Daily Archives: September 17, 2012

One of the few issues on which Barack Obama and Mitt Romney agree is the need for tax reform. Since the last overhaul in 1986, loophole after loophole has been added, producing a tax system that is complex, unfair, inefficient and detrimental to growth. Today, tax reform must also address three major challenges: escalating federal debt, rising income inequality and intensifying global competition.

Addressing the long-run deficit and stabilising the debt will require more revenue. Even after the economy recovers, current tax policies will not generate enough revenue to cover future spending on social security, health, defence and debt interest, let alone basic government operations and investments. In 2012, federal tax revenues are likely to be less than 16 per cent of gross domestic product, compared with an average of more than 18 per cent in the 20 years before the crisis hit in 2008.


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When the US economy is operating near capacity, total tax revenues – federal, state and local – are much smaller as a share of GDP than in other developed countries. And there is scant evidence that taxes as a share of GDP and economic growth are negatively correlated. Indeed, there is a small positive correlation between income per capita and tax revenue as a share of GDP.

Special tax rates and allowances are a major reason why tax revenues are comparatively low in the US. So-called tax expenditures amount to about 7 per cent of GDP; more than what the federal government spends individually on defence, health and social security. Reducing the number and limiting the size of tax expenditures would simplify the tax code, remove distorting incentives and raise revenue. Mr Obama proposes to use some of the revenue from reforming tax expenditures for deficit reduction; Mr Romney would use all of it to cut tax rates, with disproportionate benefits to high-income taxpayers.

But tax reform should not come at the expense of progressivity. Income inequality is greater in the US than in the other developed countries of the OECD. The US tax system is considerably less progressive than it was a few decades ago and it does less to counteract pre-tax income inequality than other OECD systems.

Widening inequality is reflected in opportunity gaps between children born into different income groups and a decline in intergenerational mobility: an American child’s future income is more dependent on his or her parents’ income than in most other OECD nations. Mr Obama’s plan counters these trends. The Romney-Ryan plan exacerbates them.

Proponents of greater progressivity often call for an increase in corporate taxes but this would lead to slower growth and fewer jobs. The US has the highest statutory corporate tax rate in the developed world. Even after tax expenditures are included, its effective marginal corporate tax rate is one of the highest in the world. Business decisions about where to locate investments are responsive to differences in taxes and have become more sensitive over time. Of all taxes, corporate income taxes do the most harm to economic growth.

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Both Mr Obama and Mr Romney advocate corporate tax reform that lowers the rate and broadens the base. The economic benefits could be significant. The current system has large unjustifiable differences in effective tax rates that influence business choices about what to invest in, how to finance an investment, where to produce and even what form of organisation to adopt. These differences distort capital allocation, add complexity, increase compliance costs and reduce corporate tax revenues.

A lower rate would stimulate investment, narrow the tax preference for debt over equity financing and weaken the incentives for international companies to move production to lower-tax locations. But lowering the corporate tax rate is expensive – each percentage point reduction would cut revenues by about $120bn over 10 years. Scaling back the three largest corporate tax expenditures to pay for a cut could increase the cost of capital, thereby reducing investment and growth.

A more efficient and progressive way to pay for a lower corporate tax rate would be to increase taxes on dividends and capital gains. This would shift more of the burden towards capital owners and away from labour, which bears the burden in the form of fewer jobs and lower wages. Mr Obama proposes to raise rates on capital gains and dividends for the top 2 per cent of taxpayers. Most capital gains and dividends go to this group. Mr Romney would leave these rates unchanged for this group.

The US economy needs efficient and progressive tax reform and it needs more revenues for deficit reduction. Revenue increases have been a significant component of all major deficit-reduction packages enacted over the past 30 years. This must be the case now, too. Additional revenues as part of a credible long-run deficit-reduction plan and supported by progressive tax reforms will boost economic growth and job creation.

