Daily Archives: February 3, 2013

Washington’s gamesmanship over the fiscal cliff raises a critical question: Does the US have budget rules and processes that are adequate for the nation’s looming crisis?

It does not — but today’s 100th anniversary of the 16th amendment to the US Constitution offers a reminder that the republic was designed to adapt to such challenges.

The 16th amendment, which blessed the taxation of income, opened a fiscal Pandora’s box. From that emerged a small but hungry federal government, initially taking no more than 7 per cent of the annual income of multi-millionaires. One hundred years later, it is taking 40 per cent from the incomes of citizens who will never be millionaires.

Proponents of the income tax amendment in 1913 justified its passage in terms of fairness. Tariffs had historically been the federal government’s main revenue source, and those taxes on international trade fell disproportionately on the consumption of lower-income Americans. Incomes, growing most rapidly for the highest earners in the late 19th century, remained untaxed.

Today’s budget debate should raise important concerns about fairness, too. High and rising national debt levels will sap future economic growth and portend sharply rising tax burdens and/or reductions in basic public goods such as defence, infrastructure, and scientific research. Our budget rules don’t account for short-sighted politicians, an omission that can easily be fixed.

Economists have long worried about unbalanced budgets. These warnings, coupled with countless plans to fix the budget, have been ignored while debt has piled up. A decade from now, under the Congressional Budget Office’s alternative (i.e. realistic) scenario, the debt-to-gross domestic product ratio is set to rise above its second world war level. And what the CBO calls the “explosive path of federal spending” will add the equivalent of 3 per cent of GDP to the national debt each year this decade, followed by 4 to 5 per cent per year in the next.

The federal government has resolved six major debt build-ups over the course of the nation’s history. Putting aside the Great Depression, debt spikes were driven by war — the revolutionary war, war of 1812, American civil war, and the two world wars. In contrast, today’s debt has been building up for decades and cannot be pinned on a singular event.

The US is facing is an entitlement crisis, which strains its out-of-date budget processes and raises serious questions of inter-generational fairness.

In 1973, the federal government spent 17.6 per cent of the nation’s GDP. Of these funds, 3.7 per cent of GDP went to Social Security spending, 1.1 per cent was for health care, leaving 9.9 per cent for discretionary spending (including defence).

This year will be quite a contrast. The federal government is projected to spend 21 per cent of the nation’s GDP, not counting interest payments on the debt. Of that spending, 5.1 percent of GDP will go to Social Security, 5.6 percent will be for health care entitlements, leaving only 7.8 per cent for discretionary spending.

This trend – entitlements crowding out other government responsibilities – is projected to continue. The rising cost of Washington relative to nation’s economy darkens the debt picture considerably.

While on this much nearly everyone agrees, Washington has not made serious progress towards bridging the fiscal gap. Making progress is essential, and it requires rethinking the rules; not simply the policies.

The broken budget process cries out for reform. An important step would be to use accrual accounting, as opposed to cash accounting to highlight the consequences of escalating entitlement spending. Accrual accounting counts up the cost of new long-term obligations in the year the obligation is made, not the year in the distant future when it will be paid. Changes in accrued liabilities of entitlement programs, in particular, should be assessed on budget each year. The US Congress and the president would then be required each year to consider offsetting those increases with revenue increases and/or with cuts elsewhere.

A broad-based consumption tax offers a potent tool here. Revenue from such a tax could be used to offset all revenue from the income tax, or at least the most distorting parts of it – high marginal tax rates on corporate and other business income that reduce investment, productivity, and employment. Analysis by economists of this tax reform suggest substantial economic gains on the order of 0.5 per cent of GDP each year for a decade.

While my preference would be for budget imbalance to be addressed entirely by reducing the growth of federal spending, a consumption tax also provides a means for raising additional revenue if the political process supports a larger government. A democracy should not be constrained in its use of revenue increases or spending reductions to achieve balance. But the use of the consumption tax ensures that all Americans know they are paying for the rising cost of broad-based entitlement programs. As with the case made for the 16th amendment, the US Congress could retain a modest wage tax for high earners to promote fairness.

The use of a consumption tax would not imply that the US Congress is required to support higher rates of consumption taxation to pay for rising entitlement spending. On the contrary, the US Congress – and by extension the public at large – would be compelled to choose among reducing entitlement spending (say, by slowing benefit growth for more affluent households), reducing discretionary spending (say, on defence and education), or increasing taxes in response to higher projected spending.

The adjustments could take place over several years to avoid amplifying the business cycle. And Congress would have to decide whether to initiate the new process at current levels of federal deficits and debt or, in addition, to reduce the debt-to-GDP ratio from its present level.

The centennial of the 16th amendment is a time to reflect on the income tax and on the need for tax reform. The roots of the income tax as a revenue raiser and tool to increase fairness could be better met with a reformed tax code raising the bulk of federal revenue from consumption taxation, while imposing a progressive labor income tax on high earners for fairness.

But this discussion should not crowd out as even more important one of how to restore budget discipline before both economic growth and fairness to future generations are irrevocably compromised. The combination of a revised budget process and the introduction of a broad-based tax as an instrument offer a way to reset the nation’s fiscal course while there is still time to do so.

This post was co-authored by Tim Kane, chief economist at the Hudson Institute

 

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