Peter Orszag’s Second Term Tax Reform Scenario

Ryan Lizza’s report on the agenda President Obama and his closest advisors might pursue in a second term has already sparked a great deal of commentary. My latest column for The Daily, for example, argues that the president is operating under the potentially dangerous misapprehension that his views on immigration, climate change, and campaign finance regulation aren’t contested by serious and knowledgeable people. While there are issues on which the Obama White House is closer to centrist public opinion, e.g., taxes, than the GOP, there are many others on which Republicans are arguably closer to the mark, including energy policy. 

But perhaps the best companion piece is Peter Orszag’s new essay in Democracy Journal, the timing of which is almost certainly coincidental. Orszag, who has long championed the expiration of all of the Bush-era tax cuts (and indeed, who seems to have persuaded President Obama of the merits of expiration, per Noam Scheiber’s indispensable The Escape Artists). Orszag starts from the premise that the president is reelected and Republicans once again secure a majority in the House. Orszag then argues that if President Obama fails to secure agreement on allowing only the high-income rate reductions to expire, the White House should call Republicans on their bluff. This comports with Lizza’s reporting, e.g.:

Several White House officials I talked to made it clear that if a deal, or at least the framework for a deal, is not reached before December 31st Obama would allow all the Bush tax cuts to expire—a tactic that would achieve huge deficit reduction, but in a particularly painful and ill-conceived fashion. The Administration is preparing for that outcome, and Republicans may not be willing to budge without the threat of this cataclysm. Plouffe said, “I think we’re going to have the ability to tell the American people, ‘Hey, your taxes may go up on January 1st because these guys refuse to ask the wealthy to do anything. Hey, there are going to be cuts in spending that aren’t done as smartly as they could because these guys won’t agree to ask anything from the wealthy.’ ”

One gets the impression that the White House officials in question are actually eager for this prospect, perhaps because it will demonstrate spine that was lacking during earlier budget negotiations with House Republicans. Orszag has a different reason for favoring this scenario, namely that it is more likely to yield significant revenue increases and (perhaps) a somewhat more politically stable tax settlement:

One path through this brick wall for the Administration would be to allow all the tax cuts to expire and thereby escape the intractable debate over those extensions. In the cacophony that follows, the Administration could then come back in early 2013 with a tax-reform proposal that reduces taxes (compared to the level with the expired tax cuts) disproportionately for middle- and low-income families. If the tax cuts are designed to be universal, even if they are much more progressive than the Bush tax cuts, it would presumably be harder for Republicans to vote against them. One example of this strategy would be to combine a much larger payroll-tax holiday with an increase in the standard deduction. This would provide a substantial tax cut for everyone who works, but the effect would be progressive since payroll taxes represent a larger share of income for low- and middle-income workers than for high-income workers. As with the structure in place for the current payroll tax cut, general revenue would backfill the Social Security and Medicare Part A trust funds, so that the programs would not be harmed by the tax cut.

The problem with simply cutting payroll taxes is that it leaves out nonworkers, like the elderly. Therefore the second component of this proposal would raise the standard deduction, which is claimed by almost two-thirds of elderly filers. This component would also be progressive, since almost all high-income taxpayers itemize their deductions and therefore would not benefit from an increase in the standard deduction, and it would simplify the tax code by removing the need to itemize for more taxpayers.

The Social Security payroll tax cut would be designed minimize short-term fiscal contraction, and Orszag’s ideal is that it would be temporary. The increase in the standard deduction would be permanent, as would a tweak to tax expenditures:

Many deductions are intended to promote socially beneficial activities, such as saving for retirement, purchasing health care, or owning a home. Yet with a deduction or exclusion approach, the tax benefit from spending $1 on one of these activities depends on the person’s marginal tax bracket. A person in the 15 percent marginal tax bracket who spends $1 on mortgage interest, for example, enjoys a 15-cent tax reduction from doing so; a person in the 35 percent marginal bracket enjoys a 35-cent tax cut for that same $1 in mortgage interest paid. This structure makes little sense from either a fairness or an efficiency perspective (as Lily Batchelder, Fred Goldberg, and I have argued in a Stanford Law Review article). A better approach would be to give each of these taxpayers, say, a 20-cent tax credit for each $1 in mortgage interest paid. Adopting this type of progressive approach to itemized deductions may require adding some less desirable policy—such as a second round of a corporate tax holiday on repatriated profits—to make the overall package legislatively feasible.

As ungainly as this proposal sounds, it might be the most politically feasible way to reform tax expenditures, though the complementary Feldstein-Feenberg-MacGuineas approach (which caps individual tax expenditures to 2 percent of adjusted gross income) also has its virtues. Thomas P. Miller of the American Enterprise Institute has also endorsed fixed-percentage tax credits.

Suffice it to say, the tax code that would result from Orszag’s playbook wouldn’t be nearly as conducive to growth as the X tax advocated by Robert Carroll and Alan Viard in Progressive Consumption Taxation, yet it would in many respects represent an improvement over the status quo. 

I’d like to see a rigorous effort to think through how a Romney victory might shape this landscape. Would President Obama allow another temporary extension of the Bush-era tax cuts or would he force expiration? And how might a Romney administration navigate the tax question in office? Much depends on the composition of the House and Senate, obviously. I think that something like the Orszag scenario might be as politically beneficial for a President Romney as it would be for a President Obama, as it would give him more flexibility to pursue a more ambitious restructuring of the tax system.

Reihan Salam — Reihan Salam is executive editor of National Review and a National Review Institute policy fellow.

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