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In the Nation's Interest

The Budget Deficit and Tax Reform

The nation faces a budget crisis, says one group of talking heads. The nation needs a tax cut to accelerate economic growth, says another group. What are our citizens to think?

American voters tell pollsters that they want candidates for office to tell us the truth. Then they vote against any and every candidate for office who is foolish enough to talk about cutting spending and raising taxes to reduce the deficit. But what would an honest candidate say about the choices we face?

We do have a budget problem. The burden of the nation’s debt – the amount of debt measured against our collective income (the gross domestic product, or GDP), out of which the debt must be serviced with interest payments – is just about as high as it has ever been. The only heavier debt burden, and not by much, came at the end of World War II – when the returning troops and all of the converted wartime factories and new production set off an unparalleled economic boom. Today, with a retiring baby-boom generation and much lower birth rates to feed the labor force, no such boom is in the cards.

The budget problem will slow economic growth. To invest in its future, the nation must save. Government borrowing to finance budget deficits drains that pool of saving. Less private investment (factories, machines, technology) and less public investment (roads, power, education) means less productive capacity, less productivity growth, and slower income growth year after year.

The budget problem risks another financial crisis. Our budget profligacy can go on as long as lenders around the world are willing to bankroll us. That may go on for some time. (The United States is “the best-looking horse in the glue factory.”) But the longer it does, the more our economic growth lags, and the bigger our debt – and the harder we fall if ever the rest of the world tires of buying our paper.

The major cause of the long-term budget problem is Medicare (aggravated by health care broadly). The elderly population is growing rapidly because of the retirement of the baby boom. Separately and on top of that, the elderly are living longer. As each senior ages, his or her health care needs grow. Finally and decisively, the cost of treating each individual senior is growing faster than our nation’s collective income. These mutually compounding developments grow the federal government’s health care cost bill faster than any other item in the budget.

Social Security’s cost is growing too. To a lesser degree, total Social Security benefits are growing faster than incomes. Piled on top of the even faster growth of health care costs, Social Security makes a challenging problem even worse.

Incidentally, all other spending – defense, domestic, “foreign aid,” all other “entitlements” – is growing more slowly than our income. This remains true even if we add Social Security to this residual. We can afford all the rest of the federal government, but – unless we tighten up the ship – we cannot afford health care.

Will tax “reform” help? No. The tax bills now under consideration in the Congress will slow, not speed, economic growth.

Tax reform’s primary potential positive influence on growth comes through investment. (Much of the workforce is on an institutional 40-hour week. Many pairs of married spouses are already all-in on work. Those people will enjoy their tax cuts, which will add dollar-for-dollar to the deficit and the public debt and have no “supply-side” effect.) Optimists will say that lower tax rates will induce more investment. However, the cost of investment (what economists call “the cost of capital”) is far more dependent on interest rates than it is on tax rates, and by widening the deficit by $1.5 trillion over the next decade, these tax reform bills will hurt more than they will help. Just putting money in the hands of people (including corporate shareholders, who would benefit from higher dividends or stock buybacks) would help if the economy were stuck at high unemployment, but it isn’t.

So what should we do? The nation needs to put in motion a plan to reduce the nation’s budget deficits, over time, to a level low enough that debt accumulation slows, and the debt grows more slowly than our GDP. That would allow the federal government to gradually wear away the debt burden, and would tell the world that our nation has the ability and the will to manage our collective finances. To do that, we must:

Reform our health care system. Both the Affordable Care Act and Medicare should provide individuals with credits that would pay for the least costly private health plans that meet quality standards (including essential benefits). Individuals could buy more expensive plans (which traditional Medicare likely would be), but would be responsible for the excess cost. Competition among plans to attract customers through high quality and low cost would drive improvements in the delivery of health care. These reforms must respect the needs of today’s Medicare beneficiaries, who have medical conditions and are in the care of providers they trust. We cannot change the Medicare system overnight.

Reform Social Security. The nation must recognize and meet the needs of low-income seniors, while making Social Security financially sustainable. The population now in and near retirement must be protected; remember that the 85-year-old widow in the walk-up cold-water flat cannot be confronted with an overnight benefit cut and told to get a job. She can’t. Instead, we must gradually adjust benefits according to increasing life expectancies, reduce benefits for the most well-off, but protect those who worked lifetimes at low wages or had career interruptions to raise children, and increase the share of wages that is subject to the payroll tax.

Restrain the rest of the budget. The deficit problem is so large that no part of the budget can be ignored. The non-health, non-Social Security entitlement programs are small. The run-of-the-mill government agency programs have already been cut so deeply by the 2011 “sequester” that neither party in the Congress would accept spending at those low levels. But we must do everything possible to make every dollar in the budget count, and to monitor these programs conscientiously.

What remains is revenues. The major sources of rising federal spending – Medicare and Social Security – support our vulnerable elderly population. Those programs cannot achieve quick savings; they require long-term, structural change. The rest of the budget is small and not fast-growing, and therefore is not a likely source of savings. Meanwhile, the debt is mounting, and is approaching dangerous levels. Until major reforms of Medicare and Social Security can come on line, we need to slow the growth of the public debt.

Washington should go back to the beginning and enact true tax reform. Our elected policymakers must eliminate or cut back tax preferences, and use part of the revenue proceeds to reduce tax rates, but the rest to increase revenues and reduce the deficit. This responsible program will demonstrate to the financial markets that the United States can be trusted to maintain its finances and its economy.  When such a program was last enacted, in the 1986 tax reform and the early 1990s, the United States embarked on the longest and strongest investment and economic expansion in its post-World War II history. We can do it again.