Dr. Minarik presents the third part of his three-part essay series, which began in February. His views represent those of the respected Committee for Economic Development, one of the many views covered by the series on the federal budget crises, which Prairie Fire launched in August 2007.
By Joseph J. Minarik As explained in the two preceding articles in this series, the United States faces large and growing budget deficits. Those deficits are piling up as an accumulated public debt - in fact, they are piling up so fast that the debt is growing faster than the nation’s income (its gross domestic product, or GDP). The U.S. fiscal system faces two major problems. The first is an impending fiscal crisis; large and growing federal budget deficits will soon threaten our economic growth and living standards. The second problem is that the tax system has become unnecessarily complex and riddled with inequitable special preferences that distort our market economy. These two problems are closely related: An ineffective tax system cannot raise the revenues required to finance federal expenditures and restrain budget deficits without placing heavy burdens on the economy and society. We need a simpler, more efficient and fairer tax system as the foundation of a more productive economy and a sound long-term fiscal policy. The fiscal crisis ahead will be driven largely by the impact of escalating health-care costs on Medicare and Medicaid expenditures, but also by the demographics of an aging society. These cost pressures will be so intense that fundamental changes in our health-care system, and correspondingly large reductions in the growth of Medicare and Medicaid spending, are unavoidable. Taxes cannot rise to cover federal expenditures that rise exponentially to 30, 40 and 50 percent of GDP. Tax increases of this magnitude are politically infeasible and would overwhelm the economy. However, expenditure reductions alone will not be enough. Congressional Budget Office projections indicate that even aggressive and painful changes to reduce expenditures in Medicare and Medicaid, with other spending restraints, are unlikely to restore fiscal balance if federal revenues remain at historical levels. As CED argued in a 2003 statement, the nation must undertake a budgetary “war on all fronts” by reforming entitlement programs, reducing discretionary (annually appropriated) spending and by raising additional revenues. The two previous articles in this series recommended specific changes in Social Security and the health-care system; this final installment focuses on revenues and the tax system. In theory, additional revenues could be provided simply by raising income tax rates. However, the current income tax system is complex, inefficient and inequitable. The proliferation of special tax preferences confronts the taxpayer with bewildering complexity and impairs compliance with and enforcement of the law. These preferences are also inequitable and impair economic efficiency and growth. Raising the tax rates of this dysfunctional system would compound existing distortions and disincentives, further damaging the economy. The income tax therefore should be reformed by eliminating, reducing and consolidating special tax preferences to the extent feasible. This will make the system simpler, fairer and more efficient, promoting economic productivity and growth. However, even an improved income tax is unlikely to meet our revenue needs, because there are major political and policy constraints on how far we can go in eliminating such preferences and broadening the income tax base. Such a program, however desirable, is therefore unlikely to raise large amounts of additional revenue. Indeed, a simplification and base-broadening program that repeals the Alternative Minimum Tax (AMT) - the most complex and problematic feature of the current system - is likely to raise less revenue than the present system. In addition, raising income tax rates will prove a counterproductive long-term strategy for increasing revenues, as globalization makes capital more mobile. Domestic production and jobs will become more likely to move offshore, and foreign capital less likely to be invested here, as income tax rates (and especially corporate rates) rise. Under these circumstances, the burden of capital income taxation will increasingly be shifted to workers. We therefore need a new revenue source to supplement an improved income tax. CED proposes a national value-added tax (VAT), combined with modifications to the income tax (including a refundable low-income credit) that will shield the poor from the VAT and preserve overall tax progressivity. The United States needs both a VAT and a simpler, progressive income tax - the former to raise additional revenues on a very broad base in an economically neutral manner, the latter to preserve the fairness of the tax system. This new hybrid tax framework would greatly improve the U.S. fiscal outlook. Budget projections show that, under current tax policies that produce insufficient revenue, even quite severe spending restraint (including reform of health care and Social Security, as described in the first two articles in this series) is unlikely to restore fiscal balance or even a sustainable fiscal policy. In comparison, however, the additional revenues raised in the CED tax framework, if combined with similar spending restraint, would produce budget balance or surpluses for a number of years. The new revenues would not only reduce deficits and debt directly, but, by forestalling an explosion in interest costs, allow us to “buy time” to restructure health care and other expenditure programs. The proposed CED tax framework would raise net revenues by about 3.7 percent of GDP; an increase in income tax rates of 35-40 percent would be required to produce equivalent revenues. CED also makes recommendations to improve the taxation of capital income, reform the legislative process to improve tax and budget policies, and provide the resources and support to the Internal Revenue Service (IRS) required to strengthen compliance and enforcement. Taken together, CED’s recommendations involve major changes in our tax system. However, unlike some “fundamental tax reforms” that involve scrapping the income tax entirely and thereby creating enormous problems for the transition to a new system, this “hybrid” system would be more feasible politically and could be more easily implemented. The fundamental structure of the income tax would not change, and the journey to a VAT, which would admittedly require many difficult choices, would take place on the well-prepared ground that over 100 other nations have covered in recent decades.