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WEALTH OF NATIONS

Taxes Will Go Up -- Get Used To It

There are countless stupid ways to raise more revenue but really just three intelligent ways.

When politicians in Washington are ready to talk about broadly based tax increases, and not before, you will know that they intend to do something about the long-term budget deficit. At the moment, what we have is mainly theater. Most Democrats and Republicans agree that middle-class tax increases are politically impossible. They also agree that major spending programs are off-limits. Everybody in Washington is concerned, terribly concerned, about the outlook for public debt -- but not concerned enough to do one thing about it.

Look at the argument the Republicans and Democrats are having over the Bush administration's tax cuts and who is to blame for the deficit.

 

Under current law, these tax cuts will shortly expire. The reconciliation procedure that Republicans used to push the changes through required this sunset clause. The maneuver had the added political benefit of disguising the cuts' long-term fiscal consequences.

Republicans want to extend the Bush tax cuts. Democrats, who opposed the cuts and now blame them for the exploding deficit, want them to disappear. Well, partly. Actually, the two sides are closer to agreement on this than either is willing to admit.

The Bush tax cuts for the rich account for less than half of the total loss of revenue under that policy. Middle-class tax cuts account for the rest. Democrats are right that the cuts were unaffordable. Then why stop most of them from expiring? Why does repudiating the Bush administration's fiscal profligacy not require Congress to let all of the cuts expire?

 

Since neither party wants to go there, the idea is rarely even mentioned. On the contrary, a lot of effort goes into ensuring that the subject never comes up. The administration has folded the extension of the middle-class tax cuts, which requires new law, into its "current policy" budget baseline, as though it needed no further justification.

President Obama recently said how pleased he was that Congress had adopted new "pay-as-you-go" rules. These are intended, so the theory goes, to ensure that any additional tax cuts or spending increases are paid for by extra taxes or less spending elsewhere. Because a new law is needed to extend the middle-class tax cuts, ordinarily the "paygo" rules would demand offsetting tax increases or spending cuts.

As it turns out, the new rules specifically exempt the renewal of the Bush tax cuts from the offset requirement. The rules exempt a lot of other deficit-expanding policies as well. When it comes to fiscal control, you see more posturing in Washington these days than at Milan Fashion Week.

As long as the capital market lets Congress get away with such nonsense, nothing is going to change -- least of all in the run-up to the midterm elections. Yet the administration is right to call its own budget outlook unsustainable. Sooner or later, rising bond yields and other intimations of financial stress will start to force the government's hand.

 

Think of a moderate carbon tax as relatively cheap insurance against an uncertain but grave risk.

If the U.S. is unlucky, sentiment in financial markets will change abruptly, leaving no time for an orderly fiscal correction. This is unsustainable à la Grecque. But whether the change is gradual or sudden, rest assured that higher taxes are unavoidable. The long-term fiscal gap is just too big for spending cuts alone, desirable as they may be as part of the solution, to do the job.

So get used to the idea. Taxes are going up -- a lot. The only question is, which taxes?

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There are countless stupid ways to raise more tax revenue but really just three intelligent ways. First, introduce a carbon tax; second, broaden the base of the income tax; third, design a national sales or value-added tax. In principle, each by itself, carried to an extreme, could close the gap. But it would be better to combine two or even all three approaches so that the rates of each tax would be lower for any amount of revenue raised.

We would need a VAT at close to European levels -- 10 percent or more -- if that were the only change. That would be quite a jolt. It would be easier to swallow, say, a 5 percent VAT together with a small carbon tax and a moderate broadening of the income-tax base. For further sweetening -- not to mention, added economic efficiency -- a revenue-boosting package of that kind could be designed around lower income-tax rates and more generous income support for the working poor.

Yes, obviously, this is unthinkable. Just like the Great Recession of 2008-09 was unthinkable. What I'm suggesting is about as likely to happen as the Troubled Asset Relief Program. So, bear with me.

Turning to specifics, agreed, a carbon tax looks even harder to enact now than before. The Climategate e-mails and, even more, the science establishment's subsequent excuses and evasions have wounded the campaign for action on climate change. The science commands less public confidence than it used to, and the authority of the Intergovernmental Panel on Climate Change is shot.

But this fiasco does not much alter the case for a moderate, gradually rising carbon tax. Think of it as relatively cheap insurance against an uncertain but potentially grave risk. Taxing environmental "bads," even if the harm is less than certain, is good economics and not impossible to sell politically. In the meantime, a carbon tax would reduce dependence on imported oil, which is a legitimate security consideration, and spur development of cleaner fuels. And, by the way, it would raise some revenue, which the country has to do in any case.

The second option, reforming the federal income tax, would serve a similar dual purpose, raising money and creating better incentives at the same time. Like a carbon tax -- and, for that matter, a VAT -- income-tax reform would be good even if the need to raise more revenue did not make it necessary. Other things being equal, a carbon tax could be used to lower income-tax rates. Other things being equal, so could a broader income-tax base.

The scope for increasing revenue, making better use of scarce resources, and simplifying America's insanely complex income tax code is vast -- a tribute to the depredations that Congress has visited on the system since the last comprehensive reform in the 1980s. A column last month in The Washington Post by tax expert Len Burman of Syracuse University looked at the revenue losses from so-called tax expenditures -- preferences for things such as mortgage interest relief and employer-provided health insurance. These tax breaks force tax rates higher, for any sum of revenue collected, and clumsily interfere with the decisions that people would otherwise make about how to spend their incomes.

"Capping tax expenditures at 2012 levels for three years and indexing the cap for inflation after that, as proposed [by the president] for nonsecurity discretionary spending, would reduce the deficit by about $3.5 trillion" over the next decade, Burman says. "That's right -- 14 times as much as what the president's spending freeze would save."

Capping tax expenditures and holding them to a fixed rate of growth poses some practical problems. It would be simpler to cut or eliminate them. (The administration has proposed applying a maximum 28 percent tax rate to deductions, even if a taxpayer's marginal rate is higher. Congress is not interested.) Some tax expenditures are easier to defend, or harder to attack, than others. But that giant revenue loss shows that simpler taxes, lower rates, less needless economic interference, and higher revenues can all be achieved at the same time.

A value-added tax belongs on the agenda because it carries the base-broadening logic further: If applied to almost all consumer spending, it raises a lot of revenue even at low rates. Also, it offsets some of the anti-saving bias in the income tax because it applies only to income that is spent. Lawrence Summers, Obama's chief economic adviser, once remarked (I am paraphrasing) that the Left hates the VAT because it is a flat, regressive tax; and the Right hates it because it fuels Big Government. Once the Left comes to see it as fuel for Big Government and the Right as a flat, regressive tax, he reckoned, we might get somewhere.

Obama cannot embrace this kind of program without breaking (too mild a word) his promise to avoid raising taxes on the middle class. He will need the political cover of a gathering sense of emergency, or a forceful performance by his fiscal commission, or both, and even then he might pay a high price. To his credit, though, he has already found some wiggle room -- witness his support for the excise tax on expensive health plans (watered down, admittedly, from the Senate bill's proposal). Asked whether his fiscal commission would be told not to recommend tax increases on moderate incomes, he refused to exclude any options.

It is far from easy. But in the end, as Margaret Thatcher, prime minister of a bankrupt country, once said, "There is no alternative."

This article appears in the March 6, 2010 edition of National Journal Magazine.

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