2

Understanding the Basics of Tax Policy and State Budgets

“Taxes are about values as much as they are about economic theory and policy design,” said discussion moderator Giridhar Mallya, senior policy officer at the Robert Wood Johnson Foundation. Taxes reveal society’s beliefs about what is worth investing in, Mallya added, and whether and to what extent government should be trusted. Taxes and tax credits can influence behaviors, such as consuming alcohol, purchasing a home, or even entering the workforce, he said. Taxes can promote investments in social goods, such as affordable housing and medical education, and can pay for services, from trash collection to prekindergarten programs to Social Security. Drawing on his experience with two unsuccessful attempts to tax sugar-sweetened beverages in Philadelphia, Mallya observed that establishing a new tax is much harder to do than increasing an existing tax. He also noted that the regressivity of a tax is relative: “Each time the sugar-sweetened beverage tax was not passed, the property tax was increased, and essential services were cut.”

Properties in low-income communities in large cities are often overvalued, and when property taxes are increased, those neighborhoods bear a disproportionate burden, he explained. Mallya said that the soda tax in Philadelphia was eventually successful, and a local $2 per pack tax on cigarettes also was instituted. The cigarette tax helped close socioeconomic and racial/ethnic disparities in smoking and raised money for public schools. This is just one small tale in a much larger story, he noted, and tax policy and its implications for health go well beyond those types of excise taxes.

To provide a foundation for the workshop discussions, Pete Davis of Davis Capital Investment Ideas reviewed the principles of taxation, and examined how well or poorly they are adhered to in some current tax policies.¹ This was followed by a discussion of the fiscal environment for state and local budgets by Nick Johnson, senior vice president for state fiscal policy at the Center on Budget and Policy Priorities, and discussion moderator Christopher Brown, financial policy director at PolicyLink. (Highlights of this session are presented in Box 2-1.)

TAX POLICY BASICS

Tax policy is a balancing act among competing objectives, Davis said. There are always winners and losers. According to behavioral economists, he said, losers hate to lose two or three times more than winners like to win. For a policy to be politically viable in any level of government, gains have to well exceed losses. This is a very tough standard, he noted.

___________________

¹ A background paper prepared by Davis for the workshop is available at http://nationalacademies.org/hmd/~/media/Files/Activity%20Files/PublicHealth/PopulationHealthImprovementRT/17-DEC-7/Background%20Reading.pdf (accessed February 2, 2018).

Tax Policy Principles

Every government must raise revenue. The basic principles of tax policy are to raise revenue, and to do so fairly, simply, and efficiently, Davis said. He expanded briefly on each concept:

• Fairness—Public support for a tax is important, and for a tax to be supported by the public, the public has to be convinced that it is a fair tax.
• Vertical equity relates to ability to pay. The U.S. income tax is progressive,² as the wealthy are taxed are a higher rate than the poor. However, Davis noted, when payroll taxes are taken into account, progressivity is reduced.
• Horizontal equity means that taxpayers with similar circumstances and similar income pay the same tax. Loopholes in tax policy, however, allow for wide variability in how much tax is actually paid by individuals at each income level.
• Simplicity—Taxes should be simple, such that they are easily understood and easily enforced, Davis said, and taxpayers should be able to comply without needing professional assistance. Davis observed, however, that simplicity is generally the first principle to be lost in a tax policy drafting session, and 90 percent of taxpayers resort to using paid preparers or tax software to file returns (U.S. Congress, 2014).
• Efficiency—The collection of tax should be done with a minimum of administrative and enforcement costs.

Davis reiterated that tax policy is a balancing act and said that modifying anything in the U.S. tax code likely violates one or more of these principles.³ Taxes create incentives that can help or hurt the economy. For example, Davis said, the current federal tax code has many incentives for real estate. Renters pay a subsidy, indirectly through the U.S. tax code, that supports homeowners, which he said is a violation of the principles of both vertical and horizontal equity.

