The bond vigilantes have pulverized Greece, and New York University economist Nouriel Roubini (a.k.a. “Dr. Doom”) is warning that they may eventually target the United States. Southern Europe’s riot-torn basket case has come to epitomize a nightmare scenario of budgetary meltdown triggered by unsustainable government spending. To be sure, Greece has also been hobbled by cultural factors — widespread corruption, tax evasion, extremely low birth rates — and we should be wary of drawing superficial comparisons between countries. But the Greek crisis does highlight an inescapable truth about America’s public finances: At some point, the era of Peter Pan fiscal policy will have to end.
Crunch time may arrive sooner than previously expected. The Congressional Budget Office (CBO) estimates that under President Obama’s 2011 fiscal blueprint, net interest payments on the national debt would represent 18.7 percent of total federal tax revenues in 2018. As Investor’s Business Daily reports, this level of debt service would push the U.S. toward “the outer limit of AAA-territory” established by Moody’s, the credit-rating giant. For that matter, “under more adverse scenarios than the CBO considered, including higher interest rates, Moody’s projects that debt service could hit 22.4 percent of revenue by 2013.” Obama’s budget would increase the relative size of publicly held federal debt from 63.2 percent of GDP in 2010 to 90 percent of GDP in 2020, reckons the CBO. Ninety percent is the threshold above which public debt is “associated with notably lower growth outcomes,” according to economists Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard.
America’s public-debt-to-GDP ratio is already higher than it has been since the 1950s. Writing in National Affairs, economist Donald Marron, who served as acting CBO director and a White House economic adviser under Pres. George W. Bush, says the most immediate objective of U.S. fiscal policy should be to stop that ratio from rising. He stresses that this would not require balancing the federal budget; indeed, it would be possible to run moderate deficits while simultaneously trimming the debt-to-GDP ratio, provided the economy was expanding at a fast enough pace.
Think of it this way: To maintain a constant debt-to-GDP ratio, we would have to maintain an identical deficit-to-growth ratio. For example, writes Marron, if we had a debt-to-GDP ratio of 60 percent and a deficit equal to 3 percent of GDP, then nominal GDP growth (that is, real growth plus inflation) would have to reach 5 percent in order to keep the ratio from increasing. The fact that such a humble aim — holding the debt-to-GDP ratio steady — seems so quixotic in the short run indicates the severity of America’s fiscal plight. Marron, who is now director of the Urban-Brookings Tax Policy Center, believes a practical, attainable medium-term goal should be to reduce the ratio to 60 percent by 2020. But over the long haul, he adds, even 60 percent would be unacceptably steep. From the mid–20th century through the early 2000s — until the Wall Street panic — the average ratio was roughly 40 percent.
Given the magnitude of our budget problems, it is unrealistic to think that tax hikes alone, or spending cuts alone, or economic growth alone, would be sufficient to fix them. Let’s say that real annual GDP growth averaged 3.8 percent over ten years. That hasn’t happened since the 1960s and 1970s, Marron reminds us, and it is very unlikely to happen in the decade ahead — but even with that level of growth, the federal government would still see only modest deficit reduction without serious fiscal reforms.
No, we don’t have a “silver bullet,” but we do have empirical evidence to guide our policy decisions. Marron cites a paper by Harvard economists Alberto Alesina and Silvia Ardagna, who studied OECD data from 1970 to 2007 and concluded that “spending cuts are much more effective than tax increases in stabilizing the debt and avoiding economic downturns.”
Are there any specific countries whose fiscal achievements offer grounds for optimism? In an April 16 New York Times article, George Mason University economist Tyler Cowen pointed to Canada, which was forced to address its persistent debt woes after being rocked by spillover effects from the 1994–95 Mexican peso crisis. Prior to the recent global financial shock, our northern neighbor had balanced its federal budget consistently for more than a decade. According to government projections released in early March, Canada’s deficit-to-GDP ratio will peak at 3.5 percent in the current fiscal year before plunging to 0.1 percent of GDP by 2014–15. The Canadian parliamentary budget officer, an independent federal watchdog, puts the latter figure at 0.6 percent of GDP, which is still comparatively low.
Indeed, at a time of surging debt burdens in the U.S., Europe, and Japan, Canada stands out as a beacon of fiscal stability. It now boasts the lowest ratio of total government net debt to GDP among all G7 countries. Since the mid-1990s, its federal debt has dropped from 68.4 percent of GDP to around 35 percent of GDP. Meanwhile, Canada’s rating in the Index of Economic Freedom (compiled by the Wall Street Journal and the Heritage Foundation) has improved markedly. The 2010 Index ranks Canada ahead of the U.S., owing to its superior scores in the categories of business freedom, trade freedom, fiscal freedom, financial freedom, property rights, and freedom from corruption. Doesn’t the Great White North have a lavish welfare state? Yes, but as a share of GDP, aggregate Canadian government spending is significantly lower today than it was 15 years ago.
Of course, Canada enjoys certain structural advantages. For one thing, the oil-rich country is a net energy exporter; for another, it has a relatively small defense budget, thanks to the U.S. security umbrella. Its fiscal gains were driven partly by a massive commodity windfall. Those gains were diminished somewhat by the global credit bust, but Canada was insulated from the turmoil by its conservative banking system, which weathered the storm quite impressively and did not require a state bailout. As Cowen writes, Canadians tend to have a more benign view of government than do Americans, which arguably made it easier for Ottawa to enact painful spending cuts in the 1990s: “Citizens were told by their government leadership that such cuts were necessary and, to some extent, they trusted the messenger.”
