The U.S. Fiscal Imbalance and the Challenge for Tax Policy

By :: January 27th, 2011

Three related issues dominate budget talk in Washington these days: eliminating the deficit, cutting spending, and reforming the tax system. Achieving the first will require accepting painful doses of the second and designing the third so we raise more revenue. No easy tasks there.

The difficulty shows clearly in a graph I prepared for a recent talk for the Tax Section of the American Bar Association (slides are available here) . The graph plots spending and revenues using the latest budget estimates from the Congressional Budget Office. Balancing the budget means getting to the dark blue 45-degree line where spending matches revenues. The further northwest of the line, the bigger the deficit.

For most of the past four decades, the federal budget has been above that line. Spending has averaged just under 21 percent of gross domestic product (GDP), well above the 18 percent average for revenues. Only for a few years, from 1998-2001, have revenues fully paid the government’s bills—those four lonely dots below the diagonal line. And the last few years have found us well above the balanced budget line with deficits around 9 percent of GDP.

Those huge recent deficits result mainly from reduced tax revenues due to the economic collapse and counter-cyclical policies on both the spending and the tax side. While the CBO baseline projects a substantially better deficit picture in coming years, much of the improvement results from the optimistic assumption that Congress leaves tax law alone. Specifically that means letting all of the temporary tax cuts extended by the December compromise legislation expire and discontinuing the annual “patch” to the AMT. Under those assumptions, CBO projects that revenues will increase from 15 percent of GDP this fiscal year to 20 percent by FY2014, leaving us still well above the balanced budget line in the graph.

And that is the good news. The longer-term outlook is even more troubling as demographics and health care costs that are rising faster than the overall economy put unsustainable pressures on the level of spending.

In order to have a credible path toward fiscal sustainability, we must move beyond the bickering about whether to extend the 2001-2003 tax cuts and for whom. Even with sizeable and painful spending cuts, the Federal Government will need more revenue than the 18 percent historical average. Policymakers must look to more comprehensive reforms, including base-broadening and exploring new revenue sources.

As Milton Friedman reminded us, “to spend is to tax.” We can’t keep pretending that spending and revenue are independent policy variables. At day’s end, we have to raise enough revenue to pay for the spending we choose. That said, political and ideological differences complicate any decisions on how much to cut spending and raise taxes to achieve long-run balance. As we consider fundamental tax reform, we should seek a system that not only can raise revenue efficiently, but also is flexible enough to adapt to changing spending priorities that our democratic process will ultimately determine.

No easy task indeed.

16Comments

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  3. Sid F  ::  7:10 pm on January 27th, 2011:

    Your analysis in the last paragraph is correct, but it assumes future spending at historical levels and ignores the political goals of the Radical Conservatives. Those Conservatives want to shrink Federal spending to 14-15% of GDP, which will balance the budget with existing revenues. The next decade will see the battle over this alternative vision, with the possibility signficant, albeit less than 50% that that vision will be successful.

    Under this vision the Federal government is composed primarily of defense, with a Justice and Treasury function having little or no policy activities. Gone are government programs in Agriculture, Interior, Education, Energy etc. and the regulatory agencies and functions are also abolished. The Federal Reserve System is retained, but only to serve as a banker’s bank and the bank for the government.

    Social Security becomes private accounts, similar to 401k plans and administered by Wall Street to the tune of billions in fees. Medicare and Medicaid are replaced by vouchers, and if elderly and low income people cannot buy individual coverage for a $500/month voucher, well too bad. Veterans health coverage is outsourced, and Walter Reed and other veterans health facilities are sold to private companies. Prisons are all private and there is no government support for the arts.

    Of course, taxes must still be cut. Taxes on capital gains, interest, dividends and corporate/business income are zero and there is either a flat income tax or a national sales tax. Yes the tax burden will be shifted to lower and middle income earners (that is what “broadening the base” means). The resulting deficit is temporarily financed by sale of government properties (see Indiana and Illinois). Look forward to the Delta Airlines Grand Canyon, the Walt Disney World Blue Ridge Parkway, the Exxon/Mobil Washington monument etc.