___________________

²Progressive or progressivity are terms used to describe tax policies that set higher rates for wealthy tax payers. The opposite terms—regressive and regressivity—are used to refer to tax policies that place a proportionately heavier burden on low-income taxpayers. Definitions of these and other terms may be found at https://apps.irs.gov/app/understandingTaxes/student/glossary.jsp (accessed September 10, 2018).

³ This problem of trade-offs among competing tax policy principles, which create market distortions, is often referred to as the Theory of Second Best (see a definition from the Organisation for Economic Co-operation and Development at https://stats.oecd.org/glossary/detail.asp?ID=3306 [accessed September 10, 2018]).

A participant suggested that transparency should also be a principle, and Davis remarked that in theory transparency is good, but in practice, although a congressional committee markup of a particular piece of legislation might be open to the public, there are also conversations taking place outside the room that can influence how the committee members vote. In fact, he asserted that open markups can sometimes make members more vulnerable to pressure groups (special interests or lobbyists), and he suggested that, on occasion, better policy emerges from a closed policy process.

Health Care in the Tax Code

Health care spending in the United States in 2016 was $3.3 trillion, accounting for about 18 percent of the gross domestic product, Davis said. Medicare and Medicaid account for $1.3 trillion of the federal budget. The U.S. spends more on health care than any other country, and Davis suggested that some other countries that are spending less on health are achieving better outcomes. Health expenditures through the tax code are about $200 billion per year. The majority of this expenditure comes from the exclusion of employer contributions for health benefits. Davis added that the United States is the only country in the world that involves employers in providing health care. Employer-paid health insurance grew out of the wage and price controls implemented during World War II. At that time, health and life insurance was provided as a way to attract a better workforce, Davis stated. The benefit was tax deductible for employers and tax exempt for employees. This approach to health care was never planned or analyzed, Davis said; it simply evolved.

Externalities and Unintended Consequences of Tax Policy

Externalities can lead to the creation of exceptions to the principles of tax policy, stated Davis. Externalities are benefits or costs incurred by others who are not part of a transaction. Pollution, he added, is a classic economic example of a negative externality (e.g., an energy provider produces electricity by burning coal, leading to pollution, which leads to indirect costs for those affected by the pollution). Education is an example of a positive externality. In theory, producers of negative externalities should be taxed, and producers of beneficial externalities should receive tax subsidies. As an example, Davis said that smoking has obvious negative externalities (i.e., the costs of smoking are not just borne by the smokers). It is difficult to tax the smoker, so the tax is placed on the sale of cigarettes. However, too high of a sales tax could hurt job creation in tobacco-growing states. With regard to fairness of a cigarette tax, a greater

proportion of poor people smoke than wealthy people, making a tax on cigarette sales regressive, as it places a disproportionate burden on the poor. These examples illustrate the fact that tax policy is a balancing act, as in this case, to develop a tax that is not too regressive, but achieves the intended goal of getting people to stop smoking.

Public Reaction to Taxes

Taxpayers have a variety of reactions to taxes, and Davis described avoidance, evasion, passing on the tax burden, and lobbying.

• Tax avoidance can be desirable if it gets people to stop buying or doing what is taxed. In the case of smoking, for example, if the price of cigarettes is raised high enough through taxation, it might stop some people from smoking.
• Tax evasion is not paying taxes in violation of the law. In New York State, the cigarette tax is nearly $5 per pack, bringing the total cost of a pack of cigarettes to nearly $10. This has led to a black market in which truckloads of cigarettes are transported illegally from North Carolina into New York. It is estimated that 57 percent of cigarettes in New York have been smuggled into the state. Davis added that buying black market cigarettes subsidizes the criminals doing the smuggling, which creates other negative externalities.
• Passing taxes on is an approach where producers raise prices to cover their tax burden.
• Lobbying is done to try to get a tax exemption or repeal of the tax from lawmakers (Davis, 2017).⁴

