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In the Nation's Interest

Washington Should Start Over and Enact True Tax Reform for America

The nation faces a budget crisis, say some talking heads. The nation needs a tax cut to accelerate growth, say others. Voters tell pollsters they want candidates who tell the truth. Then they vote against any and every candidate foolish enough to discuss cutting spending and raising taxes to reduce the deficit. But what would an honest candidate say now?

We have a budget problem. The nation’s debt burden, measured against our collective income measured by gross domestic product, is about as high as it has ever been. It was heavier only at World War II’s end, when returning troops and converted wartime factories ignited an economic boom. Today, with a retiring baby boom generation and lower birth rates eroding the labor force, no such boom is likely.

The budget problem will slow growth. To invest in its future, the nation must save. Government borrowing to finance deficits drains that pool of saving. Less private and public investment means less productive capacity, less productivity growth, and slower income growth. The budget problem risks another financial crisis. Our budget profligacy can continue as long as lenders around the world bankroll us. That may continue for some time. The longer it does, the more our growth lags, the bigger our debt, and the harder we fall when the rest of the world tires of buying our paper.

The major cause of the long-term budget problem is Medicare and health care in general. The elderly population mushrooms because of the retirement of the baby boom. Moreover, the elderly are living longer. As each senior ages, his or her health care needs grow. Finally, the cost of treating each senior is growing too rapidly. Social Security’s cost is rising, too, with total benefits growing. Piled on top of the even faster growth of health care, Social Security makes the problem worse. Will tax “reform” help? No. The tax bills under consideration will slow, not speed, growth.

Tax reform’s main benefit comes through investment. Optimists contend lower tax rates will induce more investment. However, the cost of investment (what economists call “the cost of capital”) depends far more on interest rates than on tax rates. By widening the deficit by $1.5 trillion over the next decade, these tax bills will hurt more than they will help. Just putting money in people’s hands would help if the economy were stuck at high unemployment, but it isn’t.

So what should we do? Gradually reduce budget deficits enough so that debt grows more slowly than our gross domestic product. That would gradually wear away the debt burden, and tell the world our nation can and will manage its collective finances. To do that, we must reform health care and Social Security, and restrain the rest of the budget.

The Affordable Care Act and Medicare should provide individuals with credits that would pay for the least costly private plans that meet quality standards. Individuals could buy more expensive plans but would bear the excess cost. Competition among plans to attract customers through high quality and low cost would drive improvements in health care delivery. These reforms must respect the needs of today’s Medicare beneficiaries, who have medical conditions and are in the care of providers they trust.

The nation must protect low-income seniors, and people in or near retirement, while making Social Security financially sustainable. The 85-year-old widow in her flat cannot be confronted with an overnight benefit cut and told to get a job. Instead, we must gradually adjust benefits for 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 subject to the payroll tax.

The non-health, non-Social Security entitlement programs are small. Government agency programs have already been cut so deeply by the 2011 “sequester” that neither party would accept such low spending. But we must make every dollar count and monitor these programs conscientiously. What remains is revenues. The major sources of rising federal spending, Medicare and Social Security, support the elderly.

Those programs cannot achieve quick savings. They require structural change over the long term. The rest of the budget is small and not fast growing, and it won’t yield enough savings. Meanwhile, the debt is mounting to dangerous levels. Pending major reforms of Medicare and Social Security, we need to slow public debt growth.

Washington should start over and enact true tax reform. Policymakers must eliminate or cut back tax preferences, use part of the revenue proceeds to reduce tax rates, and the rest to increase revenues and reduce the deficit. The 1986 tax reform and the 1990s deficit reductions produced the longest and strongest investment and economic expansion in our history after World War II. We can do it again.


This column was orginally featured in The Hill.