    If you think this is fantasy, you need to rethink.

  4. CLARENCE SWINNEY  ::  10:32 am on January 28th, 2011:

    DEBT RESPONSIBILITY
    Since 1980 three so-called Conservative presidents
    have this record

    Debt is 14,000 Billion.
    Republicans created 12,000 of it.

    9000 directly charged to the Big Three (Reagan 1700—Bush I 1300—Bush II 6000)
    3000 charged indirectly as a result of their policies and actions.
    Of that 3000—1000 Clinton paid in interest on their Debt
    and 2000 Obama has paid for (Bush Tax cuts—Bush two wars-Bush Great Recession).

    From 1945 to 1981, each President worked to pay off WWII Debt
    and had it down to 907B

    Reagan began the Conservative Spend and Borrow Let Our Kids Pay Tomorrow
    via policies of intervention in foreign affairs—huge tax cuts for the rich
    which reduce revenues—let Wall Street wealthy gamblers go unregulated.

    Those three over 20 years created 99,000 net new jobs per month or just enough to cover new entries into the work force. Carter + Clinton created 222,000 per month over 12 years. From 1921 to 2003 the Republican presidents had more years in office but created only 800,000 jobs per year compared to Democratic presidents with 1,800,000. On each domestic issue the Democratic presidents have, by far, the best record. Republicans can run only on Values not Issues. Their ideology gave us the Great Depression and Great Recession. Exact same policies.

    Will they ruin America? In 2011, they control the Major Corporations, Major Media, Wealth and Income. They had Total Control of our government for (2001-2006) six years and their belief in unrestricted Gambling came close to destroying the world’s economy..

    Their ideology, as in 1920s, created the Great Recession as a result of Housing Tsunami, and Financial Volcano. Cut taxes for the rich, increase money supply, lower interest rates and encourage gambling on Wall Street. That is why, since the Great Depression, they have been called the Country Club Party.
    The new name is WSP Wall Street Party. Their true God has always been $$$$$$$$$$$. Their promotion of Values has been a diversionary tactic to keep attention off their failed Issues policies.
    What have the done to improve the Standard of Living of the Middle Class???
    They talk Values but do not live them. They are phonies. They support pathological liars. The worse the better. They worship Mush Dimbaugh and his 10,000 lies (documented) over 4,000 hours.

    References: Google: clarence swinney + Identify a Republican + 82 Democrat Accomplishments—
    + Democrats create wealth and jobs + Reagan Firsts + Bush Waffles + Praise Clinton + Clinton Vs Reagan + Tax and Spend + Wreckonomics
    comments welcome at cswinney2@trid.rr.com
    facts + numbers not opinions

  5. Michael Bindner  ::  2:21 pm on January 28th, 2011:

    Nice chart. Another nice chart is to look at the deficit or surplus as offset by net interest payments – as expressed in percent of GDP terms and compared with economic growth in the next year. It is particularly instructive to look at these data in groups by presidential regime. You will find that Democrats have a positive slope, more often than not, and Republicans have a negative slope. In other words, when Democrats raise revenue and balance the budget, they get more growth. When Republicans cut taxes and spending, they get recessions – but running a deficit under their regimes allows growth.

    If you want to deal with the fiscal imbalance, elect Democrats – else elect Republicans (who use the imbalance as a way to create financial assets in terms of government bonds – rather than simply confiscating the same money in taxes).

    Painful cuts in Medicare, particularly on doctor fees, will simply cause doctors to quit seeing these patients – sending them to the ER to join the Medicaid patients who are already there – or to nursing homes where nurses dominate and doctor visits are rare (sick patients go to the ER already or are allowed to die). The only alternative is to consolidate and raise the taxes supporting these programs and the ACA. A VAT could be used for this, especially given the fact that the payroll tax is a fairly flat levy in percentage terms – and that short of raising the rate (which should also happen) broadening the base to all unearned income would make it absolutely proportional. A more hidden expanded business income tax (all value added, including wages, all firms – not just corporations) would also allow tax exclusions for employers who provide social services for employees, potential employees and retirees – rather than having the government do it. For example, an expanded business income tax which pays at living wage levels (if federal and state credits are combined) would obviate the need for income supplements to families – as would employer contributions to charitable organizations who provide adult literacy and pay participants for their time (and give them the same child tax credit as a supplement).

