-17-

pensions are taxed under consumption tax principles: an
exclusion is allowed for contributions, no tax is imposed on
accruing earnings, and all proceeds are taxed when
distributed. Such treatment allows tax-free accrual of
returns and is more favorable than the tax treatment allowed
under income tax principals. Limiting the exclusion would
make saving for retirement more expensive; the net effect on
the amount of saving is uncertain because of competing
substitution and income effects. If saving for retirement is
reduced by the proposal, then the Government may be induced
to increase payments to future elderly generations, which
would require additional outlays.

In general, lower-income individuals receive fewer
health and pension benefits than do high-income individuals.
Limitations on the benefits may thus increase progressivity.



-1ll-

generational accounting has estimated that future generations
will pay 79 percent more in taxes (net of transfers) than the
generation of people who have just been born.

Do deficits matter?

Even if there is no crowding out in the credit markets,
some economists believe that increases in deficits do not
matter to the aggregate economy. According to this school of
thought, changes in fiscal policy provide no net stimulus
because individuals receiving a tax cut or the income from
increased government expenditures recognize that additional
disposable income realized today will be offset by tax
increases in the future that wil} be assessed to support the
current increase in the deficit.!7 For example, it is widely
believed that consumption is a function of consumers' wealth,
which includes the current value of assets net of debt
obligations plus the present value of future after-tax
earnings. Because cuts in capital taxes increase the value of
capital and cuts in wage taxes increase the present value of
future earnings, tax cuts, especially permanent tax cuts, are
believed to increase wealth and therefore increase
consumption. However, many economists would argue that wealth
is really not increased when increased future tax obligations
(necessary to fund the current debt) are taken into account.

It may be improbable that all consumers fully take into
account increased future tax obligations that result from an
increase in the current government deficit. However, it does
seem plausible that an increase in personal wealth resulting
from a tax cut financed by an increase in public debt is less
stimulative than a real increase in wealth resuiting from

16 his calculation combines the taxes and transfers of all
levels of government, not solely the Federal Government.
See, President of the United States, Budget of the United
states Government, Fiscal Year 1993.

17 Chis proposition is known as the “Ricardian equivalence"
theorem. For more discussion, see Robert Barro, "Are
Government Bonds Net Wealth?" Journal of Political Economy,
vol. 82, November-December 1974. Ricardian equivalence does
not necessarily hold in an economy where consumers and
businesses are unable to obtain sufficient credit to meet
their demands. In that case, when the government borrows to
put cash in the hands of its citizens through lower taxes or
increased spending it is, in effect, borrowing on their
behalf. Accordingly, government borrowing may have some
impact on output even though consumers perceive the future
tax liability because in effect they get a loan for
consumption through the government that they would not
otherwise be able to obtain at the same cost.



-21-

D. Reduce Deductibility of Business Meals and Entertainment

The proposal would allow taxpayers to deduct only 50
percent of the cost of meals and entertainment expenses
incurred in connection with business activity. The proposal
would be effective for taxable years beginning after December
31, 1992.

Revenue effects (billions of dollars)

1993 1994 1995 1996 1997 1993-97

Reduce deduction

for business meals

and entertainment

to 50 percent 1.6 3.4 3.4 3.5 3.6 15.5

Under present law, taxpayers may deduct 80 percent of
the cost of meals and entertainment expenses incurred in
connection with business activity.

Businesses are allowed to deduct from gross income the
ordinary and necessary expenses of generating such income.
To the extent that some part of the expenditure on business
meals and entertainment represents consumption and not a cost
of generating income, the deduction should be limited. There
is not, however, a clear delineation of what fraction of such
expenditures represent consumption.



-3-
I. THE DEFICIT

During the past two decades large Federal budget
deficits have become a central feature of public finance as
practiced in the United States. Numerous commentators have
warned of the dirg long-term economic consequences of chronic
Federal deficits. Such widespread concern has drawn the
attention of many policymakers. Virtually all agree that the
problem of a large Federal deficit will not succumb to a
simple solution. Rather, a concerted effort by citizens and
their elected officials is needed in order to grapple with a
deficit that exceeds $350 billion (over $1400 for every
United States resident) in fiscal year 1992. The deficits
have increased the national debt. The total interest bearing
debt of the Federal government outstanding at the end of 1991
was approximately $3.8 trillion, or more than $15,000 per
capita. A concerted effort to reduce the size of the deficit
may require additional revenues and/or reductions in
expenditures at the Federal level.

Federal deficit

The Federal deficit for the 1991 fiscal year totaled
$268.7 billion and is estimated to be in exgess of $300
billion for the 1992 and 1993 fiscal years. Por 1991, this
figure represented more than g-5 percent of the nation's
gross domestic product (GDP). The projected deficits for

3 a sampling of these writings include: Richard Darman,
"Director's Introduction," in President of the United States,
Office of Management and Budget, Budget of the United States
Government, Fiscal Year 1993, January 1992; Congressional
Budget Office, Reducing the Deficit: Spending and Revenue
Options, February 1992; General Accounting Office, Budget
Policy: Prompt Action Necessary to Avert Long-term Damage to
the Economy, May 1992; and Joint Committee on Taxation, Tax
Policy and the Macroeconomy: Stabilization, Growth, and
Income Distribution (JCS-18-91), December 12, 1991.

4 President of the United States, Office of Management and
Budget, Budget of the United States Government, Fiscal Year
1993, January 1992. See, also, Congressional Budget Office,
Analysis of the President's Budgetary Proposals for Fiscal
Year 1993, March 1992. The Congressional Budget Office (CBO)
estimates the budget deficit to be $368 billion for fiscal
year 1992 and $336 billion for fiscal year 1992.

5 Gross Domestic Product (GDP) of a country is the value of

all marketed goods and services produced in that country.

Gross National Product (GNP) is GDP plus the net factor

income received by residents of that country from abroad.
(Footnote continued)



-18-

B. Limit Home Mortgage Interest Deduction

The proposal would alternatively eliminate the deduction
for mortgage interest (including home equity loans) or reduce
the maximum amount of home mortgage indebtedness that
qualifies for interest deduction to $300,000. Under the
latter aiternative, there would be no grandfathering of
existing mortgages. The proposal would be effective for
taxable years beginning after December 31, 1992.

