February 5, 2014

Yesterday’s CBO report has started a firestorm here in DC, with most of it focused on the portion that says Obamacare will result in 2 million fewer workers by the year 2017.  That’s certainly an eye-opening number, and it adds to the long list of reasons why the health reform effort is deeply unpopular.

The White House was quick to respond by pointing out that those 2 million lost jobs are the result of workers voluntarily leaving the workforce – rather than employers cutting jobs — but we’re not sure that makes much difference.  Either way, the workforce has shrunk by 2 million, which has negative implications both for economic growth and the deficit moving forward.

For deficits, the CBO forecasts they are going to bottom-out next year and then begin climbing again.  The source of the increase is growing entitlement costs – including the cost of Obamacare – plus the interest expenses on existing debt:

In CBO’s baseline, spending is boosted by the aging of the population, the expansion of federal subsidies for health insurance, rising health care costs per beneficiary, and mounting interest costs on federal debt. By contrast, all federal spending apart from outlays for Social Security, major health care programs, and net interest payments is projected to drop to its lowest percentage of GDP since 1940 (the earliest year for which comparable data have been reported).  

In other words, the items that the President spent zero time discussing in his State of the Union Address are the reasons why our budget outlook is so depressing. Fear of entitlement growth is the reason the entire business community joined hands back in 2012 to call on the Administration and Congress to make entitlement reform a priority.  As the letter warned:

Our nation’s entitlement programs are unsustainable. If we do not make sensible reforms, the programs will go bankrupt—and so will the nation. No one can dispute that.

Critics of Obamacare worry about a death spiral in the health care exchanges, where expensive premiums scare off younger, healthier workers, resulting in higher costs and higher premiums, scaring off even more young workers.

The CBO report makes clear we also need to worry about an entitlement death spiral too, where growing entitlements squeeze the very economy that is supposed to produce the taxes to fund the programs.  Entitlement growth is fueled by the retirement of the Baby Boomer population, which means we’ll have fewer workers in the job market in coming years.  Couple that with new incentives for workers below the retirement age to leave the workforce – in this case 2.5 million by the year 2024 – and you’ve got a real problem.

That should be the real lesson coming from the CBO’s report.

The Importance of Marginal Rates

Another item that stood out in the CBO report is its focus on how higher marginal tax rates affect worker behavior:

CBO’s estimate that the ACA will reduce employment reflects some of the inherent trade-offs involved in designing such legislation. Subsidies that help lower income people purchase an expensive product like health insurance must be relatively large to encourage a significant proportion of eligible people to enroll. If those subsidies are phased out with rising income in order to limit their total costs, the phaseout effectively raises people’s marginal tax rates (the tax rates applying to their last dollar of income), thus discouraging work. In addition, if the subsidies are financed at least in part by higher taxes, those taxes will further discourage work or create other economic distortions, depending on how the taxes are designed.

This analysis comes the same week as an interesting Wall Street Journal piece suggesting that the sharp hike in the capital gains tax last year had a significant impact on federal tax receipts and the stock market last year:

In late 2012, investors sold huge amounts of investments with long-term capital gains to take advantage of the expiring 15% ” Bush ” long-term capital-gains tax rate before the current 23.8% rate for higher-income investors took effect on Jan. 1, 2013. These sales left investors with few unrealized long-term gains going into 2013.

Instead, as the market surged, investors’ new gains were held mostly in short-term positions, which they were loath to sell given that short-term gains are taxed at ordinary income-tax rates (39.6% for high earners). With this inhibition there was less sales pressure last year, and for that reason the market may have risen more than it would have otherwise.

So high marginal rates affect the behavior of workers and investors alike.  What about employers?  Right now, S corporations pay as much as 9.6 percentage points (44.6 percent versus 35 percent) more than our C corporation competitors on the initial layer of tax they owe to the IRS.  Do these higher rates impact jobs and growth?  You betcha.

Our Ernst & Young study from 2012 made clear that the tax hikes that (largely) took place at the beginning of last year will have the effect of reducing long-term employment by more than 700,000 jobs.  Wages would be lower too.

So the CBO report reinforces their analysis that marginal rates do matter.  They affect taxpayer behavior in a meaningful way, with higher rates leading to less worker participation and fewer jobs.  This is the key reason S-CORP has been actively supportive of Chairman Camp’s efforts to reform the tax code and lower marginal rates for businesses and individuals alike.  But then, that’s another item the President barely mentioned last week.