America's Fiscal Constitution (66 page)

T
HE
M
IRAGE OF
D
EBT
-F
INANCED
G
ROWTH

Strong economic growth helped reduce debt’s burden after five previous spikes in debt. After each use of those emergency borrowings, the federal government balanced budgets and usually paid down debt.

Debt-financed federal spending is not necessary for economic growth. It might temporarily help in a downturn so severe that traumatized citizens and business are reluctant to consume or invest. In that circumstance, however, debt can be monetized with little risk of inflation. Modest federal borrowing during less severe downturns should not interfere with long-term growth as long as the debt is repaid or can be monetized without inflation after recovery. The goal of balancing budgets across each economic cycle was a modern variation of traditional “pay as you go” budget planning. The concept worked better in theory than in practice because federal officials were reluctant to conclude that any economic recovery was complete enough to justify moving a budget into surplus.

There are, of course, ways in which the public sector can contribute to economic growth without mortgaging the future. State laws foster durable contracts and property rights. State and local governments provide a reasonable measure of safety from crime and build most infrastructure. Few doubt that broad-based improvements in knowledge and skills can raise productivity and promote long-run growth, even though many believe
that state and local investments in public education can be made more efficiently.

One could argue that all Americans contribute to the economy by waking up each day, but staying alive is hardly a prescription for growth. Similarly, various federal activities make valuable contributions to national welfare and can be justified without exaggerated claims concerning their contribution to growth.

Federal programs that do facilitate growth—such as the funding of an interstate highway system, airports, marine facilities, regulation of the spectrum used for wireless communication, and scientific research—are often funded using trust funds financed with dedicated taxes and account for only a small percentage of overall federal funds spending. Annual federal expenditures supporting economic development—such as investments in education and infrastructure—should not require debt financing.

Strong economic growth has often occurred when the federal government balanced its budgets. The nation grew rapidly in its first thirty-six years, a period in which it paid off its debt entirely. The economy also experienced high rates of growth when surpluses were used to pay down debt in 1844–1857, 1878–1893, 1900–1915, and 1921–1929. Since World War II the nation experienced three long periods of economic growth: 1946–1957, 1961–1974, and 1984–2000. In each of those periods the share of national income devoted to all federal taxes—federal funds and trust fund revenues—rose modestly as a share of national income as the economy grew. In contrast, during 2001–2012 private sector employment stagnated despite higher borrowing levels and lower federal tax receipts as a share of national income.

Bursts of economic expansion at times accompanied spikes in wartime debt (e.g., 1917–1918, 1941–1945, and 1965–1974) or recovery from severe downturns (e.g., 1933–1937, 1976–1979, 1984–1989, and after 2009). Those circumstances do not justify routine borrowing in, say, 2013, when national income hit a record high.

Long-run economic growth depends on factors that do not require federal debt, most notably an increase in the size and productivity of the workforce. Federal borrowing will not change the plight of citizens who have fallen behind in international competition for high wage jobs. Taxing domestic employment in order to pay foreign creditors cannot possibly generate greater long-run opportunities for American workers. Public
borrowing that diverts savings from private investment does not enhance productivity.

Despite the verdict of history, many Democratic and Republican leaders now assert that balancing the budget in the near future would cripple the economy. The fig leaf of claimed harm to the economy serves to hide the naked reality of the federal dependence on debt. In some sense, of course, any nation can use debt to shift consumption from the future to the present and create an illusion of sustainable growth. The prodigal son of the New Testament parable seemed prosperous until he finished spending his inheritance. When debt-financed consumption stops, there may be an adjustment similar to that of a consumer who stops writing checks on an account with insufficient funds. But living within one’s means is hardly tantamount to damaging the economy.

American history highlights the unusual nature of the recent conversion of conservatives to the idea that federal spending should be financed with debt rather than tax revenues in order to foster economic growth. Fiscal conservatives in both parties successfully fought to amend the Employment Act of 1946 to remove language that could have been interpreted as condoning that very idea. Conservatives pushed for a constitutional amendment to balance the budget for years before Congress nearly passed it in 1995. In contrast, in 2011 various conservative organizations pressured Congress to kill that very constitutional amendment. This shift cannot be attributed to a plan to reduce the size of the federal government by “starving the beast” of tax revenues. History and common sense plainly refute the notion that debt-financed spending diminishes the size of government.

The attitude of many Democrats concerning post-2001 debt was—for a time—less remarkable. They could blame a significant portion of new debt on tax cuts passed at the initiative of a Republican president and Congress, the extended occupation of two foreign countries, and the most severe economic downturn since the Great Depression. Democrats proposed to reduce deficits by raising tax rates on the very highest incomes and phasing out spending for the wars in Iraq and Afghanistan. By 2013 that program had been implemented, yet the White House continued to estimate federal funds borrowing in fiscal year 2014 of more than $800 billion, about $5,000 per employed American and 30 percent of federal funds spending.
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T
HE
L
IMIT OF
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NCOME
T
AXATION

The federal personal income tax has generated revenue amounting to a remarkably stable level of national income since the end of the Korean War in 1953. Since then, Americans have paid personal income taxes within a range between 6.7 percent (in 1965) and 9.5 percent (in 2000) of national income.
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Personal income tax revenues in fiscal year 2014 are projected to be 8.1 percent of national income, in line with the post-1953 average.
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Personal income tax revenues expressed as a percent of reported gross taxable income—the top line of tax returns—has also fallen in a relatively stable range between 11.6 percent (in 1954) to 15.1 (in 2000).
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The average has been about 13 percent of gross taxable income.