    The only way to get government down to a lower percentage of GDP without causing deficits is to do something like this.

    The other way is to privatize Social Security – but by having accounts invest in employer voting stock – effectively buying out the secondary market over time. Employee-owned firms could then provide some of the other financial services now provided by that sector, like payroll lines of credit in lieu of charge cards and home mortgage services – keeping the loan in house and at zero interest (provided there are no outside investors). Of course, if the scenario I outlined were every widely discussed, the Tea Party would actively protest it – since it would ruin their backers in the corporate world.

    Expanding employee ownership into the multinational world also spurs the development of a stronger middle class whereever such firms have a supply chain or company. That would eventually lead to a desire for a more robust multinational or international government with the convenience of a common currency, common commitment to human rights and single military commander in chief. Of course, when the world has a unified military, no military or aerospace industry is necessary except to explore space, causing budgets for defense to a space agency, a coast guard and a disaster response corps.

    In order to gather political steam for balancing the budget, the wealthy and upper middle class must be convinced that only the children of the wealthy and upper middle class will eventually pay back the debt – since cutting spending or raising taxes on the middle class and poor would simply slow the growth of the economy (see the table I describe above to demonstrate that). An income surtax on the highest income earners (the top quintile only) dedicated to debt repayment could not only balance the budget, but pay down the debt so that the Federal Reserve lends to businesses (to fund their employee lending operations) and not government – however they must first be reimbursed for the Treasuries they hold.

    Note that this does not force any of the elderly into death or poverty, so if you think it is fantasy, you need to rethink.

  6. Michael Bindner  ::  2:25 pm on January 28th, 2011:

    Not a fantasy, but the votes aren’t there for that vision – even among Republicans in the Tea Party movement. See what I offer instead.

  7. Sid F  ::  3:25 pm on January 28th, 2011:

    Michael is correct, the votes are not there, today. While it is a fool’s role to make political predictions, one of the best bets is that in 2012 Republicans will add to their majority in the House via re-districting and gerrymanders, and will take a majority position in the Senate due to Senate math (and possibly get to 60 votes although that is more likely in 2014). Does anyone want to bet against this scenario if there is a Republican President in 2017, a huge Republican House Majority and a Filibuster Proof Republican Senate Majority? I didn’t think so.

    My feeling is that this transformation, if it takes place, will take at least a decade. On the other hand, it might just take shorter, see the article on Medicare in the WP today.

  8. Michael Bindner  ::  4:35 pm on January 28th, 2011:

    My point was that by that time the Tea Party core will be Medicare and Social Security age. No way they will go for any reduction in their benefits or the whiff that they are welfare.

  9. Sid F  ::  6:54 pm on January 28th, 2011:

    Let me list what I consider some statements of fact concerning poliics, the budget and taxes.

    1. No legislation which raises taxes will be passed by the current Congress, and if electoral trends continue no legislation which raises taxes will be passed by any future Congress.

    2. Revenue Neutral tax reform will not pass any current or future Congress if it results in raising taxes on any major group.

    3. The only tax reform legislation that can pass is legislation that lowers some taxes without raising other taxes.

    4. Deficits in excess of $1 trillion may or may not be economically feasible but they are definitely not politically feasible.

    5. Because of points 1-2 above, the only way in which the Federal budget can move towards lower deficits is cutting government spending and increasing economic growth.

    6. Future fiscal policy for both the Federal government and state and local governments will be contractionary, not expansionary. This reduces the liklihood that economic growth will be large enough to increase revenue enough to significantly reduce the deficit.

