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Obama Must Do More Than Raise Taxes

Author: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics
November 28, 2012
Financial Times


The news from Washington's budget battle is at least half positive. Thanks to the Democrats' election victory, some senior Republicans now accept that taxes should be higher. Given that American society is ageing and total government tax revenues are the lowest as a percentage of gross domestic product of any rich country, this marks a healthy reacquaintance with reality. The last time any congressional Republicans voted for a significant tax rise was in 1990.

But the early signs from the battle also contain a warning. Precisely because the election has buoyed Democrats, most seem unwilling to restrain health and pension costs. Given that these will swamp tax policy in the long run, this is a ruinous error. Barack Obama therefore faces a clear test. The president can bash Republicans on taxes and enjoy a political victory. Or he can aim for true fiscal stability, even if achieving it requires confronting fellow Democrats.

If he wants the real deal, Mr Obama must distance himself from supporters who understate the fiscal challenge. This week, for example, the economist Paul Krugman complained that "deficit scolds" are "fighting fiscal phantoms". This is fair up to a point: the extraordinary doubling in America's federal debt ratio since 2007 has been a necessary response to collapsing private spending, and fixing the deficit is not a near-term imperative. But consider what looms in the future. According to the Congressional Budget Office's "alternative fiscal scenario", which assumes that current policy continues, today's net debt ratio of 73 per cent of GDP is on track to hit 100 per cent 12 years from now.

It is true that the ratio hit 109 per cent in 1946 and then subsided without drama. But next time will be different. In 1946 a huge peace dividend, strong growth and inflation that hit 14 per cent in 1947 allowed the debt ratio to fall fast. Next time there will be no peace dividend; demographic and productivity trends are likely to be weaker and inflation will be less effective as well as undesirable, since much of the long-term budget problem consists of health and pension promises, which are in effect indexed to inflation. For all these reasons, the CBO shows the debt ratio surging upward to 241 per cent in 2037, while a longer-term projection by Alan Auerbach and William Gale anticipates a ratio above 400 per cent in the early 2060s. Could this surge trigger a crisis? Even allowing for the fact that the US issues the reserve currency, the question is when, not if.

So something must be done about the deficit. Mr Obama's favourite solution is higher taxes on the rich. America's tax regime has egregiously exacerbated inequality: the top 1 per cent of earners have pocketed the lion's share of gains in pre-tax income since 1979, even as their average tax rate has fallen by 7.5 percentage points. Moreover, the Republican claim that higher tax rates hurt growth is exaggerated. To the contrary, a CBO study found that the 2001 and 2003 tax cuts actually reduced output because the marginal improvement to incentives was outweighed by the drag from additional government borrowing.

But the trouble with higher taxes is that they are not enough to plug the deficit. Yet another study from the CBO finds that cancelling President George W. Bush's cuts for the rich (defined as individuals earning at least $200,000 and couples earning at least $250,000) would reduce the 2020 deficit by $110bn, just a tenth of that year's projected $1.1tn shortfall. It is also just a quarter of the amount needed to reduce the deficit enough to stabilise the debt-to-GDP ratio. Capping tax breaks such as mortgage interest deductions to 15 per cent of earnings would yield another $150bn, still a long way from the goal. A more radical assault on tax breaks would do the trick, but neither party seems ready for that. Meanwhile, popular targets, such as special depreciation for corporate jets and "carried interest" for private equity barons, are rounding errors.

Mr Obama of course understands that tax rises are no silver bullet. His ambition is to find $1.6tn in extra revenues over the coming decade to supplement a similar amount of spending cuts that would hit health and pensions only lightly. But there are three problems with this plan. First, fixes on this scale may be enough to stabilise the debt over a 10-year horizon, but they are not enough beyond that, when health costs will increase rapidly as the population ages and medical inflation takes its toll. Second, such spending cuts are implausible: in the blueprint enacted last year, they would drive both defence and non-defence discretionary spending lower as a percentage of GDP than ever recorded, as Richard Kogan of the Center on Budget and Policy Priorities has noted. And third, raising taxes on the rich without significantly restraining health and pension costs would ruin the chances of a comprehensive budget fix. The middle class will only swallow a large benefit cut if the rich are made to make sacrifices at the same time. Socking it to the rich now while kicking serious benefit cuts into the future would be a classic cake-before-spinach cop out.

America's core budget challenge can be expressed simply. Federal health and pension promises cost 10.4 per cent of GDP today; the CBO projects that they will cost 16.6 per cent in 2037. No plausible tax rise can offset that leap. If Mr Obama cares about his legacy, he must acknowledge this arithmetic.

The writer is a senior fellow at the Council on Foreign Relations and an FT contributing editor

This article appears in full on CFR.org by permission of its original publisher. It was originally available here (Subscription required).

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