The writer is a professor at the Haas School of Business at the University of California at Berkeley and former chair of the Council of Economic Advisers under President Bill Clinton

Eurozone leaders have decided to create a banking union to help break the vicious circle between banking fragility and state insolvency. This is a bold move and an adequate response to the growing financial fragmentation of the European currency area. Last week the European Commission tabled its proposals for a single supervisory mechanism. Discussions on concrete proposals will start soon. They are bound to be highly complex, technical and controversial, because mistrust prevails and because participant countries hold very different views. However, it is important they succeed, so here is our five-point guide for the negotiators.

1. Be comprehensive. A true banking union must involve supervision, as currently discussed, but also resolution – how to wind-down ailing institutions – and access to a common fiscal backstop. The three go together. Common supervision without any kind of fiscal backstop would ultimately mean that national taxpayers have to pay for the failures of the European Central Bank supervisor. A common fiscal backstop without common resolution would also be a recipe for conflict as national resolution authorities would have every incentive of shifting costs on to the European taxpayer instead of “bailing in” the banks’ creditors. Having one element missing or poorly designed would undermine the whole. As for the space shuttle Challenger that exploded because of a tiny O-ring seal failure in the right rocket, banking union would be as effective as its weakest component. Indeed, getting even a small part wrong may undermine the effectiveness of an entire endeavour.

2. Don’t confuse legacy issues with permanent ones. Banking ailments are daunting, but banking union is not meant to be a hospital. It should be introduced for banks healthy enough to have passed a robust screening. The costs of bad bank debt should be left to those that have been primarily responsible for them, ie creditors and national supervisors. The only exception should be for cases where government solvency is endangered. In such cases, partner countries will probably be affected one way or another and it is advisable to proceed with direct recapitalisation by a European institution. Again, this would require having at least the beginnings of the respective European supervisory and resolution tools at hand.

3. Dont get distracted. Banking systems in Europe are heterogeneous. France has basically only systemic banks whereas the German system includes Deutsche Bank, a world-class institution, and a myriad of small local saving banks. Germany has six deposit insurance schemes. An attempt to merge deposit guarantee schemes is bound to consume considerable time and political capital, for very limited benefits.

4. Plan for the worst. Good resolution policy aims at minimising costs to taxpayers while at the same time preserving economic and financial stability. Measured bail-ins of creditors and bank closures are crucial in this regard. Yet, historical evidence shows that major banking crises involve substantial fiscal costs: in one-third of all crises in advanced economies, the direct cost to the budget exceeded 10 per cent of gross domestic product. Leaving such fiscal costs exclusively to the national taxpayers would risk undermining sovereign solvency. The currently observed financial and real economic disintegration is the consequence. To complete the banking union, it is therefore indispensable to agree on fiscal burden-sharing.

5. Get the incentives right. The organisation of a common fiscal backstop raises important questions about potential distributional biases, moral hazard and contributions to the insurance pool. The design of the system should ensure that incentives are set right. This means that national taxpayers should be always involved but it also means that burden-sharing arrangements need to be made before the cost occurs. Relying on constructive ambiguity would be the wrong approach as it would not be credible in case of a crisis. The fiscal backstop thus needs to be designed with a strong institutional set-up that is robust to withstand major crises. Different options for a fiscal backstop can be envisaged. A European resolution fund financed by contributions from the financial industry would have major advantages but would unlikely have sufficient funds for the next 10 years. The European Stability Mechanism could also serve as a fiscal backstop. While insufficient in case of a dramatic banking crisis, it has the advantage of a strong governance structure. In the long-run, contingent European taxation power with appropriate democratic legitimacy should be envisaged.

Banking union is an essential piece of Europe’s plan to ward off the fragmentation of the eurozone. It can be built step-by-step but cannot be left unfinished.

This post was co-authored by Guntram B. Wolff and draws on the authors’ recent report, The Fiscal Implications of a Banking Union, Bruegel Policy Brief No 2012/02.

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