In a transcript of his remarks at the Tax Council Policy Institute’s Annual Symposium on February 20, 2008, Alan D. Viard discusses the fiscal outlook. Viard identifies three long-term budgetary realities: the middle class will bear much of the burden of addressing the fiscal imbalance, federal revenue will rise as a share of GDP, and consumption taxation will play a greater role in the federal tax system. He also discusses the tax policy choices confronting the new president and Congress.

Resident Scholar Alan D. Viard

Three Long-Term Realities

Today, I would like to discuss three long-term realities implied by current U.S. budget trends and then examine the policy choices facing Congress and the president in 2009 and 2010.

The three long-term realities are these. First, the middle class will unavoidably bear much of the burden of addressing the long-run fiscal imbalance that we face, whether that imbalance is addressed through entitlement restraint or through tax increases. Second, federal revenue will rise as a share of GDP because the American people will not accept the entitlement restraint that would be required to prevent that development. Third, as revenue rises, income taxation will play a reduced role in the federal tax system and consumption-tax features will become more important.

The point about middle-class burden is probably clearest for entitlements. Although the wealthy are eligible for Social security, Medicare, and some other entitlements, their share of total benefits is modest. Most of the entitlement benefits go to middle-income and lower-income groups. Because proposals for entitlement restraint will and should spare those at the bottom, the biggest burden will be felt by those in the middle. That was certainly true, for example, of President Bush's 2005 proposal for progressive price indexation of Social Security.

Things may seem less clear on the revenue side. Since the wealthy earn a large share of national income, couldn't revenue increases be targeted at them rather than at the middle class, perhaps by raising tax rates on people making more than $200,000 per year? Well, not really. Although the wealthy have large amounts of income, raising large amounts of revenue from them requires prohibitively steep increases in marginal tax rates. Beyond that point, the middle class has to pick up the tab. Also, when income tax rates are raised on the wealthy, middle-class workers bear part of the burden through lower wages as capital accumulation is impeded. So, even if the fiscal gap is closed with tax increases, much of the burden will fall on the middle class.

The rise in federal revenue that I am predicting is not mathematically necessary. Last year, federal revenue was almost 19 percent of GDP, slightly higher than its historical average. If entitlement spending were to remain at its current share of GDP, there would be no need for revenue increases.

Under CBO's extended baseline scenario, however, the big three entitlements--Social security, Medicare, and Medicaid--are slated to grow from eight percent of GDP today to 18 percent in 2050. So, keeping these entitlements at a fixed share of GDP would mean cutting them by more than half from their baseline trajectories. Entitlement restraint of that type would be very good for long-run GDP growth, although it might be less desirable in other respects. Whether or not I support that approach, however, the American people do not.

In the 2004 Brookings Papers on Economic Activity, Alan Blinder, along with Alan Kruger, reported public opinion survey results on how to correct the long-run Social security deficit. A mere five percent favored relying mainly on benefit cuts; many of us in this group undoubtedly work at the American Enterprise Institute and other conservative think tanks. In contrast, 30 percent favored relying mainly on payroll tax increases and 34 percent favored a mix of payroll tax increases and benefit cuts. There would surely be even less support for benefit cuts as the main response to the much larger Medicare/ Medicaid imbalance.

Given these attitudes, it is fantasy to think that the fiscal imbalance will be addressed solely through entitlement restraint. It is not surprising that progressive price indexation attracted so little support in 2005. The battle will be between exclusive reliance on tax increases and the much preferable alternative of a mix of tax increases and entitlement restraint. Either way, though, revenue will rise as a share of GDP.

Where will the extra revenue come from? By and large, not from the flawed income tax system. The distinctive shortcoming of the income tax is that, unlike wage and consumption taxes, it penalizes saving. Since the economic costs of income taxation rise as it is used to a greater extent, its relative importance should and will be scaled back as total revenue rises.

