The Tax Hike Canard

The Right Way Down the Fiscal Cliff

Obama's Fiscal Year 2013 budget. (Larry Downing / Courtesy Reuters)

Five years ago, the United States' budget deficit equaled 1.5 percent of GDP and its national debt stood at 36 percent of GDP. This year, the deficit will exceed $1 trillion, or seven percent of U.S. GDP. Over the same period, the debt ratio has doubled to 73 percent of GDP. 

Although the United States' economic weakness has contributed to the booming deficit and debt ratios, it is only a small part of the whole story. According to projections by the U.S. Congressional Budget Office, without significant reforms, the deficit would still add up to more than five percent of GDP a decade from now, even if the economy were operating at full capacity. Increased interest on the national debt is not to blame, either, since falling interest rates have made the government's net interest bill lower today as a share of GDP than it was in 2007. Moreover, the share of GDP that goes to another common scapegoat, defense, has risen less than one percent since 2007 (from 3.6 percent to 4.4 percent) and is projected to drop over the next decade.

Instead, the rising deficit and debt reflect trillions of dollars of new spending on health programs, other new and enlarged transfer programs to individuals, and a variety of transfers to state and local governments. The increased debt creates five problems: First and most obvious, paying the interest on that debt will require enacting higher taxes that will hurt incentives and weaken growth. Second, since foreign investors hold more than half of U.S. national debt, paying interest on it will require selling more U.S. products to the rest of the world and buying fewer products from abroad. That, in turn, means lowering the prices of U.S. exports and paying more for imports, lowering Americans' standard of living. Third, a large debt causes a decline in business investment and therefore in productivity and growth. Fourth, it reduces the government's room to maneuver. In the future, the U.S. government might want to increase spending for a variety of reasons -- including enacting countercyclical stimulus programs or spending more on national security, for example -- and its ability to do so could be constrained by its debt. Finally, a large national debt increases economic vulnerability, particularly to upward shocks in interest rates. 

The predicted rise of the debt during the next ten years is just a prelude to a debt explosion that could occur as the costs of Social Security and Medicare rise. The Congressional Budget Office warns that the cost of those major middle-class entitlement programs -- Social Security and Medicare -- will expand from 8.7 percent of GDP now to 12.2 percent of GDP in 2037. Many commentators have concluded that tax increases are therefore inevitable. Yet even though the population is getting older, it is also becoming more affluent. Future entitlement programs thus need not have the same budget impact as continuations of the current arrangements would. The growth in government outlays for the non-poor seniors through Social Security and Medicare must be -- and no doubt will be -- slowed to avoid higher future tax rates. But even without any increase in the tax rates used to finance these programs, the value of the benefits will continue to grow as incomes rise. 

Although that is good news for the longer run, it cannot help much in the current decade. Since the Social Security and Medicare benefits can be slowed only gradually, entitlement reform will do little to tame the sharp rise in the deficit over the next ten years. 

Preventing the deficit from reaching 100 percent of GDP will require increases in tax revenue, but that doesn't have to mean increasing tax rates. In fact, if the United States avoids increasing government spending as a share of GDP, it could actually lower tax rates. Why? Given the structure of tax rates, the revenue generated by the income tax rises faster than GDP. If GDP increases 20 percent over the next decade, personal income tax revenue will increase by about 26 percent -- even if tax rates stay steady. Furthermore, since cutting tax rates causes an increase in taxable income, all tax rates could be cut by about eight percent at the end of a decade and the revenue would still equal today's as a share of GDP. 

But that is the future, and would only work if the United States kept government spending from increasing as a share of GDP. For now, the country needs to raise revenue to reverse the rising ratio of debt to GDP.

The wrong way to get that extra revenue is to go over the fiscal cliff, which would cause tax rates on personal earnings, dividends, capital gains, and corporations to rise. When combined with the mandatory spending sequester scheduled to be implemented in 2013, demand next year could fall by a total of $600 billion -- about four percent of GDP -- and by larger sums after that. The Congressional Budget Office rightly predicts that would push the economy into a new recession.

