Consider the following two scenarios. In the first, we have a dysfunctional tax code larded with tax subsidies and plagued by a steep marginal tax schedule that chokes off economic growth. We raise 17% of GDP in revenue and GDP is $1K. In the second, we have a much better tax code, i.e., one that is largely free of tax subsidies that exacerbate cost growth and promote overinvestment in unproductive assets, etc., and that has a low top marginal tax rate and favorable treatment of capital income. In this scenario, we raise 18% of GDP in revenue and GDP is $1050.
So: the federal government raises $170 in the first case and $189 in the second case, a difference of $19. The untaxed slice of the economy is $830 in the first case and $861, a difference of $31.
You’ll notice that I bumped up long-run GDP by a modest amount — 5 percent of GDP. Coupled with entitlement reforms designed to encourage higher labor force participation, part of a broad-based reform package, we could bump up GDP by an even higher amount.
I realize that there are those who want a better tax code that raises 17% of GDP in revenue. That would be absolutely terrific, and it is a possibility if we’re able to implement structural entitlement reforms that really restrain cost growth. But it will take time to determine whether or not the limited defined contribution approach to designing health entitlements really works. For now, our priority should be revamping the tax code in a manner that enhances our long-run growth prospects and securing a down payment on structural reform. The real goal is to change the underlying conditions, i.e., to contain the growth of entitlement spending. If we manage that, we can achieve primary balance with revenue at 17% of GDP or 15% of GDP or perhaps even 10%. The political process will not end with any discrete deal.
Conservatives are engaged in a political debate over the power and the scope of government. We’ve been distracted from moving the ball forward on crucially important issues like off-balance-sheet credit guarantees — which are far more likely to swell the size of government than a bump in revenues — and regulatory creep due to a fixation on revenue as a share of GDP.
Focus on the top rate, the curve of the tax schedule, the treatment of capital income, and tax subsidies. The rest is noise.