    7. Inflationary pressure from increased commodity, food and energy prices (as a result of world-wide increased demand) and health care will cause the FRS to pursue restrictive monetary policy and higher interest rates sometime in the next two years. This will increase the interest expense for the Federal Government, making the deficit even worse.

    8. A signifiant and growing component of the American public believes that government spending has no value other than defense, and that the spending can be curtailed without any negative to them. They believe, as Dick Cheney stated in his 2000 VP debate that government has no role in their economic success.

    9. The tea party people will support reduced Medicare enthusiastically because they will be told that “free market” Medicare will increase their health care benefits at lower cost. While this is not true, and cannot be true, millions in advertising will convince them of this. History is filled with examples of interest groups voting against their own interests through ignorance and emotion. Once the Conservatives program is enacted, temporary subsidies will ease the transition. By the time the full impact is in place, it will be too late to change.

    The move to privatize Medicare is not a hidden agenda, it is public and pronounced. It is supported by the members of Congress elected and supported by the Tea Party. Far from punishing legislators that support this, they are being rewarded by the Tea Party Conservatives. These people sincerely beleive that the Federal Government is their enemy, that their freedom is being taken away, and if this results in policies which are against their economic interests, they either do not care, or more likely are so un-informed that they cannot make good choices.

    The overall point. Proposing changes in the tax system that raises revenues are interesting exercises but have no basis in reality. And for the next decade, Conservatives will move to fundamentally change the governmental structure in the U. S. and it is possible they will succeed, particularly if the majority remains ignorant of the program and its impact and if they assume the Tea Party and followers of this structural change will act rationally and in their best interests and the best interests of the country as a whole.

  10. Michael Bindner  ::  11:17 pm on January 28th, 2011:

    This is assuming that the move toward conservatism is permanent. It certainly is not – especially given the paucity of serious electoral contenders on the GOP side in 2012. While Romney would likely govern well, he can’t get the nomination. Those who can get nominated, can’t be elected. Any other analysis is overt spin. If Romney moves to the center, however, he could get elected if the economy implodes over oil or the foreclosure crisis. As a centrist, Romney may surprise you on taxes, but he won’t tip his hand while he is tilting at the GOP windmills.

  11. income tax calculator guy  ::  11:43 am on January 29th, 2011:

    I’m a pretty common sense guy. So for me it’s pretty simple. I work hard for my money. In my household I have a set amount of income and expenses. My expenses can not exceed my income. If they do I can not exist for very long. The problem with government employees and politicians is they do not earn the money they spend. So they spend the money frivolously. If they run out of money they borrow more to spend. And it becomes a viscous cycle. The difference is,I don’t borrow money. If I don’t have money how can I can’t spend it. If I want something I save for it and then buy it.

  12. Curly  ::  9:43 am on January 31st, 2011:

    I would disagree that cutting taxes is (was) the cause of the deficits. The cause of the debt problem is that spending was not cut with the tax cut. As the old song goes “You can’t have one without the other” is true in budgets also. The spending part is easier for the democrats than the republicans because a greater part of the democratic voting base is on the lower income scale and on welfare. If history was examined it would be found before welfare recipients had the right to vote there was much less welfare on the federal level. Most people whom most are self-centered are much more willing for the politicians to increase taxes (on others) to give themselves more. But the problem with welfare it dose not teach a person how to be self-reliant. I don’t know any welfare that has taugh a person how to work nor provide for their own.

  13. Michael Bindner  ::  10:24 am on January 31st, 2011:

    But the Republicans were in charge of the spending during most of the Bush era too – as well as the regulatory decisions that let the oil and housing bubbles inflate.

    There is not welfare – participants are forced into job training programs and low wage jobs. No one sits at home collecting benefits anymore.

    You have not been paying attention.

  14. Michael Bindner  ::  10:25 am on January 31st, 2011:

    What is more irresponsible, since you are a common sense guy, spending more or lowering the prices on what you sell without lowering the costs first?

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