Congress made no pretense of paying for the payroll tax cut itself. But it did claim it would pay for the rest of the package. Hint: It didn’t.

There are two bits of legerdemain happening here. Both are functions of the 10-year budget window the Congressional Budget Office and the Joint Committee on Taxation use to score legislation.

The first gimmick allows Congress to pretend tax cuts or new spending are temporary, when it is obvious to all they are not.  The second is a sort of congressional lay-away plan. Lawmakers get to buy politically popular policies today but avoid paying for them until years from now.

There is nothing new in all this. Congress has been playing games with the 10-year budget window (or its cousin the 5-year window) for decades. But the mini-stimulus showed business as usual is alive and well on Capitol Hill, despite the best efforts of the tea party caucus.  

The doc fix is a perfect example of Gimmick #1. Even though Congress has been temporarily protecting physicians from scheduled Medicare cuts for a decade, CBO must score only what Congress proposes.

So when lawmakers protect docs for only a year (or in this case 10 months) at a time, CBO has no choice but to score only the one-year cost. Thus, the limited fix appears to add only about $18 billion to the deficit over the 10-year budget window when the true 10-year expense of keeping the doc fix going would far exceed $200 billion.

Perhaps the payroll tax cut, which is supposed to be a stimulus measure, really will be allowed to expire at year’s end (though I doubt it). But the doc fix is not countercyclical economic policy. Like old man river, it just keeps rolling along. A year at a time.  Since 2002, if you can believe it. 

Here’s Gimmick #2. Most of the cost of the doc fix comes in fiscal years 2012 and 2013, as you’d expect with a “temporary” extension. But the measures to pay for them—a reduction in Medicare payments for hospitals’ bad debts and a cut in a preventive care program, don’t kick in until 2014 and beyond. One provision–a hike in federal employee retirement contributions for new workers–won’t start raising real money until 2016.

Will any of these pay-fors actually happen? Don’t bet on it. Already, Senate Democratic Leader Harry Reid (D-NV) has promised to restore the preventive care money. That took, what, four days?

In theory, this kind of budgeting makes sense. After all, while the economy seems to be recovering, it remains sluggish. Why not inject additional fiscal stimulus now and arrange to pay for those initiatives in a couple of years when the economy presumably is stronger?

The problem: Many of these pay-fors never quite seem to happen. Instead, Congress just creates more “doc fixes.”   Remember, the first fix was aimed at blocking cuts in Medicare physician payments that were included in the Balanced Budget Act of 1997.

Yes, Virginia, Congress promised that cutting reimbursements to docs would help eliminate the deficit. And, as Sarah Palin, might ask, “How’s that workin’ out for ya?”

That’s a big difference. What’s going on?

The calculation implicit in the news report is simple arithmetic—2 percent of $50,000 is $1,000. But the average worker earns much less—just under $40,000 in 2010, according to the Social Security Administration. That suggests that the average tax saving would be about $800, still more than $714.

The remaining difference results from the Social Security tax cap–$110,100 this year. Since incomes over the cap go into the overall wage average, the average wage subject to the Social Security tax is less than the average for all pay, roughly 10 percent less.

But TPC estimates that the average tax reduction will total $921, well above the average worker’s savings. That’s because TPC looks at tax units—individuals or couples who file tax returns (or would if their incomes were high enough). And TPC leaves out dependents and hence misses the tax savings for many younger workers. Tax units are similar to both families and households but not the same as either.

So here’s the bottom line (or lines):

1. Nearly 160 million workers will take home an average of $714 more during 2012.
2. About 122 million tax units will save an average of $924 in payroll taxes.

Only above-average workers will get the $1,000 repeatedly promised in the media.

Here is Rudy’s essay:

Were it not for the growth in spending on Medicare, Medicaid, and Social Security, the United States wouldn’t have much of a budget problem. The two biggest programs—Social Security and Medicare—are retirement programs that are extremely popular politically. Both need to be reformed, but they cannot be cut abruptly and they cannot be cut drastically. Consequently, it’s hard to avoid concluding that some revenue increases will be needed to solve our fiscal problems.

