Escaping the Fiscal Trap

As the 1990s begin, peace and prosperity are in abundance but so are poverty, drugs, poor schools, contaminated air and water, deteriorating roads, and a host of other problems. Although few believe that such problems can be solved with money alone, money is surely needed. Its lack has become an excuse for doing nothing or for launching rhetorical and symbolic attacks that satisfy public opinion but little else.

President Bush used the lack-of-money excuse in his inaugural address. We have more will than wallet, he said. But how can the world's richest nation believe that its wallet is empty? The truth is that we face a fiscal stalemate because we have more wallet than will. As Charles McDowell, a columnist for the Richmond Times Dispatch has observed, we put Democrats in Congress to get us the things we want and Republicans in the White House to make sure we don't have to pay for them.

Current budgetary rules are as simple as they are inadequate: no tampering with Social Security and other programs for the elderly and no new taxes. It's an impossible equation. Yet until we escape from the fiscal trap, government will be a shell game rather than a means of making constructive national choices about our future.

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The prospects of a peace dividend have, at least temporarily, made everything seem possible. Some analysts, such as William Kaufmann, believe that defense spending can be cut roughly in half over the next decade. If such cuts were to materialize, they would not only eliminate the deficit, as currently calculated, but also help to fund some new initiatives.

Although most observers are less sanguine than Kaufmann, not even Kaufmann thinks defense cuts can eliminate the deficit over the next three to five years. We might be able to freeze nominal defense spending at 1990 levels -- the equivalent of real cuts of roughly 4.3 per cent per year, according to the Congressional Budget Office. This would produce an annual peace dividend of about $55 billion by 1994 and reduce the projected deficit for that year by nearly one-half. We would still not have achieved the Gramm-Rudman target of budget balance by 1994, nor would there be any room for new initiatives. Thus, while a substantial cut in military spending is an important part of a strategy for escaping the fiscal trap, by itself it won't solve the problem. Indeed, the peace dividend will have served us poorly if its principal consequence is to provide everyone with an excuse to cling to the old budgetary rules.

To change those rules, we need to change the terms of debate in several respects. First, and most critically, it is time to challenge the political taboos against raising taxes and revising entitlements. Further, we should question the increasingly prevalent assumption that we need a surplus in the government's overall accounts. The government does need a reduced deficit, but concerns about our low rate of saving should not be allowed to curtail spending on other high priority national needs. The welfare of our children and of the nation depends on more than just the saving rate. We should particularly resist recent attempts to achieve such saving by removing Social Security from the budget. These misguided changes are an ineffective means of protecting Americans' retirement checks.

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Paying taxes is unpleasant. But so are dieting, jogging, and drinking mineral water. The difference is that the latter are fashionable, while taxes are not. The question is why.

Some argue that we can't afford the government we have. Yet tax burdens in the United States are far lower than they are in most other industrialized countries, including those that have experienced a higher rate of economic growth. We could spend about $500 billion more on public purposes if we were willing to pay taxes at the same rate as the citizens of West Germany. Even more surprisingly, we could spend an extra $86 billion if we were willing to turn over the same fraction of corporate and personal incomes to the federal government as we did in 1960. The comparison is not quite fair since other taxes -- payroll taxes in particular -- have risen so sharply that they now loom larger than income taxes for the average family. Nonetheless, overall tax burdens have not risen, so it is hard to argue that we can't afford a larger public sector.

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What is it, then, that has turned everyone, even liberal Democrats, into lily-livered, lip-reading libertarians? One is tempted to conclude that it is pure greed, but I think that is an insufficient explanation. The tax revolt is not only about what people perceive they can afford. It is also about whether they think they are getting their money's worth. As any taxi driver will tell you (and as focus group interviews confirm), the public views government as a vast, wasteful, and incompetent bureaucracy.

