What Will Happen if We Have a New Fiscal Crisis?

 

As I often remind the readers of this blog, the two main topics are what I consider to be America’s two biggest economic and fiscal problems:

  • Slow economic growth, averaging just 2% since the end of the Great Recession in June 2009. This means fewer new jobs and smaller raises.
  • Massive debt, now 77% of GDP for the public part on which we pay interest, the largest since the end of WWII and predicted by the CBO to keep getting worse. As interest rates rise from their currently unusually low levels, interest payments on the debt will skyrocket.

 

The first problem, slow growth, is being addressed by the Trump Administration with various deregulatory actions as well as likely tax reform action by Congress.  Furthermore, the current low 4.4% unemployment rate means that the labor market is tightening on its own.


The second problem, massive debt, is much more worrisome for the future.  Right now interest rates are so low that our entire debt is essentially “free” money.  But every 1% increase will add nearly $150 billion per year in interest payments.  And this continues indefinitely (and keeps getting worse with more debt) because debt is rarely if ever paid back, it is only rolled over!  What are the likely outcomes of such an upward spiral in interest payments?  There are two possibilities:

  • First, the unthinkable. We default on our debt. This would immediately end the role of the U.S. dollar as the international currency and end our superpower status. The fallout would be disastrous for world peace and stability.
  • Second, a huge tax increase. The only alternative to default will be a large tax increase just to keep afloat on interest payments. A likely new tax for this purpose is a consumption tax in the form of a value added tax.

Conclusion. It is extremely shortsighted to keep on delaying a necessary solution to our rapidly worsening debt problem. It’s going to be unpleasant to either cut back on spending or to raise taxes but the longer we delay action the more painful it will become in the end.  Isn’t it obvious that we should get started immediately?

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We Need Fundamental Tax Reform!

 

Most Americans would agree that our tax code is a mess and needs major reform.  The last reform was in 1986 when the top rate was reduced from 50% to 28% and many deductions were eliminated.  However this reform effort turned out to be short lived in the sense that many of these deductions have now been added back in.  The Romney plan of 2012, cutting all tax rates by 20% in a revenue neutral way, would have been an improvement over our current system.  But, it’s gains would likely also have been only short-lived.
CaptureConsumption taxes are now being used in many parts of the world and, in recent years, the idea of a national sales tax has gained popularity in the U.S.  The so-called Fair Tax would impose a single 30% tax on all sales at the retail level.  The proponents claim that this would raise enough income to replace all federal taxes: the individual income tax, the corporate income tax, the payroll tax and the estate tax.
The tax attorney, Michael Graetz, has evidence that a 34% tax rate would be necessary to replace just the individual and corporate income taxes alone.  This is a large discrepancy.  Regardless, a major argument against the Fair Tax is that such a high single tax of 30% or higher would create a compliance problem because of the incentive for people to try to avoid paying it.
Mr. Graetz has proposed a hybrid consumption and income tax, which he calls the Competitive Tax Plan, as a more reasonable but still fundamental change to our current tax system.  Although I have discussed this proposal previously, I will summarize it again here:

  • A broad-based Value Added Tax of about 14% is enacted on goods and services.
  • Families earning less than $100,000 per year are exempted from the income tax. The tax rate would be 15% for incomes between $100,000 and $250,000, and 25% above this level.
  • The corporate income tax rate is lowered to 15%.
  • The Earned Income Tax Credit is retained and used to provide relief from the Payroll Tax for low-income families.
  • The plan is designed to be revenue neutral as verified by the Tax Policy Center.

There are many advantages of the Graetz Plan over our current system.  100 million returns, for all those with incomes under $100,000, would be eliminated.  This would, in turn, make it less politically expedient for Congress to constantly add new exemptions and preferences into the code.  Lower income tax rates for both individuals and corporations would give the economy a big boost.
The Competitive Tax Plan is an example of the type of bold, fundamental reform that we need to make to our federal tax system.

Considering a Wealth Tax for the U.S.