We should also note that Canada introduced a federal value-added tax (VAT) in 1991. However, the VAT effectively replaced a manufacturing sales tax that had been hampering Canadian exports, and it has been slashed from 7 percent to 5 percent by the incumbent center-right government of Prime Minister Stephen Harper, which has also scheduled reductions in corporate-income taxes. Today, Canada’s combined corporate-tax rate (31 percent) and its top personal-income-tax rate at the federal level (29 percent) are both lower than the equivalent rates in the U.S. (39 percent and 35 percent, respectively). On balance, household taxes are more progressive in the U.S. than they are in Canada, according to the OECD.
All of this is worth remembering amid the ongoing fiscal debate. Tax Foundation economist Robert Carroll has observed that the combined U.S. corporate-tax rate went from being nearly twelve percentage points below the weighted G7 average in 1988 to being more than five points above it in 2009. Over that same period, the U.S. rate spiked from almost ten points below to more than eight points above the weighted OECD average. “Reducing or eliminating the corporate tax would curtail numerous wasteful tax distortions, boost growth in both the short and long run, increase America’s global competitiveness, and raise future wages,” Stanford economist Michael Boskin argues in the Wall Street Journal. He refers us to a 2008 OECD paper, which reported that, among different types of taxes, corporate taxes are “most harmful for growth, followed by personal-income taxes, and then consumption taxes.” As Marron tells me, “Not all tax increases — or tax cuts — are created equal.”
Consider a fascinating new study by economists Mathias Trabandt of the European Central Bank and Harald Uhlig of the University of Chicago, who examine the relationship between tax rates and revenues in the U.S. and Europe. Using one model of labor elasticity, Trabandt and Uhlig find that raising labor-income taxes can produce, at most, a 30 percent jump in American tax revenues, while raising U.S. capital-income taxes can yield a maximum revenue increase of only 6 percent. Trabandt and Uhlig reckon that 51 percent of a capital-tax cut in the U.S. effectively pays for itself by spurring economic growth, compared with 32 percent of a labor-tax cut. In general, Western European countries would recoup much more of the lost revenue if they cut those taxes. “There rarely is a free lunch due to tax cuts,” Trabandt and Uhlig write, but “a substantial fraction of the lunch will be paid for by the efficiency gains in the economy due to tax cuts.”
Their analysis suggests that hiking capital-income taxes would be a deeply misguided way for U.S. policymakers to tackle the deficit. It also suggests that boosting consumption taxes could deliver a “dramatic” surge of revenue. “The VAT seems to be a less economically distorting tax than income taxes,” Marron tells me. “It seems like the path of least resistance if we have to raise a lot more revenue.” But we should not underestimate its costs. A 2008 Government Accountability Office report on VAT implementation in five Western countries — Australia, Canada, France, New Zealand, and the United Kingdom — showed that “even a conceptually simple VAT” (i.e., a single statutory rate for all goods and services) would engender substantial administrative and compliance burdens.
For now, talk of a VAT remains premature. When former Federal Reserve chief and current Obama economic adviser Paul Volcker floated the idea, 85 senators — including most Senate Democrats — approved a nonbinding resolution expressing their opposition. Many conservatives would be more amenable to a VAT if it were combined with major income- and investment-tax cuts. “America taxes income and investment too much and consumption too little,” declares The Economist. Coupling a VAT with sweeping tax reforms would address this disparity, and could make the broader tax system far more efficient. Such a grand bargain seems fanciful in the present political environment, though.
It may be inevitable that a bipartisan agreement on debt reduction will include some form of tax increases, but policymakers should recognize that the labor supply can be highly sensitive to tax rates. Economists Lee Ohanian of UCLA, Andrea Raffo of the Federal Reserve Board, and Richard Rogerson of Arizona State University (ASU) have determined that variations in hours worked across 21 OECD countries from 1956 to 2004 can mostly be attributed to tax distortions. Similarly, ASU economist Edward Prescott, a 2004 Nobel laureate, has concluded that “virtually all the large differences between the U.S. labor supply and those of Germany and France are due to differences in tax systems.” Prescott reckons that if France lowered its effective tax rate on labor income to the U.S. level, “the welfare of the French people would increase by 19 percent in terms of lifetime consumption equivalents. This is a large number for a welfare gain.”
Deciding how to overhaul the U.S. tax code may ultimately prove easier than deciding how to curb federal entitlement spending. Marron recommends that Congress begin with incremental changes to Social Security. In the near term, he says, lawmakers should lift the retirement age, institute progressive price indexing of benefits, and adopt a more realistic inflation measure. The immediate revenue impact would be minimal, but these actions would send a positive signal about Washington’s commitment to pruning the welfare state. (Attempting to launch private Social Security accounts would obviously stoke greater controversy.)
Medicare poses a more daunting challenge. Rep. Paul Ryan (R., Wis.), the GOP’s leading budget wonk, has advocated voucherizing the program for Americans currently under age 55. When these folks became eligible for Medicare, his plan would give them a lump-sum payment to buy private health insurance — a payment that would be adjusted for inflation, income, and risk — and also fund tax-free Medical Savings Accounts for low-income recipients. “Both the level of expected federal spending on Medicare and the uncertainty surrounding that spending would decline, but enrollees’ spending for health care and the uncertainty surrounding that spending would increase,” according to the CBO. Democrats have sharply attacked the Ryan proposal, and relatively few Republicans have endorsed it, which underscores just how difficult Medicare reform will be.
The dollar’s status as the global reserve currency continues to shield Beltway politicians from having to make tough fiscal choices. But those choices can’t be postponed forever.
– Duncan Currie is deputy managing editor of National Review Online.