Revenue effects (billions of dollars)

1993 1994 1995 1996 1997 1993-97

Eliminate mortgage
interest deductions 31.0 52.8 54.7 56.6 58.6 253.6

$300,000 limit

on home mortgage

indebtedness that

qualifies for

interest deductions 1.0 2.6 3.2 3.7 4.2 14.7

Under present law, taxpayers who choose to itemize
deductions may claim a deduction for interest paid on home
mortgage and home equity indebtedness. The amount of home
mortgage indebtedness that may qualify for interest
deductions is limited to $1,000,000. The amount of home
equity interest that may qualify for interest deductions is
limited to the lesser of $100,000 or the amount of equity in
the house.

To the extent that the deductibility of mortgage
interest subsidizes owner-occupied housing, this proposal
reduces the subsidy. This reduction in the subsidy could
improve equity, since the value of the subsidy is larger for
those taxpayers in higher marginal tax brackets. Yet the
main subsidy to owner-occupied housing is not the
deductibility of mortgage interest but the absence of
taxation 98 the flow of housing services the house
provides. Under the proposal, this underlying benefit of

18 To illustrate this point, consider a taxpayer with
$80,000 in assets who wants to live in an $80,000 house.
Assume that the rate of return on all capital (including
housing) is 10 percent. The taxpayer has a choice of renting
an $80,000 house (for which the annual rent would be $8,000
(10 percent of the house's value)), buying an $80,000 house
for cash, or borrowing $80,000 (at 10 percent interest) in
(Footnote continued)



-24-

G. Re, 31 Percentage Depletion for Extractive Industries

Under present law, a specified percentage of a
property's gross income may be deducted in determining
taxable income, regardless of the actual capitalized costs of
the property. The proposal would eliminate the availability
of percentage depletion deductions for all extractive
industries, while retaining the availability of cost
depletion. The proposal would be effective for taxable years
beginning after December 31, 1992.

Revenue effects (billions of dollars)

1993 1994 1995 1996 1997 1993-97

Repeal percentage
depletion 0.5 0.9 1.0 1.0 1.0 4.5

Percentage depletion deduction is claimed when the
amount is larger than the deduction under cost depletion,
which permits a ratable deduction of the capitalized costs of
the property. In particular, percentage depletion deductions
are available for properties where the adjusted basis
(essentially the cost of the property less any depreciation
or depletion claimed) is small or zero. Thus, percentage
depletion deductions may result in a mismeasurement of net
income from a property. In the long run, the burden of any
tax increase resulting from this alternative would generally
fall on the owner of the mineral rights to the property,
since this would ordinarily be the least mobile factor of
production. In the short run, the burden of the tax may fall
on other parties (e.g., operators of the production facility,
workers in the production facility, consumers of the
product), since there may be fixed or contractual
relationships that cannot be altered in the short run.



-20-

Cc. Limit Benefits of Itemized Deductions to 15 Percent

The proposal would limit the benefit of itemized
deductions by in effect converting them into tax credits
equal to 15 percent of the amount of itemized deductions.
For taxpayers in the 15-percent marginal tax bracket, the
provision would result in no change from present law. For
taxpayers in higher marginal tax brackets, the value of the
itemized deductions would be reduced. The proposal would be
effective for taxable years beginning after December 31,
1992.

Revenue effects (billions of dollars)

1993 1994 1995 1996 1997 1993-97

Limit tax benefit

of itemized

deductions

to 15 percent 26.8 61.6 66.2 72.4 79.4 306.4

Taxpayers may claim either a standard deduction or
itemized deductions from adjusted gross income. The value of
itemized deductions to a taxpayer depends upon the taxpayer's
marginal tax rate. By limiting the benefit of itemized
deductions to 15 percent of the amount deducted, the proposal
would make the value of itemized deductions the same for all
taxpayers who choose to itemize.

The proposal may increase equity by allowing the same
value of itemized deductions to all taxpayers. But to the
extent that itemized deductions are allowed to reflect
reduced ability to pay (for example, in the case of medical
expenses), then the proposal would result in higher taxes for
those taxpayers less able to pay. Also, the proposal would
lead to income mismeasurement by reducing the value of
deductions such as those for casualty losses and
miscellaneous employee expenses.



-15-

B. Corporate Income Tax Rate Increases
Raise the top marginal income tax rate for corporations
from 34 percent to 35 percent, effective for taxable years
beginning after December 31, 1992.

Revenue effects (billions of dollars)

1993 1994 1995 1996 1997 1993-97

35-percent top
rate on corporate
taxable income 1.7 2.8 2.8 2.9 3.1 13.3

This tax rate increase would affect approximately 10
percent of corporate taxpayers; these corporations earn
approximately 90 percent of corporate taxable income. An
increase in the top corporate rate would increase the tax
difference between firms. that organize as corporations and
those that choose other organizational forms (e.g., sole
proprietorships, partnerships or subchapter S corporations).
This could provide a tax disincentive to organize as a
corporation, even when there are valid business reasons for
favoring the corporate form of organization. Moreover, this
increase could provide an incentive for existing investment
to shift from corporate form to other organizational forms.

Increasing the top tax rate on corporations might
increase the burden on investment activity done in the
corporate form. If this resulted in a reduced after-tax
return to these investments, fewer of these investments would
be made. This effect might lower overall output by reducing
investment.

To the extent the burden of a corporate income tax rate
increase is borne by the owners of corporate shares, this
proposal could result in a windfall loss to current
Shareholders. This would occur as the price of corporate
shares decreases to equate the after-tax rate of return to
these investments with the after-tax rate of return of
investments of comparable risk. To the extent the burden of
the corporate income tax is borne by all capital (rather than
ust corporate shares), there would be a similar windfall
loss to all owners of existing (or "old") capital.



-7-

investment projects less attractive and aggregate investment
falls as fewer investment projects are undertaken. Rates of
investment are important because when an economy's rate of
net investment (gross investment less depreciation)
increases, the economy's stock of capital increases. A
larger capital stock permits a fixed amount of labor to
produce more goods and services. The larger a country's
capital stock, the more productive its workers and generally,
the higher its real wages and salaries. Thus, increases in
investment tend to cause future increases in a nation's
standard of living. Many policy makers are concerned that
continued large deficits will continue the trend of low
growth of wages and per capita SDE experienced by the United
States for the past twenty years.

