.[58]

The precise amount of a lump-sum DRC could be calculated to be the actuarial equivalent of the standard monthly DRC, thus creating no additional system costs but potentially spurring longer taxpaying work. But even if the lump sum were designed to be slightly smaller in present value than the DRC would have provided as a monthly benefit stream—thus producing a net improvement in system finances—many individuals might still find the lump-sum option more attractive because they would have immediate access to and control over the funds.

The various reforms mentioned above would likely be useful if enacted separately, but would work best in tandem. Steepening the actuarial penalty for early benefit claims could, despite its other policy benefits, potentially worsen some early claimants’ subsequent risk of poverty if enacted as a standalone measure, but would not do so if accompanied by an increase in the EEA. If the NRA is increased while the EEA is held at the current age of 62, a higher minimum benefit could be offered to those in physically challenging jobs unable to work past age 62. However, it is worth noting that SSA only has wage data available and determining which individuals would be allowed a higher minimum benefit at EEA, instead of a regular actuarial reduction, would be administratively challenging and burdensome to say the least, and may be impossible to administer.

As mentioned earlier in my testimony, both the Bowles-Simpson and BPC plans would offer an increased minimum benefit to protect low-wage workers, as well as a bump-up in the benefit amount for those in their 80s and the long-term disabled. While the Bowles-Simpson plan recommends increasing the early eligibility and normal retirement ages, the plan also recommends that the Social Security Administration be tasked with designing a policy that would allow a hardship exemption for those that cannot physically work past age 62.

Adjusting the Benefit Formula

Another potentially important work incentive reform would be to redesign the basic benefit formula so that it operates on each separate year of work rather than on one’s career average earnings. As discussed previously, the current formula causes one’s returns from Social Security to drop with extended work, as one’s career average earnings rise and the system’s progressive benefit formula thus delivers lower returns.

An alternative suggested by Charles Blahous, a public trustee for Social Security, would be to calculate benefits by considering every year of one’s earnings, rather than only the highest average 35 years of earnings.[59] In addition to greatly improving work incentives for seniors, this reform would have other advantages. For example, the current formula often mistakes intermittent high-wage earners for low-wage earners because their career “average earnings” look the same. This confusion causes problems in the treatment of those who move in and out of Social Security coverage—for example, higher-wage state and local employees and immigrants, whom the formula mistakes for needy low-wage workers—necessitating complex fixes such as the Windfall Elimination Provision (WEP) and the Government Pension Offset (GPO). Such controversial complexities would become unnecessary if Social Security simply accrued proportional benefits with each additional year of taxpaying work, since all intermittent workers would be treated the same, more in the fashion of a traditional private-sector pension.

Constraining Nonworking Spouse Benefits for High Earners

Another work-incentive reform would be to gradually restrain the growth of nonworking spouse benefits associated with higher earners. The nonworking spouse benefit does play a useful role within Social Security by recognizing the value of stay-at-home work and of raising the next generation of wage earners. It is, however, inefficiently designed in that it is both regressive and a significant disincentive to paid employment. A two- earner couple both with low wages, for example, receives lower returns from Social Security than a high-wage one-earner couple,[60] despite the intended progressivity of the basic benefit formula.[61] Additionally, someone married to a high-earning spouse might well receive a higher nonworking spouse benefit than another individual might earn based on a full career of paying payroll taxes on modest annual earnings.

It is not necessary to eliminate the nonworking spouse benefit to address the inequities described above. One option is simply to constrain its growth so that no future nonworking spouse can receive a benefit exceeding the inflation-adjusted value of the benefits that today’s low-wage workers receive based on a full career of payroll tax contributions.

Payroll Tax Relief

Others have suggested that payroll tax relief be offered to seniors who extend their working lives.[62] There are policy downsides to this approach. For example, it would reduce much-needed Social Security tax revenues, though it would increase regular income tax revenues. Also, if enacted in the wrong way, eliminating or reducing the payroll tax contributions for seniors could embody age discrimination. That said, the positive effects such a policy could have on labor participation by seniors should not be dismissed. Versions that avoid the age- discrimination pitfall have been put forward by Mark Warshawsky and John Shoven.[63] The basic idea would be to establish a status of being “paid up” under Social Security after a given number of years of contributions (45 in the Warshawsky formulation), after which no further payroll taxes would be collected. Notably, this change would offer a work incentive to individuals on the way to paid-up status, and not only upon reaching a given age.

One policy challenge associated with improving Social Security’s work incentives is that doing so will likely shift the distribution of Social Security income somewhat from women (who are more likely to have work interruptions to bear and raise children) to men (who are more likely to have longer working careers). This income shift is indeed a likely effect of enacting work-incentive repairs in isolation, and it is a concern if one wishes to preserve the full amount of income redistribution from men to women that occurs under current-law Social Security. The concern can be addressed, however, by making the basic benefit formula incrementally more progressive at the same time that work incentive improvements are enacted.[64]

There is no way to know for certain how much Americans in late middle age would respond to reforms to render Social Security friendlier to those who extend their working careers. Evidence from Liebman, Luttner, and Seif suggests that there would be a positive labor supply effect and thus a positive effect on federal revenues, retirement income security, and broader economic growth.[65] At a time when America desperately needs the labor productivity of our skilled, healthiest younger seniors to foster economic growth, we would do well to advance a Social Security system that sides with those who provide us with the benefits of their continued work.

Financial Literacy

The Social Security Administration plays a unique role in the financial security of millions of Americans, and in helping people better prepare for retirement. Therefore, both the Bowles-Simpson and BPC plans encourage the SSA to increase financial literacy efforts to inform people about their retirement choices and to increase savings. Specifically, the BPC plan

directs SSA to revise aggressively its communications and messaging around the retirement choice. The material provided to workers during their careers about the retirement decision must more clearly show the implications of collecting benefits at different ages. It must highlight the permanent financial consequences of this choice, not only for workers, but for spouses and survivors as well. In particular, SSA should remind workers of uncertainties in retirement, such as potential health-care costs and the possibility that they may live for many years after retiring.

Although people are living longer, a significant fraction of workers continues to start receiving Social Security benefits early, though this permanently reduces monthly benefits. Research links financial literacy and saving behavior, indicating that the less financially literate are also less likely to plan for retirement.[66] Better informing people about the full costs of claiming benefits early may lead to more people choosing to delay claiming until the full retirement age, or longer, thus improving labor-force participation among seniors. For example, an innovative study by Jeff Brown, Arie Kapteyn, and Olivia Mitchell uses the American Life Panel to experiment with different ways of framing monthly benefit information. The authors hold constant the factual information presented but vary how the information is presented to highlight the financial gains of delaying or claiming. That study finds that framing information strongly shaped respondents’ expected claiming ages.[67]

Promoting financial literacy should be done regardless of any Social Security reform plan, in part because research finds differences between how much people expect to receive in Social Security benefits when they retire and what they actually receive. For example, only 19 percent of workers can correctly identify the age at which they will be eligible for full benefits from Social Security.68 Further, the 2011 Retirement Confidence Survey (RCS) found that current workers are half as likely to expect Social Security to provide a major share of their income in retirement (33 percent) as current retirees are to say Social Security makes up a major share of their income (68 percent).[69] However, research conducted by the Employee Benefit Research Institute (EBRI) found that 60 percent of those aged 65 or older received at least three-quarters of their income from Social Security in 2009.[70] Additionally, although people are living longer, a significant fraction of workers continues to take Social Security benefits at age 62 even though this permanently reduces monthly benefits for the rest of their lives. Research also links financial literacy and saving behavior, indicating that the less financially literate are also less likely to plan for retirement.[71]

A number of Social Security reforms could be implemented that provide incentives to healthy seniors to continue working. Some of these changes would produce net direct savings for the program, whereas others would benefit individual participants at some expense to program finances. The following often-discussed proposals to raise Social Security eligibility ages would likely have a positive effect on worker output and economic growth.