Some advocate broadening the income tax base as a way to raise more revenue from income taxation without an increase in explicit marginal tax rates. I don't think base broadening is a real solution. Although some base broadening would be desirable, its scope is limited and it does not correct the fundamental flaws of income taxation. As a side note, I believe that the corporate income tax will wither away over the upcoming decades in the face of increased global competition.

While I am confident that consumption taxation will become a larger part of the tax system, I am less certain about the manner in which this will happen. There are three possibilities.

• First, tax-preferred savings accounts could be expanded. That approach is likely in the short run because it is a continuation of recent trends in our hybrid income/consumption tax system. It is problematic, though, because it adds complexity and promotes tax arbitrage as much as it promotes new saving.
• Second, a consumption tax, probably a value-added tax, could be adopted alongside the income tax. That is the most likely long-run outcome, matching the manner in which Europe finances its larger public sector. It is not ideal, however, because it leaves the inefficiencies of the income tax in place and weakens the pressure for entitlement restraint.
• Third, the income tax could be replaced with a consumption tax, probably a Bradford X-tax,[1] which is a progressive-rate version of the Hall-Rabushka flat tax.[2] This outcome would be ideal, but is unlikely due to public unawareness of the X-tax. Indeed, even many of those who profess to support the Hall-Rabushka flat tax think that it is a flat-rate income tax and do not realize that it is actually a consumption tax.

Decisions in 2009-2010

Now let me turn to the key policy decisions in 2009 and 2010; whether to extend the Bush tax cuts, and if so, whether to offset the resulting revenue loss under the PAYGO budget rule.[3] I will say a few words about the tax cuts and then a few about PAYGO.

The Bush tax cuts actually have two major components. Some provisions, such as the increased child credit, the 10-percent bracket, and the special tax cuts for married couples, are largely social relief provisions designed to give favored groups more disposable income. Other provisions are growth-related, such as the cuts in the top marginal rates, the lower dividend and capital gains rates, and estate tax repeal; these provisions reduce disincentives to work and save.

The social relief provisions generally have weak economic rationales, but have strong public and political support, with Republicans and Democrats agreeing that they should be made permanent. The growth provisions are far more politically controversial because much of their direct benefits go to the top of the income distribution.

Although the PAYGO rule is often described as requiring that tax cuts and entitlement increases be paid for, that is a little misleading. With or without PAYGO, the laws of economics, specifically the government's long-run budget constraint, requires that such measures be paid for. PAYGO merely requires that they be paid for now, rather than later.

In my view, any extension of the tax cuts must include the growth provisions; extending the social relief provisions alone is unacceptable. In accordance with the PAYGO rule, any extension should include offsets, either entitlement cuts or increases in less distortionary taxes. The budgetary tradeoffs should be faced now rather than later. It is particularly imperative that the PAYGO rule be applied to the social relief provisions because they do not generate any growth to offset their direct revenue loss.

My views differ from prevailing thought in both political parties. Republicans support extending both the social relief and the growth provisions with, at best, modest entitlement cuts. Democrats support extending the social relief provisions while increasing entitlement spending.

To get a sense of what might happen to the growth provisions, we can look at the new futures market for the top marginal tax rate that was introduced on lntrade a few weeks ago. The prices observed on February 19 suggest that the reduction in the top tax rate maybe repealed or scaled back in 2009, is likely to be repealed or scaled back in 2010, and is very likely to expire in 2011. It is an extremely thin market, though, so the prices may not mean very much.

In conclusion, difficult choices lie ahead. We should face them sooner, rather than later.

Alan D. Viard is a resident scholar at AEI.

Notes

1. Designed by economist and law professor, David F. Bradford, the Bradford X-tax is value added tax (VAT) modified so that wages are deducted by businesses and taxed at progressive rates to workers.
2. Designed by economists, Robert Hall and Alvin Rabushka, at the Hoover Institution, the Hall-Rabushka flat tax is similar to the X-tax, except that wages are taxed at a flat rate.
3. The PAYGO, or pay-as-you-go, rule compels entitlement or tax changes to not add to the federal deficit. Provisions that increase entitlements or reduce taxes must be offset by some mixture of entitlement cuts and tax increases.