Stemming the tide

---list spending, revenue items http://www.economist.com/displayStory.cfm?story_id=14903024&source=hptextfeature Nov 19th 2009 WASHINGTON, DC From The Economist print edition Unprecedented levels of government debt may require radical solutions Illustration by Bill Butcher STUDENTS at National Defence University in Washington, DC, were recently given a model of the economy and told to fix the budget. To get the federal debt down, they jacked up taxes and slashed spending. The economy promptly tanked, sending the debt to higher levels than before. The lesson: “You’ll never get re-elected and you may do more harm than good,” concluded Eric Bee, an air-force colonel who took part in the exercise. This is the ugly arithmetic of America’s public finances. Recession and aggressive fiscal stimulus have hugely swollen the federal deficit. Stimulus was essential to cushion a collapse in private demand. In spite of that, the economy has barely emerged from recession and unemployment is still rising, feeding speculation that more stimulus is needed. Yet at the same time voters are growing alarmed at the tide of red ink, and it may be only a matter of time before markets do, too. On current policies the federal deficit, which hit a post-war high of 10% of GDP in the fiscal year that has just ended, will fall to 4.2% by 2014 and will then head steadily higher. Aides to Barack Obama know this is unacceptable. With a new budget due in February, government departments are said to be preparing to tighten their belts. Meanwhile an advisory committee, chaired by Paul Volcker, who used to head the Federal Reserve, will report to the president in early December on options for tweaking the tax system, though not how to raise much more revenue from it. But the administration has resisted being pinned down on concrete deficit reduction. The post-crisis experience of other countries suggests that America’s recovery will be muted and fragile. As the students found, premature tightening of fiscal policy could strangle the recovery in its cradle and worsen future deficits. “Doing the prudent thing about deficits now would be an extremely foolish thing,” observes Paul Krugman, a Nobel-winning economist. However, persistent deficits could eventually drive up interest rates, and uncertainty over when or how taxes will rise could dampen business confidence. Higher interest charges will take money from other public services, and limit the flexibility to respond to future economic shocks. “While it is premature to begin exiting from fiscal support, governments should not hesitate to announce a credible exit strategy now,” said the International Monetary Fund (IMF) on November 3rd. Such an announcement, even without immediate spending cuts or tax increases, could help steady nerves. And actual deficit reduction, if done right, could enhance economic growth. For example, fixing entitlement programmes for the elderly could extend Americans’ working lives and expand the labour force; shifting the burden of taxes to consumption could boost saving and investment. But it will not be easy. Early last year the Congressional Budget Office (CBO) thought federal debt held by the public, then about 40% of GDP, would fall to 28% in a decade’s time. It now sees it reaching 82%. As William Gale and Alan Auerbach, two prominent fiscal experts, put it: “The future is now.” Using the CBO’s economic-growth and interest-rate assumptions, and assuming that Mr Obama’s last budget is implemented (for example, that his payroll-tax credit is made permanent and that George Bush’s tax cuts remain except for the wealthiest), a deficit of 3% of GDP in 2014 (instead of 4.2%) would stabilise debt at about 70% of GDP. That would require trimming more than 200 billion from the 2014 deficit and more than 500 billion from the 2019 shortfall. This amounts to a cumulative 1.2% fiscal contraction over three years, and about double that over seven. The specific timeline is not important; stretching it over more years means a higher debt. Either way there are risks: it may hobble a still-weak economy. And it may not be enough. The spending bonanza Further efforts after 2019 would be needed because of growing pressure on the debt from entitlement spending. This will go on relentlessly rising as the baby-boomers continue to reach retirement age, and then become infirm. Most of the growth in the deficit comes from spending, which averaged 21% of GDP from 1980 to 2007 but will approach 25% by 2019, according to the CBO (see chart 1). Some of that comes from interest charges on the debt, expected to more than triple from their current 5% of total spending. But entitlements are the elephant in the budget. On current policies, pensions and health care for the retired (Social Security and Medicare, respectively) and health care for the poor (Medicaid) will grow from 10% of GDP in 2011 to 18% by 2050. Mr Obama had long planned that his health reform would not just cover the uninsured but also