Conclusion

Social Security faces real financial challenges. Dismissing the real and current fiscal challenges facing the Social Security system and kicking the “reform can” further down the road will only increase the severity of the burden associated with reforms when they inevitably must take place.

In order to ensure that Social Security remains solvent and continues to provide retirement security for generations to come, while minimizing the burden on current and future generations, reforms must happen sooner rather than later. The Social Security Trustees

recommend that lawmakers address the projected trust fund shortfalls in a timely way in order to phase in necessary changes and give workers and beneficiaries time to adjust to them. Implementing changes soon would allow more generations to share in the needed revenue increases or reductions in scheduled benefits. Social Security will play a critical role the lives of 56 million beneficiaries and 159 million covered workers and their families in 2012. With informed discus- sion, creative thinking, and timely legislative action, Social Security can continue to protect future generations.[72]

These reforms should not only address the program’s fiscal solvency issues, but also remove the disincentives to working later in life.

Thank you again for your time and this opportunity to testify today. I look forward to your questions.

See footnotes as a PDF

The Effect of Tax Increases and Spending Cuts on Economic Growth

Veronique de Rugy — Wed, 22 May 2013 15:07:02 -0400

Publication

Good morning, Chairman Murray, Ranking Member Sessions, and members of the committee. Thank you for the chance to discuss the effect of tax increases and spending cuts on economic growth. I appreciate the opportunity to testify today.

Last week the Congressional Budget Office released a revision of its budget outlook for FY 2013.[1] According to CBO, our short-term outlook seems to be improving, at least on a superficial level, with this year’s deficit now expected to be $642 billion. That is $200 billion lower than projected in February, which would make it the smallest deficit since 2008.

There are many reasons for continued pessimism, however. At 76 percent, the debt-to-GDP ratio is still much higher than the 2008 level of 36 percent. Unfortunately, even under the new projections the debt- to-GDP ratio will still be around 74 percent at the end of the decade. And that’s assuming Congress doesn’t overturn sequestration and all of CBO’s assumptions hold true. In CBO’s alternative scenario, debt will be above 83 percent of GDP by the end of the decade.

The explosion of spending from programs such as Social Security, Medicare, and Medicaid will trigger even higher levels of debt in the years outside the 10-year budget window. Unfortunately, high debt levels are problematic. As CBO explains,

Such high and rising debt later in the coming decade would have serious negative con- sequences: When interest rates return to higher (more typical) levels, federal spending on interest payments would increase substantially. Moreover, because federal borrowing reduces national saving, over time the capital stock would be smaller and total wages would be lower than they would be if the debt was reduced. In addition, lawmakers would have less flexibility than they would have if debt levels were lower to use tax and spending policy to respond to unexpected challenges. Finally, a large debt increases the risk of a fiscal crisis, during which investors would lose so much confidence in the government’s ability to manage its budget that the government would be unable to borrow at affordable rates.

In other words, a brief dip in the deficit is no reason to be complacent. The federal government should continue to work on addressing its long-term debt problem. However, in the pursuit of debt reduction, it is important to remember that the type of fiscal adjustment that we implement is more important than its size.

In theory, debt reduction can be achieved by cutting spending or by raising taxes, or by adopting a mix of spending cuts and tax increases.

When anti-austerity policymakers or critics talk about austerity without even alluding to this distinction in how deficit reduction is achieved, they do a disservice to the clarity of the issues at hand, since different types of austerity measures produce very different results.[2]

This testimony is based on a paper I wrote with Harvard University economist Alberto Alesina, called “Austerity: The Relative Effects of Tax Increases versus Spending Cuts.” As we explain in detail in that paper, the consensus in the academic literature is that the composition of fiscal adjustment is a key factor in achieving successful and lasting reductions in the debt-to-GDP ratio. The general consensus is that fiscal adjustment packages comprising mostly spending cuts are more likely to lead to lasting debt reduction than those composed of tax increases.

There is still significant debate about the short-term economic impact of fiscal adjustments, but some important lessons have emerged. First, fiscal adjustments and economic growth are not incompatible. Second, while fiscal adjustments may not always trigger immediate economic growth, spending-based adjustments are much less costly in terms of output than tax-based ones. In fact, when governments try to reduce their debt by raising taxes, the policy is more likely to result in deep and pronounced recessions, possibly making the fiscal adjustment counterproductive. Finally, there is some evidence that expansionary fiscal adjustments are more likely to occur when they are accompanied by growth-oriented policies, such as policies liberalizing both labor regulations and markets for goods and services, in addition to a monetary policy that keeps interest rates low.

These findings are key to designing proper policies for the United States. They also suggest that the budget plans proposed by both President Obama and Chairman Murray are unlikely to reduce the country’s debt and may also slow economic growth if implemented as proposed.

1. How To Reduce Debt-to-GDP Ratios

The United States is not the first nation to struggle with a worrisomely high debt-to-GDP ratio. The evidence suggests that the types of fiscal adjustment packages that are most likely to reduce debt are those that are heavily weighted toward spending reductions, not tax increases.[3]

One of the difficulties of studying the impact of large fiscal adjustments on both debt and economic growth involves the definition and identification of successful and expansionary episodes. For a long time, the identification criteria were based on observed outcomes: a large fiscal adjustment was one where the cyclically adjusted primary-deficit-over-GDP ratio fell by a certain amount (normally at least 1.5 percent of GDP). Following the approach pioneered by University of California, Berkeley, economists Christina Romer and David Romer,[4] IMF economists suggested a different way to identify large exogenous fiscal adjustments: a large fiscal adjustment is an explicit attempt by the government to reduce the debt aggressively and it is unrelated to the economic cycle.[5] This new approach was meant to guarantee the “exogeneity” of the fiscal adjustments.

