public finance

Simon Johnson is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management.

A great deal of attention is currently focused on the notion that a “fiscal cliff” of higher taxes and spending cuts awaits at the end of this year. The good news is that politicians are finally talking about the budget – and working hard to communicate their competing messages regarding what should be done to put public finance on a more sustainable footing.

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The bad news is that almost the entire national conversation on deficits and debts misses the real fiscal risks that we face.

There are three major issues.

First, the main risk is that in the near future the government will do too little by way of fiscal adjustment.

The drama of the word “cliff” and the image of falling off it makes things seem more worse than they are. To be sure, if all the scheduled tax increases and spending cuts go into effect, 2013 would be a difficult year – although there is no sign that this kind of fiscal adjustment would lead to the problems of the financial crisis of 2008.

The politicians will do a deal. Probably not now, when the Republicans are pressed to raise tax rates – this goes too deeply against what has become an ideology over the last 30 years.

It will be much easier to reach an agreement in January or February, when tax rates have gone up — which they will do automatically, if there is no agreement by Dec. 31 – and the Republicans are being asked to vote for what would presumably include cutting tax rates for middle-class Americans relative to those new levels.

But the deal to be struck between the White House and the Republican House will probably be too small to adequately address our fiscal issues.

If we want to start putting federal government debt on a more sustainable path, we should find a path to fiscal adjustment that undoes the net effect on the budget of the George W. Bush-era tax cuts, which represent about $4 trillion over the next 10 years. You can do that through revenue or through spending reductions, but that is the right goal to aim for – putting our federal finances back closer to where they were in the late 1990s. (For a primer, I recommend this piece by my colleague James Kwak.)

Such a change would put government debt on track to stabilize around 40 to 50 percent of gross domestic product by 2030 – an entirely reasonable and responsible goal. (In “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You,” James and I run through alternative scenarios and discuss the policy options. You can tweak the numbers up or down somewhat, but the most important goal is to take debt off its current explosive path.)

President Obama has suggested a headline number for fiscal adjustment of $1.6 trillion, while the recent Republicans counterbid was $800 billion – both over 10 years (a standard accounting convention for this kind of discussion.)

Irrespective of how you feel about the policy combination each side is proposing, the “big numbers” are too small.

The United States doesn’t need to do more immediately. In contrast to many parts of Europe, we have some time to make our fiscal adjustments – particularly while interest rates remain low. The country should phase in a big part of its needed fiscal adjustment as the economy recovers. For example, part of any budget adjustment should be linked to employment relative to G.D.P. – any tax cuts in the new year could be phased out as the economy recovers.

Second, the working assumption of all American politicians is that the dollar will remain the predominant reserve currency indefinitely – the United States is the safe haven for investors and governments around the world. They particularly regard United States government debt as a safe asset in troubled times – and this is what allows us to borrow so much at low interest rates. (For a brief history of public debt in the United States – including how it has been useful in the past and how overreliance on foreign borrowing now makes us vulnerable, see the PBS NewsHour profile of “White House Burning.”)

About half of all federal government debt outstanding is held by foreigners. Sooner or later, foreigners will want to buy less United States debt. Either they will want to hold other assets – the fashion in currencies comes and goes over time, just like everything else – or they will save less (in which case they may hold onto their existing United States government debt but not want to buy so much of new issues).

Many countries hold their foreign reserves in dollars and have built these up over time. China, for example, holds over $1 trillion (the exact number is not public information; some people say the true number is significantly higher). This is far more than China needs, and it is no surprise that its interest in buying more United States Treasury debt is waning (see the latest official data).

No American politician wants to talk in public about what the implications of shifts in China’s savings and investments would be on our ability to finance federal government debt at reasonable interest rates. The middle class will pay more tax or receive fewer benefits, or both, over the coming decades – that’s the inconvenient math of the Congressional Budget Office. Which politician wants to level with voters on the scale of this issue?

The third risk is that our process of fiscal adjustment will undermine social insurance, primarily Social Security and Medicare.

We insure each other against outliving our assets and encountering an expensive version of ill health in old age. This insurance is mostly run through the federal government, for one simple reason. There was no private insurance market for older Americans before Medicare was created – and there will be none if Medicare is phased out or withers.

The most likely situation is this. After much shouting, a fiscal deal is reached in the new year – with a headline adjustment of around $1 trillion over 10 years, and perhaps with a 50-50 split between tax increases and spending cuts. Public attention recedes. Commentators proclaim that the budget problem has been fixed.

But then we hit a real fiscal crisis, with foreigners declining to buy newly issued Treasury paper and interest rates on that debt – and interest rates more broadly throughout the economy – rising sharply. The Federal Reserve fights to keep interest rates down, but its monetary policy in that instance is regarded as inflationary, further destabilizing the situation.

That crisis – date unknown but intense for sure – forces much more damaging fiscal cuts, including cuts in Medicare but also across the board (and bringing higher taxes). This is exactly the kind of disruptive fiscal austerity that damages an economy. One such dramatic, even humiliating, potential scenario is described in gripping detail in the opening pages of “Eclipse” by Arvind Subramanian (my colleague at the Peterson Institute for International Economics).

