In the light of the new Congressional panel on debt reduction, part of the agreement to end the shutdown, I thought it might be interesting to reflect on the revenue side of the federal budget’s equation. President Obama has repeatedly said that increased revenues were a necessary part of any debt reduction package:
WASHINGTON — Be skeptical. Be very, very skeptical.
That was the reaction from nearly all corners to the talk of convening yet another round of bipartisan negotiations to reduce the nation’s long-term debt. The idea has resurfaced as a way of resolving the standoff between President Obama and the Republican-controlled House over reopening the government and increasing its legal borrowing limit, perhaps for months or even just weeks.
But even if the current talks soon resolve the immediate impasse, which did not look likely on Saturday, any renewal of negotiations for a long-term fiscal plan will run into the same underlying problem that has doomed efforts for the past three years.
Republicans refuse to raise additional tax revenue, and until they do, Mr. Obama will not support even his own tentative proposals for reducing spending on fast-growing social benefit programs, chiefly Medicare. During a White House meeting with Senate Republicans on Friday, he reiterated that the two go hand in hand, according to people who were there.
The Republicans’ usual retort is that the president has already received additional revenues (in 2012) without accepting any cuts to entitlement spending.
I’d like to examine the question from a different angle. How could additional revenues be realized?
The most obvious answer is by increasing the tax rates on the highest income earners but that doesn’t really answer the question. The objective, presumably, is not just to raise marginal tax rates for the sake of increasing them but to increase effective revenues. Sadly, higher marginal tax rates, particularly on the highest income earners, have not historically been a reliable way of raising effective revenues. Consider this table from the Tax Policy Center of the Brookings Institution and the Urban Institute, reporting federal taxes as a percent of GDP from 1934 to the present. In only three years, 1944, 1945, and 2000, have federal revenues exceeded 20% of GDP.
Now, that’s not a physical law but it’s almost as good as one. It’s a political reality. Americans will accept the federal government’s extracting 20% of GDP from the economy at a time of national existential crisis or they’ll accept it briefly during a boom that looks like it will go on forever but it will be followed by a move to cut taxes. Is it possible that higher federal revenues would become politically acceptable? Anything is possible but the history of the last 80 years says it’s pretty darned unlikely.
The other obvious answer is via growth. Increased national income will increase federal revenues without increasing the proportion of GDP that goes to the federal government. Sadly, no one really knows how to do that. Paraphrasing my old economics prof, we know how to produce shortages but we don’t know how to produce growth.
As of this writing federal spending is hovering around 25% of GDP and expected to increase while revenues are around 17%. Growth is less than 2% per year. Can we all agree that persistent federal spending in excess of 25% of GDP with persistent federal revenues plus growth at less than 20% of GDP constitutes a problem?
I do not believe that increasing the marginal tax rates on the highest income earners in the absence of robust growth in the economy will increase effective federal revenue, largely because, other than under the conditions I’ve outlined above, it never has. The more income is in the hands of the highest income earners the more difficult it becomes to extract from them.
If you really want reliable increased federal revenues, you really need to increase taxes on those in the bottom 90% of income earners rather than on those in the top brackets. That can be done most easily by increasing FICA. IMO that’s a perverse policy.
Another alternative would be some sort of a consumption tax—either a VAT or a national sales tax.
So, let’s return to my question. How can what President Obama is insisting on be accomplished? How can effective federal revenues as a percentage of GDP be increased?