The authors also suggest that a difference in the way fiscal adjustments are measured would change the overall results. However, the difference in the way fiscal adjustments are defined does not change the overall result. A 2012 study by Alberto Alesina and Goldman Sachs’s economist Silvia Ardagna shows that spending-based adjustments are more likely to reduce the debt-to-GDP ratio, regardless of whether fiscal adjustments are defined in terms of improvements in the cyclically adjusted primary budget deficit or in terms of premeditated policy changes designed to improve a country’s fiscal outlook. [6] Similar results with more advanced technical tools using the IMF episodes are also reached by Alberto Alesina and Bocconi University economists Carlo A. Favero and Francesco Giavazzi.[7]

Other research has found that fiscal adjustments based mostly on the spending side are less likely to be reversed and, consequently, have led to more long-lasting reductions in debt-to-GDP ratios.[8] Beyond showing whether spending-based adjustments or revenue-based ones are more effective at reducing debt, the literature has also looked at which components of expenditures and revenue are more important. The results on these points are not as clear-cut, partly due to the wide differences in countries’ tax and spending systems. With that caveat in mind, successful fiscal adjustments are often rooted in reform of social programs and reductions to the size and pay of the government workforce rather than in other types of spending cuts.[9] Results about which type of revenue increases contribute to successful fiscal adjustment are much less clear.[10]

Also, while successfully reducing the debt-to-GDP ratio is possible, a majority of historical fiscal adjustment episodes fail to do so. Data from studies by Alesina and Ardagna and by Andrew Biggs and his colleagues show that roughly 80 percent of the adjustments studied were failures.[11] One explanation is that even (or especially) in a time of crisis, lawmakers are driven more by politics than by good public policy. Countries in fiscal trouble generally get there through years of catering to pro-spending constituencies, be they senior citizens or members of the military industrial complex, and their fiscal adjustments tend to make too many of the same mistakes. As a result, failed fiscal consolidations are more the rule than the exception.

2. Fiscal Adjustments and Economic Growth

While there is little debate over the fact that sound fiscal balance and restraints in government spending have a positive impact on GDP in the long run, the question of whether, in the short term, budget cuts shrink or expand GDP is far from settled.[12] This is an especially important question for countries where government spending as a share of GDP is close to or above 50 percent. A few uncontroversial points have emerged, however, despite the differences in approaches and in the definitions of successful or expansionary episodes.[13]

First, expansionary fiscal adjustments are not impossible. There is now a long trail of academic papers that have studied and documented the impact of fiscal adjustments on economic growth. The first in the series was by Francesco Giavazzi and Marco Pagano in 1990.[14] It was followed by a large literature, which was reviewed in depth by Alesina and Ardagna in 2010.[15] However, today the question is not whether expansionary fiscal adjustments are possible, but whether in the current circumstances it is possible to design fiscal adjustments with as little cost as possible to the economy, given that monetary conditions will provide little additional help. It is perfectly possible that fiscal adjustment today might be on average more costly than in the past, but this does not mean that the medicine is not necessary.

Second, while not all fiscal adjustments lead to economic expansion, spending-based adjustments are less recessionary than those achieved through tax increases.[16] Moreover, when successful spending-based adjustments were not expansionary, they were associated with mild and short-lived recessions, while tax increases were unsuccessful at reducing the debt and associated with large recessions.[17] These findings hold even when using the IMF definitions of fiscal adjustments.[18]

In fact, these findings are consistent with IMF studies themselves.[19] For instance, IMF economists Jaime Guajardo, Daniel Leigh, and Andrea Pescatori study 173 fiscal consolidations in rich countries and find that “nations that mostly raised taxes suffered about twice as much as nations that mostly cut spending.”[20]

Third, successful and expansionary fiscal adjustments were those based mostly on spending cuts rather than tax increases.21 Also, these adjustments lasted slightly longer and were associated with higher growth during the adjustment. Using data from [21] Organisation for Economic Co-operation and Development countries from 1970 to 2010, Alesina and Ardagna find that successful fiscal adjustments on average reduced the debt-to-GDP ratio by 0.19 percentage points of GDP in a given year. GDP grew by 3.47 percentage points in total, which is 0.58 percentage points higher than the average growth of G7 countries. Successful adjustments lasted for three years on average.[22]

How can we explain the fact that spending-based adjustments can result in lower output costs for the economy than tax-based ones, or in no output costs at all? IMF economists Prakash Kannan, Alasdair Scott, and Marco Terrones argue that this difference in outcomes is not a result of the composition of the fiscal adjustment packages, but rather a result of the business cycle having picked up because of other forms of government interventions, such as expansionary monetary policy.[23] However, Alesina, Favero, and Giavazzi’s work shows that taking the business cycle and monetary policy into account does not change the main finding.[24]

If the difference between tax-based and spending-based fiscal adjustments is not the result of the business cycle or of monetary policy, what explains it? The standard explanation is that lower spending reduces the expectation of higher taxes in the future, with positive effects on consumers and investors. In particular, there might be a boost in the confidence of the latter—as Alesina, Favero, and Giavazzi have shown. But there is more. As is often the case, the devil is in the details. Studies by Alesina and Ardagna and by Roberto Perotti have noted that fiscal adjustments are multiyear rich policy packages.[25] Austerity measures are often undertaken at the same time that other growth-enhancing policy changes are made, and, as such, there is much to learn by looking into the details of each successful episode.

One important lesson is that several accompanying policies can moderate the contractionary effects of fiscal adjustments on the economy and enhance their chances of success.[26] For instance, spending-based fiscal adjustment accompanied by supply-side reforms, such as liberalization of markets for labor, goods, and services; readjustments of public sector size and pay; public pension reform; and other structural changes tend to be less recessionary or even to have positive economic growth.[27]

Such reforms signal a credible commitment to more market-friendly policies: less taxation, fewer impediments to trade, fewer barriers to entry, less labor market and business regulation. And, of course, with enhanced economic freedom, unit labor costs fall and productivity improves, making an expansionary fiscal adjustment more likely than a contractionary one.

Germany’s fiscal adjustment of 2004–2007 provides a good example.[28] First, the country implemented a stimulus by reducing income tax rates. This reduction was part of a series of supply-side-oriented reforms implemented between 1999 and 2005, including a wide-ranging overhaul of the income tax system that was meant to boost potential growth but that did not have much effect until 2004. In addition, significant structural reforms to tackle rigidity in the labor market were put in place, as well as changes to the pension system to relieve demographic pressures. These reforms included “an increase in the statutory retirement age, the elimination of early retirement clauses, and tighter rules for calculating imputed pension contributions.”[29] Finally, Germany adopted large expenditure cuts to the fringe benefits in public administration (such as ending Christmas-related extra payments) and also serious reductions in subsidies for specific industries, including residential construction, coal mining, and agriculture.[30]

Sweden provides another example of successful adjustment. The data show that after the recession Sweden’s finance minister, Anders Borg, not only successfully implemented reduction in welfare spending but also pursued economic stimulus through a permanent reduction in the country’s taxes, including a 20-point reduction to the top marginal income tax rate. At the same time, Sweden benefited from a very aggressive monetary policy followed by strong export revenues and firm domestic demand. The country’s economy is now the fastest-growing in Europe, with real GDP growth of 5.6 percent, which has helped the country to rapidly shrink its debt as a percentage of GDP over the past decade.[31]

The Swedish example raises the question of the appropriate role of monetary policy in successful fiscal adjustments. For instance, there is some evidence that at times exchange rate devaluation (induced by an accommodating monetary policy) can help to boost a country’s exports as the country becomes more competitive and, as a result, can compensate for a previous slowdown in domestic demand.[32]

Economist Scott Sumner has made the case that the best way to get austerity and growth simultaneously is to increase “[nominal] GDP and budget surpluses—the Swedish way.”[33] To be sure, monetary policy in Europe—or in the United States, for that matter—could increase the effectiveness of spending cuts and structural reforms (a little like the water you drink to help the medicine to go down). But it is a mistake to oversell it, and it certainly will not achieve our long-term goals without serious reductions in government spending. In particular, the devaluation of a country’s currency is neither a necessary nor sufficient condition for success, as shown by Alesina and Ardagna.[34]

