Can higher taxes reduce the deficit?

Neil Munro | White House Correspondent

President Barack Obama’s deputies say he wants to tackle the budget deficit by raising taxes on wealthy people and oil companies, but there’s not much evidence that increased taxation can significantly reduce the annual flood of red-ink, now amounting to roughly $1,500 billion, or 40 percent of federal spending.

“This budget deficit is way too large to be solved by tax increases,” said Brian Riedl, an economist at the right-of-center Heritage Foundation.

Even optimists aren’t reassuring. “The first thing you have to to ask is ‘Are you going to cut spending?’” said Stan Collender, a budget expert and a managing director at the P.R. firm, Qorvis Communications. “If not, you have to make up a gap of about 5 percent of GDP … you’re asking a lot.”

The deficit is being driven by the high cost of popular entitlement programs, such as Social Security, Medicaid and Medicare, not by the relatively smaller discretionary programs, such as defense, environmental regulation and education. But the underlying problem is not economics, say advocates and experts. It is the ballot-box reward for politicians who keep spending larger amounts of taxpayer funds, no matter how much revenue comes in from taxpayers.

Tax increases can’t close the gap because any new taxes will spur further spending, argues Richard Vedder, an economist at Ohio University. Politicians want to be reelected, and tax-increases make reelection more difficult, so “they offset the negative political effect of [imposing] higher taxes by increasing spending,” said Vedder, who has tracked taxes and spending from just after World War II until 2009. During that period, he said, every $1.00 of increased tax-revenue spurred federal spending by roughly $1.17.

Obvious and painful tax increases, such as boosts in income-tax rates, are more likely to spur spending, he said. “Dollar for dollar, you get more political damage by raising income taxes than by raising taxes on corporations,” said Vedder.

Vedder’s analysis suggests that even if every dollar of new tax-revenue were to spur government spending by merely 50 cents, the deficit would be reduced by only 50 cents for every new tax-dollar, assuming nothing else changes.

The scale of the current deficit is another problem. Until the November election, President Obama has supported an end to the lower tax rates won by President George W. Bush. If the the Bush-era taxes on people earning more than $250,000 were boosted from 33 percent up to almost 40 percent, as many Democrats urge, the estimated 10-year deficit of $13,600 billion would reduced by only five percent, assuming the government did not increase spending elsewhere, Riedl noted.

Another common target for a tax hike are oil companies. Currently, the industry gets about $4 billion in federal tax breaks each year. But those tax breaks are similar to the investment-related tax rules governing other small and large companies, such as Microsoft, Starbucks and General Motors, said Stephen Comstock, manager of tax policy at the D.C.-based American Petroleum Institute, which represents oil and gas industries. If the federal government denied the oil and gas industry’s use of those standard tax-breaks, it would shrink exploration, cut jobs, increase reliance on foreign oil, and shrivel the taxes paid by energy companies, supplies, workers and their customers, he said.

Similarly, Riedl argued that a 20 percent tax on sales would close the deficit, but only on paper. If imposed, a massive sales-tax would choke the economy and crimp revenues, he said.

There’s much evidence for this dynamic feedback between taxes and revenues, he said. For example, U.S. income-tax rates in the 1960s reached up to 91 percent, and dipped to 33 percent after 2000, but tax revenues never rose above 21 percent of gross domestic product, he said. The ceiling exists because higher tax-rates cause people to change their work, to move assets or to change business, so reducing taxes paid in the treasury, he said. “The higher the rates, the more you shrink the tax base,” he said.

The recession has temporarily pushed revenues down to 15 percent of the economy, widening the deficit. But those revenues will surge back to 18 percent as the economy recovers, assuming current taxes remain, he said.

However, that’s still far short of federal spending, which now amounts to 25 percent of the economy, he said.

Cuts to spending programs would also hurt the economy, so curbing taxes revenues, warned Jagasdeesh Gokhale, an economist at the libertarian Cato Institute. That damned-if-you do, damned-if-you-don’t problem exists because benefit-cuts would shrink consumer spending and consumption, which is now roughly 75 percent of the economy. The resulting cuts to consumption would reduce economic activity and tax-revenues, he said. “We are now in a situation were both tax-increases and benefit-cuts would hurt… because the economy is basically 75 percent consumption,” he said.

The deficit is also being boosted by growing interest-payments on the fast-growing debt. Any attempt to erode the debt by stimulating inflation won’t work, Reidl said, because the international “bankers are smart… [and] they’ll raise interest rates to match inflation.”

But even faster economic growth can’t close the deficit, because the major entitlement programs grow in tandem with the economy, Gokhale said. “We need to grow [the economy] fast, but the faster growth will worsen our entitlement problem” because those programs pay to beneficiaries when workers’ productivity rises. The entitlement programs should be modified to ensure that benefits are linked to retired beneficiaries’ past productivity, not to the subsequent generation’s current productivity, he said.

“There’s no escape from hard choices,“ he said.

The only fixes, said Riedl, are reforms to the entitlement programs. Those reforms, he said, could curb benefits to wealthier individuals and also delegate money and control to individual recipients. If Medicare is reformed to allow efficiency-boosting marketplace pressures, for example, beneficiaries would reap a large slice of the efficiency improvements, and the overall burden would be reduced, he said.

“I’m not sure I see a grand [budget] compromise out there yet…. because there are not any events that gives politicians the ability to move from their positions” of either opposing tax increases or spending cuts, Collender said. A refusal by foreign bankers to fund the deficits, or deficit-driven inflation would likely prompt action, he said. Politicians would “hold hands and jump of the cliff together,” he said.

Short of those disasters, politicians are simply using the threat of a damaging deficit to advance their normal goals, such as cutting programs or raising taxes, he said. “The budget deficit is everyone’s boogyman,” he said.

Tags : cato institute deficit deficit spending economics gas tax heritage foundation income tax social security
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