Effect on trade.--Besides the contractionary effects of
higher interest rates on consumer durables and investment
goods, higher interest rates may also have a negative effect
on net exports. Higher domestic interest rates attract
foreign investment which drives up the value of the dollar.
An appreciation of the dollar reduces the cost of imports to
U.S. residents and raises the price of U.S. exports in
foreign markets. As the price of imported goods falls
relative to domestically produced goods, United States
residents may substitute imported goods for domestically
produced goods to the detriment of trade sensitive
industries. If these price changes result in a reduction in
net exports (or an increase in net imports), there would be a
contraction in the aggregate demand for U.S. goods and
services.

Dearth of saving.--The effect on investment and on trade
is exacerbated by the low rate of saving in the United
States. Either domestic saving or borrowing from qbroad
funds private investment and government deficits.+ The
United States national saving rate is low when compared to
that of other developed nations.*~ With saving rates lower
and deficits larger than those that prevailed in the late

9 For more discussion of long-term economic performance,
see, Joint Committee on Taxation, Tax Policy and the
Macroeconomy: Stabilization, Growth, and Income Distribution
(JCS-18-91}, December 12, 1991.

19 For a more detailed discussion of saving, investment, and
foreign borrowing, see Joint Committee on Taxation, Factors
Affecting the International Competitiveness of the United
States (JCS-6-91), May 30, 1991.

11 gee Joint Committee on Taxation, Factors Affecting the
International Competitiveness of the United States, for more
data and discussion on this point.



-30-

imposed at equivalent rates based on alcohol content, since
the major types of alcoholic beverages often are substitutes
for each other.

In addition, the excise tax on alcoholic beverages could
be indexed for future inflation. This alternative proposal
is not reflected in the above revenue estimates.


-27-
B. Impose a Broad-Based Energy Tax

The proposal would impose a 5-percent ad valorem excise
tax on a broad class of energy purchases. Conceptually, this
tax would be a retail level tax on all consumption of energy
(e.g., coal, petroleum, natural gas, electricity). The tax
would apply to all energy purchases on or after October 1,
1992.

Revenue effects (billions of dollars)
1993 1994 1995 1996 1997 1993-97

5-percent ad

valorem tax on

all energy

consumption 13.4 16.6 17.4 18.2 19.0 84.6

A broad-based energy tax could be justified as
correcting the externality caused by the market price of
energy being below. its social cost (e.g., social costs due to
pollution caused by energy consumption). The proposed excise
tax would make energy purchases more costly in relative terms
than other types of consumption. This would encourage
conservation of all forms of energy, potentially limiting
emissions of carbon dioxide, often cited as a "greenhouse
gas". To the extent the tax is borne by firms that consume
energy in the production process, U.S. manufacturers may be
put at a competitive disadvantage relative to foreign firms
that operate in jurisdictions without such energy taxes.
Mitigating this potential effect, though, is the observation
that almost all other countries tax energy consumption more
heavily than does the United States.

Generally, it is believed that much of the burden of an
excise tax on energy consumption would be passed forward in
the form cf higher prices to consumers of energy. To the
extent that energy consumption increases less than
proportionately with income, this excise tax would be
regressive with respect to annual income. This larger
relative consumption of energy among lower-income individuals
could be the case if these individuals are unable to easily
shift to more energy-efficient heaters, automobiles, and/or
appliances. .

This excise tax could be imposed as a retail level tax
on all energy sales. Such a point of imposition would have
the beneficial effect of not altering relative prices for
different energy sources, thereby minimizing market
distortions. However, a retail level tax would entail many
more taxpayers being brought into the excise tax system than
if the tax were imposed at the producer level. In this case,
administrative costs must be weighed against efficiency costs
in choosing the point where the tax is levied.



6

-7

Percent

i
1970 1972

Department of Commerce,
Bureau of Economic Analysis

Figure 1
Federal Deficit as a Percentage
of Real GNP, 1970-1991

i | 1 as ra | rr

1974 1976 1978 1980 1982 1984 1986 1988

1
1990



-4-

1992 and 1993 are estimated to represent more than six
percept of GDP in 1992 and more than five percent of GOP in
1993. While deficits of $200 billion or more represent
large numbers, they are smaller in comparison to the size of
the economy than some previous deficits incurred by the
Federal Government. Figure 1 presents the Federal deficit as
a percentage of real gross national product (GNP) from 1970
through 1991. Relative to the size of the economy, the
deficit was larger from 1982 through 1987 than it is today.
During the World War II, the Federal deficit exceeded 20
percent of GNP. However, between the end of the World War II
and 1982, the Federal deficit only rarely exceeded 2.5
percent of GNP.

What does the deficit measure?

Overview.--The reported deficit measures the difference
between current year Federal receipts and outlays. This
measure has been subjected to criticisms on several grounds
by accountants, economists, budget analysts, and
policymakers. A common theme of the criticisms is that the
measured deficit is an inadequate guide for policymakers to
use in a number of situations and should not be relied upon
to the exclusion of all other measures. Below is a
nonexhaustive list of these criticisms.

Full-employment deficit.--Many observers argue that the
actual size of the Federal deficit provides an inaccurate
measure of government stimulus of aggregate demand. Even with
no change in government policy the size of the deficit will
change in a recession as the economic downturn reduces tax
revenues and increases counter cyclical spending (e.g.,
unemployment benefits). These observers argue that for
purposes of assessing macroeconomic policy, the_deficit
should be measured relative to full employment.’ For example,
a deficit of $100 billion when the economy is experiencing
eight percent unemployment might be reduced to $25 billion if

5 (continued)

Thus wages earned by a United States resident from temporary

work abroad constitutes part of GNP but not GDP. Similarly,

the returns from investment abroad constitute part of GNP but
not GDP. Empirically, the difference between GDP and GNP is

small for the United States.

6 Congressional Budget Office, Analysis of the President's
Budgetary Proposals for Fiscal Year 1993.

7 By full employment, economists do not mean an unemployment
rate of zero, but rather some larger number to reflect the
normal quitting and search process of labor markets. There is
debate about the "correct" measure of full employment for the
United States economy.