Once that need is accepted, we have to ask, “What kind of revenue increases?” The least desirable approach would raise income tax rates in the current system without fixing its complications, inefficiencies, and inequities. If raising rates is rejected, we must either create a new tax— such as a value-added tax or an energy tax—or design a significant, revenue-raising tax reform.

A VAT or an energy tax is probably a nonstarter politically. Republicans see a new tax as a money machine that would finance a much larger government. Democrats worry about the complexity of making such taxes sufficiently progressive

The Bowles-Simpson presidential fiscal commission showed that there are income tax reforms that can raise revenues progressively and efficiently. In one option, they got rid of a host of special tax provisions while limiting, but not eliminating, some of the most politically sensitive, such as the charitable and mortgage-interest deductions. That allowed them to lower the top rate for individuals to 28 percent while still raising $80 billion more in 2015. With three rates—12.7 percent, 21 percent, and 28 percent—the top 0.1 percent of the income distribution lost 11.8 percent of its after-tax income and the top 1 percent lost 7.8 percent. The middle three quintiles lost less than 2 percent.

Erskine Bowles and Alan Simpson achieved a high degree of progressivity by taxing capital gains and dividends at ordinary income tax rates. That imposes a very high double tax on corporate profits. A more radical option would limit the double tax by integrating the corporate and individual tax systems. An even more radical change would move toward a progressive consumption tax. Capital gains and dividends wouldn’t be taxed if reinvested, but would be hit if used to finance consumption.

None of this discussion implies that radical tax reform is easy. The revenue-neutral reforms of 1986 were anything but. A revenue-raising reform greatly increases the ratio of losers to winners. Accomplishing reform seems easy only when compared to persuading Americans to accept a VAT or new energy tax.

Here is Donald’s:

America’s tax system is a mess. It’s needlessly complicated, economically harmful, and often unfair. And it doesn’t raise enough money to pay our bills. That’s why almost everyone agrees that tax reform should be a top priority. Democrats, Republicans, and independents. Accountants, lawyers, and economists. Elected officials and ordinary citizens. All know our tax system is deeply flawed.

Unfortunately, they don’t agree on how to fix it. Some want revenue-neutral tax reform, while others want higher revenues to cut deficits and pay for rising entitlement spending. Some want to fix the income tax, while others want to tax consumption. Some want to cut tax rates across the board, while others would lift rates for high earners.

Public discourse, meanwhile, is hung up on the idea of attacking “loopholes” when the real action is in tax breaks that benefit millions of taxpayers. Tax reform isn’t just about corporate jets or carried interest. It’s about the mortgage interest deduction, the tax exemption for employer provided health insurance, and generous tax incentives for debt-financed corporate investment. Those policies have major flaws, but they are not loopholes. They reflect fundamental economic and social choices, and they benefit well-defined constituencies.

Tax reform will thus involve a prolonged political struggle, as reformers seek some compromise that can attract enough support to overcome the inevitable inertia against change. That won’t be easy, but given our sky-rocketing debt, weak recovery, and flawed tax system, it’s clearly worth the effort.

Even as they seek a reasonable compromise, reformers should continue to articulate their visions of an ideal tax system. Mine would reflect five principles. First, the government should raise enough money to pay its bills. That likely means higher revenues, relative to GDP, than we’ve had historically. Second, it’s better to tax bads rather than goods. That means greater reliance on energy and environmental taxes. Third, it’s better to tax consumption than income; policymakers should thus limit how much they tax saving and investment. Fourth, the tax burden should be shared equitably both across income levels and among people of similar means who make different choices (for example, renting versus owning a home).

Finally, the best tax systems have a broad base and low rates. Policymakers should thus emphasize cutting tax breaks rather than raising tax rates. Indeed, some rates, like the 35 percent rate on corporate profits, should come down.

To afford such cuts, policymakers should go after the dozens of deductions, credits, exclusions, and exemptions that complicate the code and narrow the tax base, often with little economic or social gain. Many of these provisions have been sold as tax cuts, but are really spending in disguise. They should get the same scrutiny that policymakers devote to traditional spending programs.

Nearly half of American workers – an estimated 78 million- currently have no employer-sponsored retirement savings plan. The Automatic IRA is a simple, easy to administer and understand system that is designed to meet the needs of small businesses and their employees.