That image is mostly wrong. To give the government an overall grade on its performance, we have to look at exactly what it does with our money. One of its biggest expenses, and certainly the most rapidly growing in the 1980s, has been interest on the debt, now consuming one out of every seven dollars in the federal budget. At one level, there is nothing more wasteful. Unless the debt represents money borrowed to fight a recession or to invest in long-lived assets -- neither of which was so in recent years -- interest payments are money down the drain. The benefits of many government programs are uncertain and not always equal to their costs, but the benefits of paying interest are zero. We do it primarily to retain the privilege of borrowing again. Of course, if we insist on living on borrowed money, there is no better bargain around. The Treasury can raise money in financial markets as cheaply as anyone. But the sheer waste of devoting one out of every seven tax dollars to interest stands out.

How do we avoid throwing good money after bad? The simplest way is to raise taxes now. Give government an A for performing its interest-paying task efficiently and give us an F for asking it to take on the job.

Another thing the government does with our money is to transfer it to other people who are older or sicker or poorer than the rest of us -- but mostly older. These transfer payments represent 45 percent of the budget. Whether all these transfers are justified or affordable is an important question; but relative to the sums of money involved, the administrative expenses are minuscule. By and large, this is an efficient check-cutting operation. No wasteful bureaucracy here.

Next, we come to defense, which represents 25 percent of total outlays. One need not be an expert in this area to suspect that the Pentagon can be run more efficiently During the rapid buildup of the early 1980s we threw fistfuls of money at the military. After 1985 real spending began to decline. This roller coaster approach reduces efficiency. Tales of $600 toilet seats and $7,000 coffee pots brought the point home to the public, which finally rebelled. However, one should not exaggerate the waste. In the absence of a redefinition of foreign policy interests and defense strategies, we might at best cull $5 to $10 billion in savings out of the defense budget. The big savings, if they occur, will come from the kind of fundamental shifts in policy now being discussed in response to events in Eastern Europe.

This accounting leaves a mere 15 percent of the budget for everything else from forecasting the weather to running the White House. It includes a certain amount of political pork -- especially in the areas of business, farm, and community development subsidies. These ought to be curtailed. In addition, many federal government operations could be better managed. But the more fundamental point is that much of what the government does is pretty efficient simply because it is a check-cutting effort and not an attempt to produce goods and services. The most egregious examples of waste, such as spiralling interest on the debt, bad management at agencies such as HUD and FSLIC, and an overly rapid defense buildup, occurred while most politicians were railing against fraud, waste, and abuse. It will take more than words to restore confidence in government.

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There remains one area of the budget that invites a lot of pruning and retargeting: tax expenditures. As the name implies, these are neither pure taxes nor pure expenditures. However, since their purpose is not to finance government but rather to accomplish some policy purpose or to transfer in- come to a particular group, they resemble expenditures more than taxes. A dollar spent on housing, health care, or capital investment through the tax code has the same effects on the allocation of resources and the distribution of income as a dollar in direct spending for the same purposes. Yet, because they are hidden and do not affect calculations of the "size of government" as measured by the ratio of outlays to gross national product, they get far less scrutiny than do regular budget items.

The basic principle should be to tax all forms of income the same way, including government transfer payments and various forms of noncash income such as fringe benefits and owner-occupied housing. People should not be able to escape taxation simply because their income comes in one form rather than another.

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Consider the mortgage interest deduction, which cost the Treasury $32 billion in lost revenue in 1989. It may not be feasible or desirable to eliminate the deduction entirely; that would be too disruptive to housing markets and unfair to those who purchased a home on the assumption that current rules would not be changed. But some limits, lower than the $1 million cap introduced in 1987, would make a lot of sense. Limiting the mortgage interest that could be deducted to $20,000 on a joint return ($12,000 on a single return) would produce an extra $8 billion in revenues over the next five years. At a mortgage' interest rate of 10 percent (the average for houses purchased since 1970), this change would affect only the tiny fraction (less than one percent) of all homeowners with mortgages worth more than $200,000. Thus, such limits would not likely affect the broad middle class or significantly depress real estate markets.