-16-
III. POSSIBLE INCOME TAX BASE BROADENING OPTIONS
A. Limit Individual Exclusion for Fringe Benefits

The proposal would limit the exclusion from gross income
for employer-provided health insurance to $335 per month for
family coverage and $135 per month for individual coverage
(these amounts are expressed in 1993 dollars and would be
indexed for inflation). In addition, the proposal would
limit the benefits payable under a defined benefit pension
plan to the Social Security wage base ($55,500 in 1992
dollars), with commensurate reductions in the limits on
contributions for defined contribution pension plans. The
proposal would be effective for years beginning after
December 31, 1992.

Revenue effects (billions of dollars)

1993 1994 1995 1996 1997 1993-97

Limit on exclusion
for employer-paid
health insurance 11.6 19.4 24.1 29.5 35.5 120.1

Decrease limits

on defined benefit

pension plans to the

Social Security wage

base (with commensurate

reduction for defined

contribution plans) 1.3 3.7 4.1 4.5 4.5 18.1

Under present law, amounts contributed by employers for
employee health and pension benefits generally are excluded
from the employee's gross income. The proposal would limit
the amount of health and pension benefits that may be
excluded.

Because the tax rate on health benefits is less than
that on cash wages, employees and employers have an incentive
to fashion compensation packages to include more health
benefits than they would if there were no difference in tax
treatment. An employee would prefer to be compensated with
heaith benefits as long as the value of a dollar of health
benefits is worth at least (1 - employee's marginal tax rate)
doliars in cash wages to the employee. This incentive for
overconsumption of health benefits could be reduced if the
value of an extra dollar of health benefits would be equal to
that of a dollar of cash wages.

The tax treatment of pension benefits creates a similar
bias in favor of compensation in =he form of pension
contributions. Subject to annual contribution limits,



RRRRE Ro errs

Foes

-6-

substantially reduced by inflation over the past two decades.
Similarly, the real value of mineral rights on Federai lands
has increased substantially. The reduction in the value of
the debt and the increase in the value of mineral rights are
like additional revenue to the government. In the case of
debt, the government will now require fewer real resources to
service the existing debt. In the case of mineral rights,
the government in the future could auction such rights for
greater revenues. To the extent that measures of current
receipts and outlays omit changes in values of assets, the
measured deficit need not tell policy makers anything about
the current net income position of the government.

Policy concerns relating to large deficits

Constraints on current expenditures

Some policymakers are concerned about the size of the
budget deficit because of the indirect effect it has on the
level of current government expenditures for goods and
services. By adding to the stock of the national debt, large
budget deficits increase required outlays to meet interest
expense on the national debt. If policy makers have agreed
to limit the size of aggregate government expenditures, an
increase in expenditures for interest reduces resources
available for other purposes.

Potential "crowding out" of the private sector in the
credit markets

Effect on investment and purchases of consumer
durables.--Federal government spending that is financed with
increased issuance of government bonds may increase the rate
of interest in the Treasury bond markets. This rise in the
Treasury bond rate in turn will raise rates for bonds issued
by corporations and State and local governments as well as
rates for consumer, mortgage, and business loans and may
cause the rationing of credit. Such a tightening of credit
markets can reduce business investment and personal
consumption expenditures. This especially may be true for
interest-sensitive sectors such as housing and consumer
durables and for capital goods purchased by businesses that
may have difficulty in obtaining credit. The Federal deficit
is said to “crowd out" private investment and consumption.

Alternatively stated, by raising real borrowing costs,
the cost of capital (the rate of return that investments must
earn to be profitable) is increased. This makes many

8 Robert Eisner and Paul J. Pieper, "How to Make Sense of
the Deficit," Public Interest, vol. 78, Winter 1985, pp.
101-118.


-22-
E. Include Capital Gains in the Last Tax Return at Death

Under present law, at the death of an individual who
holds appreciated capital assets the basis of such assets is
stepped up to the fair market value at the time of the death.
Thus heirs who later sell such assets are liable for tax only
on capital gains since the death of the previous holder. Any
capital gains on the asset prior to the death of the holder
are untaxed. The proposal would include the capital gains
prior to the death of the holder in the decedent's last tax
return. The proposal would be effective for taxable years
beginning after December 31, 1992.

Revenue effects (billions of dollars)

1993 1994 1995 1996 1997 1993-97

Tax capital gains
at death x 3.2 3.9 4.6 5.3 17.0

* Less than. $50 million

Because holding appreciated capital assets until death
results in an effective tax rate of zero on these capital
gains, taxpayers have an incentive to hold on to such assets
until death. This incentive is a major contributor to the
so-called “lock-in effect" of capital gain taxation rules.
Investors may forego higher before-tax returns that could be
earned on another asset because selling the appreciated
capital asset to purchase the new asset would result ina
lower after-tax return. Eliminating the step-up in basis as
death would reduce the lock-in effect. On the other hand,
taxing the appreciation of an asset at death will reduce the
after-tax return to these assets, compared to current law.
This may act to discourage saving, where the intent is to
pass assets on to one's heirs.



ISSUES INVOLVED IN POSSIBLE REVENUE OPTIONS
TO REDUCE THE FEDERAL DEFICIT

Scheduled for a Hearing
Before the

SUBCOMMITTEE ON DEFICITS, DEBT
MANAGEMENT, AND INTERNATIONAL DEBT

of the
SENATE COMMITTEE ON FINANCE

on June 5, 1992

Prepared by the Staff
of the
JOINT COMMITTEE ON TAXATION
June 4, 1992

JCX-20-92


1977 4.6 3.1 7.7 -1.0 6.7
1978 4.9 3.1 8.0 0.0 7.9
1979 4.7 2.5 7.2 0.5 7.6
1980 5.0 1.4 6.4 -1.3 5.1
1981 5.2 1.4 6.6 -1.0 5.7
1982 4.9 0.6 5.5 -3.5 2.0
1983 3.8 1.9 5.7 -3.8 2.0
1984 4.4 2.5 6.8 -2.8 4.1
1985 3.1 2.6 5.7 -3.3 2.4
1986 3.0 2.0 4.9 "3.4 1.5
1987 2.0 1.8 3.9 -2.4 1.5
1988 3.0 1.9 4.9 -2.0 2.9
1989 3.3 1.0 4.3 -1.7 2.6
1990 3.3 0.5 3.8 72.3 1.5
Average

