- The Washington Times - Thursday, April 28, 2011


The federal government spent $1.7 trillion last year more than it brought in tax revenue. It had to borrow that amount. This increased the outstanding public debt to $14.2 trillion - or 96 percent of GDP. This includes that part owned by the Social Security trust fund and the Federal Reserve, but does not include the unfunded liabilities of Medicare, Medicaid and Social Security, which will add an additional $46 trillion to the deficit in present-value terms over the next 75 years.

This is not sustainable. Without spending cuts and/or tax increases, this amount will not only continue growing without end but will increase as a share of GDP until bondholders no longer trust the governments ability to pay the interest required. At that point, they will dump U.S. Treasuries.

There is no longer any choice about the need to cut spending and/or raise taxes. But it makes a big difference which expenditures are cut and which taxes are raised. Specific spending cuts and tax increases affect income growth, national security and public welfare differently.

The job of our political representatives is to determine what the government should be doing, within the set of things permitted by the Constitution and the resources the public wishes to make available. The government’s job is to carefully and wisely set priorities on the use of the limited resources made available to it. All spending should pass a strict cost-benefit analysis, but setting a cap on total spending relative to GDP (e.g., 18 percent or 19 percent) would be a useful disciplining tool for forcing a more careful setting of priorities. We must cut deeply but not evenly. This will not be an easy debate.

The same must be said for taxes. Not all taxes have the same effect on the economic growth that lifts our standard of living and makes a given debt easier to service. And not all taxes are equally fair. While the revenue generated by taxes should match the level of government spending over the business cycle, how that revenue is raised is as important as how it is spent.

The primary standards for judging tax systems are neutrality, fairness and simplicity. Neutrality means that the tax does not distort business and spending decisions so that investment and economic resources are misallocated. Economists across the political spectrum broadly accept the arguments in favor of neutrality. The tax base (whether income or consumption) should be comprehensive, making the marginal tax rate as low as possible.

Business-income taxation double-taxes the same income (by the business and again by the shareholders as individuals) and introduces wasteful and risky behavior as businesses try to minimize their tax bills. Everyone agrees that the corporate income tax in the U.S. should be lowered, but in fact the tax should be abolished. It raises only modest revenue and causes great damage.

I favor complete reliance on a flat, comprehensive consumption - or value-added - tax (VAT) because it does not tax saving (and thus encourages more investment and growth), is simpler to collect and is fairer all around. By taxing the value added at every stage of production, a VAT is more difficult to evade than taxing the full amount of value at the final point of sale as with a sales tax. The spending cap should prevent revenue creep.

There is less agreement about what is fair. Everyone agrees that the rich should pay more than the poor, but how much more? Under the existing tax code, those with incomes in the top 1 percent paid 40 percent of all income-tax revenue in 2006 and earned only 22 percent of all income, the top 10 percent paid 71 percent, and the bottom 50 percent paid less than 3 percent.

President Obama thinks that this is not progressive enough and wants to tax high-income families even more. Republicans think the tax bite is already too high both in terms of fairness and in discouraging investment that promotes faster growth.

A “flat” income tax - the same marginal tax rate for everyone with incomes large enough to pay taxes at all - is the most neutral system. But it is also a good benchmark for discussing fairness. A flat rate means basically that someone with twice the income pays twice the tax. I consider that fair, but of course our existing rate structure increases with income so that tax payments more than double when income doubles. Our tax system needs to be made more neutral and more equitable. The debate over how to do that will not be easy, either.

Warren Coats, a Bethesda-based international economist, advises the central banks of several foreign countries.

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