Curtailing this particular tax benefit may seem like a direct attack on homeownership and is certain to be politically unpopular. Nevertheless, there are good reasons to favor it. Purchases of new homes now absorb more than 100 percent of personal savings in the United States, compared to less than 25 percent as recently as 1970. Encouraging such purchases drains savings away from investments in the modernization of factories and equipment. In the long run, these are the source of greater national productivity and wealth.

Logically, if we are really intent on encouraging homeownership, we should provide people with a direct grant toward the cost of their homes. But few of us would explicitly choose to pay higher tax rates or to sacrifice other national needs in order to subsidize the housing of the relatively affluent. I would prefer to reduce the deficit or provide more assistance to the homeless and to those low-income families who cannot now afford decent housing.

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Another hidden subsidy worth reducing is the exclusion from taxable income of certain employer provided fringe benefits, notably health insurance. The value of medical insurance premiums should be treated as a taxable form of compensation. If it were, the Treasury would net an additional $46 billion in 1990 -- enough to cover the federal and state costs of expanding Medicaid to cover all low-income families with incomes less than twice the poverty level. Alternatively, one could use these revenues as an opportunity to reduce payroll taxes, as Senator Moynihan has proposed. A revenue-neutral trade of this sort could benefit the vast majority of wage earners. The gains would flow disproportionately to lower-wage workers who, as a percentage of their income, often pay the highest payroll taxes and receive the fewest fringe benefits. If only the amount needed to purchase a basic health insurance plan -- say, $250 a month for family coverage and $100 a month for individual coverage-were excluded from taxation, the budgetary savings would be $5 billion in 1990 and $61 billion over the next five years.

The current tax exclusion of medical premiums encourages employers to provide extensive health insurance coverage in lieu of higher wages. The comprehensiveness of many plans -- especially those with no deductible or employee co-payment -- has encouraged greater, and sometimes unnecessary, use of medical services and contributed to health care inflation. This inflation puts upward pressure on both federal spending and private sector costs.

Finally, all government benefit payments should be taxed. At first glance, this approach would seem to hurt the poor. But means-tested transfer payments typically go to people whose incomes are too low to be taxable. Other benefits, such as Medicare and Social Security, go to higher income households as well. Taxing benefits is the best way to avoid oversubsidizing the affluent, while keeping the middle class and the poor in the same program. Under current Social Security rules, only up to one-half of benefits are taxed for those whose incomes exceed $32,000 on a joint return ($25,000 on an individual return). We should exclude the portion of benefits that represent a return of past contributions since these have already been taxed. But only about 15 percent, not 50 percent, of current benefits fall into this category. Current income thresholds have little or no justification. Why should someone who receives $25,000 from their job or from a private pension pay higher taxes than someone who receives exactly the same income from Social Security? If 85 percent of benefits were taxed at all income levels, this would raise $6 billion in 1990 and $97 billion in revenues over the next five years. Such revenues should be returned to the general fund where they might finance, among other things, higher benefits for the low-income elderly under Supplemental Security Income (SSI).

The foregoing examples are only the tip of the tax expenditure iceberg. Despite the broadening of the tax base in 1986, much more could be done. According to the Office of Management and Budget, tax expenditures totalled $310 billion in fiscal 1989, more than double the entire deficit.

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These subsidies are at present very poorly targeted on those who need them most. We have neglected the housing, health care, and income security needs of lower-income families while simultaneously providing billions in assistance to the affluent and the middle class. Moreover, the majority of tax expenditures do not even achieve their intended purpose. Most represent a windfall that accrues to homeowners, workers with generous compensation packages, municipal bond holders, those who inherit appreciated assets, and other favored groups. As such, most of these hidden expenditures would never pass a cost-benefit test, even assuming agreement with their objectives. They are, by and large, both inequitable and inefficient. Their elimination will be strongly resisted, but some of the most egregious uses of the public's money could be curbed by at least capping various tax preferences.