1950-59 4.7 2.8 7.5 -O.1 7.4
Average

1960-69 4.6 3.5 8.1 -0.3 7.9
Average

1970-79 5.6 2.4 8.0 -1.0 7.1
Average

1980-89 3.8 1.7 5.5 -2.5 3.0

Source: Department of Commerce, Bureau of Economic Analysis

Potential “accommodation" by the Federal Reserve

An additional concern caused by large Federal deficits
is that Federal Reserve may "monetize" the debt. Expansionary
monetary policy couid keep interest rates low and credit
abundant despite increased demand for money and loanable
funds. This type of accommodating monetary policy may
alleviate any tightening of credit, especially in the short
run. However, many economists believe that, whatever
improvements in credit conditions are provided by
expansionary monetary policy, they are not sustained in the
long run ang are earned only at the cost of a higher rate of
inflation.+*

13° Milton Friedman, "The Role of Monetary Policy," American
Economic Review, vol. 58 (March 1968), pp. 1-17.


-8-

1960s, the share of national income devoted to investment
must decline unless funds are borrowed from abroad.

Tabie 1 presents United States net saving by component
as a percentage of gross national product. National saving
is divided into private saving and public saving. Private
saving comprises household or personal saving and business
saving. Households save by not spending all of their
disposable (i.e., after-tax) income. Businesses save by
retaining some of their after-tax earnings. Public saving
reflects the extent to which the Federal, State, and local
governments run budges surpluses. As Table 1 demonstrates,
net business saving, net personal saving, and public saving
were all lower during the 1980s than in any of the three
previous decades. Though private saving remained positive, it
fell during the 1980s. Moreover, public saving was
consistently negative during the 1980s as the result of
Federal deficits. The magnitude of public dissaving generally
was larger relative to GNP in the 1980s than in earlier
years. As the table indicates, net national saving is lower
after 1981 than at any time in the post-World War II era. In
1983, 1985, 1986, and 1987 aggregate governmental dissaving
consumed all, or more than all, of personal saving.

Table 1.--Components of United States Net National Savings
as a Percentage of GNP, Selected Years, 1929-1990

Net Net . Total net Total net

personal business private public national
Year saving saving saving saving saving
1929 2.5 2.3 4.8 1.0 5.8
1939 2.0 0.3 2.3 72.4 -O.1
1949 2.8 4.0 6.9 ° -1.3 5.6
1954 4.4 2.6 7.0 -1.9 5.1
1959 4.4 3.2 7.6 -0.3 7.2
1964 4.8 3.9 8.8 -0.4 8.4
1969 4.4 2.6 7.0 1.0 8.0
1974 6.6 1.4 7.9 -0.3 7.6
1975 6.5 2.3 8.9 -4.1 4.8
1976 5.4 2.6 8.0 -2.2 5.8
12

Table 1 presents net saving, which equals gross saving
less capital consumption (depreciation).


-29-

D. Increase Excise Tax Rates on Alcoholic Beverages

The proposal would increase all alcoholic beverage
excise taxes to the equivalent of $16.00 per proof gallon,
effective on October 1, 1992.

Revenue effects (billions of dollars)

1993 1994 1995 1996 1997 1993-97

Increase excise

tax rates on all

alcoholic beverages

to $16.00 per proof

gallon equivalent 5.0 4.9 4.9 4.9 5.0 23.

wu

Current Federal excise taxes on beer and wine are
significantly lower than the tax on distilled spirits on an
equivalent alcohol. content basis. The current tax on
distilled spirits of $13.50 per proof gallon is a tax of
about 21 cents per ounce of alcohol. This compares to a tax
rate of about 10 cents per ounce of alcohol for beer
(assuming an average alcoholic content of 4.5 percent for
beer) and a tax rate of about 8 cents per ounce of alcohol
for table wine (assuming an average alcoholic content of 11
percent for table wine). A tax of $16.00 per proof gallon on
all alcoholic beverages would result in a tax of about 25
cents per ounce of alcohol.

Studies have indicated that the direct and indirect
social costs ("external costs") from alcohol consumption are
much higher than the pgvenues currently generated from
alcohol excise taxes. Increasing the alcoholic beverage
taxes could help discourage consumption of alcoholic
beverages ang ,reduce some of the external costs of alconol
consumption.

Although excise taxes are generally viewed as
regressive, the alcoholic beverage taxes are imposed on
discretionary purchases as compared to necessities for
lower-income persons. From a public policy perspective, it
could be argued that alcoholic beverage taxes should be

23 ww. Manning, E. Keeler, J. Newhouse, E. Sloss, and J.
Wasserman, "The Taxes of Sin: Do Smokers and Drinkers Pay
Their Way?", Journal of the American Medical Association,
Vol. 261, No. 11, March 17, 1989.

24 Philip Cook and George Tauchen, "The Effect of Liquor
Taxes on Heavy Drinking", Bell Journal of Economics, Vol. 13,
No. 2, Autumn 1982.



-28-
C. Increase Motor Fuel Excise Taxes
The excise taxes on motor fuels (currently 14.1 cents
per gallon for gasoline and 20.1 cents per gallon for diesel
fuel) could be increased by 12 cents per gallon. The
proposal would be effective on October 1, 1992.

Revenue effects (billions of dollars)

1993 1994 1995 1996 1997 1993-97

Increase motor

fuels taxes by

12 cents per

gallon 10.9 11.0 10.8 10.9 11.2 54.8

More than 25 percent of total energy consumption in the
United States is attributed to transportation, the bulk of
which is motor fuels consumption. Increasing the excise
taxes on motor fuels would provide encouragement for
conservation of these energy sources, reducing U.S.
dependence on imported. petroleum.

Generally, it is believed that much of the burden the
motor fuels excise tax is passed forward in the form of
higher prices to consumers. To the extent that motor fuels
consumption increases less than proportionately with income,
this excise tax will be regressive with respect to annual
income. This larger relative consumption of motor fuels
among lower-income individuals could be the case if these
individuals drive less energy-efficient automobiles. To the
extent that consumption of motor fuels is larger in some
regions of the country than others, this proposal might be
considered regionally non-neutral. For example, it is often
asserted that residents of western States drive much greater
distances than do residents of more densely populated eastern

tates.

