Six long-run tax and budget realities

Reuters

Members of the House of Representatives and their staffs leave the U.S. Capitol, adjourning after their final vote of the day in Washington April 26, 2013. The House unanimously approved a Senate plan to ease nationwide air-traffic delays caused by automatic federal spending cuts, seeking to calm an irritated traveling public as lawmakers themselves flew out of Washington for a week-long recess.

Article Highlights

  • The realities of the severe long-run fiscal imbalance

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  • While the future comes with no certainty, here are some strongly supported hypotheses about our fiscal future

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  • We need the hard work of long-run fiscal consolidation to begin today

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The United States confronts a severe long-run fiscal imbalance. Federal spending on healthcare programs and other SIX LONG-RUN TAX AND BUDGET REALITIES

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entitlements is projected to outstrip federal revenue over the next 50 years and beyond. The decisions of precisely how and when to address the imbalance will be made through the political process and will reflect the values that the American people express through their elected representatives. Nevertheless, arithmetical, economic, and political constraints restrict the possible decisions. In this article, we outline six realities that will likely shape the broad response of major budgetary components to the long-run fiscal imbalance.

The first three realities involve changes in spending and revenue levels. We believe defense spending will likely continue trending downward as a share of GDP over the long run because defense needs do not rise proportionately to income, and defense will likely be a tempting political target. We conclude that entitlement benefits will be restrained relative to the explosive growth projected under the current-law path because sustaining that growth would lead to intolerably high tax burdens. We argue that revenue will rise as a share of GDP relative to its recent average because the degree of entitlement restraint required to avoid a revenue increase is politically impossible.

The next two realities concern changes in the structure and distribution of the federal tax and transfer system. We argue that as revenue rises relative to GDP, the federal tax system will likely shift toward consumption taxation to some extent and in some form, to limit the economic and political damage inflicted by significantly increasing marginal income tax rates. The most likely, although not most desirable, way for this shift to occur is the introduction of a VAT alongside the income tax. We argue that the middle class, as broadly defined by today's political debate, will bear much of the burden of addressing the fiscal imbalance through entitlement benefit cuts and tax increases. Contrary to the beliefs or hopes of some policymakers, the long-run fiscal imbalance cannot be closed solely by taxing the top 2 or 3 percent of the income distribution or by gutting safety net programs for the bottom 20 percent.

The sixth and final reality addresses the process by which the fiscal imbalance will be addressed. Because it will be difficult for either party to make serious progress alone, the necessary combination of entitlement benefit cuts and tax increases will likely arise through a series of bipartisan agreements.Those agreements may occur under crisis conditions, although it is preferable that they occur sooner and under more stable conditions. Divided government is probably a necessary, although far from sufficient, condition for the latter type of agreement. Despite frequent claims that spending-cut provisions in bipartisan agreements are not implemented, the historical record indicates that this is not a problem if the agreement enacts changes in entitlement benefit formulas. 

Although we are using the word ‘‘realities,'' we obviously do not claim to have a crystal ball. No one can know with certainty what will happen over the upcoming decades. In light of the fundamental economic forces at work and the size of the projected fiscal imbalance, however, we believe that policy will follow the broad directions outlined in this article.

The six realities constrain the policies that can be adopted, but they leave an ample range of policies from which elected representatives must choose. Although the fiscal imbalance must eventually be addressed through significant policy changes, Americans can opt to act quickly or to delay. While a combination of entitlement benefit cuts and tax increases will be necessary, Americans have a choice of how to mix the two policies. Also, Americans can continue the harmful and ultimately futile attempts to address our fiscal imbalance by taxing the top 2 percent and cutting spending for the bottom 20 percent until the failure of that approach becomes undeniable, or they can soon acknowledge that a wider distribution of burdens that includes the broad middle class is required.

Throughout this article, we offer broad recommendations for how to proceed. Because the necessary measures become more painful the longer we wait, we strongly suggest that the hard work of long-run fiscal consolidation begin today. Policies to reduce the long-run deficit should be agreed upon and enacted as soon as possible, to be implemented over a period after the economy recovers from the Great Recession. We particularly warn against waiting to see whether the long-run projections will change. Even if healthcare costs grow at a dramatically slower pace than projected, it is still certain that a large imbalance will need to be addressed. Given the massive size of the projected imbalance, prudence dictates that the projections be taken seriously, if not conclusively, and acted upon. To support robust economic growth, we propose heavy reliance on entitlement cuts rather than revenue increases. We emphatically recommend acknowledging that the broad middle class must bear much of the burden of long-run deficit reduction. 

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Michael R.
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