The Agenda

A Nice Middle-Ground

Howard Gleckman of the Tax Policy Center recounts the conversation at a recent Urban Institute panel on the near-term implications of the fiscal cliff deal:

A big part of the problem is the vast gulf between Democrats and Republicans over how much revenue any new tax code should raise. The GOP insists it should be no more than 18 or 19 percent of the Gross Domestic Product, and the fiscal cliff deal already would raise that level to about 19.4 percent. Thus, it is no surprise to hear Senate Minority Leader Mitch McConnell say he is done talking about tax increases.

For their part, many Democrats see the government collecting somewhere around 25 percent of GDP in taxes. Interestingly, both Rudy (a Republican) and Bob (a Democrat) figure a reasonable level for now is probably around 22 percent. That is a nice middle-ground. But how to get there?

It is worth recalling that from 1946 to 2008, federal tax revenues averaged 17.8 percent of GDP, and so 19.4 percent represents a significant departure. This isn’t an intrinsically bad thing. Because old-age social insurance programs represent a large share of federal expenditures, the aging of the population will tend to increase federal expenditures. Stabilizing the debt-to-GDP ratio requires federal budget deficits that are somewhat smaller than GDP growth, to provide a cushion, so it is reasonable to assume that structural deficits in the range of 1-2 percent of GDP are acceptable.

The problem, however, is that the cost of meeting entitlement obligations, and in particular the cost of health entitlements, is outstripping GDP growth, which means (a) crowding out other federal expenditures, including growth-enhancing public investments (e.g., biogerontological research that might delay the onset of various age-related diseases, thus extending healthy lifespan and reducing medical expenditures); (b) deficits that outpace GDP growth and, as a result, increase the debt-to-GDP ratio; (c) sharp increases in taxes relative to the historical average; or (d) some combination of the above. We are basically living through (d).

One of the reasons tax increases of the kind Gleckman considers “a nice middle-ground” strike me as potentially problematic is that, as Northwestern University economist Robert Gordon has observed, the labor quality of the U.S. workforce is no longer improving at a fast clip:

Jorgenson, Ho, and Stiroh (2006), show that educational attainment has reached a plateau in the US, in their estimates implying that the improvement in labor quality (the BLS labor composition effect) will gradually decline toward zero over the next 10 to 15 years.  Similarly, Goldin and Katz (2008) both lament and explain the plateau in U. S. educational attainment.  They point out (2008, Figure 9.1, p. 327) that unlike most European nations, where a catching‐up process has made the 25‐34 age group much better educated than the 55‐64 age group, in the U. S. the educational attainment of both age groups is the same, the very definition of a plateau. 

Were labor quality improving, i.e., if the 25-34 age group were substantially better educated than the 55-64 age group, the case for imposing substantially higher taxes on prime-age earners would be much stronger. But instead many U.S. workers find their labor market position deteriorating. We could focus all tax increases on high-earners — those who by definition have the greatest ability to pay — yet as we have often discussed, this strategy risks undermining growth, which is why most European social market democracies impose broad-based consumption taxes

Moreover, it is important to focus on lifetime net tax rates. Most politically plausible entitlement reform proposals entail measures like shifting to chained CPI to set cost-of-living-adjustments for Social Security benefits, i.e., measures that will reduce the growth of benefits for retirees. Apart from the fact that such measures have a particularly big impact on the very old, these measures also tend to increase the lifetime net tax rate. Raising taxes to 22 to 25 percent of GDP through steeply graduated income taxes will tend to shield low- and middle-earners on the tax side, yet it might depress economic growth and dull the incentives for younger workers to invest in human capital. Raising additional revenues via broad-based consumption taxes will be somewhat less likely to depress economic growth, yet these additional revenues will presumably go to pay for benefits for current retirees rather than programs that will deliver tangible material benefits to those prime-age workers who do not rely on safety net programs. The emerging four-tranche universal health system might represent an exception, in that its subsidies will flow to many prime-age middle-earners. But it remains to be seen whether the four-tranche structure is stable.

None of this is to say that Gleckman is wrong that 22 percent is an appropriate target. But I think he is too quick to gloss over the potential consequences for low- and middle-earners. 

By way of comparison, AEI’s “Fiscal Solutions: A Balanced Plan for Fiscal Stability and Economic Growth” envisions federal revenues in the range of 19-20 percent and federal expenditures in the range of 21-23 percent. I don’t think it’s at all unreasonable for conservatives to see tax revenues in this neighborhood as a nice middle-ground: higher than the post-war historical average, but acceptable given demographic change. 


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Jack Phillips has a right to free speech, which includes freedom from compelled speech.