An increase in the tax rates for motor fuels that is
intended to promote conservation might have its effect
blunted somewhat if the various exemptions for motor fuels
taxation are maintained. For instance, State and local
government use of motor fuels is tax-exempt, as is off-road
use (e.g., farming). It might be appropriate to extend the
increase in motor fuels taxes to these currently exempt uses.



-S-

the economy were at full employment. The concept of the
full-employment deficit is meant to measure the net fiscal
stimulus the government is adding to the economy.

Accrual rather than cash accounting.--Some economists
have commented that neither the actual nor the
full-employment deficit is an accurate measure of Federal
fiscal policy. They argue that such measures of the deficit
include outlays, the liability for which may have occurred
earlier and that the actual timing of the outlay has no real
effect on the economy. An example in the current economic
context would be the expansion in the actual Federal deficit
incurred to cover insured deposits in the thrift and banking
industries. Such liabilities were incurred when it became
apparent the financial institutions were insolvent which
occurred prior to the current outlays. Similarly, the cash
budget does not include the outlays or receipts from future
years for which the liability is incurred by a policy enacted
today. For this reason, certain increases or decreases in
the cash deficit may not accurately represent changes in
government fiscal policy. On the other hand, it is often
difficult to determine the proper amount of income to accrue
under an accrual accounting system. For example, In the case
of deposit insurance, it is not clear at what point
liabilities should have been determined to have accrued.

Capital expenditure and trust fund budgeting.--Some
analysts object to lumping together expenditures on capital
goods with current expenditures on nondurable goods. They
observe that capital expenditures, such as for the
construction of a bridge, provide services to the public for
Many years while non-capital spending may finance current
consumption (e.g., transfer payments). They argue it is
therefore appropriate to borrow to fund capital expenditures
because borrowing and servicing the debt better matches the
benefits and costs on an annual basis. To the extent that a
deficit exists to finance capital expenditures, these
analysts would argue the deficit should be no cause for
concern. Similarly, these analysts argue that the budget
should report separately capital expenditures and operating
expenditures. This is the budget reporting practice of many
States and local governments.

Similarly, others argue that where earmarked revenues
have been provided to trust funds, separate accounting should
be given to each trust fund. They argue that separate trust
fund accounting would help policymakers better assess the
costs and benefits associated with specific government
programs.

Changes in values of government assets.~-Another
criticism of current deficit measures is that they do not
account for the changing real value of government assets.8
For example, the value of the national debt has been



-19-

untaxed flows of services will continue to be worth more for
taxpayers in higher brackets.

Denial of the deduction for mortgage interest may put
otherwise similar renters and mortgagee owners on an equal
footing (the renter gets no deduction for rent payments and
the mortgagee gets no interest deduction). But taxpayers who
are able to buy their homes outright are advantaged relative
to mortgagee owners because the retyrn to their investment in
owner-occupied housing is untaxed. .

18 (continued)

order to buy a house. In all three cases, the taxpayer
receives an identical amount of housing services; only the
tax treatment differs across the choices.

If the taxpayer rents, he can invest his $80,000 to
yield taxable dividends of $8,000. What remains after tax
can be used to pay some of the $8,000 rent. He has taxable
income of $8,000 on the transaction.

If the taxpayer purchases the home for cash, he has no
taxable income on the transaction.

Under present law, if the taxpayer borrows $80,000 to
purchase the house, he can invest his own $80,000 to yield
dividends of $8,000 sufficient to pay the interest on his
mortgage. Because the mortgage interest is deductible, it
offsets his dividend income, leaving him with no taxable
income on the transaction. Thus, under present law,
homeowners are benefitted relative to renters regardiess of
whether they have a mortgage or not.

19 Return to the example from the previous footnote. Under
the proposal to eliminate the deduction for mortgage
interest, if the taxpayer borrows $80,000 to purchase the
house, he can no longer offset the $8,000 of dividend income
with mortgage interest. He is in the same situation as if he
rented.



=-25-

H. Repeal the Possessions Tax Credit

A United States corporation operating in Puerto Rico or
any U.S. possession may claim the possessions tax credit
instead of the foreign tax credit (the possessions tax credit
is referred to as the Section 936 credit). The possessions
tax credit effectively exempts income sourced by a U.S.
corporation to Puerto Rico or another U.S. possession from
U.S. corporate income tax. This alternative would repeal the
possessions tax credit for taxable years beginning after
December 31, 1992.

Revenue effects (billions of dollars)

1993 1994 1995 1996 1997 1993-97

Repeal possessions
tax credit 1.7 3.1 3.3 3.4 3.6 15.0

A U.S. .corporation may elect to claim the possessions
tax credit if. at least 80-percent of its gross income for the
last three years is sourced to Puerto Rico or another U.S.
possession and at least 75 percent of this income is from the
active conduct of a trade or business. The possessions tax
credit is intended to promote employment in Puerto Rico and
other U.S. possessions, and studies indicate that a
substantial fraction of all manufacturing employment in
Puerto Rico takes placg in corporations claiming the
possession tax credit. 0 “However, one effect of the
possessions tax credit appears to be the encouragement of the
reallocation of income generated by intangible assets (e.g.,
patents) to sources located in U.S. possessions. This
artificial reallocation of income does not, by itself,
promote employment in the possessions, and may be viewed as
an inefficient use of society's resources. When viewed in
the context of revenue foregone per job created, the
possessions tax credit is sometimes considered an expensive
economic development tool. For instance, a recent report by
the General Accounting Office has estimated that the average
amount of tax benefits received by firms in the drug industry
{a major user of the possession tax credit) in 1989 was over
$70,000 per job created.

20 For example, see Internal Revenue Service, U.S.
Possessions Corporation Returns--1987, Statistics of Income
Bulletin, Summer 1991.

21 General Accounting Office, Pharmaceutical Industry: Tax
Benefits of Operating in Puerto Rico, GAO/GGD-92-72BR, May
1992,



-2-

context of the individual and corporate income taxes. Part
III presents several income tax base broadeners for the
individuai and corporate income taxes. Finally, Part IV
presents a number of excise and other consumption tax
alternatives.


Sn st i eiReaye ets

-12-

higher pre-tax (and after-tax) income.


