Is it time for American parents to get a tax cut? That idea is at the heart of new conservative pro-growth, pro-family economic agenda. Recently Senator Mike Lee, a Utah Republican, introduced legislation that would help offset the parent tax penalty by providing an additional $2,500-per child tax credit, available to all parents of dependent children and applicable to payroll taxes as well as income taxes. Lee’s bill also, among other things:
– establishes two individual income tax rates: 15% on all income up to $87,850 – and twice that amount for married couples – and 35% on all income above that;
– provides a $2,000 personal credit to offset the removal of the 10% bracket and the personal exemption
– provided a new charitable deduction that would be available to all taxpayers, not just current itemizers;
– provides new mortgage interest deduction, also available to all home-owners, but capped at $300,000 worth of principal
– eliminates the state and local deduction.
The intellectual basis of that plan is a 2010 National Affairs essay by economist Robert Stein. In a new episode of my Ricochet Money & Politics podcast, I interviewed Stein about the political and policy impact of his proposal.
Stein is currently deputy chief economist at First Trust Advisors. Immediately prior to joining First Trust, Stein was assistant secretary for economic policy at the U.S. Treasury Department. Between 1996 and 2002 Stein was chief economist for the Senate Budget Committee on Capitol Hill and an economist for the Senate Banking Committee and Joint Economic Committee. Prior to his tenure on Capitol Hill and the Treasury Department, Stein was a journalist for Investor’s Business Daily.
Here are the lightly edited highlights of our chat:
In 2010, you wrote the following in a piece for National Affairs:
It is time to rethink how the tax code treats parents. Too many free-market economists still consider families an afterthought, arguing that the tax code should be “neutral” about raising children, as if parenting were merely one hobby among many. But raising children is hardly just another pastime: it is one of the most important services any American can perform for our country. Even if we ignore the societal and cultural implications of parenting and consider economic factors alone, no government can be neutral toward the very existence of future generations of taxpayers. By targeting tax reform, policymakers would both offer meaningful relief to American families and create political opportunities to enact other pro-growth policies.
Why don’t you just lay out a little bit what your general plan is and why you think it makes economic sense.
Well, basically, the plan originates from about three insights that I came upon when I was working on Capitol Hill. So it really dates back a long time, the seed for the idea. And it comes from three thoughts.
First is that Republicans, and conservatives in particular, generally talk about marginal tax rates. And we should talk about that because that’s what really matters in terms of tax policy — the tax treatment of the next dollar you earn because that decides the incentive for engaging in a productive capacity or not.
Liberals tend to focus much more on the average tax rate, on what they deem to be the middle class and below. And they really couldn’t give a rat’s behind about what the marginal rate is. They just want to know what the after-tax living standard of these people are going to be in. I don’t think those two positions, the conservative position and the liberal position, can be reconciled. They seem to be talking past each other a lot.
The second key insight is basically that the value of a child in the Social Security system and the Medicare system is not net zero. What most conservatives — and in fact what most economists do — is they assume that, well, if an additional child is born, that child will contribute to the Social Security and Medicare system. But let’s assume that that child will get benefits as well and so on net it’s zero.
But that’s not really the case. And the reason is because if an additional child is born, we need to impute to that additional child the same fertility rate that everybody else has. And so if we have an additional child, whether or not that child himself or herself will be able to get benefits will depend on whether they move forward and have children. If they don’t, well, then, they’re not going to get any benefits. And so when you really look at society and if you were to assume one generation as additional children, the net contributions from that generation of children will be positive, not net zero.
The other key insight – and this is going to be tougher sell for supply-siders — is that supply-side economics was dumbed down from the very beginning. And it reached its nadir under President Bush, for whom I worked for four years at the U.S. Treasury Department, by the way. And here’s why. If you look at the Bush tax cuts from 2001 and even 2003 – now, I happen to be a big fan of the tax cuts on dividends and capital gains — if you look at the changes in the income tax rates, when we carved out a 10 percent bracket out of the 15 percent bracket for people of low income, the vast majority of the income earned in that 10 percent bracket is not earned by people whose top rate is 10 percent. Most of it – 90 percent of it – maybe a little bit more is earned by people above that.
And so it really wasn’t a supply-side tax cut. That portion of it was a Keynesian tax cut. But then as I looked further up the income tax brackets — at the other rates that were cut, like the 28 percent rate was I think cut to 25, each and every tax bracket — the same argument is true. Even the tax bracket below the very top, most of the income earned in the tax bracket, just below the very top, is earned by people who have money in a higher bracket, the highest bracket.