Employers facilitate employee savings without having to sponsor a 401(k)-type plan, make matching contributions or meet complex eligibility rules. Employees are enrolled automatically into an IRA with a simplified system of investment choices and a set automatic savings level. However, they retain complete control over all aspects of the account including how much to save, which investment choice to use, or even whether to opt out completely.

Automatic IRAs also offer savings options for the self-employed and independent contractors, and  provide those who are changing jobs the ability to continue their retirement savings.

The new 2013 budget would also double the size of the tax credit that employers receive in return for starting a new 401(k) plan from $500 annually for three years to $1,000 annually for the same period. This increase will ensure that the credit covers more of an employer’s costs, and should encourage more employers to offer such a plan.

This is a very good move, but the annual credit could be still further expanded to $1,500 for three years as will be proposed by a new House bill coming from Rep. Richard Neal (D-MA).  As Congress examines the proposal, it will have the opportunity to also expand the smaller credit that would be offered to employers that start an Automatic IRA to ensure that they are fully reimbursed for all expenses connected with starting and operating such an account for their workers.

A disappointing development is the failure to again include proposals to expand and improve the Saver’s Credit by making it fully refundable. The Saver’s Credit is an incentive for middle-and lower-income taxpayers to save in 401(k)-type accounts or IRAs.

Retirement Security Project research found that more than 69 million taxpayers had income that was low enough for them to be eligible for the Saver’s Credit in 2007. However, nearly 45 million of these filers actually failed to qualify for the credit because they had no federal tax liability. If the Saver’s Credit was made refundable as RSP has proposed and deposited directly into the account as a match for savings, those 45 million taxpayers could have taken advantage of the program and had significantly higher retirement savings.

The matter at hand is the payroll tax, of course. And after months of squabbling, it looks as if Congress is about to extend a “temporary” tax cut for another 10 months. And it will borrow $100 billion to do it. That would be OK if this was a short-term stimulus. But I don’t think it is.

How did we get here? To briefly review the bidding, in late 2010 Congress backed a plan by President Obama cut the employee share of the Social Security payroll tax from 6.2 percent to 4.2 percent for 2011 only.

Just as the tax cut was about to expire, Republicans and Democrats locked themselves in their usual fiscal death grip. But in a nice bit of political jujitsu, Democrats stole the GOP’s best anti-tax rhetoric. Letting the temporary tax cut expire as planned, they thundered, would raise taxes on 160 million working people.

The talking point was wildly successful. Just before they headed home for the winter holidays, Republicans went into duck and cover mode and Congress voted to extend the payroll tax break for two months—without paying for the extension, of course. The theoretically temporary tax cut is due to expire again in a couple of weeks. And until this week, Ds and Rs were rehashing the same old argument. Except for some tea party conservatives, most lawmakers insisted they wanted to extend the payroll tax break, but nobody would budge when it came to paying for it.

On Monday, the House Republican leadership announced it would support a 10-month extension without offsetting spending cuts. Problem solved. Just put another $100 billion on the tab.

This wouldn’t bother me if I thought the payroll tax cut was really going to expire in 10 months. But I don’t.  Given the Democrats’ politically successful claim that allowing the tax break to expire was akin to a tax increase, it is hard to imagine them abandoning the provision–or the issue– anytime soon.

And if Congress can’t agree on how to pay for it now, how will it do so at the end of the year? That’s exactly when lawmakers will be locked in an epic fiscal policy battle over what to do about trillions of dollars of other expiring tax cuts, how to dodge $1.2 trillion in automatic spending reductions that were mandated by Congress’ failed deficit reduction efforts last year, and how to increase the debt limit.

I can imagine the payroll tax extension becoming another version of the Alternative Minimum Tax patch–extended year after year with borrowed money.  To make matters worse, a permanently temporary tax cut further damages the credibility of the Social Security system which the payroll levy is supposed to fund. The government can fill the hole by shifting general fund dollars into the system, but this bit of legerdemain is not going to boost confidence in the retirement program.

Perhaps Congress will find a way to sort out this mess without adding trillions more to the budget deficit. Perhaps it will somehow let the temporary payroll tax cut quietly fade away at year’s end. But, somehow, I doubt it.