There is growing evidence, however, that private investment tends to react more positively to spending- based adjustments. The data from Alesina and Ardagna, and Alesina, Favero, and Giavazzi, for instance, show that private-sector capital accumulation increases after governments cut spending, which compen- sates for the reduction in aggregate demand due to the fiscal adjustments.[35]

The good news is that it is possible to design a fiscal adjustment that could both reduce the deficit and have a minimal or even, in some cases, positive impact on the economy. It requires austerity based mostly on spending cuts. This can be accomplished without hurting the least advantaged in society. As Alesina wrote in November 2012,

But if we cut spending, do we necessarily hurt the poor? Not in such countries as Greece, Portugal, Spain, and Italy, whose public sectors are so inefficient and wasteful that they can certainly spend less without affecting basic services. Even in countries with better-functioning public sectors— such as France, where public spending is nearly 60 percent of GDP—there’s a lot of room to economize without hurting the poorest and most vulnerable. And even in America, public spending is about 43 percent of GDP, a level common in Europe not long ago, and up from 34 percent in 2000.[36]

In other words, Western governments can save money and avoid inflicting injury on lower-income earners or the poor by improving the way welfare programs are targeted; scaling back programs such as Medicare that use taxes raised in part from the middle class to give public services right back to the middle class; and gradually raising the retirement age to 70. The same holds true for Social Security. What is more, lots of savings could be achieved by cutting subsidies going to businesses—which are often large, well-established, and politically connected firms, such as gas and oil companies, farms, automobile manufacturers, and banks.[37]

Conclusion

Economists disagree a lot when it comes to fiscal policy. For instance, there is no consensus about the size of the spending multiplier or where on the Laffer curve most countries are situated. However, a consensus seems to have emerged recently that spending-based fiscal adjustments are not only more likely to reduce the debt-to-GDP ratio than tax-based ones but also less likely to trigger a recession. In fact, if accompanied by the right type of policies (especially changes to public employees’ pay and public pension reforms), spending-based adjustments can actually be associated with economic growth.

Fortunately, successful fiscal adjustments are possible when based mostly on spending cuts and accompanied by policies that increase competiveness, as we have seen in the case of Germany, Finland, and other more recent examples, such as Estonia and Sweden. However, it is important to refrain from oversimplifying these results since fiscal adjustment packages are often complex and multiyear affairs. Also, many of the successful (i.e., expansionary and debt-to-GDP-reducing) fiscal adjustments in this literature are ones where the growth is export-led during times when the rest of the global economy is healthy or even booming. While there has been some recovery in the midst of the recession, we should recognize that it may be much harder today to achieve export-led growth when many countries are struggling.

The cost of well-designed adjustments plans will not be zero, but will be relatively low. Besides, it is not clear that the alternative to reducing spending is more economic growth. In fact, the alternative for certain countries could be a very messy debt crisis.

See footnotes as a PDF

Patient Protection and Affordable Care Act; Health Insurance Market Rules; Rate Review

contact@mercatus.org (Mercatus.org) — Wed, 22 May 2013 14:52:48 -0400

Regulatory Report Card

This proposed rule would implement the Affordable Care Act’s policies related to health insurance premiums, guaranteed availability, guaranteed renewability, risk pools, and catastrophic plans. The proposed rule allows health insurance issuers to vary premium rates for health insurance coverage in the individual and small group markets based on a limited set of specified factors: (1) whether the plan or coverage applies to an individual or family; (2) rating area; (3) age, limited to a variation of 3:1 for adults; and (4) tobacco use, limited to a variation of 1:5. The proposed rule also defines catastrophic plans to include preventative coverage.

The Patient Protection and Affordable Care Act, and Standards Related to Essential Health Benefits, Actuarial Value, and Accreditation

contact@mercatus.org (Mercatus.org) — Wed, 22 May 2013 14:06:44 -0400

Regulatory Report Card

This proposed rule provides details of standards for health-insurance issuers consistent with Title I of the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act of 2010 (collectively referred to as the Affordable Care Act). This proposed rule outlines exchange and issuer standards related to coverage of essential health benefits and actuarial value. This proposed rule also proposes a timeline for qualified health plans to be accredited in federally facilitated exchanges and an amendment that provides an application process for the recognition of additional accrediting entities for purposes of certification of qualified health plans.

Energy Conservation Program: Energy Conservation Standards for Standby Mode and Off Mode for Microwave Ovens

contact@mercatus.org (Mercatus.org) — Wed, 22 May 2013 14:14:21 -0400

Regulatory Report Card

Per the requirements established in the Energy Policy and Conservation Act (EPCA), which prescribes energy-conservation standards for various consumer products and commercial and industrial equipment, and the Energy Independence and Security Act of 2007, the DOE proposes energy-use standards for microwave ovens in the standby and off modes. Specifically, the rule would prescribe the maximum allowable energy use when a product is in standby or off mode. For microwave-only ovens and countertop combination microwave ovens the maximum allowable energy use will be 1 watt. For built-in and over-the-range combination microwave ovens, the maximum allowable energy use will be 2.2 watts. DOE estimates a 0.06 percent reduction in projected household energy use as a result of the proposed rule.

For the rule's Regulatory Impact Analysis, go to Regulations.gov.

If The IRS Bothers You, So Should The FSOC and CFPB

Hester Peirce — Wed, 22 May 2013 11:29:03 -0400

Expert Commentary

The recent revelations about the goings-on at the Internal Revenue Service have gotten a lot of attention. When the patina of government impartiality shows itself so disturbingly thin, people of all political stripes sit up and take notice. The hard lessons drawn from the IRS experience should inform the broader policy debates about regulatory structure and oversight.

When the IRS activities came to light, the president expressed his disapproval and cited the agency's independence. As others have pointed out, the IRS is actually not-as agencies go-particularly independent. It is part of the Treasury Department, an executive agency that answers directly to the president, and the head of the IRS serves at the pleasure of the president. Nevertheless, the president's mention of independence reminds us of the importance of accountability in government-a government official who does not answer to anybody else can do quite a bit of damage without anyone noticing, let alone stopping her.

Our elected officials ought to be taking steps to ensure that other agencies do not follow the IRS's lead. If, instead, they refuse to subject regulatory agencies to basic accountability measures, they will help to clear the way for the next agency misdeed.

The need for accountability is relevant to a number of ongoing debates. The Senate is moving closer to a vote on the president's nomination of Richard Cordray to head the Bureau of Consumer Financial Protection. He is already serving in that capacity by virtue of a recess appointment that has been legally challenged, but Senate confirmation would give him a full five-year term in office.

Dodd-Frank intentionally made the CFPB super-independent and put all of its powers in the hands of one person, the director, who does not have to answer to anyone-not to congressional appropriators, not to House and Senate oversight committees, not to the American consumer, not to the chairman of the Federal Reserve (where the Bureau is technically housed), and not to the president. The president may remove the director, but only "for cause." Before the Senate votes to lock in Cordray's autonomy, it ought to ensure that Congress has the necessary tools to monitor him and hold him accountable. Otherwise, the president may one day be citing the director's independence as the reason that agency misdeeds went unnoticed and unstopped.