Davis and participants discussed that there is a fine line between producing a benefit (e.g., avoidance/reducing smoking) and generating a cost (e.g., fostering evasion/black market sales). Davis recommended starting out small when changing tax policy, for example, piloting a tax increase, credit, deduction, or other approach at the state level to achieve a track record of success. If a jurisdiction is able to demonstrate a reduction in smoking after enacting a tax, policy makers can increase the tax incrementally until an optimal level is reached. The challenge, he said, is finding the optimal level while still balancing the tax principles. He described the challenges of setting a tobacco tax, taking into account that price elasticity is different for smokers over age 25 (who are generally

___________________

⁴ Davis added, “Voters can always call upon their elected representatives in Congress to change the tax law, and they do, either directly or through trade associations and paid lobbyists.”

addicted to nicotine, and would keep smoking regardless of any increase in tax), and under age 25 (who are more influenced against purchasing cigarettes by tax increases).

Another element is the effect of inflation on a fixed dollar tax, and the need to restore a tax to the same real value that it was at institution. Davis noted that there are now taxes on eight different types of tobacco products, covering cigarettes, cigars, smokeless tobacco, and snuff. Developing a uniform tax policy is challenging when there are diverse communities with wide variations in income, expenses, and lifestyles. Tax policy is complicated, in part, because of those differences.

Tax Expenditures

Income taxes are paid at graduated rates. The greater the income, the higher the marginal tax rate. However, tax owed is reduced by income tax expenditures. Davis described several types of tax expenditures.

Above-the-line deductions apply to everyone who files a tax return and include deductions for the costs of producing the income (e.g., business travel expenses), leading to an adjusted gross income. Below-the-line deductions are itemized deductions that reduce the taxable income (e.g., medical expenses, charitable contributions, home mortgage interest). Only about 25 percent of taxpayers itemize deductions, Davis noted, and they are generally taxpayers in the top 30 to 40 percent of the income distribution who own homes. In effect, this means that one-quarter of the taxpayers pay a lower tax that is essentially subsidized by the other three-quarters of taxpayers.⁵ In essence, renters are subsidizing homeowners, he said. There are externalities of home ownership (e.g., safer communities, better upkeep of housing), and attempts to reduce the mortgage interest deduction are met with strong resistance from construction trades, builders, realtors, and others. Charitable deductions can support public hospitals, universities, and social and religious organizations. Again, however, only one-quarter of the taxpayers are benefitting by donating, as most low- and middle-income people do not have enough itemized deductions to benefit from the charitable deduction. The conflict between principles here is that charitable donations serve worthy purposes, but only the wealthiest 25 percent of taxpayers itemize and thus benefit from the charitable deduction, Davis explained.

Tax credits reduce the tax owed. The earned income tax credit (EITC) was instituted in 1975 to address the fact that poor people were often better off if they stayed on welfare than if they got a job. Models were used

___________________

⁵ A specific example of this is the mortgage interest deduction, which costs the federal treasury more than $60 billion annually.

to determine a fair amount of money for the EITC that would encourage employment. The program has expanded significantly, and Davis noted that whenever a program is expanded there is some fraud that must be addressed (e.g., EITC claims for children not supported by the taxpayer). Other examples of tax credits mentioned by Davis included the targeted jobs tax credit, now called the work opportunity credit, and the low-income housing tax credit (LIHTC). There are benefits and unintended consequences of all of these approaches, he said. The LIHTC goes to the investors, not to the renters, but the intent was that renters would benefit from the housing being built. He added that, although new low-income housing is being built, the overall availability of affordable housing has declined as existing structures are not being rehabilitated.

Mallya noted the importance of considering the value of intended and unintended consequences of tax credits, and referred participants to a recent report by the Bipartisan Policy Center on the LIHTC and its effect on health.⁶ Davis suggested that tax credits are a better policy approach than deductions to reduce income taxes. They are easier to keep track of as they do not vary by the marginal rate, and, unlike itemized deductions, credits apply to everyone. Credits are also, he suggested, more easily designed.