Of course, economists don’t just want to know the total tax burden; we also care about incentives. So we looked at how PFSA would affect the amount of tax people pay on their next dollar of income – that is, their effective marginal tax rates.

We care about marginal rates because they measure the tax disincentive for earning additional income. High effective marginal rates on wages may discourage work effort, and high effective marginal rates on capital gains may distort investment decisions and discourage realizations of capital gains. Beyond generating efficiency loss, these reductions in realizations would mitigate the revenue pickup from raising capital gains rates.

Since effective marginal rates depend on all taxes applied to work effort and capital gains and include the effects of tax preferences, the statutory rate brackets in the income tax are only part of the story. Wages face an additional 7.65 percent payroll tax on both the employee and employer, so payroll taxes contribute an extra 14.2 percentage points to the marginal tax rate on pretax earnings (15.3 divided by 107.65, the gross wage including the employer tax). However, earnings above the Social Security wage threshold face only the Medicare Hospital Insurance (HI) tax, which is 1.45 percent on both employees and employers, for a total rate of 2.86 percent (2.9/101.45). And earnings above $125,000 (or $250,000 for joint filers) get hit with an additional 0.9% surtax starting in 2013.

Meanwhile, capital gains and qualified dividends face a top rate of only 15 percent – plus an additional 3.8 percent on net investment income for high earners beginning in 2013, courtesy of health reform. Various phase-ins and phase-outs in the tax code complicate things further; for example, taxpayers in the AMT exemption phase-out range face effective marginal rates several percentage points higher than their statutory rates on both earnings and capital gains.

How would PFSA affect all of this? TPC estimates that the proposal would increase average effective marginal rates for high-income taxpayers – but not for all types of income. Effective marginal tax rates on capital gains would nearly double from 18 percent (under current policy) to 34 percent for taxpayers with incomes between $1 million and $2 million, and would climb to 29 percent for taxpayers with incomes over $2 million. That jump shouldn’t come as a surprise. As Warren Buffett has been telling us, high-income taxpayers who face low tax rates tend to have lots of capital gains, which are currently taxed far below the fair share tax rate of 30 percent. (If you’re wondering, taxpayers with incomes between $1 million and $2 million face a higher effective marginal rate than taxpayers with incomes over $2 million because the fair share tax phases in over that range.) Capital gains realizations would fall dramatically in response to these high marginal rates, which – according to some estimates – would actually exceed the revenue-maximizing tax rate on capital gains.

The average effective marginal rate on wages actually decreases slightly for those with very high incomes. While this seems counterintuitive, it actually makes sense. Between income and payroll taxes, most high-income taxpayers already face a marginal rate above 30 percent on their wages. If they end up on PFSA – most likely because their capital gains pull their average tax rate down below 30 percent – their 30 percent marginal rate on earnings will actually be less than they were paying before.

Yes, raising taxes on a couple hundred thousand of the highest-income Americans sounds awfully appealing. But narrowly based tax increases often come at an efficiency cost. And in this case, the most likely source of efficiency loss comes from discouraging realizations of capital gains.

Some background:  Revenue increases are going to have to be part of the medium- and long-term fiscal solutions.  The required spending cuts from solving the budget problem on the tax side alone would be too draconian to gain public support, and durable budget deals that addressed earlier fiscal problems in the 1980s and 1990s contained a balance of spending cuts and revenue increases.  In addition, the public supports having a combination of revenue increases and spending cuts, rather than all one or the other.  And, if shared sacrifice is a key theme for fiscal solutions, tax increases are the only way to ensure that households with very high income participate meaningfully in helping to close the fiscal gap the nation faces.

The first “big idea” is a specific proposal in the budget – to limit the benefit from itemizing deductions to 28 cents on the dollar.  Current itemized deductions are expensive, regressive, and often ineffective in achieving their goals.  The mortgage interest deduction, for example, does not seem to raise home ownership rates.  Limiting the benefits of the deductions for top income households is a way of reducing the distortions created by the tax code, making taxes more progressive and raising revenue.  All good ideas.

