In the last two weeks, we have seen two comprehensive proposals to address the federal government’s long-term budget deficit. We previously discussed in detail the co-chairs’ draft proposal from the President’s National Commission on Fiscal Responsibility and Reform. This week, a separate group, the Debt Reduction Task Force, which is a project of the Bipartisan Policy Center, presented another proposal to close the fiscal gap. Led by former Senator Pete Domenici and former CBO director Alice Rivlin, the task force’s plan differs in several ways from the co-chairs’ proposal, particularly with respect to the housing policies.

Macroeconomic Targets

An important way to examine and distinguish these long-term economic tax and spending plans is to examine a few key target variables. The most important are federal revenues, federal spending, the deficit and debt held by the public, all measured as a percentage of GDP (economists tend prefer to use this measure – the share of the national economy – rather than other measures because it provides an easier metric to compare over time and controls for inflation). These variables give a sense of the underlying priorities and preferences of the groups making these plans and provide a guide for public debate.

Here’s how the two proposals line up with respect to the key macroeconomic targets, relative to a baseline that assumes most major current policies are extended (roughly the “Alternative Fiscal Scenario” from CBO’s August 2010 Long-Term Budget Outlook).

Federal revenues (% of GDP) in 2020:    

                Baseline: 18.6%

                Co-Chairs’ Proposal: 20.5%

                Domenici-Rivlin Plan: 21.4%

Federal spending (% of GDP) in 2020:

                Baseline: 26%

                Co-Chairs’ Proposal: 22%

                Domenici-Rivlin Plan: 23%

Federal deficit (revenues minus spending, % of GDP) in 2020:

                Baseline: 7.4%

                Co-Chairs’ Proposal: 1.4%

                Domenici-Rivlin Plan: 1.5%

Federal debt outstanding (accumulated deficits, % of GDP) in 2020:

                Baseline: 87%

                Co-Chairs’ Proposal: 65%       

                Domenici-Rivlin Plan:60%

(Some estimates may not add due to rounding.)

As these numbers indicate, the plans have fairly similar objectives, althought federal taxes and spending are slightly higher in the Domenici-Rivlin plan. 

An obvious question arises: why 60% of GDP for national debt?  As the total debt outstanding rises, the share of national income that is required for interest payments to debt holders rises, crowding out resources for consumption, investment and government spending. However, the higher the target, the smaller tax increases and spending reductions that are required. For a historical guide on a threshold level, economists Carmen Reinhart and Kenneth Rogoff have reported that half of debt crises have occurred in counties with debt ratios of less than 60 percent. This level was also a target used by the EU in establishing the rules for its monetary union. These findings, and a desire to lean toward a prudent approach, appear to be the reasons for the selection of a 60% level.

Housing Proposals

There are a number of specific differences with respect to housing policy worth noting as well. 

The most important difference is that the Domenici-Rivlin plan endorses a 6.5% national sales tax. A key characteristic of sales tax is its tax base. This proposal would not tax rental payments, imputed owner-occupier rent or existing home purchases, but it would tax remodeling and newly-constructed home purchases. For an average new home, this would add more than $17,000 to the final sales price, perhaps pricing out more than 3 million homebuyers from the possibility of buying new construction.  

Secondly, while the co-chairs’ proposal would eliminate or curtail the mortgage interest deduction, the Domenici-Rivlin plan would convert the deduction, as well as the deduction for charitable contributions, into a refundable 15% tax credit. Only interest payments paid on loans allocable to a principal residence would qualify and then only for a maximum of $25,000 (not indexed to inflation) of interest. For a 5%, 30-year mortgage this effectively caps the 15% tax credit for mortgage amounts no larger than $500,000. For a 6% interest rate, it would cap the tax credit for mortgage amounts no high higher than $425,000.

The proposed tax credit would not operate as taxpayers are familiar with tax credits under present law. Instead, the credit would operate as a payment to the mortgage servicer, with a direct rebate or payment reduction issued for mortgage interest payments by the servicer to the homeowner. For charitable contributions, for every 85 cents contributed, the Treasury would “match” an additional 15 cents directly to the charity.

With respect to tax rates, the Domenici-Rivlin proposal would establish two rates: 15% and 27% (the corporate rate would be 27% as well). There would be no standard deduction, and most other itemized deductions, exclusions and credits, including the real estate tax deduction, would be eliminated. However, the $500,000 ($250,000 for single taxpayers) capital gain exclusion for principal residence home sales would be retained.

As we analyze these proposals, both from the macroeconomic and specific policy angles, it is important to note information we don’t have.  In particular, given the long-run nature of these proposals, it will be important for any plan to include age or cohort-distributional information to gauge any intergenerational transfer impacts.  That is, to what extent do these proposals transfer funds from one generation to another via proposed changes in tax, entitlement, and housing policies?