Wednesday, May 16, 2012

When a Spending Cut Can Be Like a Tax Increase

Copyright, The New York Times Company

Sometimes Republicans and Democrats are like Coke and Pepsi: a lot more different in marketing than they are in substance.

Aging, changes in the health sector and the recession all serve to increase what the government spends on social welfare programs. Republicans and Democrats both acknowledge that some kind of adjustment is needed to bring the amount the government spends in line with the amount that it taxes.

Republicans are more apt to say that spending needs to be cut in order to match government revenues that are currently less than spending. Indeed, many of them have taken a “no new taxes” pledge. Democrats are more apt to consider raising revenue to help pay for the cost of social spending.

To the degree that Republicans propose to cut spending by means-testing programs that were formerly provided to all income groups, there may be little or no economic difference between Democratic and Republican proposals.

Take, as an example, Medicare, the health-insurance program administered by the federal government primarily for people 65 and older. It is a universal program, rather than an antipoverty program: all citizens can receive benefits from the program when they become old, regardless of how rich or poor they are.

To simplify the arithmetic, suppose the medical goods and services provided cost an average of $11,000 a year per beneficiary. The government could provide Medicare free of charge, in which case each beneficiary effectively receives $11,000 in premium assistance from the public treasury in order to pay for the cost of the program.

The premium assistance by itself tends to increase the government deficit in proportion to the size of the older population, because the government has to pay for the medical goods and services. One idea, close to some Republican thinking, is to reduce the deficit by cutting government spending by “means-testing”: limiting the assistance to people who cannot afford to pay the premium themselves.

For example, the premium assistance might be reduced 10 cents for every dollar of a beneficiary’s income. (Medicare Part A is currently is a universal program. Medicare Parts B and D currently subsidize premiums for all beneficiaries, but to a greater degree for those with low incomes; in this regard Medicare is a means-tested premium assistance program.)

The universal and means-tested approaches are shown in blue and red, respectively. The horizontal axis shows annual income ranging from zero to $120,000 a year. The universal premium assistance approach is shown as a horizontal line, because all beneficiaries receive the same assistance regardless of income. The green means-tested schedule slopes down, because high income people receive less assistance than low-income people.

An alternative approach would be to keep the universal assistance but help pay for it with an additional 10 percent income tax on people 65 and older. A 10 percent income tax on incomes below $110,000 a year is shown in red in the chart. Democrats have proposed raising taxes on wealthier Americans to avoid deeper spending cuts, though none have called for a tax on the elderly, as in this hypothetical example.

Under the income tax version, the net benefit to beneficiaries is the difference between the blue and the red lines in the chart, which coincides with the green means-tested proposal.

Although the new tax and cut-by-means-test proposals sound different – the former proposal raises revenue without cutting spending while the latter proposal cuts spending without raising taxes – they are economically equivalent in these examples.

Both proposals cut net benefits (or raise net taxes) more for higher-income beneficiaries than for low-income beneficiaries. Putting more of the burden on higher-income beneficiaries is sometimes described as fair or equitable, but it also adds to the penalty for having a high income and, equivalently, subtracts from the burden of having a low income. That results in more people with low incomes, because incomes are determined in part by effort, which is affected by costs and benefits.

My point here is to advocate equity rather than incentives and to point out that both proposals — tax increase and spending cut — can increase equity and reduce incentives, in much the same ways.

Despite the economic similarities between the two approaches, I expect Republicans and Democrats to continue to differentiate their policies excessively, with Republicans arousing taxpayers over Democratic plans to raise taxes and Democrats alarming beneficiaries about imminent cuts in important social programs.

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