This week's hearings on the Financial Stability Oversight Council's annual report present another opportunity to incorporate the lessons from the IRS. The council is made up of the heads of the other financial regulators. With so many cooks in the kitchen, it is hard to know whom to hold accountable for the council's decisions-decisions that could fundamentally reshape the financial sector. The hearings offer an opportunity to explore ways to remake the council so that its actions are transparent, its members represent their agencies' views rather than their own, and its staff is properly supervised.

As it functions now, it is difficult to know who is making decisions at the council and on what basis those decisions are being made. The Government Accountability Office and others have noted this lack of transparency. The members of the council are the agency heads, rather than the agencies themselves, which increases the potential for conflicting signals coming from the council and the other federal financial regulators.

It would also be worth thinking about how the council's sister agency, the Office of Financial Research, can be made accountable. Its director serves a six-year term and, like the CFPB director, sets his own budget and answers only to himself. The OFR is a data collection agency, but the IRS incident is a reminder that even data requests can be wielded in a way that disproportionately burdens certain entities.

Our elected officials should use this moment to reconsider the design of the CFPB, the FSOC, and the OFR. These agencies must be accountable, transparent, and balanced so that the American people understand what these agencies are doing and why they are doing it. We can't eliminate government lapses of judgment through regulatory redesign, but we can make it less likely that they will go undetected and unpunished.

The Film Tax Credit Farse

Antony Davies, James R. Harrigan — Wed, 22 May 2013 10:10:22 -0400

Expert Commentary

Everyone loves a good movie, but with an average cost of more than $8, most Pennsylvanians have to choose carefully what they will spend their money on. Too bad we don't have that same luxury with our tax dollars, which subsidize the film industry to the tune of $60 million a year. If lobbyists for the “film tax credit” have their way, this will increase to $100 million in short order.

The debate over whether to increase the credit clouds the real issue: The debate should be whether the credit should exist at all. Simply put, it should not.

The credit, we are told, is an “investment” in Pennsylvania. By offering this credit we entice out-of-state productions to the state, which creates jobs and increases the tax base. Everybody wins! But if you really want to see who wins, look at who is pushing for the benefit. Filmmakers win. Taxpayers will be left holding the empty popcorn bag.

The film industry claims that the tax credit creates 18,000 jobs and innumerable others benefit as out-of-state money filters through our economy. What is casually omitted from this rosy scenario is the money lost by businesses that are already here.

When people are taxed to subsidize one industry, they have less money to spend the way they want. Some people win, but a lot of others lose. Politicians are simply picking the winners and losers.

Proponents say that our taxes aren't really going up because the $60 million is a credit. Out-of-state film crews don't pay taxes in Pennsylvania, so enticing them here with tax credits means only that they still won't be paying taxes in Pennsylvania. But this ignores the fact that they will be using state services: police and fire protection, public schools, roads and — notably — unemployment benefits when their movies wrap up. We taxpayers will be footing the bill for these services.

According to the nonpartisan Tax Foundation, every independent study of film tax credits has found that the credits are money-losers for the states. Arizona's Department of Commerce calculated that Arizona made back 28 cents in tax revenue for every $1 it “invested” in film tax credits. Connecticut's Department of Economic Development estimated that the state earned 7 cents in tax revenue for every $1 it lost. State agencies in Massachusetts, Michigan, New Mexico and even Pennsylvania's Legislative Budget and Finance Committee found that state coffers received less than 30 cents for every dollar they paid out in film tax credits.

If film production is such a great cash cow, why aren't venture capitalists lining up for a piece of the action? The problem is that the film industry wants special treatment. It wants someone else to shoulder the risk of investment while it keeps the profit for itself. No investor would agree to such a deal, and that is why the film industry has turned to our state government.

Filmmakers know the state can force taxpayers to invest in something taxpayers would never choose on their own.

The Top 3 Things I Learned at the Bitcoin Conference

Jerry Brito — Wed, 22 May 2013 10:03:57 -0400

Expert Commentary

This past weekend I attended the Bitcoin 2013 conference in San Jose, where over one thousand enthusiasts, developers, entrepreneurs, venture capitalists, and, yes, lawyers gathered to chart the future of the virtual currency. Here are the top three things I learned at the conference.

Bitcoin is about more than payments

Bitcoin is an even bigger deal than I thought. While the currency is best known as a censorship-resistant and somewhat-anonymous payments system, it has the potential to be so much more.

“Ultimately bitcoins are data, and you can use a data transit protocol to transit information other than just ‘I’m sending you bitcoins.’ It could be ‘I’m sending you a stock,’ or it could be ‘I’m sending you a bet,’” says Jeff Garzik, one of the six Bitcoin core developers.

Thought of this way, the Bitcoin network is a platform on top of which other layers of functionality can run, much like the Web or e-mail are protocols that run on top of the Internet’s foundational TCP/IP protocol. Bitcoin therefore has the potential to spawn any number of other services that are decentralized, and thus difficult to regulate or control.

One application for such an extension to Bitcoin would be decentralized electronic markets—whether for futures contracts, sports betting, or anything else.

J.R. Willett, author of a white paper proposing such a system, explains with a thought experiment: Suppose two parties, A and B, want to bet on the future price of Google stock, and there is a third party, C, that publishes the price on the network every few minutes. A thinks the price of Google will go up and publishes a message to that effect, while B thinks it will go down and publishes a message accepting the bet.

“Now, they’re interacting on a protocol layer above bitcoin; they’re using a currency that’s on top of bitcoin that recognizes these kinds of messages,” says Willett. “So they’ve actually both committed and there’s an agreement that everybody in the world can see.”

Others on the distributed network don’t know the identities of who placed the bet, but they can see that A said it would go up, and that B said it would go down, and they can see C publish the price of Google in the future.

“If the price goes up, then the whole protocol recognizes that A won that bet; the whole protocol recognizes that A now owns B’s coins,” says Willett.

And voila, welcome to a world of decentralized electronic futures markets. The predictions market Intrade, a darling of academic economists and political scientists, recently ceased operations after it was sued by the CFTC. Yet such a predictions market built as a peer-to-peer network on top of Bitcoin could not be easily shut down, nor would there be an operator that could run away with user’s funds, as it’s also alleged of Intrade.

And it’s not just markets. Treating Bitcoin as a protocol would allow for a vast number of other decentralized applications, including communications messaging and broadcasting, a decentralized domain name system, and much more.

The hobbyists give way to the pros

Bitcoin to date has been the domain of geeks, gold bugs, and cypherpunks, but sensing its disruptive (and profitable) potential, entrepreneurs and venture capitalists are pouring into the space.

Peter Thiel’s Founders Fund last week made a $2 million investment in merchant services firm BitPay, Google Ventures recently backed bitcoin exchange Ripple, and Fred Wilson’s Union Square Ventures has invested $5 million in the transactions platform Coinbase.

This transition from ideological enclave to professionalized financial network was on display at the conference’s exhibit hall. Row after row was lined with the booths of professional venture-backed businesses, while nestled in between were those of the Seasteading Institute and Antiwar.com.

It’s just like the late-90’s rush to commercialize the Internet once entrepreneurs recognized its revolutionary potential. And just like the late ‘90s, the early adopters are not all fond of the gentrification.

