Fixing the Fiscal Nightmare

I’d like to get back to a problem that I was writing about last week: the possibility of using a value-added tax (VAT) to fix the “on-budget” federal budget deficit. That deficit, which excludes the Social Security trust fund (which will run a modest but declining surplus), is likely to be in the neighborhood of 4-5% of GDP per year during the next decade, and after that will start growing alarmingly, if for no other reason then simply to make interest payments on the debt. Let me repost the picture of the US’s “Fiscal Nightmare” for reference (see that post for details of my assumptions).

Note that this may be an optimistic scenario: it assumes that the Bush tax cuts are all reversed in four years, and that there are no major recessions. A moderate recession could easily worsen the deficit significantly.

Let us suppose that the deficit is big enough, persistent enough, and growing fast enough (all of which seems reasonably likely in another 15 years) that it can not be left unchecked – the financial markets will start to wreak havoc with interest rates if we do.

So here’s your assignment, should you choose to accept it: close a budget gap of $600-$700bn (expressed in today’s dollars, as are all dollar figures below) per year. As I laid out in my “Fiscal Nightmare” post, it’s awfully hard to get there through spending cuts, with the possible exception of enacting a radical change in the way health care is paid for in the US. Let’s suppose that such a major overhaul in the nation’s health care system is not going to happen any time soon.

But let’s be optimistic and suppose that you could wring out $200bn worth of savings from the spending side of the budget, e.g. by substantially cutting defense spending, identifying some “corporate welfare” that can be cut, and perhaps by reducing some non-Social Security entitlements. That would still leave you with an annual general fund deficit of perhaps $500bn. What are your options?

1. Cut spending even more. Perhaps we could trim another $100bn off of defense spending, bringing defense spending down to around 2% of GDP (which would be the lowest rate of defense spending since the 1930s). Any further spending cuts to close the remaining $400bn gap would almost surely hit the poor the hardest, and substantially (or completely) unravel the US’s social safety net. But they are certainly a possibility, and what many “starve the beast” conservatives hope would happen. Myself, I am not a fan of this option.
2. Raise income tax rates. My back-of-the-envelope calculations suggest that, to raise an additional $500bn in revenue per year through income taxes, changes in marginal rates would have to be of roughly this order of magnitude: today’s 15% rate would rise to 25%, today’s 25% rate would rise to 35%, today’s 33% rate would rise to 45%, today’s 35% rate would rise to 55%. The political impact of suggesting that a middle-class family go from a current tax rate of 25% to a tax rate of 35% would be substantial, and not only the wealthy would complain about top marginal tax rates of 50% or more. Marginal tax rates that are that high also probably imply a substantial increase in tax-avoiding behavior, particularly by the wealthy, and may also have adverse macroeconomic effects. However, this is an important possibility to consider.
3. Enact other taxes. A gas tax of even $1.00 per gallon would only raise $75-$100bn per year, depending on how much conservation you think we would start to see. Taxing capital gains and dividends at marginal income tax rates might raise $25-$50bn per year. Other suggestions? So far we’re about one-fourth of the way there.

   Maybe we could end the tax exclusion of employer-provided health insurance, which would raise another $50bn annually, or impose a carbon tax, which would raise perhaps $25-$50bn annually, or end the home mortgage-interest deduction, raising another $50-$75bn annually. We’re still far from balancing the budget, but this package of tax changes will certainly provoke a political response. (For a good list of other possibilities, see the CBO document “Budget Options”.)

4. Enact a VAT. A 10% VAT, paired with an increase in personal exemptions/deductions/tax credits to ensure that lower-income families do not contribute a larger share of tax revenue (see this post on why a VAT need not be regressive), would probably do the trick and raise the necessary $500bn.

Are there other possible options? Certainly. But I doubt you can think of any that would close more than a tiny fraction of the looming general fund deficit. Given that, I think it’s reasonable to say that in 10 or 15 years policy-makers in the US will be forced to pick from a list much like the one I’ve given above. If they happen to bite the bullet a bit earlier, then so much the better, because then the needed changes to fix the problem would be smaller. But the basic policy choices would still be the same.

Obviously, there would be significant political resistance to all of these options. It’s just a question of picking your poison. Which flavor would you choose?

Kash