So if you really want to do a supply-side tax cut, you should not do what Bush did. The vast majority of his tax cut was Keynesian tax cut that was dressed up to masquerade as if it were a supply-side tax cut. What you really want to do with the supply-side tax cut is just cut rates at the very top. And that’s even true from the very beginning. What the Kemp-Roth bill really was to a great extent was a Keynesian tax cut. When you cut tax rates across the board, it’s actually a Keynesian tax cut because except for the tax rate cut at the top — where we cut the 70 percent bracket to 50 percent — the vast majority of those marginal rate cuts went to people who had money in a higher bracket. And so it really was to a great extent a Keynesian tax cut.
And how does – how does this play into what you want to do for families?
So in trying to design a tax cut that would appeal to both supply-side conservatives and liberals. we could cut the rate at the very top — which is now right around 40 percent — maybe cut that rate to 35 or 36, and then provide much more generous benefits to people who have children. So the idea in the Lee plan, or as Senator Lee has incorporated it, it’s to create an additional credit of $2,500 per child. The credit would have no income cap. So we wouldn’t create these phase-outs that generate higher marginal tax rates for some people, like with the current $1,000 credit.
It would be a universal tax credit?
It would be universal, except it would not go to people who have zero payroll in income tax liability.
So you could apply against both the income and payroll taxes?
Exactly, Jim. So let’s say, you know, you would look at your taxes and in the end, you know, you have maybe $6,000 in income tax liability. Well, for every additional child – let’s say you have three kids, you would get $7,500 off of your taxes.
Now, if you have $6,000 in income liability, then it would go down, you’d get an income tax credit to offset your payroll tax liability. And it would offset the burden on the payroll tax. And the reason you want to do that is because the old age pension system, Social Security and Medicare, are largely, not completely, but largely financed by payroll taxes, not income taxes. And that system has itself created what I believe is the worst distortion in life, whether at work or at home, created by fiscal policy. And that’s the disincentive to raise children.
It seems that many supply-siders are universally focused on the incentives and disincentives associated with a workplace. If you open a business, but when you leave that business door at the end of the day and before you get to it in the morning, they are completely blind to the incentives taking place in the household.
What Medicare and Social Security and combination have done is promised people that if they contribute to the system through payroll taxes, well, then they’ll be kept out of old age poverty. Before these systems existed, you know, the only way to really keep out of old age poverty was either to accumulate financial assets or raise kids that would take care of you in old age. And so it has implicitly deterred people from using that natural step, which is to raise children, try to get them to be able to generate an income in the future to support yourself in old age, or at least as old age insurance against poverty.
And the idea is that if that’s creating a distortion in the way people live, we should, as good Republicans, as supply-siders, focus on that distortion and not just what’s going on in the business sector.
So is this a demographic, fertility-rate issue that people have more kids? Is there some other positive, pro-growth economic impact? Or is this a fairness issue: “I have a big family, and I am creating future taxpayers to support Social Security and Medicare at my own expense. Yet, I’m also paying these payroll taxes. So this would allow me to capture some of my economic investment in these kids.” Is it more that issue?
I think it’s all of the above, Jim. In terms of messaging, I think fairness has to be at the heart of it that parents are essentially funding everybody’s future social – the parents of this generation are essentially funding everybody’s future Social Security and Medicare benefits. But everybody will enjoy those benefits, whether they’ve raised kids or not. And that’s unfair. Parents are facing a double burden. They have to pay into the system and raise kids. And non-parents, you know, they just pay into the system. They’re not carrying the full burden and are, in part, getting a free ride on the system.
So fairness has to be at the heart of messaging because I think it’s what most voters understand and will understand intuitively. In terms of fertility and incentives, those are also why I think the program deserves support.
There’s been some work by economists – Isaac Ehrlich and Michele Boldrin, as well as some others — looking at the effect of the old age retirement system, not just in the United States, but around the world on fertility. And what they found is that countries with larger old age retirement systems, controlling for all other variables like labor force participation rates among women, education among women, literacy rates, size of government issues, otherwise – have found that countries with larger old age pension systems reduced fertility. And there’re other reasons for reduction in fertility in the last, you know, 50, 60, 80 years, like more widespread use of financial assets. And that’s OK. And there’re other reasons obviously as well, both abortion and contraception. And those are separate issues. I’m not trying to address those either way. But I am trying to get people to think and act in a way where the government is not interfering with their behavior.
