Federal deficit, tax inequities, entitlement programs vie for lawmakers’ attention

Q. What is the long-term fiscal outlook for the United States?

The federal government debt held by the public stands at 99 percent of annual GDP—just about the amount that the economy produces in a year. That's almost the highest level in our history; we were at just about 105 percent at the end of World War II.

After World War II, however, the debt declined rapidly, relative to the size of the economy. Today, however, the debt is poised to escalate rapidly throughout the upcoming decades. The Congressional Budget Office (CBO) just updated its long-term fiscal outlook, and it shows that the debt will rise to 172 percent of annual GDP by 2054 under current policies.

The CBO lists several reasons why we should be concerned about the debt buildup. All else equal, higher debt reduces long-term economic growth by crowding out private investment and by increasing borrowing from abroad. It also increases the risk of a crisis in which investors lose confidence in the government debt and demand sharply higher interest rates to hold it.

The debt buildup also could lead to higher inflation expectations and could reduce the flexibility that Congress and the president have to respond to unforeseen events. Debt is like termites gradually eating away at the foundation of the house. You may not see a dramatic impact in any given year, but it will cause trouble if you keep ignoring it.

Q. Is there a presumption that a combination of tax increases and spending cuts will be needed to address the fiscal imbalance? What is the government considering?

It's not clear that Congress and the president are actively considering very much at the moment.

Realistically, we need a combination of tax increases and spending cuts. In principle, you could just use tax increases with no spending cuts or, you could just use spending cuts with no tax increases. But, I believe that when Americans actually see what either of those kinds of packages look like, they will say that's too extreme, either in one direction or the other, and that it really makes more sense to have a combination of tax increases and spending cuts.

Q. Some of the programs that affect most of us are entitlement programs like Social Security and Medicare. Would they be affected by spending cuts?

Yes. If you're going to have a viable deficit-reduction package, those large entitlement programs need to be at the front and center of the package’s spending component. And you can see why if you look at the CBO’s long-term budget outlook.

Social Security, Medicare, Medicaid, the Children’s Health Insurance Program and the premium subsidies for the [Affordable Care Act] health insurance exchanges are slated, under current policies, to grow from 10.7 percent of GDP today to 14.5 percent in 2054. That, of course, reflects rising health care costs and population aging.

In contrast, all other noninterest spending—small entitlement programs plus defense and nondefense discretionary spending—is well under control, declining from 9.5 percent of GDP today to 6.9 percent in 2054 under current policies. So, spending on Social Security and health care is going up by almost 4 percentage points of GDP, while the other noninterest spending is going down by more than 2 percentage points.

If you really want to address the deficit, the spending component has to be focused on the large entitlement programs. It's not popular, of course, because so many people benefit from these programs.

Q. You are a proponent of a national value-added tax, also known as a VAT. What is it and why do you think it would work?

The VAT is economically similar to the retail sales tax that state and local governments in the United States use, but it's administratively different. Under a value-added tax, every business is taxed on the amount that it adds to the value of a product. In other words, the amount for which it sells a product, minus the cost of items it purchased that went into that product.

For example, a manufacturer might sell something they produced for $10. If they made it using their own workers and didn't buy anything from another business, they would have added $10 in value and that's what they would pay tax on.

Suppose that a wholesaler buys that product from the manufacturer and the wholesaler’s workers make it better and they can sell it for $20 to a retailer. They've added another $10 to the value of the product, and they would pay the VAT on that $10. Then, suppose the retailer sells it for $30 to the consumer. The retailer added another $10 of value, so that $10 would be taxed.

Under the VAT’s multistage process, the $30 of value of the final product has been taxed across the three separate stages of production. A retail sales tax tries to get to the exact same bottom line, but the entire $30 is taxed when it's sold by the retailer. The advantage of the VAT is that the tax payments can be tracked along the chain of production, making it less likely that any company can cheat.

I believe that a VAT is indispensable as we try to craft a fiscal package to address the fiscal imbalance.

The VAT occupies a middle ground between income tax increases on high-income households and entitlement benefit cuts. It avoids most of the economic distortions of the income tax, although it has a few, such as work disincentives. And while the VAT is mildly regressive, it is vastly less regressive than entitlement benefit cuts. Also, its regressivity can be largely offset by providing rebates to low-income households.

Entitlement cuts are not popular with either party. Income tax increases on high-income households may have more political appeal, but their revenue potential is limited.

Q. Texas relies on two main sources of revenue: the sales tax and the property tax. The property tax greatly increased in recent years as home prices climbed. In response, the state adopted a relief plan based on increasing the homestead exemption. How durable is this strategy?

It's very hard to predict what will happen to house prices. But the one thing we can say with certainty is that they will fluctuate, with price increases in some periods and price declines in other periods.

Property taxes tend to be very sensitive to the state of the housing market. That creates problems. When home prices are high, you have extra revenue coming in, but that puts an unexpected burden on taxpayers. If home prices are low, homeowners get tax relief, but the revenue loss may reduce public services.

Now, you probably wouldn't want to stabilize the revenues completely. If home prices are going down, you could give some relief to homeowners. If prices are going up, homeowners probably can afford to pay a bit more. But you almost certainly want to smooth out those fluctuations to some extent.

The best solution is an automatic adjustment mechanism that applies to all homeowners. The obvious thing would be to adjust the property tax rate. If a lot of revenue is pouring in because you have rising home prices, the tax rate could go down. If home prices are falling, the tax rate could go up. Or, you could do adjustments to the homestead exemption that would apply to everyone.

The worst thing to do, in my opinion, is to freeze the appraisal of existing homes and ignore the changes that are taking place in home values, because that undermines the integrity of the property tax. Different people with homes of the same value are paying different taxes.

Freezing appraisals protects you if you already own a home and its price is going up. But the protections don’t apply when somebody buys a home or a new home is constructed—they're hit with the full appraised value. That's a very discriminatory type of relief. It discourages new people from coming into the state. Some people call these laws, “Welcome stranger” laws, with the “welcome” being sarcastic because you're welcomed with a property tax bill bigger than the tax on a similar home owned by somebody who's already there.