A new study from the National Academy of Sciences looks at the federal government’s finances and lays out different paths the nation might take in the coming decades. Choosing the Nation’s Fiscal Future focuses on efforts to control government debt and notes that a simplified tax system could make the process of raising revenue less damaging to the economy.
As a member of the NAS committee, I was honored to discuss and debate vital budget issues with such a high-caliber group. The following are my views on some of the more interesting aspects of the report.
Four Fiscal Paths
The NAS report does not provide a specific plan to cut federal deficits or reform fast-growing entitlement programs such as Medicare. Instead, it describes four possible fiscal paths the government might take in coming years. The paths are defined by the share of gross domestic product the government will consume.
For decades, federal spending has hovered around 20 percent of GDP. But official projections show if no cuts are made to entitlements, spending could rise to 33 percent of GDP by 2040 and about 60 percent of GDP by 2080. That would create massive increases in federal debt, crushing tax burdens, or both.
The four NAS scenarios would limit federal public debt to 60 percent of GDP under various taxing and spending combinations. The low scenario would keep the government at about the same size as today. Under the other scenarios, payroll taxes would increase and all individual income tax rates would rise to generate added revenues.
The NAS report focuses on controlling government debt and is neutral on the overall size of government. The report concludes that unless reforms are made, rising debt may raise interest rates, reduce domestic investment, push the dollar down, and create other economic damage.
The report’s projections do not take into account the macroeconomic effects of tax changes. If tax rates were to rise as under the larger-government options, GDP would likely shrink, and higher tax rates would be needed to generate the revenues required to stabilize federal debt.
The NAS report recognizes that for any given level of federal spending, the tax code could be reformed to make raising the needed revenue less damaging. As such, an alternative Simplified Tax was modeled for each of the four spending scenarios. The ST would scrap almost all deductions, exemptions, and credits under the individual income tax, and it would have rates of 10 and 25 percent instead of the current six rates.
The lower rates and more neutral tax base of the ST would reduce the economic damage caused by taxation. To that end, the plan would also cut the federal corporate tax rate from 35 to 25 percent. A study by the Organization for Economic Cooperation and Development found the corporate income tax is the most economically harmful tax.
If Congress holds spending to the “low” level, the ST would allow families to enjoy a simpler tax system with lower rates. The ST would have the same “distribution” with respect to income groups as the current tax code when implemented in 2012, although the NAS report shows the distribution would change modestly over time.
For those people who favor the higher spending scenarios, an ST-style tax reform would also be attractive. The higher economic growth generated by the ST would partly ease the rising burden of increased entitlement costs. And the ST’s broader tax base would mean a VAT would not be needed under any scenario.
The NAS report leaves it an open question how a larger government may affect living standards. In thinking about that, note that government spending is of two basic types: production of goods and services, and income transfers through subsidies and benefits. As a share of GDP, government production has been fairly stable over time, but income transfers have skyrocketed.
Income transfers reduce GDP because extracting taxes creates economic distortions and providing handouts generates unproductive behavior by the recipients.
For example, Social Security reduces savings and encourages early retirement; welfare reduces work incentives; farm subsidies induce inefficient farming practices; and so on.
By contrast, government production activities could, in theory, generate positive returns. However, experience has shown that the performance of federal programs and investments is often abysmal. Another problem is that governments in the United States already consume well over one-third of GDP, so it is unlikely that added spending could earn a high enough return to overcome the economic losses caused by higher taxes.
Restrictions on Freedom
The future size of government will affect individual freedom as well as economic growth. Larger governments inevitably restrict the autonomy of individuals and their communities. The health care bill before Congress, for example, would give new powers to the Internal Revenue Service, mandate the purchase of health insurance, and impose new regulations on businesses. Or consider how expanded federal education spending has gone hand-in-hand with greater federal control over local schools.
The NAS report provides a useful framework to help the public understand the options for solving the looming fiscal crisis. When considering those options, people should think about both the economic and civil liberties implications of alternative fiscal paths.
Chris Edwards ([email protected]) is director of tax policy at the Cato Institute.
Choosing the Nation’s Fiscal Future, report of the National Academies: http://www.heartland.org/budgetandtax-news.org/article/26991