stop the long-term growth in health costs. In the bills currently in Congress, that second goal may be out of reach. Although Mr Obama insists that the reform will not raise the deficit, it will still absorb some of the revenue that could have been used to reduce it. Social Security is more straightforward. First, because Americans live longer and healthier lives than a generation ago, the age of eligibility, which will rise to 67 in 2027, could be raised to 70 and be linked to life expectancy thereafter. Medicare’s eligible age, now 65, could also be raised. Second, starting benefits could be based on how much prices, rather than wages, have risen during a beneficiary’s working life, except for the lowest-paid workers. Third, benefits could be linked to an inflation index with less upward bias than the one now used. Fourth, while married retirees are both alive, the spousal benefit could be reduced. Overall, a worker’s benefits would be lower than currently projected, but not in real terms. Lower-income workers and anyone now nearing retirement would be spared. Currently the federal government pays 50-83% of Medicaid; states pay the rest. This encourages states to expand coverage and benefits because they pay only a portion of the extra cost. Switching Medicaid to a block grant, indexed to inflation and population, and requiring wealthy states to pay most of their share, would encourage states to control costs. The model would be the 1996 welfare reform, which shifted funding to block grants; in exchange, states gained flexibility in designing their programmes. States and their congressional delegations will complain that this simply shifts costs from federal to state budgets. Still, states that really want more generous programmes could raise their own taxes to fund them. Because most are required to run balanced budgets and have less-than-AAA credit ratings, they would be less likely than the federal government to fund cost overruns by borrowing. Because entitlement changes have to be phased in slowly, they offer only limited savings in the short term. Other programmes such as highway funding and farm assistance could be trimmed, and perhaps handed over to the states. Defence and discretionary items represent just a third of spending, and Mr Obama has already planned to shrink both in nominal dollars by 2014, as the wars in Iraq and Afghanistan (with luck) wind down and the stimulus expires. Thereafter, they would grow only slightly faster than inflation. Freezing both at 2014 levels would shrink them in real terms. Still, it would save only $160 billion a year by 2019. Even elimination of the notorious “earmarks”, favoured projects slid into the federal budget by individual congressmen, would save little; they add up to less than $20 billion a year, and in any case they only rearrange, rather than expand, the budget. Taxation’s maze The measures outlined above could generate perhaps half the savings needed to get the deficit down to 3% of GDP (see table). Without more drastic cuts, achieving the other half requires higher tax revenue. George Bush’s tax cuts expire at the end of next year. This could provide a catalyst for more fundamental tax reform. America depends inordinately on payroll and income taxes, on both people and corporations (see chart 2 and article). This penalises work and investment, and encourages borrowing and spending. Exemptions, credits and loopholes worth $1 trillion a year riddle the system and distort behaviour. The deduction for employer-provided health insurance encourages richer plans and more spending. The mortgage-interest deduction fosters borrowing and leverage. The largest loopholes also favour the rich, making the tax system less progressive, and encourage rampant tax avoidance. The tax code is now several million words long and changes, on average, more than once a day. Compliance costs Americans the equivalent of $200 billion annually. That complexity is magnified by the “alternative minimum tax” (AMT), a parallel income tax aimed at the wealthy that must be fixed each year to avoid ensnaring more of the middle class. Economists generally see two goals for tax reform: less complexity and more bias towards taxing consumption. There are two broad ways to achieve that. The first would broaden the income-tax base by eliminating loopholes while lowering rates, as occurred with the last big reform in 1986. Some exemptions, such as the one for retirement saving, would be kept. Abolishing deductions for employer-provided health care, mortgage interest, capital gains on homes and state and local taxes would raise over $500 billion in 2014. Some of that could be used to reduce the deficit, and the rest to shrink or scrap the AMT. Junking these deductions entirely may be politically impossible. But much the same result could be achieved by capping the exclusion for employer-provided health care (exempting most lower-cost plans) and replacing the mortgage-interest deduction with a tax credit. Some