“A year or more ago there was very much an ‘Occupy’ type feel to Bitcoin, where this is the anti-establishment currency, and now the establishment is getting interested in Bitcoin,” says Garzik. “There is a tension and you definitely see the libertarian crypto-anarchist roots bang heads with the venture capital that’s coming in right now.”

One point of contention is mixing. As professional and regulated businesses enter, they are keen to tie real identities to transactions, and they are loath to touch bitcoins of unknown provenance. Many in the community rightly see this as a threat to Bitcoin’s fungibility.

“If someone says, ‘I will not accept these bitcoins over here because I think they are stolen funds,’ then their value is different from these other bitcoins that are not necessarily stolen funds,” explains Garzik. “And so some people of the crypto-anarchist, libertarian mindset feel it’s very important to mix because that preserves the fungibility of Bitcoin.”

Mixing is essentially laundering. It is combining bitcoins of different origins in a pool before handing them back to their owners in order to obfuscate who has which coin. Some even suggest that mixing should be built into the Bitcoin protocol itself. Businesses, to say the least, don’t like the sound of that. Everyone, however, will have to accept that Bitcoin is an open source project, and it’s ultimately consensus that will resolve the differences.

There’s no escaping regulation

Just two days before the conference, the Department of Homeland Security seized accounts belonging to Mt. Gox, the largest Bitcoin exchange (and a major sponsor of the conference), in what looks like the beginning of a criminal enforcement. You’d think this would have put a pall on the festivities, but in a way it only served to underscore the growing professionalization of the Bitcoin ecosystem.

Mt. Gox seems to have been operating without the requisite money transmitter licenses, and DHS alleges it lied about its status as a money transmitter in bank documents. In contrast, the new Bitcoin businesses that are springing up are working with state and federal regulators to cross every T and dot every I. And panelist after panelist on the conference’s “Legal and Regulatory” track explained to attendees how to comply with the law, as uncertain as it is. Dilettante time is over.

If the message wan’t clear enough, the Bitcoin Foundation—which helps organize Bitcoin’s development on the same model as the Linux Foundation—announced that it would be hiring a full time lawyer in Washington to represent the community’s interests. The thinking is that Bitcoin businesses and users are going to be regulated even if the protocol itself can’t be, so it’s time to engage the regulators and policy makers before they make any hasty moves.

This willingness to lobby and work with regulators, however, was not well received by many of the old guard. As one exasperated Foundation member tweeted, “I got into Bitcoin to improve this miserable planet and ESCAPE the iron grip of privileged moneyed interests, not JOIN THEM!”

But the fact is that Bitcoin is growing up. Its revolutionary potential is greater than most have yet understood. Entrepreneurs and venture capitalists are seeking to professionalize and legitimizing the network, and to do that regulators will have to understand and accept it.

It’s true that Bitcoin could continue to operate even if it was outlawed outright, but then it would only serve as an underworld currency, and its development would not doubt be hampered. The more subversive path may well be to let regulators create their rules for what at base is an uncontrollable system.

Oklahoma City Supporter and Friend Lunch

Maurice P. McTigue — Tue, 21 May 2013 17:04:21 -0400

Events

Please join us for one of our special events and discussions with the Honorable Maurice McTigue. As a former New Zealand cabinet minister and now a Mercatus Center vice president, Maurice speaks from experience about solutions and reforms that can be made to address the serious economic issues our country faces.

The Mercatus Center’s clear-headed research is shaping the conversation on government spending, fiscal austerity, and financial market regulation. Come hear what the former New Zealand cabinet minister would do in this country to promote economic growth and fiscal responsibility.

This is not a fundraising event, and there is no charge to join us. We are pleased to have you as our guest to show our thanks and appreciation to our donors. Dress is business casual. Please invite friends or associates who might be interested.

Questions? Contact Elizabeth Leibundguth at 703-993-4967 or eleibundguth@mercatus.gmu.edu.

Tulsa Supporter and Friend Lunch

Maurice P. McTigue — Tue, 21 May 2013 17:00:58 -0400

Events

Questions? Contact Elizabeth Leibundguth at 703-993-4967 or eleibundguth@mercatus.gmu.edu.

Why Is There No Milton Friedman Today?

Tue, 21 May 2013 14:57:12 -0400

Expert Commentary

Imagine that someone with all the endowments of a Milton Friedman were born in the 1960s or 1970s. Is it conceivable that such a person would develop into a ‘Milton Friedman’ like we know the actual Friedman to have been, including his academic eminence and his eloquent and influential advocacy of classical liberalism? Here leading economists address the question: Why is there no Milton Friedman today?

Click to see essays by authors below:

Learn more at Econ Journal Watch

Why Government Aid Programs Aren’t the Best Way to End Poverty

Christopher Coyne — Tue, 21 May 2013 14:52:35 -0400

Expert Commentary

Based on the high standards of living enjoyed by their citizens, you might think that the governments of First World countries know how to create development. They don’t. Development isn’t created by anyone, not least well-intentioned politicians or development “experts”. The process of improving well-being only takes place in an environment that encourages constant innovation and experimentation.

Unfortunately, the state-led aid industry not only neglects the realities of development, but often takes actions that actively undermine it. For First World countries, development does not mean allowing other societies to go through the same messy process they did themselves. It entails top-down planning and grandiose promises that – this time – their plans will end poverty and suffering for good. Just consider the $9bn (£5.9bn) pledged to Haiti following its 2010 earthquake. Only a small portion was delivered, and even that has proven ineffective. Haiti’s President Michel Martelly recently concluded that aid “isn’t showing results”.

There are two reasons why state-provided aid cannot create society-wide prosperity. First, policymakers do not have access to the knowledge needed to allocate scarce resources to their best uses. In his critique of socialism in the 1930s and 1940s, Nobel Laureate Friedrich Hayek made this exact point, noting that even the most qualified and benevolent planners lack the knowledge to produce even the most basic items in a cost-effective manner.

Investor Thomas Thwaites recently embarked on a fascinating endeavour, the Toaster Project, which illustrates Hayek’s point. Thwaites tried to build a simple toaster from scratch. He quickly found the task was overly complex, involving hundreds of parts and materials from many locations. After much travel and effort to extract and process these materials, he constructed his (extremely ugly) toaster. Upon being plugged into an electric socket, it burned out within seconds. Thwaites realised that “the scale of industry involved in making a toaster is ridiculous, but at the same time the chain of discoveries and small technological developments that occurred along the way make it entirely reasonable.” No central planner determined the process, yet toasters are readily available. This is economic development.

The perverse incentives associated with aid are a second reason governments can’t create development. These exist both within the recipient and donor governments. For recipients, aid creates the incentive for already dysfunctional governments to remain ineffective. A cross-country study by Stephen Knack of the World Bank found that foreign assistance undermines the quality of political institutions in recipient countries through weakened accountability of political actors, more corruption, greater chances of conflict, and a weakening of the incentive to reform inefficient institutions and policies.

For donors, government agencies tend to focus on spending money as quickly as possible on observable outputs to signal their importance and the need for more money. In the absence of clear lines of accountability, money is often wasted. Consider that a recent report by the Special Inspector General for the Iraq Reconstruction (SIGIR) identified $8bn in funds that were either wasted or unaccounted for. When people are not held responsible for their actions, they tend to act carelessly. Aid efforts are plagued by similar issues.

