It’s Time For Tax Reform — Tomorrow

July 1st, 2011 by Lee Eldridge

Uncle Sam is in debt, who will bail him out?If you know me by now, you know that I’m an advocate for tax reform. We need to overhaul our tax code. Not just overhaul it, we need to dump it in the trash and start over. And I have ideas for how to start.

However, that can wait till tomorrow.

Today, the Republicans and the Democrats are stalled as they attempt to work towards some type of compromise on raising the debt ceiling. This is the problem we need to solve today.

Raising the Debt Ceiling
Some people have expressed concern by what will happen if Congress fails to raise the debt ceiling in a timely manner. Democrats like to cite examples of organizations who have said that it will hurt America’s credit rating if we default on our debt and fail to raise the debt ceiling. And they are correct. Though it’s selective representation of the facts when they ignore that these same organizations have also warned that it will hurt America’s credit rating if we fail to implement an intelligent strategy for dealing with our deficits and our national debt.

But let me be clear (I love that phrase), we will not default on our debt. And we will raise the debt ceiling, despite all of the political posturing by both parties. And like most negotiations, it won’t happen until late in the game.

The Polls
What’s impressive to me is that the American people get it, even when politicians don’t. According to Gallup:

By a 47% to 19% margin, Americans say they would want their member of Congress to vote against raising the U.S. debt ceiling, while 34% don’t know enough to say. Republicans oppose raising the debt ceiling by 70% to 8% and independents by 46% to 15%. Democrats favor raising the ceiling by 33% to 26%.

This poll is a couple months old. More recent polls have shown some shift as voters become more aware of the negative ramifications of not raising the debt ceiling. But what is consistent through virtually every poll is that Americans only want the debt ceiling raised if it is accompanied by significant spending cuts. The American people get it.

What Economists Want
The President likes to talk about a “balanced approach” to these negotiations. What this means is that the President wants increased tax revenues as part of the deal to raise the debt ceiling. The President likes to say that this is what fair minded people believe needs to happen. Yet what do economists say? Did you know that 150 economists got together and sent a letter to the President urging him to rein in spending and to avoid tax hikes? Here’s the letter:

The national unemployment rate in our country remains unacceptably high, well above the levels promised to the American people when the 2009 ‘stimulus’ spending bill was signed into law.  Efforts to spark private-sector job creation through government ‘stimulus’ spending have been unsuccessful.

As economists deeply concerned about our nation’s future, we urge a change in direction.  To support real economic growth and support the creation of private-sector jobs, immediate action is needed to rein in federal spending.  The need for such action is particularly acute in light of your request for Congress to pass legislation in the coming weeks to increase the national debt limit, and the increased burden small businesses face as a result of the new health care law and other regulatory challenges that create uncertainty for private-sector job-creators.

Action is needed now to begin to slow government spending, reduce uncertainty and support the creation of new private-sector jobs.  For the sake of millions of Americans who remain out of work – and future generations of Americans, who will carry the debt burden we are accumulating today – we respectfully urge that the leaders of both parties take action immediately to eliminate unnecessary federal spending, prevent tax hikes, stop regulatory threats to job creation, and enact reforms to put our nation back on a true path to prosperity.

Non-Keynesian economists get it. (I added the bold copy to emphasize my points.)

Why Wait on Tax Reform?
The big picture is that we need significant tax reform, and this cannot be negotiated in the next couple of weeks. Obama’s own debt commission has explained the need to overhaul our tax system. While I don’t believe their recommendations go far enough, they’re on the right track with many of their suggestions. And trying to tweak a bad system by closing a couple tax loop holes or adjusting tax rates does nothing to solve the long-term problems with the tax code. This debt ceiling negotiation needs to focus on spending cuts, not tax increases. The American people get it. And non-Keynesian economists get it.

It’s a Spending Problem
If you follow politics, you’ve likely heard this mantra from the right. We have a spending problem, not a revenue problem. I have detailed in past articles some facts that support this position. What’s important to remember is that over the last 60 years we have had periods with much higher tax rates than we have today, and periods where we’ve had lower tax rates than we have today. And historically, we still collect LESS than 20% of GDP in taxes. It’s the economy that drives tax revenues, not tax rates. So to me, there’s a significant amount of logic in holding government expenditures to less than 20% of GDP. Yet according to the CBO, by 2021 we will be spending 25.9% of GDP, and by 2035, we’ll be spending 33.9% of GDP. That’s a spending problem.

James Pethokoukis from Reuters has written a powerful article detailing why we should not raise taxes:

It’s up to House Speaker John Boehner now. Democrats, the media and Wall Street will be pounding him to agree to raise taxes as part of a debt ceiling deal. But now is no time for Republicans to go wobbly. Here’s why the GOP should stick to its guns until Aug. 2 – and beyond if necessary:

1. The last thing the economy needs is a tax hike.
If the economy was too weak to absorb a tax hike last December – when the White House and Congress agreed to extend all the Bush tax cuts for two more years – its health is even worse today. The economy grew at just a 1.9 percent pace in the first quarter, and many economists now think it might grow just 2.0 percent in the second quarter – or even less. This should be a red flag to Washington. New research from the Federal Reserve finds that that since 1947, when two-quarter annualized real GDP growth falls below 2 percent, recession follows within a year 48 percent of the time. (And when year-over-year real GDP growth falls below 2 percent, recession follows within a year 70 percent of the time.)

