Testimony of Edmund J. McMahon before the New York City Council

Good afternoon, Chairman Weprin and Chairman Rivera. Thank you for this opportunity to testify before your committees today.

My name is Edmund J. McMahon, and I am senior fellow for tax and budgetary studies at the Manhattan Institute for Policy Research. I am also director of the Institute’s Empire Center for New York State Policy. The Manhattan Institute, based here in New York City, is a non-partisan, non-profit research organization whose mission is to develop and disseminate ideas that foster greater economic choice, opportunity and personal responsibility.

To begin with, I want to commend your committees for taking a timely step to recognize the vital importance to New York City of some potential changes in federal tax policy. However, the resolution that is the subject of this hearing is limited in scope, dealing specifically with the recommendations of the President’s Advisory Panel on Federal Tax Reform. While I find myself in at least partial agreement with the resolution’s conclusions, I believe the Council needs to go further to protect New York’s vital economic interests.

With last week’s votes by the House of Representatives, both the House and Senate have now approved separate, similar bills extending that would prevent the expansion of the Alternative Minimum Tax (AMT) for at least an added year. Unfortunately, among other differences between the two houses, the Senate’s tax-cut package does not also include an extension of the dividend and capital gains tax cuts first enacted in 2003. These tax cuts have played an important role in New York City’s economic recovery over the last two years. Their continuation will be equally important to the city’s economic future.

AMT relief and favorable treatment of investment income both should be regarded as pressing and immediate federal tax priorities for New York. Therefore, I would respectfully suggest that you amend your resolution to reflect these priorities.

The Tax Reform Panel

President Bush instructed his advisory panel on federal tax reform to emphasize simplicity, fairness and economic growth – objectives on which we can all surely agree. However, he also asked for recommendations that would be “revenue neutral” from a budgetary standpoint. The panel chose to interpret this guideline very narrowly, which limited its ability to recommend the kind of sweeping and fundamental change that would most fully realize the president’s other objectives.

Moreover, even before issuing any other recommendations, the tax reform panel decided to seek the complete elimination of the Alternative Minimum Tax (AMT) -- effectively putting itself in a fiscal straitjacket. As a result, the panel’s final recommendations were flawed in precisely the manner recognized by your pending resolution: as far as many New Yorkers are concerned, the reform proposals would simply substitute one form of tax increase (loss of the state and federal tax deduction) for another (an expansion of the AMT).

To be sure, there are some very good ideas in the panel’s report. As your resolution points out, the negative impact of eliminating the state and local tax deduction, coupled with proposed limits on mortgage interest deductions, would be “mitigated by [the panel’s] proposed reductions in marginal tax rates and in the taxation of investment income.”

Nonetheless, in the absence of a more detailed analysis, I agree that the proposed reform plans – compared to the tax levels in effect as of 2005 -- would not be a good deal for an unacceptably large number of taxpayers here in New York City and in the surrounding region. The positive aspects of the panel’s recommendations do not go far enough to make up for the negatives of an effective tax increase that would fall disproportionately on households in high-cost, high-taxed jurisdictions like New York.

Politics and regional issues aside, allow me to utter a bit of tax-reform heresy: The case against the state and local tax deduction is not nearly as strong as it is often made out to be. Nonetheless, as the reform debate continues to unfold, I don’t think the City Council should rule out the possibility that significant benefits would flow to New York from a broader, flatter, more investor-friendly tax structure that does not allow for this deduction.

I will not dwell on the mortgage interest deduction, except to say that I think this change – in isolation -- would be far less unfair and damaging to New York than you might assume. But in the context of the panel’s recommendations, I agree that it simply will exacerbate the tax burden shift to New York and the rest of the metro region.

Little more needs to be said here about the AMT. The problems it poses to New Yorkers – and the threat of its future expansion – are quite well-documented. Suffice to say, short of outright repeal, permanent indexing to inflation would be desirable. A renewal of the current AMT “patch,” at a minimum, is essential.

Broadening the focus

If the City Council means to seriously confront the implications for New York of changes in federal tax policy, it is not enough to simply denounce some recommendations of the president’s tax reform panel. Federal tax policy is very unsettled at the moment – and appears likely to stay that way for a few years to come. Virtually all of the major tax cuts enacted since 2001 are scheduled to expire at the end of the decade. Moreover, looming federal deficits are generating pressure in some quarters to roll back the tax cuts. New York has a very big stake in the outcome.

As you weigh the consequences of possible developments in Washington, I would urge you to move beyond a simple “winners and losers” approach to give more consideration to the broader issues here.

The resolution on the table reflects your belief that certain tax policy changes would be bad for New York. Left unanswered is the question of what would be good for New York. What kind of federal tax reform will best promote the kind of sustained economic growth the city needs? The answer, I believe, is clear, from recent experience.