In closing, Davis reiterated that tax policy is a balancing act among the principles of raising revenue, fairness (vertical and horizontal), simplicity, transparency, and efficiency. There are always trade-offs. He highlighted the need for policy makers to understand the situations people are facing when considering the design of tax policy.

THE FISCAL ENVIRONMENT OF STATE BUDGETS⁷

State and local governments collect about one-third of the taxes collected in the United States, and they account for about half of all domestic public-sector spending, Johnson said. He noted that states and localities are often grouped and discussed together because, to a large degree, states set the rules for what taxes localities can levy. States spend the majority of that money (80 to 90 percent) on kindergarten through 12th grade and higher education; Medicaid, the Children’s Health Insurance Program (CHIP), and other health care expenditures; human services; public safety; and transportation. He added that a sound state and local tax system is needed to make investments in population health.

___________________

⁶ Available at https://bipartisanpolicy.org/library/building-the-case-low-income-housing-tax-credits-and-health (accessed February 2, 2018).

⁷ This section is the rapporteur’s synopsis of the presentation made by Nick Johnson of the Center on Budget and Policy Priorities, and the statements have not been endorsed or verified by the National Academies of Sciences, Engineering, and Medicine.

Regressivity of State Tax Systems

While the federal tax system is “at least roughly [speaking] generally progressive” (i.e., the percentage of tax owed at the federal level increases as income increases), state tax systems range “from mildly to very regressive,” Johnson said. Low- and middle-income people are paying a higher share of their incomes in taxes than people at the top of the income scale. On average, the poorest 20 percent of the population is paying about 11 percent of their income in state and local taxes, while the top 1 percent might pay around 5 percent of their income in state and local taxes. In the states with the most regressive tax codes, particularly states that do not have income taxes, he said that the differential might be as much as sevenfold between the tax rate paid by the people at the top of the income scale and the rate paid by people at the bottom of the income scale.

Transparency and Engagement Around the Process

Another tax policy concern at the state level is engagement and transparency. State-level tax codes are generally written by a very small group of people. Johnson suggested that state tax policy is essentially a way to disempower people, including those who are most affected by these decisions. He added that the Center on Budget and Policy Priorities is working to “pull back the curtain” on state and local tax policy so ordinary people, or those who represent them, can be part of the conversation about those taxes.

Bringing people to the table is very important, Brown agreed. Tax expenditures include subsidies or programs that funnel money into households through deductions or credits. These expenditures allow people to pay less tax, and also to receive additional dollars, for example through refundable credit programs such as the EITC. In 2016, at the federal level, $640 billion was diverted through tax expenditures in four main categories: housing and home ownership, retirement savings, children’s savings (e.g., college savings programs), and low-income family and worker programs like EITC and the child tax credit (CTC). He noted that most of these expenditures go primarily to wealthy families. Brown said that one of the reasons the EITC and CTC are widely popular with legislators and the public is that people receive a check in the mail. One does not have to be a tax expert to understand that they will receive a credit refund check, regardless of where they fall on the income spectrum. Around the country, legislators and advocates are trying to identify other programs that could be changed to bring more dollars directly to people (e.g., change a nonrefundable credit into a refundable credit, or a deduction into a credit).

For additional background, Brown referred participants to an overview by PolicyLink, Building an Equitable Tax Code: A Primer for Advocates,

which explains who receives what tax benefits across the income scale.⁸ He added that an analysis, done in partnership with the Urban-Brookings Tax Policy Center, found that it is primarily the refundable credit programs, such as EITC, that provide the most benefit for low-income people, and particularly in communities of color. In contrast, a deduction for capital gains does not generally help people in low-income communities. Such deductions are specific asset-building strategies, helping people build wealth through home buying and investing in the stock market. These activities are incentivized by the government through the tax code. The problem, he said, is that this type of tax saving does not funnel down to the people who actually need it.

Brown asked Johnson for suggestions on how to engage a broader group in tax policy discussions. One challenge to increasing engagement, Johnson said, is that many people think of themselves as beginners with regard to understanding tax policy. However, people can come together around something as challenging as tax policy and discuss what it means for real families and real communities.

