Taxes and Debt: Left and Right Dare to Agree

The smart money in Washington is betting that the Joint Select Committee on Deficit Reduction--the so-called super committee--will fail because the two parties cannot find common ground.

What a shame, because the common ground is there for the taking.

Bipartisan agreement can start with the recognition that the status quo won't hold: The U.S. government's deficit and the national debt are now on unsustainable paths. (Read: National debt: What you need to know)

As the late economist Herb Stein once famously quipped, "If something cannot go on forever, it will stop." And the current U.S. fiscal trajectory will stop. The question is how, and at what cost.

We can do it sensibly, through timely fiscal adjustments, or the markets will do it to us rudely. Everyone, we think, favors the former.

Despite all the hullabaloo about the next 10 years--with $2.5 trillion plans, $4 trillion plans and more--the truly alarming budget problems come later.

Case in point: The Congressional Budget Office's most recent long-term projection shows that the primary deficit (excluding interest payments) will shrink until 2018 but then begin to rise. By 2035, it will go to 6.6% of GDP--and then just keep on rising.

Including interest payments, the overall deficit is forecast to reach an impossible 15.5% of GDP by 2035. By then, the national debt would be 187% of GDP. That cannot and will not happen.

The main culprit behind the exploding primary deficit is increased health care spending, which CBO projects to rise from 5.6% of GDP now to 10.4% by 2035.

There are two undisputed reasons for rising health care costs: the aging of the population (the minor part) and the rising relative cost of health care (the major part).

These two "problems" suggest two very different remedies. And that's where the political consensus begins to fray.

The stark fact that we will have more senior citizens suggests that either Social Security and Medicare benefits (perhaps mainly those for upper-income households) must be made less generous or tax revenue must rise above its historic average of 18% to 19% of GDP.

However, the inexorable arithmetic of ever-rising health care costs implies that, without reform, even modestly higher taxes won't be enough--and no one wants the tax share to keep rising without limit.

Thus most of the long-run fiscal consolidation must come on the spending side and most of the spending reductions must come from health care. If our political leaders oppose cost savings in Medicare and Medicaid, we will not solve the problem.

Optimists believe that the 2010 Affordable Care Act has paved the way for such cost savings; pessimists believe that health care reform will actually result in higher costs. But if the act is not enough, we must be prepared to do more--maybe much more.

The principles behind our plan

So what principles should guide the necessary budget changes and revenue enhancements? We suggest three that should command broad bipartisan support:

-- To the maximum extent possible, fiscal adjustments should promote economic growth rather than retard it. Indeed, enhancing the prospects for long-run growth is one of the chief rationales for deficit reduction in the first place. We don't want to undercut that with growth-retarding tax or spending policies

-- The burden of policy adjustment should be borne progressively. That means it should ask more sacrifices from more-well-off households than from less-well-off households.

Specifically, changes in entitlement programs should preserve benefits as much as possible for lower-income households, and any additional tax revenue should be raised progressively.

-- The fiscal adjustment should be gradual. Given the fragile state of the economic recovery, the growth and jobs deficits are at least as urgent as the budget deficit. This is not the time for either large tax hikes or large cutbacks in spending.

But that doesn't justify inaction. Substantial future deficit reduction legislated today will boost confidence right now by moving us closer to a sustainable budget path--provided credible mechanisms are in place to achieve those reductions.

Details of our plan

Principles alone don't translate into a concrete, comprehensive deficit-reduction program. Political horse trading will no doubt be necessary to forge a deal--and that's where a little good will on both sides would go a long way.

Here are a few specifics on which we--a Democrat and a Republican--can agree:

-- Social Security: The program's finances need to be shored up, and part of the solution will almost certainly be an increase in the normal retirement age--eventually.

-- Medicare and Medicaid: As mentioned earlier, one way or another, a substantial share of the budget cuts must come out of Medicare and Medicaid. That might mean, for example, greater means-testing in Medicare.

--Tax reform: Tax reform can enhance growth. And if voters want a larger government, a reformed system would raise the necessary revenue with less damage to growth.

The current corporate income tax code is a mess. The tax reformer's standard battle cry ("broaden the base, lower the rates" ) applies well. Doing so would be pro-growth.

The same applies to the personal income tax code. If revenue is to be raised, raising net revenue from tax reform is better for growth than raising marginal tax rates. Limiting or ending a variety of tax expenditures, many of which are ripe for trimming, are among the most promising ways to raise revenue.

Give and take

A budget cutting exercise is, almost by definition, a process of apportioning pain. Every spending program and every tax provision has a constituency behind it. So to reach a budgetary "grand bargain," each side will have to give a little.

But the good news is that there are a variety of fiscal changes, phased in gradually, that can do the trick without doing great violence to either Republican or Democratic principles.

Editor's Note: This is the first in Project Compromise--a planned series of commentaries bringing together leading thinkers from the left and right to find common ground on how to address the national debt.

R. Glenn Hubbard is a visiting scholar at AEI. Alan Blinder is an economics professor at Princeton University.

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