 

What should a country do when it has

  • Massive accumulated debt and annual deficits predicted to grow indefinitely.
  • A rapidly growing population of retirees heavily dependent on expensive entitlement programs such as Social Security and Medicare.
  • A national Congress which is unwilling to make significant spending cuts for fear of offending powerful constituent groups.
  • Growing income inequality and wealth inequality.
  • A stagnant economy and high unemployment which makes inequality worse.
  • An inefficient income tax system which does not take in enough tax revenue to pay the bills.

The best response by far is to implement broad-based, pro-growth, tax reform.  I have often discussed how to make major changes to our current income tax system.  I have also described an attractive way to introduce a consumption tax, the so-called Graetz Plan.
CaptureAnother way to reform taxes is to introduce a wealth tax.  The economist Ronald McKinnon has described a way to do this in a Wall Street Journal column, “The Conservative Case for a Wealth Tax”.  His plan is to implement a federal wealth tax in addition to the federal income tax.  It would consist of a flat tax of about 3% imposed on household wealth in excess of a $3 million exemption which would exclude 95% of the population.  In addition to bringing in a significant amount of new revenue each year, which is its principal objective, it would serve the purpose of making a flatter, pro-growth, income-tax system more palatable to people who are concerned about inequality, and therefore to a much wider audience.
The economics journalist, Daniel Altman, recently reported in the New York Times, “To Reduce Inequality, Tax Wealth, not Income” that American household wealth totaled more than $58 trillion in 2010.  The most recent issue of Forbes Magazine reports that there are now 492 billionaires in the U.S. with a total wealth of $2.3 trillion.  A 2% tax on the wealth of just these billionaires alone would raise $46 billion.  A 0.5% tax on the wealth of all Americans would raise $290 billion annually.  These examples show that a “moderate” wealth tax could bring in a significant amount of new tax revenue which would make a big dent in shrinking our annual deficit.
We have to do something and do it quickly.  The problem will occur when interest rates return to their normal level as they surely will before long.  When this happens, interest payments on our national debt will sky rocket.  It’s going to be painful regardless, but let’s try to head for the softest landing we can manage!

Wealth and Taxation

 

As I reported in my last blog post a few days ago, wealth inequality in the United States and the rest of the developed world is growing rapidly and is likely to get much worse in the foreseeable future.   This is happening because income from wealth, i.e. the return on investment, typically grows faster than wages and GDP.  As income inequality also grows, and top wage earners have more and more money to invest, then the gap between investment income and wage income will become even wider.  There is nothing wrong with this and the more money that is reinvested in our economy, the faster it will grow and the more jobs that will be created.
At the same time that huge new wealth is being created we have an archaic tax system in the U.S. which is not only incredibly complicated and inefficient, but also discourages investment because the top individual and corporate rates are so high.  And it doesn’t collect enough tax to pay our bills.  We have huge deficits already and the CBO says that they’ll just keep getting worse.
Making government operate more efficiently with less spending is highly desirable but will only go so far.  Every government program has a constituency of supporters who complain when their own program is targeted for cuts.  And the biggest and most expensive, the entitlement programs of Social Security and Medicare, have the largest constituency of all, over 50 million retirees at the present time and growing rapidly as the baby boomers retire at the rate of 10,000 per day.
This huge crunch can only be resolved by fundamental tax reform.  Several different ways have been proposed to do this:

  • Reform the current income tax system by broadening the base, lowering rates and eliminating deductions and loopholes to pay for it.  The problem with this approach is that no one wants to give up their own deductions (for mortgage interest, charitable contributions, employer provided healthcare, state and municipal taxes, etc.)
  • Introduce a consumption tax such as the Graetz Plan which I described in my January 7, 2014 post.  It would establish a 14% Value Added Tax on consumption, supplemented by a lower but still progressive tax on incomes over $100,000.  It would avoid being regressive on low wage workers by using an Earned Income Tax Credit to offset the Payroll Tax.
  • Introduce a wealth tax.

Sorry, I’m over my (self-imposed) word limit already.  I’ll describe a possible wealth tax in my next post!