By focusing on tax expenditures, I do not mean to imply that we cannot afford higher tax rates. Each one percentage point increase in personal and corporate income tax rates would yield $30 billion in additional revenue. Moreover, for equity reasons, we ought to correct the current anomaly that enables the truly rich to pay a lower marginal tax rate than the merely affluent and we should not flinch from reintroducing a top rate of 40 or 50 percent.

However, rates do not have to be raised to pay for high priority national needs. A scaling back of low-priority expenditures, in particular those that are shoveled out through the Treasury's back door, would be sufficient. Conservatives have been preaching this gospel of retrenchment for some time. What liberals have failed to realize is that they can, with good conscience, preach it, too -- as long as expenditures are defined to include everything the government does to subsidize private activity.

As I have indicated, there are bargains to be struck in pursuing this agenda. One can curtail certain tax expenditures in return for greater support for related, but higher priority, programs on the spending side of the ledger. One can trade greater taxation of fringe benefits in return for lower payroll taxes, a move that would enhance the progressivity of the tax system, yet leave most people's takehome pay a little higher. We would do well to imagine more such bargains.

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If politicians have lacked the political courage to tackle the inefficiencies and inequities buried in a variety of popular tax subsidies, they have been even more cowardly about confronting the escalating costs of popular entitlements such as Social Security and Medicare. As every budget analyst knows, programs for the elderly are rapidly squeezing out everything else in the budget. Between 1980 and 1988, Social Security and Medicare outlays increased from 37 percent to 48 percent of nondefense, non-interest expenditures. These two programs have been responsible for all of the growth in federal outlays relative to GNP since 1962. Unless this growth is contained, or overall tax burdens are increased substantially, the rest of government will be starved for funds. Spending for such purposes as education, the war on drugs, preventive health care, infrastructure, research, the environment and other investments in the future will be crowded out by the escalating costs of programs for the elderly. As a group the elderly are better off than the nonelderly in terms of assets and poverty rates, and about as well-off in terms of after-tax incomes.

Among the elderly, however, there is a considerable gap between the affluent and the poor. The sensible thing to do would be to ask the better-off elderly to foot some of the bill for their health care and retirement. Taxing Social Security benefits would be one way to accomplish this. Indexing the retirement age to life expectancy in a way that kept total benefits constant is another. The savings could then be reallocated to the neediest within the elderly population -- the poor, the infirm, and those needing long-term care.

Some argue that a scaling back of current benefits would break the current social contract with the elderly. But today's retirees receive more benefits than any prior generation simply because they live longer. In 1940, soon after Social Security was introduced, the average 65 year old man could expect to live another 12 years. By the year 2020, that figure is projected to be 16 years. Likewise, a 65 year old woman's life expectancy has increased from 13 years in 1940 to a projected 21 years in 2020.

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Many conservatives, and some liberals, argue that Social Security should be removed from the budget to prevent the current annual surplus in the Social Security accounts from being used to offset part of the deficit. This scheme is being promoted as a necessary means of assuring the solvency of the Social Security system for the baby boom generation, but in reality all it would do is intensify the fiscal straitjacket.

Payroll tax receipts currently exceed benefit payments because of a 1983 attempt partially to fund the system, which was previously operated, more or less, on a pay-as-you-go basis. But excluding these surpluses from budgetary calculations would balloon the estimated deficit by $54 billion in 1989 and by over $200 billion by the end of the decade.

Most of the proposals currently being debated in Congress would revise the Gramm-Rudman targets to require eliminating the deficits in the non-Social Security portion of the budget (thereby creating large surpluses in the overall budget, as conventionally measured). This is a gargantuan task that could be accomplished only by stretching out the Gramm-Rudman process until the end of the decade. In considering this idea, some liberals are gambling that the resulting extreme budgetary pressure would trigger a tax increase. But politics would almost certainly demand a matching cut in domestic spending. Most likely, if recent history is any guide, we would see a continuing flow of red ink that would maintain downward pressure on government spending for the rest of the century.