So what you think would be the impact on the US fertility rate? And I think the point here is not that this tax credit is going to encourage people to have more kids than what they would want, but to give them a bit of help and a nudge to have the number of kids they would prefer.
Exactly. The Agriculture Department, every year, does its analysis of the cost of raising a child per year. It comes out that’s somewhere $13,000-$15,000 per child. So an extra tax credit of $2,500 layered across what we already have, which is $1,000 tax credit and a deduction, that’s essentially for a middle class parent worth $500, so a total of say $4,000 is not going to – is not going to take raising children and make it a money-making opportunity in and of itself. You’ll still be losing $10,000 a year as a parent.
And so we’re still treating it to some extent – to a great extent as consumption, consumer kids. We have kids because we want them. But if society as a whole benefits from people raising kids, we don’t want fiscal policy to deter people from having the family size they would otherwise prefer. We are not trying to manage and manipulate people’s fertility behavior. We’re trying to return it to what it would be in the absence of inadvertent government policies that have reduced it.
When I write about this, my libertarian friends accuse of not crony capitalism but crony familialism. But, no, what you’re doing is you’re removing a distortion rather than creating subsidy.
That’s right. And to be frank, we’re not really removing the distortion. I know that’s just a word you happen to use at this moment. What we’re trying to do is offset a distortion. And a lot of people have trouble coming to grips with the distortion even being there, and frankly, most of the people [in the policy wonk world] have the number of kids they want, regardless of Social Security and Medicare because frankly they have higher earnings. And even if they do not, they would not accept money from their kids in old age. They’ll just accumulate enough financial assets to do so because they know how to do that.
What we’re really talking about are middle-class people and below who are not particularly sophisticated in their long-term financial planning. And that’s OK. You know, a lot of people are good businessmen. A plumber is really good at what he does. An electrician is really good at what he does. But he might not be a financial planner and know what financial assets to accumulate to make his retirement work.
And so it’s quite normal for people in the middle class to raise kids – or at least was before Social Security and Medicare – to raise kids to take care of yourself in old age. I mean, it was kind of explicit. And to some extent, it was reinforced by religion.
One way to see how the Social Security and Medicare system can make a difference is imagine if we went back to 1936 and 1938, when they were first getting the Social Security system or thinking about it and getting started to get it up and running, imagine if they simply said you do not pay into the system as a whole. You do not pay the government. What we’re simply going to do is require each and every child, for whatever the Social Security wage base is, to make that payment to their own parents.
I think the light bulb would go off over most people. They’ll realize, oh, obviously it can make a difference. If people were required to make a mandatory payment of the same amount they pay now to the government to their own parents, well then those parents would have a different incentive structure in terms of – in terms of how they value and how they pursue their own spending.
You know, even today, do I get granite countertops in my new kitchen or do I send my kid to a better middle school, so that maybe he can earn a little more money when he or she i older.
So what would be the impact on fertility? And would it create enough additional economic growth that it would pay for itself over the long term?
I don’t want it to necessarily be scored dynamically. That’d be nice, but my expectation of that is minimal. What we would probably see is an increase in the fertility rate in the United States from around two child per lifetime per woman to around 2.4, 2.5. It’s a little bit of a change.
Now, that doesn’t necessarily mean will immediately go up from 2 to 2.4. It’ll take maybe a generation to get there as people – it dawns on people gradually that, oh, you know, people who raise children are better off relative to where they would have been in the absence of this program, compared to their non-parent peers. It takes a while for that to happen.
When Social Security and Medicare were created, we didn’t immediately see a huge drop off in fertility and we still haven’t seen any particular decade where there’s a massive drop. It’s a gradual process as it dawned on people that the incentive structure is a little bit different.
And you know, the research that’s been done shows that in Europe, where the old age pension system is even more generous, that those systems have reduced fertility by about one child per woman. In the United States, where the pension system is a little bit smaller, at least the public pension system, it’s reduced it by about half of a child per woman.
So we gradually work ourselves back up there. And these children would eventually generate more cash flow and it would make the system more solvent for everybody, both parents and non-parents alike.
So you’re helping the solvency of the social insurance system and perhaps you wouldn’t have to raise taxes to help make it solvent. But you would also be increasing the labor supply, and that’s a factor in economic growth, yes?