Economic freedom, which requires general protections of person and property, avoids both of these problems. It does not fall prey to the knowledge problem that Hayek warned of because it recognises that attempting to micromanage economic outcomes is doomed to fail. Likewise, it avoids creating perverse incentives because it limits direct political interventions into voluntary interaction between people.

What can be done? Instead of looking to fix other societies, developed nations should focus on their own policies towards people living elsewhere. As the Toaster Project illustrates, increasing the extent of the market is the best means of delivering more and cheaper goods and services. If the desired end is to help the worst off, this provides a benchmark for judging policies: does it contribute to increasing the extent of the voluntary market? If the answer is “yes”, those policies will be most effective at improving living standards and removing suffering.

Renewable-Energy Subsidies and Electricity Generation

Veronique de Rugy — Wed, 22 May 2013 13:17:21 -0400

Publication

This chart uses data from the US Energy Information Administration to compare federal investments in green energy and the share of green energy in electricity generation.

Wind energy receives the lion’s share of renewable-energy grants. The industry has received nearly $30 billion in federal subsidies and cash grants over the past 35 years, and Washington has promised another $12 billion in subsidies in the next decade.

Among the specific fuels and technologies, wind plants received the largest share of direct federal subsidies and support in fiscal year 2010, accounting for 42 percent of total electricity-related subsidies. From 2000 to 2010, federal wind subsidies grew by an average of 32 percent per year while subsidies for other energy sources remained relatively flat. Between fiscal years 2007 and 2010, annual wind subsidies grew from $476 million to nearly $5 billion almost tenfold.

While the data of the full amount of subsidies is not available, as of March 21, 2013 DOE’s 1603 program funded $18.2 billion in cash grants for renewable energy projects. Furthermore, according to the National Renewable Energy Laboratory, the wind industry has received $8.4 billion in subsidies through May 2012.

Wind energy is subsidized through dozens of different federal credits, grants, and loan guarantees. These programs give wind producers significant pricing advantages over other, more reliable sources of energy. Despite this advantage and the extraordinary federal investments in wind energy, wind energy produced only four percent of the entire US electricity generation in 2012, coming in a distant fifth place behind coal, nuclear, natural gas, and hydropower.

Taxpayers should not be forced to shell out billions of dollars on subsidies for such a low-value energy generator that has already been heavily subsidized for 35 years.

Data note: electricity generation data from the EIA were updated in May 2013; subsidy data were not. Therefore, we use the 2010 figures in order to compare total subsidies, support received, and share in total generation. Solar provided 0.02 percent of total electricity generation in 2010.

Current Good Manufacturing Practice and Hazard Analysis and Risk-Based Preventive Controls for Human Food

Michael L. Marlow — Mon, 20 May 2013 17:09:27 -0400

Publication

Introduction

The Regulatory Studies Program of the Mercatus Center at George Mason University is dedicated to advancing knowledge about the economic effects of regulation on society. As part of its mission, the program conducts careful and independent analyses that employ contemporary economic scholarship to assess rulemaking proposals and their effects on the economic opportunities and the social well-being available to all members of American society.

This comment addresses the efficiency and efficacy of this proposed rule from an economic point of view. Specifically, it examines how the proposed rule may be improved by more closely examining the societal goals the rule intends to achieve and whether the proposed regulation will successfully achieve those goals. In many instances, regulations can be substantially improved by choosing more effective regulatory options or more carefully assessing the actual societal problem.

Summary

The proposed rule revises the FDA’s current good manufacturing practice (CGMP) regulations regarding the manufacturing, processing, packing, or holding of human food in two ways. First, it adds preventive controls provisions as required by the FDA Food Safety Modernization Act (FSMA) that generally apply to facilities under the FDA’s current food facility registration regulations. It includes requirements for covered facilities to maintain a food safety plan, perform a hazard analysis, institute preventive controls for the mitigation of those hazards, monitor their controls, verify that they are effective, take any appropriate corrective actions, and maintain records documenting these actions. Second, the proposed rule updates, revises, or otherwise clarifies certain requirements of CGMP regulations, which were last updated in 1986. The FDA states that the primary benefit of this rule would be a decrease in the expected incidence of illnesses caused by the manufacturing, processing, packing or holding practices of human food.

My comment argues that the FDA has failed to conduct a thorough and quantitative analysis. The FDA admits it is unable to quantify health benefits derived from this rule. Instead, the FDA has developed a qualitative assessment that describes how implementing this rule would likely reduce the level of foodborne illness. The FDA estimates the “breakeven illness percentage” for each of three closely related regulatory options that are not developed within a model of optimal food safety. The FDA thus does not conduct an in-depth benefit-cost analysis of this major revision of our nation’s food safety regulations.

This rule is a Hazard Analysis Critical Control Point (HACCP) rule without calling it that. The FDA has two HACCP rules in place for seafood and juice that, by now, should have generated ample evidence as to how well these two rules have reduced the rate of foodborne disease. The most logical one to study is rule for seafood, as the FDA promised in the final rule to analyze it and determine if it had been effective, whereas the juice rule primarily moved raw fruit juice producers to either pasteurize their products or go out of business. The analysis for the seafood rule has not been done, but it should be done before implementing HACCP for all other foods under FDA’s jurisdiction. The measure of the seafood HACCP program’s success would be the first indicator of the likely effectiveness of this program for other foods.

Even before that the FDA needs a baseline risk assessment that attributes different pathogens and other contaminants both to specific food categories as well as to failures at the processing level, failures that this proposed rule is intended to address.

Finally, the FDA needs to consider a wider set of alternatives within a model of an optimal level of food safety that can be quantitatively assessed through conventional benefit-cost analysis.

Standards for the Growing, Harvesting, Packing, and Holding of Produce for Human Consumption

Michael L. Marlow — Mon, 20 May 2013 17:00:56 -0400

Publication

Introduction

The Regulatory Studies Program of the Mercatus Center at George Mason University is dedicated to advancing knowledge about the effects of regulation on society. As part of its mission, the program conducts careful and independent analyses that employ contemporary economic scholarship to assess rulemaking proposals and their effects on the economic opportunities and the social well-being available to all members of American society.

This comment addresses the efficiency and efficacy of this proposed rule from an economic point of view. Specifically, it examines how the proposed rule may be improved by more closely examining the societal goals the rule intends to achieve and whether this proposed regulation will successfully achieve those goals. In many instances, regulations can be substantially improved by choosing more effective regulatory options or more carefully assessing the actual societal problem.

Summary

The proposed regulation is designed to meet Section 105(a) of the FDA Food Safety and Modernization Act (FSMA) requirement that “not later than 1 year after enactment, the Secretary . . . shall publish a notice of proposed rulemaking to establish science-based minimum standards for the safe production and harvesting of those types of fruits and vegetables, including specific mixes or categories of fruits and vegetables, that are raw agricultural commodities for which the Secretary has determined that such standards minimize the risk of serious adverse health consequences or death.”

