Posted by: dstieglitz | March 30, 2010

TAKING OUR TAX MEDICINE

    Despite his firm promise to “rein in our debt,” President Obama submitted a $3.8 trillion budget for 2011 (the largest in history) that will add $1.3 trillion to the national debt after allowing the Bush tax cuts to expire for families earning more than $250,000 a year, raising capital gains and estate taxes, and charging banks a fee to recover bailout costs. Similarly, the cost of the health-care bill is financed by raising Medicare payroll taxes and collecting Medicare taxes on investment and interest income for the first time. So what’s left for new revenue to close the $1.3 trillion gap?  The federal budget is broken on both the spending and revenue sides, but our focus in this article is the revenue side – that harsh medicine called taxes.

    To understand why reducing the deficit will require more tax increases than budget cuts, look at what drives the gap between spending and revenue. Government spending is rising as a percentage of GDP for three reasons:

  • The financial crisis has cost nearly $2 trillion in bailouts, stimulus, and jobs bills,
  • Our aging population is consuming more Medicare and Social Security, and
  • Globalization increases the demand for employment safety nets.

Revenue, on the other hand, is collected almost entirely from payroll taxes, and personal and corporate income taxes that rise or fall in proportion with GDP.  The U.S. tax system’s over-dependence on income taxes is exacerbated by a narrow tax base (only about 50% of families pay any income tax at all) and a smorgasbord of loopholes and deductions that encourage rampant tax avoidance. 

    The U.S. is incurring annual deficits near 10% of GDP, a massive shortfall in peace time. Most people believe it’s because of the recession. But it’s also because a system that depends on income taxes works okay when business booms, but falls flat when a recession reduces incomes, increases unemployment, and shrivels investments. Furthermore, the budget gap is far too wide for the rich to pay – there just aren’t enough of them. In 1986, the IRS reported the top 1% of taxpayers paid 25% of all income taxes. By 2005, their share increased to 38%. But if the rich can’t pay the bill for a growing government, who will?  What Obama has been afraid to tell Americans is that the only practical solution is new taxes that will affect everyone.

    Despite the political hoopla surrounding the deficit commission that President Obama established, there is hope that it might produce meaningful change. The panel is supposed to narrow the budget gap by proposing changes in the tax system, entitlement programs, and other spending. Hopefully, it will be creative in increasing revenue through a multi-faceted tax program. Basically, there are three ways to increase the federal government’s revenue: (1) restructure income taxes, (2) broaden the tax base, and (3) stimulate economic growth as discussed in the following paragraphs. 

    The deficit commission’s most explosive challenge will be to restructure the income tax system to limit deductions, each of which has its own special interest group. There are several candidates:

  • Put a cap on the mortgage-interest deduction,
  • Eliminate or cap the deduction for state and local taxes,
  • Do away with tax exclusions for employer-paid life insurance,
  • Count part of employer-provided health care as income, and
  • Abolish deductions for charitable giving.

Cutting these deductions could increase tax receipts by more than $1 trillion per year!  Interestingly, the commission could recommend lowering income tax rates if deductions were eliminated or capped. 

    Since income is already heavily taxed, restructuring the income tax system can only produce part of the additional revenue needed to close the budget gap. The deficit commission probably will recommend consumption taxes to make up the difference. Most economists consider consumption taxes to be less damaging to growth than income taxes; plus they are more stable during economic peaks and valleys. Three types of consumption taxes could be implemented to distribute the tax medicine fairly: carbon taxes, sin taxes, and sales taxes. 

Carbon Taxes: The cap-and-trade plan President Obama endorsed would raise about $50 billion per year, even if some receipts were used to help coal-mining towns and low-income families who may be impacted by the tax. Increasing the federal fuel tax is an alternative. Such taxes not only are a source of stable revenue, they also slow the growth in emissions. Carbon taxes actually are a sin tax on a product whose trading price does not reflect the true cost on society of its consumption.

Sin Taxes: Since Prohibition ended in 1933, the government has used taxes to control socially harmful products like cigarettes, alcohol, and gambling. The logic behind sin taxes is that smoking increases the risk of cancer for people who are near the smoker, and gambling and alcohol abuse contribute to broken families, crime and violence.  Sin taxes defray the cost of additional medical care, social programs, and law enforcement. It seems entirely logical to extend sin taxes to junk foods, sugary drinks, and fattening foods to off-set the rising health-care costs of epidemic levels of obesity in the U.S.

Sales Taxes: The deficit commission also may recommend some form of Value-Added Tax (VAT) or national sales tax. Fortunately, a VAT would tax such a large range of products and services that a relative low tax rate could produce the revenue to balance the budget. Since the cost of a VAT would be passed to consumers in higher prices, certain products (e.g., food) could be exempted to preserve the progressive nature of the tax system. A VAT also could impact our balance of trade favorably since the tax could be rebated on exports when they left the U.S. and added on imports when they entered the U.S. – every $1 billion increase in exports creates about 7,000 jobs!

    President Obama and Congress should recall that just nine years ago the U.S. had four years of budget surpluses (1998-2001) when businesses and people prospered and paid high income taxes on bonuses in the financial industry, capital-gains taxes on rising stock values for dot-com companies, and corporate taxes on bank profits. Those revenue sources unfortunately have dried-up and are unlikely to return until the White House and Congress replace business-bashing with initiatives that produce real economic growth such as:

  • Doubling exports by passing free trade bills, cutting overseas taxes, and loosening export regulations
  • Building infrastructure that accelerates growth such as a high-speed rail system, broadband communications, nuclear power plants, and power distribution systems
  • Expanding research and development (R&D) by increasing funding for basic research in academia and at national labs, and making R&D tax credits permanent
  • Breaking the poverty cycle by investing in education so that every person who wants a college education can get one.

Programs like these are less expensive and more essential to our national well-being than national health care!  Hopefully, the deficit commission will recommend specific government investments such as these to increase tax revenue through economic prosperity.

     Without doubt, taxes are painful medicine. If I haven’t mentioned a new tax that goes against your special interests, then something else should be added. It is possible to reduce the deficit – but it will require each of us to pay more taxes in some form than we pay today. While 2010 isn’t the right time economically for a massive tax increase, the government should announce a viable recovery strategy now. Even though tax increases and spending cuts might be deferred for a year or two, the announcement would reassure markets, increase consumer confidence, and stimulate long-term growth.

      If done correctly, new taxes could encourage economic growth.  For example, consumption taxes promote personal savings and investment, and Social Security eligibility changes will expand the labor force by extending the working lives of Americans. But it won’t be politically easy. The deficit commission’s challenge is more about rebuilding a paralyzed political system than fixing a faulted tax system. Congress seems incapable of accepting short-term pain to achieve future gains. The Bush tax cuts will expire and the Commission’s report is due after the 2010 election, so there’s little chance this burned-out Congress will tackle the budget challenge. 33 Senate seats and all 435 House seats are up for grabs in the 2010 election. Hopefully, the Congress we elect in November will do a better job of working together to solve the country’s growing financial problems.

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Responses

  1. Hey there! This post could not be written any better!
    Reading this post reminds me of my old room mate!
    He always kept chatting about this. I will forward this article to him.
    Fairly certain he will have a good read. Thank you for
    sharing!


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