The U.S. Federal Government spent $1.7 trillion dollars last year more than its tax revenue. It had to borrow that amount. This increased the outstanding public debt of the Federal government to 14.2 trillion dollars 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 year’s federal deficit is expected to be 1.4 trillion. Interest payments on this debt are forecast to be $287 billion this year (almost 8% of total outlays) and are expected to grow to three or four times that over the next decade as the stock of debt grows and interest rates rise.
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 bond holders are no longer willing to trust the government’s ability to pay the interest required. At that point they will dump U.S. Treasuries and the U.S. will be forced to default. Standard & Poors has already downgraded its “credit outlook” for the U.S. to negative.
All of this is by now well-known as is the fact that there is no longer any choice about the need to cut spending and/or raise taxes. But that is just the beginning of the search for responsible and effective governance by our representatives here in Washington. It makes a big difference which expenditures are cut and which taxes are raised. The deficit will fall and our ability to finance it will increase with the growth of our output/income. Specific spending cuts and tax increases effect income growth differently.
The job of our political representatives is to determine what the government should be doing within the set of things it is permitted to do by the Constitution and the resources the public wishes to make available. Their job is to carefully and wisely set priorities on the use of the limited resources available to them.
David Ignatius provides one of many examples that I strongly agree with: “Today, the United States is allocating about $110 billion annually for the Afghan war, about $3.2 billion for military and economic aid to Pakistan, and about $0.15 billion in special assistance to help Egypt’s democratic revolution. In terms of U.S. national interests, those spending levels don’t make sense. The pyramid is upside down.”
The budget for the Defense Department in 2010, including our several wars, was $664 billion while the State Department (including all foreign aid) was $52 billion. We have the best fighting machine the world has ever seen and rather mediocre diplomatic capabilities. Better and more extensive use of diplomacy and less use of drones and lesser-guided bombs can often produce better results (improved security for the U.S.). Spending more to develop well-trained (history, culture, language) Foreign Service officers and less to manufacture more munitions might be a good idea. It is hard to imagine that spending less on DOD and more on DOS wouldn’t improve our security for less money.
All spending should pass a strict cost benefit analysis but setting a cap on total spending relative to GDP (e.g., 18 or 19 percent) would be a useful disciplining tool for forcing more careful prioritization. So we must cut deeply but not evenly. We can and should spend less and get more benefit by better prioritizing what is really important to our safety and quality of life. 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 easer to service. And not all taxes are equally fair. So 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 and fairness. Neutrality means that the tax does not distort business and spending decisions so that the allocation of investment and economic resources are not distorted. A neutral tax damages economic growth less than, say, a tax that falls largely on investments. A neutral income tax, for example, treats all sources of income the same.
If tax revenue is raised in ways that do not discourage economic growth, income growth itself will increase tax revenue and reduce a given debt as a share of national income (an indicator of the government’s ability to services it). The arguments in favor of the most neutral possible tax structures are well-known and broadly accepted by economists across the political spectrum. 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 corporate behavior in their effort to minimize the tax. Everyone agrees that the corporate profits tax in the U.S. should be lowered more in line with the rates in other countries, but in fact the corporate tax should be abolished. It raises only modest revenue and causes great damage. I favor complete reliance on a flat comprehensive consumption tax (VAT) because it does not tax saving and thus encourages more investment and growth, is simpler to collect and is fairer. 
There is less agreement about what is fair. Everyone agrees that the rich should pay more taxes than the poor but how much more. Actually, under the existing tax code those with incomes in the top 1 per cent paid 40 per cent of all income tax revenue in 2006 and earned only 22 per cent of all income, the top 10 per cent paid 71 per cent and the bottom 50 per cent less than 3 per cent.
President Obama thinks that this is not progressive enough and wants to tax high income families even more and the Republicans think it is already too progressive 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 rate structure when applied to a comprehensive income (or consumption) base. But it is also a good benchmark for discussing fairness. A flat rate means basically that someone with twice the income pays twice as much tax. I consider that fair, but of course our existing rate structure increases with income so that tax payments would more than double when income doubles. Increasing marginal rates is a rather open field. Where should you stop? Clearly our tax system needs to be made more neutral and more fair. The debate over how to do that will not be easy either.