The second “big idea” is to repeal the alternative minimum tax and replace it with the so-called Buffett rule, which would establish a 30 percent tax rate for taxpayers with income above $1 million. As a guideline for tax reform, rather than a specific budget item, this proposal would move the tax system in the right direction, with a caveat.  The alternative minimum tax was originally designed to stop taxpayers from taking excessive amounts of deductions or tax-preferred income, chiefly in the form of capital gains.  However, as the tax has evolved, it now increasingly falls on middle-income taxpayers, and liability is mainly due to having many children or living in a high-tax state, hardly what most people think of as aggressive tax sheltering techniques.  Replacing the AMT with a tax system that truly increased the progressivity of taxes and closed loopholes — what the Buffett rule is intended to do — would be an improvement.

However, there is that caveat — it will not be possible to do that in the existing system, without imposing either a big jump in taxes as households reach $1 million in income, or high effective marginal tax rates over a range in which the tax phases in.  That is probably why the Buffett-AMT switch is being a proposed as a guideline for reform, rather a budget line item.  Done right, and done as part of a broader reform, the switch would broaden the base, raise revenue, and reduce inequities in the tax system — all the right directions for tax reform.

This is understandable with what is effectively a reelection manifesto. In high campaign season, specifics get a candidate in nothing but trouble. Still, this framework is at once disappointing and illuminating.

It sets up a powerful contrast with whomever the GOP nominates to replace Obama: Should tax reform be used to raise revenues, an explicit goal of this budget, or should it be a vehicle to cut taxes and increase the deficit—the specific aim of every remaining GOP presidential contender?

Yet, Obama’s fiscal plan is disappointing because it is so vague. There is simply no chance Congress will make the tough votes necessary to enact any serious tax reform without a president who is prepared to take the heat for specific, deeply controversial cuts in popular middle-class tax preferences.

But Obama’s budget contains little more than gauzy promises for a “simpler, fairer and more progressive” tax system or, elsewhere, a “simpler, fairer and more efficient’ system. Know anybody against those principles?

There are plenty of proposals to end corporate tax breaks, but when it comes to individual taxes, the Obama budget is the Oakland of tax policy. To borrow from Gertrude Stein, there is no there there.

Yes, he’s proposed taxing dividends at ordinary income rates and found a new way to tax investment firm partners so they could no longer treat their compensation as capital gains. Talking to you, Mitt Romney.  But otherwise, the White House has done little more than rehash some Golden Goodies—allowing the 2001/2003/2010 tax cuts to expire for those making more than $200,000, and capping the economic value of itemized deductions at 28 percent.

This adds up to little more than raising taxes on “the fella behind the tree” and ignores those deductions, exclusions, and credits that benefit middle-income households, pervert the tax code, and keep tax rates high.

Even the much-ballyhooed “Buffett tax” is an empty vessel. After making a major fuss in his State of the Union address about requiring those making a million dollars a year to pay their “fair share” in income taxes, President Obama has proposed…nothing.

As a result, the only plan on the table is one proposed by Senator Sheldon Whitehouse (D-RI). With all respect to the senator, a plan by Whitehouse is not the same as a bill from the White House.

Obama’s unwillingness to get down and dirty with legislative specifics seems ingrained in his DNA. He did the same thing with the health reform law, which Congress turned into a mess. And he did it with financial reregulation which, despite whining from Wall Street and the banks, has done little to prevent a rerun of the financial abuses of the past decade.

Still, pay attention to Obama’s principles for tax reform. They set the stage for what could become an epic battle, if Obama gets reelected and is serious about pursuing tax reform (I wouldn’t bet on either at the moment).

Obama laid out five principles. Three–lowering rates, increasing job creation and growth, and cutting “inefficient and unfair tax breaks” –are the mom and apple pie of tax reform.  It’s just that nobody can agree on what inefficient and unfair means.

But numbers 3 and 5 will generate a political donnybrook. Number 5 is the Buffett rule. Number 3 is to use tax reform to cut the deficit by $1.5 trillion over the next 10 years.

The last one will do the most to separate Obama from his GOP challenger. Rather than shying from the charge that he’s a tax-hiking Democrat,  Obama explicitly vows to use reform to raise revenues—but says he’d get the money almost entirely from rich people. This promise alone will make for an interesting campaign.

That sounds straightforward but it’s not.

First, there’s the matter of how to measure income. The rule would define income as adjusted gross income minus a modified measure of charitable contributions. The adjustment avoids discouraging charitable donations.