Engagement takes many forms. Johnson noted that California was the birth place of the tax revolt when, in 1978, Proposition 13 to limit property taxes passed with overwhelming support from across demographic groups. This inspired similar tax revolts in other parts of the nation, with some states enacting property tax caps and slashing income taxes. Over the years, states have experimented with reducing investments in the public sector (e.g., education, health care, transportation) and the results have been very bad in many places, he said. Infrastructure is crumbling, for example, and many schools are not performing as they should be. Johnson observed that this is starting to change. In California, for example, recently passed sales tax increases and income tax increases target those revenues toward families and communities. Several years ago, Minnesota passed a $1 billion tax increase, raised income taxes on the wealthy, closed corporate tax loopholes, and targeted the money toward community health clinics and education. Tax policy change is possible, and is happening, because people are seeing evidence of what happens when the tax system is eroded. Brown suggested that the constituency in California that was already engaged in school reform issues found themselves engaged in a tax conversation. Johnson agreed and said that, in essence, all roads lead to tax and budget policy, whether one is concerned about education, or transportation, or another system. It is not necessarily an obvious road, he said, and it is often necessary to explain why the quality of schools, for example, is directly related to the quality of the state tax system.

___________________

⁸ Available at http://www.policylink.org/sites/default/files/pl_brief_tax_110714_c_0.pdf (accessed February 2, 2018).

Brown observed that, at the federal level, legislators understand the connections across all of these issues and their relationship to tax policy. However, when it comes to passing a set of federal tax cuts, members of Congress have said that their constituencies are not directly engaging them on tax issues. Constituents are calling their members of Congress about health care, immigration, education, and other major issues that all have ties to tax policy, but they are not specifically engaging on tax policy issues. Johnson pointed out that unlike states, the federal government does not have to balance its budget every year. When passing a tax cut—and Johnson noted that the tax legislation being prepared at the time of the workshop (and enacted December 21, 2017) would add more than $1 trillion to the national debt over the next 10 years—Congress is not required to specify what the effect will be or how that effect will be paid for. Each year, 49 of the 50 states have explicit requirements to balance their budget. He suggested that this motivates people to make the call to their state-level representatives about state tax issues.

Linda Rudolph of the Public Health Institute said that Proposition 13 has been one of the major tax policy drivers of underfunding of government in California, and that a ballot initiative to improve how Proposition 13 works is under discussion. She asked about the interplay between federal tax policy and state initiatives to fix problems in state budgets. Johnson said it is not known how the impending federal tax reforms will affect states. He hoped that, when a federal tax bill was passed, states would see it as a wake-up call that they can no longer rely on the federal government to be a force for tax progressivity, or for revenue to support key programs in their communities. He hoped that this realization might create additional momentum behind some of the state-level movements, such as the efforts under way to rethink Proposition 13. States are already thinking about what reforms to their tax codes will be needed in the wake of the current federal tax debate, he said. One example of how federal tax changes could directly affect state revenues is that the calculation of some state income taxes starts with the federal adjusted gross income. Changes to the definition of federal adjusted gross income would directly and immediately affect many states’ revenues.

Tax Cuts and the Economy

Tax reform is up against the myth that cutting taxes is good for the economy, Johnson said. Economic studies and regression analyses show that this is a myth. In addition, experience shows that states that cut taxes do not fare better economically than states that do not cut taxes or that raise them. Looking at the five states that have implemented the largest state-level tax cuts over the past 5 years or so, four of the five have

had below average economic growth. Minnesota, which raised taxes, neighbors Wisconsin, which cut taxes, and Minnesota’s economy has done better than Wisconsin’s, he said. The California economy is currently doing quite well in the face of not just tax increases, but a range of other policies affecting families and communities. There is also a political aspect to the myth, where elected officials like to talk about tax cuts as if they can save the economy. This argument is wearing thin, Johnson said, and there is growing cynicism about the notion that simply cutting taxes will magically lead to economic growth. Another part of the myth is that tax cuts work in red states. Two-thirds of the states currently have Republican legislatures, and two-thirds of the states have Republican governors. Johnson said that, in some states under conservative control, a number of members of the governing party are starting to say that making tax cuts is not necessarily why voters elected them to office. He suggested that there are also changes in public attitudes toward taxes.