What I would expect to see – a couple of things – now, you would see a little bit of a faster pace of economic growth over the long term. In the short term – in the medium term, you might not actually see that. You might see families ordering themselves differently. You know, if raising children is recognized as a social benefit by the tax system and we offset the pain that people are now feeling, you might have some people leave the labor force in order to focus more on raising their children than they do today. If I don’t know what the effect on labor force participation would be, that’s only because labor force participation doesn’t include raising kids, which is – as we talked for the past half hour – it’s also a social benefit. Just that, you know, the bean counters in the government don’t recognize it. Or maybe some families will organize themselves by more parents going into the workforce, earning more to get the full benefit of this tax allowance, and then hiring somebody to take care of the kids if that’s what their preference is.
I see this is as sort of a different kind of capital gains tax cut, a human capital gain tax cut. Is that the right way to think about it?
That is absolutely the right way, but I think – I think conservatives have kind of bought into the way liberals talk about human capital. And I want to make a distinction between two types of supply-siders now. There what I call the Golden Calf supply-siders, and what I guess I would call Ten Commandments supply-siders. And the golden calf supply-siders – I’m not going to name anybody in here, but you could probably figure out who they are. — the golden calf supply-siders tend to believe that the tax system that is right for the United States would be right for it regardless of the nature of our society as whole, our religious and cultural nature. That the right tax system for the United States is the right tax system for a society that would pray before the golden calf. Doesn’t matter.
A Ten Commandments supply-sider believes that the nature of our society is important in designing the tax system. And we need to recognize our role as, for instance, getting rid – you know, getting rid of the marriage penalty because marriage is an institution within our society and the costs associated with raising kids for the next generation. Because it’s been if nobody raises kids, well, you don’t even have a workforce in the next generation.
So it’s not just about a person who’s 18, going off to school and expensing their college education. That’s what a golden calf supply-sider would look like. It’s the cost of putting food and energy into your children and actually bearing children. That cost should be deductible. We should allow for deductions, in theory at least, for all the costs associated with raising children, in the same way that we allow for the expensing of plant equipment. And so this is one way of getting to that area.
Now, some people say, well, maybe we shouldn’t allow expensing of plant equipment. And I think that’s kind of ridiculous. It’s an investment, just like raising kids is an investment. And we ought to treat them roughly equally.
If you have a country where the population is shrinking and getting older, you’re going to get a less innovative risk-taking entrepreneurial society. I think Gary Becker has written some about that.
Yeah, I think that’s absolutely right. Now, free trade kind of lets you short-circuit that price just a little bit because you can access the younger, cheaper workers abroad –
Right, and their innovations and entrepreneurship..
That’s right. Now, one effect I think you might see is that people focus more on raising their children well, raising children and raising them well. Then, you might see a little bit of a crowding out of immigration flows into the United States. And there’re other reasons to think that immigration is going to slow down because fertility rates in the emerging world are dropping rapidly. But you might see more endogenous growth of the, you know, so-called native population, versus population growth through immigration.
But this plan would not be scored dynamically. Is someone going to pay more taxes if parents are are paying less?
So I’m assuming we’ll have some Republican president in the future, a Republican majority in the Senate. And then there’ll be a choice essentially, whether or not try to push it through a reconciliation process, a budget reconciliation process like President Bush did with his tax cut, where you only need a simple majority in the Senate and the House. But then, it’s only a temporary tax cut.
We’re trying to do it in a different way. My best guess is – my personal preference is to do it on a permanent basis. And to make adjustments to the Lee tax plan to make it revenue neutral, just in case it is scored as negative. And it’s not that difficult to do it. Instead of having a top rate of 35 percent, well, make it 37 or 38 percent, you know a little lower than it is now, but not much because really from going from 40 to 35 percent is not much of an incentive effect anyhow. And then to kick that rate in at a somewhat lower level than the Lee plan would otherwise kick that rate in, whatever the top rate is.
So, yeah, in the end, if parents as a class are paying less, then some people are going to pay more. I think that the plan is designed in such a way that the people who will pay more are essentially high-earning childless workers. So if you’re a high earner, if you’re – if you are – you know, you just graduated Yale. You went to work on Wall Street. You’re making $500,000 a year and you’re cruising the bars and clubs at night and you’re living fancy-free, you’re going to pay a boatload more in taxes under my design than under the current system, boatload more
But the plan you outline in “National Affairs,” there were some other – there were some other “pay fors.” Didn’t you mention the state and local tax deduction?
Yeah, basically –
And there were also some other tax cuts, I think, the corporate rate or something.
