Tax Policy and Growth
Chapter in "Rules for Growth: Promoting Innovation and Growth Through Legal Reform"

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As discussed in Chapter 1, long-term economic growth is heavily influenced by capital accumulation and technical innovation. This chapter discusses the potential role of a move from income to consumption taxation in promoting capital accumulation and the potential role of research tax credit reforms in promoting innovation.

BACKGROUND:THE LONG-RUN FISCAL IMBALANCE

Choices about tax policy structure, particularly major issues such as the role of income and consumption taxes, cannot be properly examined without first looking at the federal government's severe long-run fiscal imbalance. As is widely recognized, the growth of Social Security, Medicare, and Medicaid is slated to dramatically outstrip the growth of revenue over the upcoming decades. The discussion below focuses on the alternative fiscal scenario set forth in a 2010 report by the Congressional Budget Office titled "The Long-Term Budget Outlook," which most analysts accept as a reasonable description of current policy.

Under this scenario, non-interest federal spending rises from 22.9 percent of GDP (itself unusually high, due to the recession, financial- sector bailout, and stimulus spending) in 2010 to 26.4 percent of GDP in 2035. Social Security accounts for part of the increase, rising from 4.8 to 6.2 percent of GDP. But its role is eclipsed by that of medical spending. Medicare roughly doubles as a share of the economy, from 3.6 to 7.0 percent of GDP. Medicaid and related spending also posts rapid growth, from 1.9 to 3.9 percent of GDP, partly due to the March 2010 health care reform law. These programs account for more than all of the growth in non-interest spending, as other programs shrink from 12.5 to 9.3 percent of GDP.

The Congressional Budget Office's alternative fiscal scenario assumes that federal revenue settles down at 19.3 percent of GDP, its average value in recent decades. (Revenue is an unusually low 14.9 percent of GDP in 2010, reflecting the recession and the stimulus tax cuts.) The gap between non-interest spending and revenue gives rise to large deficits, with the resulting debt obligations triggering large interest outlays that further add to the deficit. In 2035, publicly held debt is projected to be a staggering 185 percent of annual GDP, up from 63 percent in 2010. Interest on the debt is forecast to be 8.7 percent of GDP, which combined with the excess of non-interest spending over revenue, results in a deficit of 15.9 percent of GDP. Of course, the situation only becomes worse after 2035.

These projections are not intended to describe what will actually happen, but rather what would happen if current policies were maintained. The projections demonstrate that current policies are unsustainable and must be modified. It will be necessary to restrain the growth of Social Security and (especially) medical spending relative to its current policy path, increase revenue relative to its recent share of GDP, or both.

Economic growth is likely to be stronger to the extent that the fiscal gap is addressed through spending restraint rather than tax increases. Depending on the specific provisions, though, spending restraint can have distributional and other disadvantages. I argued, in Viard 2009, that spending restraint should be a major part of the response to the fiscal imbalance. But I also noted that it is politically impossible to close the fiscal gap solely on the spending side and that revenue will need to rise, as a share of GDP.

Because this chapter is devoted to tax rather than spending policy, I do not further address spending restraint. Instead, I consider the ways in which the tax system can be reconfigured to minimize any drag on economic growth, even as the overall tax burden increases. I first discuss a possible shift to consumption taxation and then consider more modest measures, related to the research tax credit, that can be pursued within the current income tax system.

Alan D. Viard is a resident scholar at AEI.

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