The NY boost from federal tax cuts

The federal government has enacted two significant federal tax cuts in the last five years. The first – the Economic Growth and Tax Relief Reconciliation Act of 2001 (Ã’EGTRRAÓ) included across-the-board reductions in marginal income tax rates, elimination of the so-called marriage penalty, and a significant increase in the child credit. Under the slow phase-in schedule of the original law, most of these changes were not to become fully effective until 2006.

In 2003, however, the President proposed a major expansion of the 2001 cuts. The resulting law – the Jobs and Growth Tax Reform Reconciliation Act, or JGTRRA, passed by Congress in May 2003 — accelerated all the 2001 rate reductions and family tax relief so these changes became immediately effective, adding provisions designed to prevent the AMT from stealing away the new cuts. The 2003 law also included two significant tax cuts for investors: A preferential 15 percent tax rate on income from corporate dividends, and reduction of the tax rates on long-term capital gains from 20 percent in the top bracket and 10 percent in lower brackets to 15 percent and 5 percent, respectively, with the lower rate declining to zero in 2008.

The benefits to New York have been enormous. In an August 2004 report, we estimated that New York City residents would save $16 billion through the first four years of the tax cuts, and another $46 billion from 2005 through 2010.

In addition to direct savings for individuals, the tax cuts brought significant indirect benefits to New York’s economy. Reductions in dividends and capital gains tax rates contributed to a strong rebound in stock prices in 2003, providing a shot in the arm to the City’s vitally important financial sector. The acceleration of marginal rate cuts also offset large temporary hikes in New York State and City income tax rates, which took effect at the same time as the 2003 federal changes.

The latest version of the STAMP (State Tax Analysis Modeling Program) model commissioned by the Manhattan Institute indicates that, if the 2003 federal tax cuts had not been enacted, state and city tax hikes effective in 2003 would have reduced baseline private sector employment by 37,200 jobs -- offset only partially by an added 16,300 government jobs. The net result would have been about 20,900 fewer total jobs.

The federal tax changes had a countervailing impact. Our STAMP model estimates the combined effect in New York City of reduced federal tax rates and increased state and city taxes was a net gain of at least 16,000 jobs, including at least 6,000 private sector jobs and 10,000 public-sector jobs.

It should be noted that the model’s estimate of the combined impact of the federal, state and city tax changes in 2003 does not fully reflect the ancillary economic benefits of significant reductions in capital gains and dividends taxes, which boosted asset values and ignited a fresh Wall Street boom. Thus, if anything, the model significantly understates the countervailing economic effects of the 2003 federal tax cut in New York City.

Priorities: at a minimum, stay the lower-tax course

The economic gains I’ve just cited could easily be reversed if, in the worst-case scenario, federal tax rates on wage and investment income revert to their pre-2003 levels. In the long term, it would be in the best interests of New York and the nation as a whole to either make these cuts permanent -- or replace them with a greatly simplified tax code that packs an even stronger punch for sustained economic growth.

 

In the short-term, again, there are clearly two priorities for New York: stop the spread of the already obnoxious AMT, and extend the dividend and capital gains tax cuts, which are otherwise scheduled to expire in 2008.

Unfortunately, most members of New York’s House delegation voted “no” on the extension of these investment tax cuts last week. Now the spotlight turns to the upper house. Senators Schumer and Clinton should be urged to not only continue supporting AMT relief (for which they both voted “yea” last month), but to support the dividends tax cut and capital gains cuts included in HR 4297, the Tax Relief Extension Reconciliation Act of 2005.

Local government officials traditionally have shown much more interest in spending programs than in tax policies at the federal levels. But this is a particularly shortsighted approach for New York. After all, as a state, we now get back only 80 cents in federal spending for every dollar we send to the federal treasury. In other words, on average, every added dollar New York wrings out of Washington will end up costing us a buck-twenty-five. This continuing disparity inspired the late Senator Daniel Patrick Moynihan to suggest a new approach:

““It’s time to go beyond the arguments about Big Government and States Rights, and all that. After some 40 years in Washington, I attest that we get involved in too many miniature issues [such as] school uniforms. This needs not be done from Washington. Can’t be done effectively. It belongs to levels of government closer to the problems involved. This means those governments have to be solvent. For New York, this means keeping more of our money at home. This won’t happen, however, until we break the century-long habit of preferring that the money go to Washington first.””

Moynihan closed by wondering: “How did we become the state with the second-highest poverty rate in the nation?”

Good question.

Looking beyond the immediately pending federal tax bills, if and when the debate on federal tax reform begins in earnest, there will no end of details to sort out and analyze. But the evidence is strong that a federal tax policy carving out favorable treatment for savings and investment would be a win-win proposition for New York. It would boost economic growth for the nation as a whole. And it would further boost the financial markets based here – strengthening the city’s finances in the process.