Saturday, January 23, 2010

Why federal taxes will have to go up

Only two people got the answer correct to the question I posted in my last entry!

By far the most common answer was off by two orders of magnitude.

The correct answer is that the federal government is currently able to get away with paying only about $1 for the privilege of borrowing $10,000 for three months.

That is a fantastically low interest rate, one that many people certainly never expected to see in our lifetimes.

Right now, investors all over the world think the US Treasury is the safest possible place to park their money, and they are willing to accept peanuts for doing so. But that's not going to continue forever and ever.

It is completely unrealistic to believe that investors will continue indefinitely to lend the US government vast quantities of money at such absurdly low rates, especially given that Congress shows very little evidence it can get its economic act together.

Do the math: the current levels of federal government spending and taxation shown in the graph at the top of this blog are simply not sustainable.

We can't keep deluding ourselves that the current state of affairs can go on indefinitely.

The Treasury has taken on massive amounts of short-term debt. In November, the New York Times reported that over a third of US Treasury obligations took the form of short-term debt financed at unsustainable levels.

As that article discussed, government debt service costs are going to explode once interest rates return to normal levels.

Since the article appeared, short-term interest rates have headed to even ridiculously lower levels.

But it can't continue.

If Americans think that the current state of government finances can continue indefinitely or that we can somehow "grow" our way out of the problem, then they are even more deluded than those subprime borrowers who took out those teaser rate negative amortization mortgages that led to the housing bubble.

Congress needs to get its act together. Tax revenues have to go up. Recovery and economic growth will help, but Congress has got to get its long term fiscal house in order or the consequences will be disastrous.

The "relatively rosy" scenario depicted in the graph above shows the deficit gap decreasing in the future thanks to a combination of expenditure rates decreasing and tax revenues increasing.

Getting government expenditure rates to come down at a time when debt service costs could be going through the roof: hmmm.....if you think that's going to happen, I have a bridge to sell you.

Realistically, at least part of the answer has to be that tax revenues have to grow by a lot.

Congress can either raise statutory rates or get rid of some of the more esoteric, exotic, and ultimately counterproductive bed buffaloes ("tax expenditures") in the tax code, or some combination of both.

The Tax Policy Center has looked at the rate increases that would be needed to narrow the long-term deficit gap (not close it, mind you, just narrow it!) and the answers they come up with would be pretty hard to swallow:

The Congressional Budget Office projects an average deficit over the 2015-2019 period of 3.2 percent of GDP under current law—that is, if the Bush tax cuts expire next year as scheduled and Congress stops patching the AMT. The average deficit jumps to 6 percent of GDP in the more likely event that Congress follows current policy and makes both the Bush tax cuts and AMT patches permanent as the president has proposed.

Katie used TPC’s tax model to simulate three income tax increases scaled to meet our deficit goals under both current law and current policy: raise all tax rates proportionally, raise just the top three income tax rates, or raise rates for taxpayers targeted by President Obama—couples with income over $250,000 and singles with income over $200,000. We also tried eliminating or limiting itemized deductions.

The results were discouraging, to say the least. Under the higher tax baseline of current law, we’d have to raise all individual rates by 15 percent to meet our 2 percent deficit goal. But under the lower-revenue scenario of current policy, rates would have to jump nearly 50 percent. In other words, the 10 percent bracket would become nearly 15 percent and the 35 percent top rate would go to 52 percent.

What if Congress just raised taxes for high-income taxpayers? Their rates would go up more than 40 percent under current law and more than 150 percent under current policy. In other words, the top tax rate would return to the bad old days of 90 percent. Even if we go for the Administration’s more modest goals—start with current policy and aim for deficits averaging 3 percent of GDP—those top tax rates would have to more than double, taking the top rate over 75 percent.

And our estimates ignore behavioral response. Research has shown that tax increases lead people, particularly at the top of the income distribution, to cut back their taxable income. While analysts disagree on the magnitude of that income shift, they’d all acknowledge that cranking the top rate up to 90 percent would lead to a massive reduction in taxable income and hence a lot less additional revenue than we found. People facing those high tax rates might work less or hire smart accountants. Either way, reaching our 2 percent deficit goal would require even higher tax rates and would quite likely prove impossible.

If we start with current law, we could also meet our goal by eliminating all itemized deductions, but that wouldn’t yield enough revenue under current policy. Besides, wiping out popular deductions for home mortgage interest, state and local taxes, charitable contributions, and other expenses would never fly. We even looked at capping the tax-reducing value of itemized deductions to 15 percent, but that wouldn’t raise nearly enough under either current law or current policy. (Last year, Obama proposed a more lenient 28 percent cap.)

Our simple exercise yields two important messages: We can’t balance the budget with income tax increases alone. We also have to cut spending and perhaps look for another revenue source as well. VAT, anyone?

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