In other words, the economic recovery is sputtering with stall speed fast approaching. Now would be a terrible time to penalize investors and business, both big and small, with new taxes.

2. Tax revenue isn’t the problem. Spending is.
The recent Congressional Budget Office budget outlook was illustrative. The CBO forecast to note is its “alternative fiscal scenario” which “incorporates several changes to current law that are widely expected to occur or that would modify some provisions that might be difficult to sustain for a long period.”

By 2021, the the CBO says, the annual budget deficit would be 7.5 percent of GDP and by 2035 a truly monstrous 15.5 percent. Throughout this period, tax revenue would be 18.4 percent, right around the historical average. But spending would be 25.9 percent in 2021, 33.9 percent in 2035 vs. an average of roughly 21 percent. It’s spending that’s way out of whack, not revenue.

But let’s say all the Bush tax cuts were left to expire, as was AMT relief. Assuming no economic fallout, according to the CBO, revenue would be 23.2 percent of GDP by 2035. Three problems here: a) even with all those tax increases, the annual budget deficit would still be nearly an unsustainable 10.7 percent of GDP in 2035; b) the U.S. tax code has never generated that level of revenue and almost certainly can’t without a value-added tax; and c) there would be tremendous economic fallout. Axing all the Bush tax cuts would chop three percentage points off GDP growth, according to Goldman Sachs, certainly sending America back into recession. Tax revenue would again plummet.

And as bad as those numbers are, they don’t fully take into account the economic impact of all that debt. When the CBO does makes those calculations, total debt as a share of output is not 187 percent of GDP – the number you frequently see in media accounts – but rather 250 percent of GDP since economic growth would slow sharply due to debt overload. And more than likely the economy would suffer a debt crisis long before 2035 came around.

3. The key to boosting tax revenue is faster economic growth.
A team of economists from the American Enterprise Institute recently fashioned a debt-reduction plan that would raise tax revenue to a long-term level of 19.9 percent of GDP. That’s pretty high when you consider there have only been three years in U.S. history that have seen a higher tax burden. Its tax plan:

“To achieve this goal, the income tax system would be replaced by a progressive consumption tax, in the form of a Bradford X tax. To address environmental externalities in a more cost-effective and market-based manner, energy subsidies, tax credits, and regulations would be replaced by a carbon tax.”

But the AEI team also notes that such a tax plan would more than likely boost growth:

“Economic simulations have repeatedly indicated that replacing the income tax system with a consumption tax can boost economic growth, although the magnitude of the gains depends on the assumptions that are made and on the detailed provisions of the consumption tax. One widely cited study estimates a 6.4 percent gain in long-run output from the adoption of an X tax.

“Our plan also reduces transfer payments to the elderly, which should further increase private saving and long-run growth. These growth effects have not been taken into account in the estimation of our plan. Accounting for them suggests that actual revenue requirements are lower than those stated above. For example, if our plan increases long-run output by even 5 percent and if government spending does not increase in response to the expansion of output, then the actual long-run revenue requirement will be 19.0, rather than 19.9, percent of GDP.”

Revenue of 19.0 percent of GDP happens to be the same revenue requirement of Rep. Paul Ryan’s Path to Prosperity debt-reduction plan. And tax reform isn’t the only thing that can boost economic growth. Increasing high-skill immigration, implementing regulatory reform, and raising productivity in education, government and healthcare could pump up economy-wide GDP growth by at least a full percentage point, according to McKinsey Global Insitute.

Bottom line: Higher taxes would hurt the economy, wouldn’t solve the debt problem and aren’t really needed anyway.

Double Dip is Looming
We are on the verge of a double dip recession. If we have a second consecutive quarter of economic growth of less than 2%, which appears very possible, history tells us that it’s nearly a 50% chance that we’ll experience a recession within the next year. We must get our spending under control, we must rein in government, and we must create a pro-business environment, or we’re all in trouble.


2 Responses to “It’s Time For Tax Reform — Tomorrow”

  1. Frank Says:

    Good grief. Just read this article:

    There will be a deal in the end. But really disingenuous to say that since the Repubs are going to dig in their heals and not raise taxes that they are 1) not normal, 2) “infected by a faction that is more of a psychological protest than a practical, governing alternative” (AKA blasted Tea Party) and hence 3) the independents will realize that Repubs are not fit to govern.

    This is exactly why the liberal Dems are going to lose, and lose big – the assumption that because Repubs aren’t biting on their debt ceiling debate framework as class warfare, they are evil, but more likely crazy.

  2. The Art of (No)Compromise | Lee Eldridge Blogs on Sports and Politics Says:

    […] To Be Done It’s still my opinion that this negotiation should only include spending cuts (as I stated here). We need real tax reform, not just closing a few loopholes to generate more tax revenues. And we […]