conservatives go further, advocating a single “flat” tax bracket above a basic personal exemption. But that would make the system much less progressive. The second type of tax reform would replace or supplement the income tax with a broad tax on consumption. There are many ways to do this. One would allow an unlimited exemption for saving, in effect turning the current income tax into a consumption tax. Another would be a national sales tax, similar to state sales taxes but charged federally. An alternative is a value-added tax, which all other OECD countries have (see article). VAT is levied at each stage of production. For example, a baker might pay five cents VAT on flour and collect 25 cents VAT on the bread he sells, remitting 20 cents to the government. An analysis for The Economist by the Tax Policy Centre estimates that a 5% VAT that exempted education, housing, and religious and charitable services would raise a net $324 billion in 2014 and $411 billion in 2019. Some of that could be used to reduce the impact on the poor, for example by expanding Mr Obama’s payroll-tax credit. The rest could be used to lower corporate and personal rates and reduce the deficit. An alternative or complement to either of those reforms would be a tax on carbon emissions. This would raise revenue, penalise consumption and encourage energy efficiency. The most economically efficient method would be a carbon tax. Mr Obama and Congress are instead pursuing a cap-and-trade system; that could do the same thing, provided permits to emit carbon dioxide are sold rather than given away. Raising the current federal fuel tax would have similar benefits with fewer complications: a 50-cent boost, to 68 cents a gallon, would raise some $60 billion a year. Whether America adopts a broader-based income tax with lower rates, or a VAT, or any serious tax reform, depends more on politics than economics. Each of the tax code’s loopholes has fierce defenders. Yet it might be even harder to persuade almost everyone to pay a new federal tax where none has existed. Join hands and jump Historically, politicians are most likely to tackle deficits when prodded by markets. Denmark in 1982, Ireland in 1987 and Canada in 1995 all embarked on ambitious programmes after spiralling debts had driven up interest rates. In the same way, American deficit-reduction deals in 1985, 1990 and 1993 were nudged along by nervous markets. Such concerns are notably absent now. “Until the bond-market vigilantes form a posse again, it’s just too easy to ignore this issue,” says Alan Blinder, a Princeton University professor and former adviser to Bill Clinton. One way to moderate the political resistance to cutting entitlements and raising taxes is to bypass regular legislative procedures. Kent Conrad and Judd Gregg, the Democratic chairman and top Republican respectively on the Senate Budget Committee, have proposed a bipartisan commission, probably composed of legislators and administration officials. They would produce a single proposal which Congress must approve or reject, but cannot amend. “The only way you do this is if everyone joins hands and jumps off the cliff together,” says Mr Gregg. It is “institutional insurrection”, admits Evan Bayh, an Indiana senator. He means that in a good way. At least three other, similar proposals are before Congress now. A dozen senators have said they will support a higher national debt limit—scheduled for a vote in the next couple of months—only if it is tied to the creation of such a commission. Mr Obama has previously expressed interest in the idea. But many congressmen think it would usurp their responsibilities. Nancy Pelosi, the speaker of the House of Representatives, is adamantly opposed. A similar commission was set up to restore solvency to Social Security in 1982-83. It succeeded because the problem was imminent, the consequences of failure were unacceptable to both parties, and its members were trusted and pragmatic dealmakers, according to a joint analysis by the Brookings Institution and the Heritage Foundation. Entitlements and tax reform today are a far larger, more amorphous problem, the threat of catastrophe is absent so far, and politics is more polarised. But “the alternative—political paralysis—is far worse,” the analysis concluded. Of course, if the commission failed, it “would be a very damaging moment in the eyes of our international creditors,” says Douglas Holtz-Eakin, a former CBO director. “To raise the political stakes so high in this environment has some real risks.” Yet that could also put pressure on the commission to succeed, and on Congress to approve its recommendations. Back at National Defence University, Mr Bee, the student, did eventually find a way to reduce the deficit without sending the economy into a tailspin. Unfortunately, it required America to keep borrowing from abroad. Mr Bee asked the students representing China in a similar exercise if they would advance the money. “They said, ‘We’ll think about it’.”