The FDA argues that the proposed rule would establish science-based minimum standards for the safe growing, harvesting, packing, and holding of produce on farms. It would address microbiological risks from all agricultural inputs (people, agricultural water, biological soil amendments, and tools and equipment), from unsanitary conditions in buildings, and from contact with wild and domesticated animals during growing, harvesting, packing, and holding activities of covered produce, including sprouts intended for human consumption. The primary benefit of the provisions in this rule is an expected decrease in the incidence of illnesses relating microbial contamination of produce.

I argue that the FDA needs to conduct a more comprehensive analysis. There is insufficient effort to establish the current state of food safety practices and little to no connection is made between those practices and public health. The FDA has not even presented a careful economic modeling of what an optimal set of rules for food safety practices would look like. Rather, the FDA wants to impose a “shotgun” approach on all covered foods rather than one that focuses on those foods or farms that pose the greatest risks. The FDA has acknowledged that it is required by law, by the Food Safety Modernization Act, to pass these standards. However, it is also required by OMB guidelines to analyze options that are not currently legal so as to inform the President and Congress when there are more efficient ways of solving a particular social problem than Congress had envisioned. The FDA should rethink its proposed regulation since there is little to suggest that it is the most efficient or effective option to improve public health.

The Hidden Costs of Tax Compliance

Jason J. Fichtner, Jacob Feldman — Thu, 23 May 2013 13:08:09 -0400

Publication

Washington has long employed the tax code for purposes extending beyond collecting revenue to fund the federal government. Lawmakers use special provisions inserted in the code to advance objectives ranging from increasing “fairness” to granting competitive advantage to favored businesses or industries.

The price of riddling the tax code with special provisions is, however, far higher than the revenue lost from the tax breaks themselves. The true cost of tax compliance also exceeds the obvious time and money expended on tax preparation.

A new study published by the Mercatus Center at George Mason University surveys the current economic literature to document the hidden costs of the US tax system. Beyond accounting costs, the study takes a broad look at other hidden costs and implications of taxation: lobbying to gain and maintain tax advantages; economy-wide costs as tax incentives alter work, leisure, savings, consumption, production, and investments; and lost revenues as a result of taxpayer noncompliance.

The study finds that Americans face up to nearly $1 trillion annually in hidden tax-compliance costs, while the Treasury forgoes approximately $450 billion per year in unreported taxes.

Below is a brief summary. To read the study in its entirety and learn more about the study’s authors, please see “The Hidden Costs of Tax Compliance.”

KEY POINTS

According to the National Taxpayer Advocate, there were 4,428 changes to the Internal Revenue Code between 2001 and 2010, including an estimated 579 changes in 2010 alone. The tax code averages more than one change per day. The resulting complexity creates hidden compliance costs between $215 billion and $987 billion annually. To put this in perspective, total revenue collected by the federal government in 2012 was $2.5 trillion.

Accounting Costs

Americans spend an estimated between $67 billion and $378 billion annually in accounting costs related to filing taxes. Americans spent more than 6 billion hours (2011) complying with the tax code. This represents an annual workforce of 3.4 million—a population that could be the third largest city in the United States, surpassing Chicago (2,707,120), Houston (2,145,146), and Philadelphia (1,536,471), and larger than the population of 21 states. A workforce equivalent to that employed by the four largest US companies—Walmart, IBM, McDonald’s and Target—combined.

Economic Costs

The impact of taxes on the economy extends beyond the revenue taken by the government. The compliance burden results in estimates of foregone economic growth from $148 billion to $609 billion annually.

Lobbying Costs

While an estimate for tax lobbying specifically, is not available, lobbyists spent nearly $28 billion petitioning federal, state, and local governments for policy preferences between 2002 and 2011.

Lost Revenue

The United States has a tax-reporting compliance rate of 85.5 percent—leaving a 2012 revenue gap of $452 billion in unreported taxes, some of which is can be attributed to complexities in the tax code.

SUMMARY

Accounting Expenses and Economic Distortions

In 2011, there were 173 different tax deductions and credits for individuals and corporations that amounted to around 7 percent of GDP. The economic costs of these tax provisions and marginal rates are estimated between $148 billion and $609 billion.

Itemized Deductions:

Nearly one-third US taxpayers itemize specific tax deductions. This increases the costs of filing taxes, and distorts prices of goods and services ranging from homes to medical care.
In a 2011 study (using 2006 tax data), the IRS estimated individuals spent more than 3 billion hours complying with personal deductions.
The IRS also estimated businesses spent nearly 3 billion hours complying with deductions.

Corporate Tax Code:

The deductibility of interest payments also provides incentives for companies to load up on debt, rather than issue stock, to finance new business ventures.
Larger companies possess the resources and scale to more easily comply with a complicated depreciation schedule for capital investments than smaller companies. Further, while recent changes to the depreciation schedule under the American Taxpayer Relief Act provides more favorable treatment to both small and large firms, the provision favors capital intensive firms over those that are more labor intensive.

Tax Avoidance

Tax avoidance occurs when individuals or businesses adjust consumption and savings patterns in order to reduce tax burdens. This results in forgone economic transactions—or “deadweight loss”—that would have increased standards of living: the vacation not taken, the food not purchased, and so on. Estimates of this foregone invest- ment and consumption range from $148 billion to $609 billion.

Gaining and Protecting Current Tax Advantages

Lobbyists spent more than $27 billion to petition federal, state and local governments between 2002 and 2011. While not all of this lobbying was related to obtaining and protecting tax advantages, research confirms a strong relationship between lobbying expenditures and changes in tax policy.

A 2009 study found:

Each additional dollar spent on lobbying translated into $6 to $20 of tax benefits.
Firms that increase lobbying expenditures by one percent reduce their effective tax rates by an amount in the range of 0.5 to 1.6 percentage points the following year.

Complying with Complexity—The IRS

According to the National Taxpayer Advocate—part of the Internal Revenue Service—the IRS itself cannot meet the needs of taxpayers who attempt to contact the agency.

Of the 115 million phone calls the IRS received in fiscal year 2012, it was only able to answer (actually pick-up) 68 percent of the calls, down from an 87-percent pickup rate in 2004.
The IRS also failed to respond to almost half (48 percent) of all taxpayer letters within the agency’s own established time frame—a dramatic increase from the 12 percent rate in 2004.
The US Treasury Inspector General’s semiannual report to Congress (2011) found that most taxpayers who contact the IRS do not receive quality responses to their correspondence. It cited
a review of three IRS functions—the Accounts Management function, Automated Underreporter Program, and Field Assistance Office—where 19 percent, 56 percent and 8 percent, respectively, of correspondents received both timely and accurate responses.

POLICY RECOMMENDATIONS

US history and international reform can guide legislators to reduce the staggering compliance costs of the overly complex tax code. Reform must significantly reduce or eliminate special tax provisions and lower rates. A simplified tax code will yield a more equitable, higher-performance economy with more federal revenues while reducing economic and accounting burdens.

The Tax Reform Act of 1986 was passed with significant bipartisan support and was the first tax reform in US his- tory to replace a significant number of tax expenditures by lower tax rates on individuals. Federal Reserve Bank economist Anil Kumar found (2007) that TRA86 reduced deadweight losses as a percentage of taxes by 6 percent. Studies estimate that US revenue lost from individual and corporate overseas tax evasion alone is between $50 billion and $130 billion.