There has been some political barrier, reflecting public opinion, when personal income taxation approaches 10 percent of national income. President Franklin Roosevelt insisted on higher personal income tax revenues than that when he vetoed a tax bill in 1944. Congress easily overrode that veto even though Americans at the time were willing to make enormous sacrifices in support of the war effort.

Federal personal income taxes have always been based on the ability to pay. So a personal income tax that yields 10 percent of national income and 15 percent or so of gross taxable personal income (before deductions) signifies much higher tax rates applicable to high incomes. Five percent of households with the greatest taxable incomes in 2010—6.7 million households out of 135 million filing returns—earned a third of adjusted gross income and paid three-fifths of all federal income taxes.
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When they are allocated a portion of the corporate income tax based on their share of capital income, in 2009 that top 5 percent paid 27.9 percent of all their income in federal income taxes.
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Marginal tax rates on earned income are much higher, even excluding the burden of federal payroll taxes or state and local taxes.

The Affordable Care Act of 2010 and the Taxpayer Relief Act (passed on January 1, 2013) raised the marginal tax rates on earned income for Americans in the highest income bracket to over 40 percent (39.6 percent on earned income, plus an extra .9 percent for Medicare, plus the impact of a phaseout of various deductions).
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Some view higher tax rates for the “top 1 percent” as class warfare, while others consider them long overdue. Regardless of one’s perspective, federal funds revenues will continue to cover only 70 percent of federal funds spending in fiscal year 2014.

Tax rates well above the mid-30 percent range will inevitably incentivize activity designed to defer or reduce taxes. Investors can postpone selling investments for a gain, and a tax system that imposes extraordinary penalties on the sale and reinvestment of capital impairs the efficient allocation of capital. No nation can tax business income made and reinvested in another nation, a fact particularly important in a world of mobile capital. To avoid these and other unintended effects on investment decisions, the United States and other nations tax investment income at lower rates than those applied to salaries and wages. That pragmatic policy, in turn, limits the ability to tax earned income at vastly higher rates without creating artificial incentives to convert income from fees or salaries into equity. The limit on efficient taxation of domestic investment income also implies some upper limit on taxation of earned income, since most people consider it unfair to tax income from salaries at double the rate applied to investment income.

The persistent gap between spending and revenues is unlikely to be closed by higher corporate taxation. Corporate tax revenues as a share of national income steadily diminished between 1953 and 1983. Since 1983 those revenues have leveled out to within half a percent above or below an average of slightly more than 2 percent of national income.
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Corporate tax revenues are estimated to yield 2 percent of national income in 2014.
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The decline in the contribution of corporate tax revenues from pre-1983 levels results largely from the effect of international competition for investment and the necessary ability of corporations to substitute debt for equity in their capital structures.

By 2012 income after taxes of US-based corporations accounted for roughly 10 percent of national income, the highest level since shortly after World War II.
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That amount, however, includes record earnings of US-based corporations from foreign operations not subject to federal taxation if reinvested abroad. The United States cannot stop other nations from setting tax rates that attract production facilities and corporate headquarters; it cannot even prevent its own states from competing against one other using tax breaks. When the federal government has tried to capture more foreign income by taxing corporate profits brought back into the United States, it has unintentionally discouraged the domestic reinvestment of those profits. Today the practical desire to attract greater domestic investment fosters far more pressure to lower corporate tax rates than to raise them.

If personal income tax revenues remain below their post-1953 high of 10 percent of national income, and corporate tax revenues remain at their thirty-year average of 2 percent of national income, then—even with other existing taxes—it will be difficult for federal funds revenues to return to or exceed the level of 13.3 percent of national income obtained in 2000. In light of rising expenses for medical services and interest on the debt, federal funds revenue of less than 13.3 percent of national income is unlikely to cover the cost of maintaining existing levels of national security and all other federal services. (That level of federal taxation could, however, cover those costs without the interest expenses on prior debt, most of which was incurred after 2000.)

T
AX
R
EFORM
?

Federal income tax law has often been reformed. Another round of tax reform may be desirable for a variety of reasons, but it is unlikely to close the budget gap. The word “reform” connotes improvement—generally greater simplicity and fairness. Those concepts are attractive and polls show that the public likes “tax reform” far better than a “tax increase.”

New members of Congress quickly find out that simplification and fairness often conflict. For example, some tax reformers seek to simplify tax reporting by reducing the number of tax brackets. On close examination, however, greater gaps between the tax rates applicable to adjacent income tax brackets do not seem more equitable and taxpayers will still need calculators to fill out tax forms. A “flat tax” system, or at least one with fewer rates and a lower top rate, seems simpler but less fair when tax rates applied to lower income brackets must rise in order to replace the loss in revenue from a lower top rate.

Federal personal income taxation has always been based on the ability to pay. A standard deduction eliminated taxes on the lowest incomes and higher tax rates applied to higher incomes. A majority of citizens support the principle of ability to pay and voters are unlikely to change their views in the wake of several decades in which taxpayers with the highest incomes have fared better than other Americans. The average taxable income of one-fifth of taxpayers filing tax returns with the lowest income was $23,500 in 2009, compared to $17,400 in inflation-adjusted dollars thirty years earlier.
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Americans making $23,500 will hardly consider it fair to increase their income tax rate in order to lower rates applicable to higher incomes.
And their share of national income is so small that the additional tax revenues will do very little to close the budget gap.