Measuring taxes is more complicated. The proposal defines taxes to include the regular income tax, the individual alternative minimum tax (AMT), the employee’s share of payroll taxes that finance Social Security and Medicare, and the 3.8 percent tax on investment income and the 0.9 percent tax on earnings imposed on high-income taxpayers to help finance healthcare. That’s a broader measure than what most people see on their tax returns today, but it still excludes other taxes that people pay indirectly like corporate income taxes and the employer’s share of payroll taxes.

If you make at least $1 million (by the act’s definition) and your tax is less than 30 percent of that, you’ll owe more tax, presumably yet another addition on your income tax return. That’s certainly not tax simplification.

The Tax Policy Center estimates the proposal would increase 2015 taxes for about 116,000 households by an average of more than $170,000, assuming the Bush-era tax cuts expire as scheduled and Congress stops patching the AMT. That’s an overall tax increase of about $20 billion, not chump change but less than a tenth of the projected 2015 deficit. If Congress extends tax law in place this year, about 217,000 tax units would owe an average of nearly $190,000 more, yielding about twice as much additional revenue but still less than a tenth of a larger deficit.

The Buffett rule sounds good in principle. High-income taxpayers should pay at least as large a share of their income in taxes as the rest of us. But most already do. On average, middle-income households will pay 2015 taxes totaling about 15 percent of their income (using the legislation’s definition). Without the Buffett rule, more than 99 percent of millionaires will pay more than that and only about 4,000 will pay less. Barely 10 percent of them will pay less than 20 percent.

The proposed legislation would certainly raise taxes on a lot of high-income taxpayers. But the price would be even more complicated tax code. There are better ways to raise taxes on the rich.

This competiton is similar to the way states use tax subsidies to woo businesses. It make not make much sense, but it sure is trendy.  

For instance, in 2010 the Georgia legislature voted to exempt nearly all retirement income from tax starting in 2016. Last year, the governor of Maine proposed making all pension income tax-free.

Not all states are headed in this direction. Michigan, which is in deep financial distress, recently rolled back some generous tax exemptions for pension income. But nearly every state offers some tax breaks for seniors.

Why? Many seniors have plenty of money to spend including Medicare dollars, and Social Security and pension benefits. Just as important, they use relatively few state and local services:  The elderly don’t need K-12 education and spend relatively little time in jail. And their health care is largely funded by the federal Medicare program.

This tax race for seniors is described in a fascinating new paper that Karen Smith Conway of the University of New Hampshire and Jonathan Rork of Reed College presented last week at a Tax Policy Center/UCLA Law School conference on state taxes.

States offer seniors three buckets of tax breaks. They exclude some or all Social Security benefits from tax; grant seniors extra deductions, exemptions, or credits; and exempt at least some pension income from tax. Combined, these preferences cost states more than $24 billion annually. The biggest beneficiaries: middle- and upper-income elders–the very people states want to keep or attract.

For instance, Conway and Rork found that 12 states offer a modest tax exemption for pension income, three exempt income of $70,000 or more, and five exempt all pension income from tax.  

Conway and Rork quote Georgia Gov. Sonny Purdue, who said his state’s plan to eliminate taxes on retirement income “will help attract retirees to our state and make our economy even stronger.”  

Is he right? Do low taxes attract seniors and are they worth the revenue cost?

Lots of prior research suggests Purdue is engaged in little more than wishful thinking. Last year, fewer than one percent of seniors moved from state to state after age 65 for any reason. And very few appear to do so to reduce their taxes.

This limited mobility may result in another major downside for states. About 70 percent of seniors will eventually require long-term care services in old age, and 20 percent will need this assistance for five years or more.

Many are middle-income seniors who spend down their assets on personal care and eventually become eligible for Medicaid. About one-third of Medicaid dollars are spent on long-term care services and the program is a growing burden on state budgets.

Thus, while states may benefit in the short-run from attracting a few relatively young, healthy, and wealthy pensioners, they may end up paying a substantial price when middle-income seniors become frail, go broke, and require Medicaid long-term care services.

When that happens, states such as Georgia may regret giving up revenue to subsidize seniors. Of course, the price for that mistake will be paid by some future governor who has the misfortune of serving years from now.