The plan to segregate Social Security funds is based on a misunderstanding about how the Social Security system works. Whatever the Gramm-Rudman rules, the Social Security surplus is invested, by law, in government securities. The Treasury then spends the money either to finance a portion of the operating deficit (as it is doing now) or to retire previously accumulated debt by repurchasing bonds from the public (as it would do if there were no operating deficit). In both cases, the Social Security Trust Fund is left with nothing but pieces of paper that say that the government owes the government money. Writing a promissory note to oneself never made anyone richer. Similarly, these governmental "IOMES" will not produce any additional real resources to meet the needs of a burgeoning elderly population.

To be sure, a more ambitious set of deficit reduction targets than is currently on the books could, if achieved, produce more national savings and more economic growth. More growth is a good thing, but it won't solve the long-term problems of the Social Security system. The reason is that higher growth would raise Social Security benefits because these are tied to wages. To be sure, growth would also increase payroll tax revenues, but the net result would be only a modest improvement in the solvency of the system. Thus, removing Social Security from the budget in no way guarantees that the baby boomers will receive their retirement checks. Tax burdens will have to be increased or other expenditures reduced in the twenty-first century if current claims are to be met. There will be no money under the mattress for this purpose.

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We should not choose a deficit target on the basis of demographically-driven swings in Social Security balances. The key consideration is the importance we place on economic growth and what we are willing to sacrifice to achieve it. Almost everyone agrees that current deficits are too large. But as a percent of GNP, they are now within hailing distance of their postwar average (excluding the 1980s). Measured at high employment, deficits averaged 1.4 percent of GNP in the 1960s and 1970s. With only modest help from the peace dividend (no nominal increases in defense spending over the next four years) and deficit-neutral budgeting for any new initiatives, the deficit is expected to fall to 1.0 percent of GNP by 1994.

The major argument for improving our earlier record is the need to improve the competitiveness of the economy. But competitiveness depends on more than the national savings rate. It also depends on the education and health of our children, the condition of our roads and research laboratories, the outcome of the war on drugs, and our success in integrating various disadvantaged groups into the economy Overly ambitious deficit reduction targets that limit government's ability to respond creatively and efficiently to these needs are not conducive to long-run economic success. Further, there are obvious limits on the extent to which the current generation can be asked to sacrifice in the interests of future ones. As long as there is any economic growth, our children will be better off than we are.

For all these reasons the White House and Congress should resist tightening the budgetary rules one more time in a misguided effort to protect future Social Security benefits. Better yet, they should scrap Gramm-Rudman entirely. The whole Gramm-Rudman process has badly distorted budget-making in Washington and contributed little to reducing the long-term deficit.

As we enter the 1990s, the size of the peace dividend is hard to estimate but a good guess is that it will reduce the deficit to reasonable levels assuming we leave Social Security "on budget" and are content to live with deficits similar to those experienced in the 1960s and 1970s. The deficit hawks are busily working on a new Gramm-Rudman flying machine designed to take us to surplus regions previously unseen. One doesn't have to be a dove to think that we should learn to walk first -- preferably without a Gramm-Rudman crutch.

Growing Social Security surpluses will make an enormous contribution to reducing the deficit if we let them. However, they also imply funding government with regressive taxes. To combat this trend, one option is to tax fringe benefits more fully and to use the proceeds to reduce payroll taxes. The distributive effects should be precisely calculated, but it appears that most wage-earners would gain.

New initiatives to address a variety of national problems will need to meet a strict cost-benefit test to allay public concerns about governmental inefficiency. The best way to insure such discipline may be to force deficit-neutral trade-offs among expenditures -- broadly defined to include tax subsidies as well as direct outlays. Curbing these hidden expenditures should be given high priority on the grounds that most are both inequitable and inefficient. This is a politically challenging agenda. In the Eighties, Americans got caught in a fiscal fantasy. The 1990s could restore sobriety and realism to our public business, but only if we find a way to escape the fiscal trap.

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