Yeah, the plan in National Affairs – and Senator Lee hasn’t really touched on the corporate side yet and the capital gains and dividend side yet — would also move to greater expensing of plant equipment and the double taxation of capital gains and dividends, basically adopting the old plan by Glenn Hubbard that he developed in the early 1990s to reduce taxes on capital investment.
So you know, in the end, somebody has to pay more and that will be high labor income, you know, people who make a lot of labor income, who aren’t investing, aren’t raising kids are going to pay more. Parents will pay less. And investors will pay less as well.
But for the money this would cost, why not just lower marginal tax rates?
Well, if you’re talking about lowering the top marginal tax rate, good luck. I mean, our society seems to have an appetite for a rate that’s clearly about 28 percent and maybe below 40. So I think it would be very difficult to get it below 35 in any circumstance. It would also be difficult –
The House GOP is shooting for 25 percent.
Yeah, well, they’re dreaming. It’s just not going to happen. And frankly, you know, back when I was at the Treasury Department, I had them run some special numbers for me and even after we cut the top rate to 35 percent, the average rate – the average rate, not the marginal rate — on labor income for people in the highest brackets was still in the low 30s. So the only possible way to lower the top marginal rate below the low 30s is to have a massive tax cut for the upscale. And so that because of the budget reconciliation process would have to be another temporary tax cut, which would limit its own improvement in economic incentives.
So they’re just dreaming. And you know, let them dream, but eventually they’ll come back to reality and figure out the tax cut that can pass and can be essentially a camel’s nose under the tent for better incentives for capital gains and for parenting.
Where do you think this is going politically? Is this something that could happen as early as, you know, 2017, if there’s a Republican president?
I am very surprised at how little pushback we’ve gotten from areas you would expect to push back, and like The Wall Street Journal editorial page. And so I’m pleasantly surprised at that. And anytime I talk to people outside the beltway about this, they’re very positive about it. I’ve talked to Democrats about it. They’re positive about it. They like the idea about doing something for middle class parents as parents. And they recognize the burden that – the actual burden those people feel. So I think it’s hard to resist.
The candidate who, in the end, I think is most likely to take this up as a presidential candidate from the Republican side, and I’m just kind of reading the tea leaves here, is Chris Christie. And the reason is because he is going to need something to appeal to social conservatives. And I think this will because it recognizes the value of raising children that no other politician is out front recognizing. And if he did that, I think it would bridge a gap for him that he needs to bridge in order to get the nomination and in order to bring conservatives home and feel good about supporting him.
One final question, since we’re talking about taxes. What – when you look at government spending and how much tax revenues are coming in, when you’re at Treasury, what do you think is sort of reasonable as far how small we can keep government, given the aging of the population and the desire to have the world’s most lethal, power-projecting military over the next 25 years. Some folks who would like to get us back to, you know, spending 17 or 18 percent as a share of GDP. What do you think is reasonable?
Given our global commitments militarily, given, you know, the debt servicing costs, which will eventually go back up to around 2 plus percent of GDP, where we were in the ’80s and ’90s for many years, given that we can reduce Medicare spending, Medicaid spending, and maybe gradually evolve Social Security into an old age poverty insurance program that has a minimum benefit, rather than really going up through the income classes, and the aging of the population and the public’s appetite for raising retirement age. You know, if you look at the 75-year horizon, we’re going up 30 percent of – 30 percent plus of GDP by the federal government spending. Or maybe, you know, 33-34. My best guess if we really work hard, we can bring down that long-term trajectory to about 25 percent.
And it’s going to take a lot of smart policy to do it.
Yeah, but the key here – and I hate to agree with Peter Orszag because I think he’s the devil incarnate – (laughter) – and yes, I know this will go out in public. I hate to agree with him, but a lot of this is just rising health care costs over the past generation. So that even our population we’re not aging, because the government has gotten into the business of promising health care, even before “Obamacare,” just with Medicaid and Medicare, and because of productivity growth in this sector, that you’re going to have – that you’re going to have a larger share of the federal budget just going to these things. And it’s going to require more resources.
So even if you make efficiency improvements, you know, a larger share of our social revenue generation is going to go into these benefits. And that’s also even if we increase retirement ages a little bit here and there. And that’s unfortunate, in my view. If the government were only in the business of providing food and basic shelter, then we wouldn’t necessarily see this big blowout in government spending over the next generation. But you know, because it’s medical care, we will.
Follow James Pethokoukis on Twitter at @JimPethokoukis