U.S. President Barack Obama's proposed alternative to the fiscal cliff would also substantially raise tax rates and limit tax deductions for the top two percent of earners, a group that already pays more than 45 percent of all personal income taxes. In addition, his budget would increase taxes on corporations. Together, these changes would significantly lower total demand in 2013. And the higher marginal tax rates would reduce incentives to work and invest, further hurting economic activity. All of that could be fateful for an economy that is struggling to sustain a growth rate of less than two percent.

A better way to raise revenue would be to broaden the tax base by capping the tax reductions that each taxpayer can claim. Each taxpayer would retain all of his or her existing deductions and exclusions, but the overall cap would limit the total amount by which the taxpayer could reduce his or her tax liability. The limit would apply not to the size of deductions and exclusions but to the resulting tax benefit to each individual. A cap of two percent of each individual's adjusted gross income -- applied to the taxpayer benefits from all itemized deductions and excluding municipal bond interest and the value of employer payments for high-value health insurance -- would raise about $150 billion at the 2013 level of income, or about one percent of GDP. 

It would make sense to modify an overall cap to retain the deduction for charitable gifts. Unlike most other deductions and exclusions, charitable gifts do not benefit the taxpayer. The increased giving generated by tax deductibility is important for maintaining private support for universities, churches, hospitals, and cultural institutions. If all charitable gifts remain deductible, the two percent cap would still produce $130 billion in revenue in 2013. 

A limit on deductions would cause the number of taxpayers who itemize their deductions to fall sharply, from 47 million under current tax rules to only 18 million -- a major simplification for 29 million taxpayers. The cap would also make the tax system more progressive, reducing after-tax income more for higher-income taxpayers than for lower-income taxpayers. Nearly two-thirds of the $130 billion in extra revenue would be collected from the 20 percent of taxpayers with incomes above $100,000. 

There is a danger that the resulting $130 billion of extra revenue would be too much for the economy to swallow in 2013, particularly when combined with reductions in government spending. The United States could avoid that risk by starting with a higher cap and gradually reducing it over several years. For example, a four percent cap on the tax expenditure benefits would raise only about $65 billion in 2013. 

As reasonable as this approach would be, budget negotiators might reject it and the economy might go over the fiscal cliff. There are two problems: The president and the Democrats want to avoid any extra tax on individuals with incomes below $200,000, while raising taxes on individuals above that level. Republicans want to preserve the current tax rates for everyone but appear willing to accept tax reforms that would boost revenue if they were coupled with entitlement reforms to reduce future deficits. Obama wants to leave Social Security unchanged and make only small changes in Medicare.

In this confrontation, Obama might believe he has the winning cards. He can hold out until after the first of January and allow the economy to fall over the fiscal cliff. At that point, tax rates would automatically rise on high-income taxpayers. The president could then put forward legislation to cut taxes for the 98 percent of taxpayers with incomes below $250,000, daring Republicans to vote against such a broad tax cut. 

That could be a winning strategy, but not necessarily. Since the Republicans control the House of Representatives, they could prevent the president's plan from coming to a vote. Instead, they could propose a tax cut for everyone that would reinstate the 2012 tax rates. If Obama rejects the cut and the country then slides into recession, the Republicans could blame the situation on his desire to raise tax rates rather than pursue reforms that would raise revenue by broadening the tax base. 

Republicans may resist the president's strategy for reasons of both politics and principle. The political reason is that Republican members of the House have to worry about their next primary campaign. Voting to raise tax rates now, after promising not to do so in the recent campaign, could leave them vulnerable to a challenge from the right. 

There is also a matter of principle. Distributional fairness is in the eyes of the beholder. The line between a fair distribution of the tax burden and spiteful egalitarianism is unclear. But many of us believe that placing the full burden of deficit reduction on the top two percent of taxpayers goes too far. After all, if 98 percent of the voters can exempt themselves while raising taxes on just the top two percent -- who already pay 45 percent of all personal income taxes -- where will the process stop? 

One possible resolution to the current impasse would be for the budget negotiators to avoid the immediate tax rate increases and the sequester, substituting a new fallback plan that would be triggered six months from now if alternative budget legislation is not enacted. The best version of that fallback plan would again be the basic cap on tax expenditures. For now, the country must watch the budget negotiations and the process of tax reform to see where the line will be drawn. Let's hope that finding out will not require going over the fiscal cliff.

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