We end up poorer, more unequal and struggling to remember how we ever cared for one another in old age.

Article source: http://economix.blogs.nytimes.com/2012/12/06/the-real-fiscal-risks-in-the-united-states/?partner=rss&emc=rss

There is. Economists who study public finance have long agreed with William E. Simon, the former Treasury secretary, who said that “the nation should have a tax system that looks like someone designed it on purpose.” Here are four principles of tax reform that most of those economists would endorse:

BROADEN THE BASE AND LOWER RATES The United States tax code is filled with deductions and exclusions that shrink the basis of taxation. The smaller base in turn requires higher tax rates to raise the revenue needed to fund government. The starting point of reform is to reverse this process.

This principle was endorsed both by President George W. Bush’s tax reform commission in 2005 and by President Obama’s deficit reduction commission in 2010. Neither report had much impact, because eliminating deductions and exclusions is politically treacherous. Yet each made a good case on the merits.

Consider the deduction for mortgage interest. The policy is politically popular, but economists have long thought it has little justification. Because of this provision, among others, our tax system gives a better treatment to residential capital than it does to corporate capital. As a result, too much of the nation’s saving ends up in the form of housing rather than in business investment, where it could have increased productivity and wages.

This efficiency cost might be worth bearing if the deduction had a benefit from the standpoint of equality, but it fails there as well. Subsidies to homeowners are, in effect, penalties on renters — after all, someone has to pick up the tab. But there is nothing wrong with renting. And once one acknowledges that renters are poorer, on average, than homeowners, the mortgage interest deduction becomes even harder to justify.

TAX CONSUMPTION RATHER THAN INCOME Almost four centuries ago, the philosopher Thomas Hobbes suggested that taxes should be based on consumption, not income. Income measures a person’s contribution of labor and capital to society’s production of goods and services. Consumption measures the quantity of those goods and services he gets to enjoy. Hobbes reasoned that because consumption better reflects the benefits a person receives as a member of society, it is the proper basis of taxation.

Much modern economic theory confirms that conclusion. In standard models, a consumption tax allows the economy to achieve the best allocation of resources over time, whereas an income tax needlessly discourages saving, investment and economic growth.

Moving to a consumption tax might seem to require wholesale reform of our current system. But such a politically difficult step isn’t necessary. In fact, as our tax system has evolved over many years, legislators have come to appreciate the logic of taxing consumption, if only implicitly.

The United States now has an income tax, or at least that is what it is called. But because many Americans do most of their saving through tax-preferred accounts, such as I.R.A.’s and 401(k) plans, they in effect pay taxes based on how much they consume. Tax reform could expand and simplify the availability of such tax-preferred savings accounts. In this way, our progressive income tax could further evolve toward a progressive consumption tax.

TAX BADS RATHER THAN GOODS A good rule of thumb is that when you tax something, you get less of it. That means that taxes on hard work, saving and entrepreneurial risk-taking impede these fundamental drivers of economic growth. The alternative is to tax those things we would like to get less of.

Consider the tax on gasoline. Driving your car is associated with various adverse side effects, which economists call externalities. These include traffic congestion, accidents, local pollution and global climate change. If the tax on gasoline were higher, people would alter their behavior to drive less. They would be more likely to take public transportation, use car pools or live closer to work. The incentives they face when deciding how much to drive would more closely match the true social costs and benefits.

Economists who have added up all the externalities associated with driving conclude that a tax exceeding $2 a gallon makes sense. That would provide substantial revenue that could be used to reduce other taxes. By taxing bad things more, we could tax good things less.

KEEP IT SIMPLE, STUPID This engineering aphorism is based on the timeless insight that complex systems are more likely to break down, often in ways the designer failed to anticipate. It applies with force to tax systems.

Indeed, unlike engineering systems, complex tax systems go awry because an army of highly paid accountants and tax lawyers is ready to take advantage of any loophole it can find. Remember when President Obama’s stimulus plan offered tax credits for electric cars? Suddenly, the sale of golf carts took off.

To be sure, any tax system will be subject to gaming, which is why we will always need the Internal Revenue Service. But the more we use narrowly targeted taxes and tax breaks, the more gaming there will be.

Filling out tax returns will never be a delight. But if reform included simplification, the task might become a bit less onerous. And if a few accountants and tax lawyers were induced to become engineers and doctors instead, society will have moved a big step in the right direction.

N. Gregory Mankiw is a professor of economics at Harvard. He is advising Mitt Romney, the former governor of Massachusetts, in the campaign for the Republican presidential nomination.

Article source: http://feeds.nytimes.com/click.phdo?i=a60619b8e1fb3eccc792f0a0cb9c2439

Today’s Economist: Simon Johnson: The Real Fiscal Risks in the United States

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Economic View: Four Keys to a Better Tax System — Economic View

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