-14-

the highest income people in society are the most productive,
this tax rate increase may have some effect on overall cutput
by discouraging labor, supply from these members of society.
To the extent that high incomes are primarily the result of
random events and not due to extraordinarily high
productivity, the effect on overall output will be smaller
and perhaps negligible. Similarly, this tax rate increase
will act to reduce the after-tax return to saving by affected
individuals, perhaps discouraging these taxpayers from
undertaking saving and encouraging consumption.

The proposed rate increase would widen the gap between
the tax rate on ordinary income and the tax rate on capital
gains income. This would provide additional incentive for
individuals to attempt to convert ordinary income into
tax-favored capital gains income.



INTRODUCTION

The Senate Finance Subcommittee on Deficits, Debt
Management, and International Debt has scheduled a public
hearing on June 5, 1992, to address the long-term economic
implications of the Federal budget deficit.

This document,? prepared by the staff of the Joint
Committee on Taxation in connection with the June 5
Subcommittee hearing, discusses why policy makers might be
concerned about the deficit and examines several selected
revenue raising options to illustrate both the magnitude of
revenues that could be generated by the alternatives and the
potential economic impact of enacting these alternatives.
The discussion of economic effects is brief; however, this
discussion attempts to highlight key economic concerns that
policymakers should address. Among the economic issues
covered are: the potential for economic inefficiency that
could be caused by enactment of the alternative; the
distributional consequences of the alternative (i.e., who in
society actually would bear the burden of the alternative);
and the administrative or transitional costs that would
accompany enactment of the alternative. Discussion of
possible expenditure reducing or cost saving options is not
within the scope of this document.

Inclusion of particular revenue raising options in this
document should not be construed as endorsement by the staff
of the Joint Committee on Taxation. These alternatives were
selected as representative of the categories of alternatives
which might be considered as part of a serious effort to
reduce the Federal deficit by raising additional Federal
revenues. The primary goal of these illustrative revenue
raising alternatives is to provide information for
policymakers to help evaluate the alternatives.

The document is organized as follows. Part I presents
some data on the size of the Federal deficit and briefly
@iscusses why policymakers are concerned about the deficit.
Part II presents several alternative rate increases in the

1 This document may be cited as follows: Joint Committee on
Taxation, Issues Involved in Possible Revenue Options to

Reduce the Federal Deficit (JCX-20-92), June 4, 1992.

2 Similarly, omission of a particular alternative should not
be perceived as a statement of the preferences of the staff
of the Joint Committee on Taxation. Time constraints in
preparation of this document for the June 5 Subcommittee
hearing precluded an in-depth analysis of various revenue
options and limited as the number of alternatives discussed
within each of the major categories.



-23-

F. Increase the Portion of Social Security Benefits
Subject to Income Tax

Under present law, a portion of Social Security and tier
1 railroad retirement benefits is included in taxable income
for taxpayers whose combined income, defined as adjusted
gross income (AGI) plus (1) interest on tax-exempt bonds and
(2) 50 percent of Social Security and tier 1 railroad
retirement benefits, exceeds a threshold amount. The
threshold amount is $32,000 for married taxpayers filing
joint returns and $25,000 for unmarried taxpayers. The
amount of benefits included in taxable income is the lesser
of (1) 50 percent of Social Security and tier 1 railroad
retirement benefits, or (2) 50 percent of the excess of the
taxpayer's combined income over the threshold amount. The
Proposal would increase the maximum portion of Social
Security and tier 1 railroad retirement benefits included in
gross income from 50 percent to 85 percent. The alternative
would be effective for taxable years beginning after December
31, 1992.

Revenue effects (billions of dollars)

1993 1994 1995 1996 1997 1993-97

increase maximum

portion of Social

Security benefits

in taxable income

from 50 percent

to 85 percent 2.7 5.6 6.2 6.9 7.7 29.1

This proposal would increase the individual income tax
liabilities of those Social Security and railroad retirement
recipients with combined incomes above the applicable
threshold. Thus, the proposal would primarily affect older
taxpayers with incomes above the median for elderly
households. A large percentage of any current Social
Security recipient's benefits does not constitute a return of
the original contribution made with after-tax dollars.
Rather, the bulk of benefits received consists of the
employer's contribution plus the implicit earnings on these
contributions. The Social Security Administration has
estimated that, for individuals retiring between 2025 and
2030, the lifetime aggregate employee contributions will, on
average, equal approximately 7 percent of aggregate benefits.
Similarly, CBO has estimated that the highest corresponding
figure for single males earning the maximum Social Security
taxable wage base is 15 percent. These estimates indicate
that the 85-percent inclusion figure used in this proposal is
a reasonable estimate of the portion of benefits received
that represents amounts other than employee contributions
made with previously taxed dollars.



CONTENTS

Page
INTRODUCTION ..... beeen eee e cece eee eeeeetenseceseeeees 1
I. THE DEFICIT ............0000. sete e eee ee eee eceee 3
II. POSSIBLE INCOME TAX RATE INCREASES .............. 13
III. POSSIBLE INCOME TAX BASE BROADENING OPTIONS...... 16
IV. POSSIBLE CONSUMPTION TAX INCREASES ..........+-+++ 26


-31-
E. Increase Excise Tax on Cigarettes

The proposal would increase the scheduled excise tax
rate for cigarettes on January 1, 1993, from 24 cents per
pack (of 20 cigarettes) to 48 cents per pack. (The current
law tax is scheduled to increase from 20 cents to 24 cents
per pack on January 1, 1993.)

Revenue effects (billions of dollars)

1993 1994 1995 1996 1997 1993-97

Increase excise

tax on cigarettes

to 48 cents per

pack 2.9 3.9 3.8 3.8 3.7 18.1

The current Federal cigarette excise tax rate is imposed
at a flat rate per unit, rather than being adjusted to
reflect inflation. Although the cigarette tax rate was
increased from 16.cents to 20 cents per pack on January 1,
1991, and is scheduled to be increased further to 24 cents
per pack on January 1, 1993, the effective rate (in real
terms) is still much lower than it was in 1951 (the excise
tax rate for 1951 translated to 1992 dollars would be
approximately 42 cents per pack).

Studies have indicated that there are significant direct
and indirect social costs ("external costs") associated with
cigarette smoking as well as governmental hgalth expenditures
attributable to cigarette-related diseases. Increasing
cigarette excise taxes could discourage consumption and might
prevent people from starting to smoke, which would reduce
long-term health costs and premature deaths associated with
smoking.

