The Long-Term Budget Outlook”
February 2006 Monthly Luncheon
Speaker: John Irons
Affiliation: Director of Tax and Budget Policy, Center for American Progress
Rapporteur: Michael Wolf
Dr. John Irons focused his presentation on the long-run challenges in the federal budget situation, noting that little has changed in this regard over the past few years. After addressing the long-run situation, he also looked at the implications of the Administration’s current budget proposal as well as the prospects for future budget reforms.
Dr. Irons identified three main fiscal challenges: the medical entitlement programs Medicare and Medicaid, which are expected to grow faster than GDP due to rising health care costs and shifting demographics; an historically low revenue to GDP ratio, caused in part by the recent tax cuts; and Social Security, which like Medicare will continue to grow with the aging population.
Defence and other discretionary spending are considered only minor challenges. Spending as a share of GDP is not currently at an historically high level, despite a small increase in recent years (caused mainly by increased defense spending). Revenue, however, fell sharply from 2000, and in 2004 reached its lowest level since 1959. Current deficits are therefore more a function of reduced revenue than increased spending. The Federal government now receives almost as much revenue from payroll taxes as from income taxes. In fact, 70 percent of the population pays more in payroll taxes (when employer contributions are included) than they do in income taxes.
The total tax burden that US residents face, however, is low when compared with peer economies. Another revenue issue that clouds the long-term budget situation is the status of the alternative minimum tax (AMT). As more households are affected by the AMT, the pressure to reform it will increase, which will likely result in reduced revenues. The long-term budget outlook is of continued yearly deficits, with only a politically unlikely combination of reduced spending and increased revenues likely to result in a decrease in the debt.
Given this long-term situation, Dr. Irons then addressed the current budget situation and possible solutions. Many politicians believe that simply growing the economy will solve the problem of long-run deficits, but most economists (including those in the audience) are skeptical of this possibility. Dr. Irons also believes that the public is not fully aware of the seriousness of the situation, believing that deficits are the result of short-term issues, such as spending on Iraq, rather than long-term structural problems.
Since growth is not likely to solve the problem, there need to be policy changes with regard either to spending or to revenue. Recent efforts to cut spending by $39 billion over five years met considerable resistance before passing, making more substantial spending reductions unlikely. Tax reform is a possibility, given the recent panel formed by the President, but this panel was directed to propose revenue-neutral reforms rather than reforms that would increase revenue. It is questionable whether long-term deficits can be addressed without changes to both spending and revenue as a package reform. It also remains to be seen whether major reforms can happen before a crisis forces them, or given the current political situation of one party control of congress and the presidency.
Looking at the current budget proposal with an eye to long-term economic growth, Dr. Irons sees that the government can impact growth through investments in education, science, energy and other research, as well as by increasing economic security, reducing deficits, and reforming tax policy. The current budget proposal, however, calls for about a four percent cut in federal education spending. It also cuts federal science and technology investment by $600 million, most of these cuts being in defense research, while energy research is slated to rise by $519 million.
Dr. Irons also suggested that the policies of the current Administration have weakened the social safety net, which may affect economic growth by leading to less risk-taking behavior, such as job retraining and entrepreneurship.
The other major federal impact on economic growth is tax policy. Currently, the tax code favors physical capital, particularly with the recent cuts in tax rates for dividends and capital gains. However, as the modern economy is driven by skills and as more labor-intensive tasks are replaced with technology, human capital has become more important in sustaining economic growth. Failure to correct this imbalance in taxation of human as opposed to physical capital could lead to lower long-run growth.
In addition to the previously discussed tax issues of the increasing reliance on the payroll tax, the problems with the AMT, and capital tax imbalances, any tax reform is also likely to address the progressiveness of the tax code. Another proposed plan involves the addition of a value added tax (VAT), either as a supplement or as a replacement to the current income tax structure.
Dr. Irons gave as one example of tax reform the Center for American Progress tax plan. It involves cutting the payroll tax rate in half but removing the cap, taxing capital income at the normal income tax rate for those with incomes over $1 million, abolition of the AMT, and a three-tiered rate structure, with rates of 15, 25, and 39.6 percent. This reform would generate $500 billion more revenue over 10 years than expected if the recent tax cuts are extended. It also is a more progressive tax structure, resulting in lower taxes for 70 percent of taxpayers, but increases for the wealthiest.
The probability of any significant budgetary reform depends on changes in the current political situation and in public opinion. Some sort of compromise is necessary for most large political changes, and will likely be needed for any significant progress to be made on entitlement and tax reform. The public also needs to have a better understanding of the issue, and here Dr. Irons sees a role for the media; if they focused less on the political jockeying and more on the underlying issues being debated, the public would be better informed and more likely to see the need for change.