Mary Pittman of the Public Health Institute raised the issue of corporate taxes, particularly at the state level, and the huge tax incentives that are implemented when states are trying to attract businesses. Such incentives are bad economics, Johnson said, adding that states are directing resources at corporations both through individual incentives, and through the design of their tax codes more broadly. He added that state corporate tax codes were designed more than half of a century ago for brick-and-mortar retailers and corporations, and these tax codes are not sufficient for capturing revenue from today’s multinational corporations. Some states have made corrections and are starting to eliminate some of the corporate tax breaks. Ultimately, the taxes paid by corporations flow through to someone else, typically shareholders and investors, which is all part of the tax policy conversation. He noted that interstate tax arguments are especially politically challenging for advocates of fair and adequate taxation. State leadership is often threatened with a corporation moving operations to another state if certain economic demands are not met.

Tax Policy and Population Health

The connection between tax policy and population health is just beginning to enter the discourse. Johnson observed that a number of people in the public health sphere have been speaking up about these connections in the current federal tax debate. For example, he mentioned that Medicaid and CHIP are very large shares of state and local budgets, and Medicare takes a significant portion of the federal budget. He added examples of expenditures that are not related to health care that are important to achieving improved health outcomes at the population level. Study after study has demonstrated that children who succeed in school have

better health outcomes over the long term, he noted. Johnson added that there are demonstrable effects on both the short- and long-term health of parents and children who receive the EITC (see, for example, Neumark and Shirley, 2017). Better health outcomes result from the increased ability to earn resources and make ends meet, and the related reduction in stress in their lives. Brown reiterated that some of these tax cuts look to cover their cost by pulling funds from key programs that support population health (e.g., Medicare or Medicaid).

Philip Alberti, of the Association of American Medical Colleges (AAMC), wondered if it was overcomplicating the solution set to develop tax policies that support specific population health-related programs, rather than simply focusing on income and wealth equity, which are known to be linked to health. Brown agreed and noted that PolicyLink is focused on income inequality as a health issue and is working toward trying to represent low-income communities at tax policy discussions. Johnson also agreed that income inequality leads to significant wealth inequality and significant health differences, and he highlighted the connection between income inequality and tax policy. As an example, he said that a recent study by the University of California (UC), San Diego, found that, because of the way Proposition 13 provides benefits to homeowners (particularly homeowners in high-wealth communities), it is increasing the disparity in after-tax incomes between white homeowners and African American homeowners.⁹ Other similar measures around the country are fostering the same income disparity. That is an example of how a bad tax policy at the state level is directly driving income inequality, he said. That said, it is important to also consider targeted investments in specific programs, he added. Regressive tax policy can lead to investment in programs that are very beneficial for communities. This is the balancing act that has been discussed by Davis, he said.

Paula Lantz of the University of Michigan said that the budget crisis in her state has led to cuts in funding from the state to local areas for mental health. Her county recently passed a millage rate increase that is earmarked for addressing mental health issues within the county, including the opioid epidemic. She noted that this strategy raises money for mental health, but also raises property taxes, making it harder for lower-income families to purchase property in the county. Johnson observed that this is another good example of the balancing act in tax policy. Part of becoming more fluent in tax policy is thinking about “the art of the possible,” that is, what is possible to accomplish.

___________________

⁹ See Martin and Beck (2015), http://journals.sagepub.com/doi/abs/10.1177/0896920515607073 (accessed June 11, 2018).

In closing, Brown charged participants to engage, and to inform and inspire others to engage, in tax policy discussions about not just raising new revenue but diverting existing money to the households and communities that need it the most.

This page intentionally left blank.