While excise taxes generally are viewed as regressive,
cigarette excise taxes are imposed on discretionary purchases
rather than necessities for lower-income persons. This may
ameliorate the concern with the regressive nature of this
proposal.

In addition, the excise tax on cigarettes could be
indexed for future inflation. This alternative proposal is
not reflected in the above revenue estimate.

25 Manning, et al, "The Taxes of Sin: Do Smokers and
Drinkers Pay Their Way?".



-26-

IV. POSSIBLE CONSUMPTION TAX INCREASES
A. Impose a Narrow-Based Federal Value~Added Tax

The proposal would impose a 5-percent value-added tax on
consumption, with exemptions for food, housing, and medical
care. The proposal would be effective as of January 1, 1994,
due to the lead time needed to implement a Federal
value-added tax.

Revenue effects (billions of dollars)

1993 1994 1995 1996 1997 1993-97

S-percent value-

added tax on

narrow consumption

base -- 47.0 70.7 73.0 77.0 267.0

A Federal value-added tax has approximately the same
economic effect as a national level retail sales tax. This
means that a value-added tax would discourage consumption of
the affected goods and services, and generally would
encourage saving over current consumption. The burden of
this tax is generally believed to fall on those individuals
purchasing taxed goods and services. When compared to annual
income, a vaiue-added tax is regressive, since the relative
burden is larger for those who consume all, or nearly all, of
their annual income. When compared to a measure of lifetime
income, a value-added tax is more nearly proportional, since
nearly gyi taxpayers consume the vast bulk of their lifetime
income. Imposition of a value-added tax would be expected
to cause a one-time increase in consumer prices, and hence,
measured inflation. However, assuming the Federal Reserve
reacted to accommodate this price increase, there would not
be an acceleration in ongoing inflation. Most countries have
chosen to implement a value-added tax instead of a national
level sales tax (even though both have very similar economic
effects) since there is less scope for tax evasion under the
multi-stage collection procedures inherent in a value-added
tax. However, the administrative costs of starting a new tax
system would be substantial. Accordingly, conventional
wisdom is that if a value-added tax is adopted, the rate
should be sufficiently high (say, 5 percent) to offset the
initially large start-up costs.

22 See, for example, Congressional Budget Office, Effects of
Adopting a Value-Added Tax, February 1992.



-10-

Intergenerational equity

Overview.--Policymakers have long argued whether deficit
finance is Fair to future generations. The simple analysis
is that borrowing to fund current expenditures necessitates
future taxes to service the debt obligation. The benefit of
the expenditure may be received by current generations, while
the debt is serviced by future generations. Historically,
prior to the last twenty years, most debt incurred by the
Federal government has been related to war finance.

Arguably, the benefits of insuring freedom are valuable to
all future generations. Many analysts have noted that the
recent sizeable additions to the national debt have not been
war related, although they may, in part, be related to
increased defense expenditures.

The discussion of alternative deficit measures suggested
that the simple analysis of current expenditures leading to
current benefits is not always accurate. There is,
however, a popular perception that the national debt is a
burden on future generations and that large increases to that
burden may represent a shifting of a portion of the burden
from one generation to the next.

Generational accounts.--Recently, the notion of
“generational accounting" has been developed to attempt to
address the shortcomings of the defjgit as a measure of
intergenerational wealth transfers. The goal of
generational accounting is to calculate the present value
over many years of the benefits and costs of government
programs and assign the net value to various age cohorts of
the current population as well as to cohorts yet unborn. For
example, generational accounting would compute the present
value of social security benefits that each individual might
expect to receive during his or her lifetime and the present
value of the same individual's payroll tax liability. In
theory, generational accounts would reflect not only the
burdens of taxes and the benefits from expenditure programs,
but also the burdens and benefits of regulatory policies.
Because the concept of generational accounting requires
estimates of future economic activity such calculations are
only suggestive. Accepting these caveats, one exercise in

4 : :
14 Discussion below introduces the economic concept of
"Ricardian equivalence" which suggests that the debt service
obligation may not create a burden for future generations.

15 see Alan J. Auerbach, Jagadeesh Gokhale, and Laurence J.
Kotlikof£, "Generational Accounts: A Meaningful Alternative
to Deficit Accounting," in David Bradford, ed., Tax Policy
and the Economy, vol. 5 (Cambridge: MIT Press for the
National Bureau of Economic Research), 1991.


-13-

II. POSSIBLE INCOME TAX RATE INCREASES
A. Individual Income Tax Rate Increases

l. Create a 35-percent rate bracket for taxable incomes
above $135,000 (unmarried individuals filing separate
returns), $150,000 (unmarried individuals filing as heads of
households), $200,000 (married individuals filing joint
returns), and $100,000 (married individuals filing separate
returns).

2. Impose a 10-percent surtax on individuals with taxable
income over. $1,000,000 ($500,000 for married taxpayers filing
separate returns).

These proposals would be effective for taxable years
beginning after December 31, 1992.

Revenue effects (billions of dollars)

1993 1994 1995 1996 1997 1993-97

1. 35-percent

rate for

higher-income

taxpayers 3.9 71 7.5 7.4 7.4 33.3

2. Surtax on
taxable income
over $1,000,000 0.9 1.6 1.8 1.9 2.0 8.2

Proposals similar to these two alternatives were
included in H.R. 4210, which was passed by the Congress on
March 20, 1992, and vetoed by the President. Capital gains
income would continue to be taxed at a maximum rate of 28
percent, as under present law. The threshoids for the
35-percent bracket would be indexed for inflation in the same
manner as present law. The surtax would equal 10 percent of
otherwise computed tax liability multiplied by the ratio of
taxable income in excess of $1,000,000 to total taxabie
income. The effect of the surtax is that the more taxable
income exceeds $1,000,000, the closer the surtax approaches a
10-percent increase in total tax liability. For alternative
minimum tax purposes, the surtax would be implemented by
increasing the tentative minimum tax by 2.4 percent of the
amount by which alternative minimum taxable income exceeds
$1,000,000.

The burden of these rate increases would be concentrated
among those taxpayers with the highest incomes. This could
result in an increase in the progressivity of the individual
income tax system. It can be argued that this tax increase
provides a disincentive to labor supply. To the extent that