The Tax Hike Canard: The Right Way Down the Fiscal Cliff
Five years ago, the United States’ budget deficit equaled 1.5 percent of GDP and its national debt stood at 36 percent of GDP. This year, the deficit will exceed $1 trillion, or seven percent of U.S. GDP. Over the same period, the debt ratio has doubled to 73 percent of GDP.
Although the United States’ economic weakness has contributed to the booming deficit and debt ratios, it is only a small part of the whole story. According to projections by the U.S. Congressional Budget Office, without significant reforms, the deficit would still add up to more than five percent of GDP a decade from now, even if the economy were operating at full capacity. Increased interest on the national debt is not to blame, either, since falling interest rates have made the government’s net interest bill lower today as a share of GDP than it was in 2007. Moreover, the share of GDP that goes to another common scapegoat, defense, has risen less than one percent since 2007 (from 3.6 percent to 4.4 percent) and is projected to drop over the next decade.
Instead, the rising deficit and debt reflect trillions of dollars of new spending on health programs, other new and enlarged transfer programs to individuals, and a variety of transfers to state and local governments. The increased debt creates five problems: First and most obvious, paying the interest on that debt will require enacting higher taxes that will hurt incentives and weaken growth. Second, since foreign investors hold more than half of U.S. national debt, paying interest on it will require selling more U.S. products to the rest of the world and buying fewer products from abroad. That, in turn, means lowering the prices of U.S. exports and paying more for imports, lowering Americans’ standard of living. Third, a large debt causes a decline in business investment and therefore in productivity and growth. Fourth, it reduces the government’s room to maneuver. In the future, the U.S. government might want to increase spending for a variety of reasons — including enacting countercyclical stimulus programs or spending more on national security, for example — and its ability to do so could be constrained by its debt. Finally, a large national debt increases economic vulnerability, particularly to upward shocks in interest rates.
The predicted rise of the debt during the next ten years is just a prelude to a debt explosion that could occur as the costs of Social Security and Medicare rise. The Congressional Budget Office warns that the cost of those major middle-class entitlement programs — Social Security and Medicare — will expand from 8.7 percent of GDP now to 12.2 percent of GDP in 2037. Many commentators have concluded that tax increases are therefore inevitable. Yet even though the population is getting older, it is also becoming more affluent. Future entitlement programs thus need not have the same budget impact as continuations of the current arrangements would. The growth in government outlays for the non-poor seniors through Social Security and Medicare must be — and no doubt will be — slowed to avoid higher future tax rates. But even without any increase in the tax rates used to finance these programs, the value of the benefits will continue to grow as incomes rise.