America's Fiscal Constitution (67 page)

It also seems unreasonable to believe—as some tax reformers do—that all corporations should pay the same amount of taxes in any year in which they have the same pretax income as calculated using standard financial accounting. Corporate income statements do not account for losses in prior years or higher costs of equity in industries with large and recurrent capital expenditures that consistently reduce annual cash flow available to investors.

Tax reform is often the banner for efforts to raise tax revenues by reducing exclusions and deductions. That approach was recommended in 2010 by a majority of the members on the National Commission on Fiscal Responsibility and Reform (Simpson-Bowles) and is typical of many balanced budget plans crafted by unelected experts. Simple math accounts for the interest in plans to raise revenue without raising tax rates: only 60 percent of national income—as estimated by economists—qualifies as gross income subject to personal taxation, and less than that is taxable after deductions.

Yet—since the refinement in the income tax system in the decade following increased the passage of the Revenue Act of 1917—tax reform has rarely raised revenue. People have strong and reasonable disagreements about what should be treated as a loophole or “tax expenditure.” Most taxpayers consider it unfair to pay taxes on some categories of income—as defined by economists—that are not readily available for payment of taxes. That includes the largest categories of exclusions from personal income taxation, which were designed to encourage investments for retirement and the availability of employer-based health insurance. A nation that saves too little will hesitate to raise taxes on savings that are not available to taxpayers until retirement. A government that borrows too much for federal medical services will be reluctant to reduce the attraction of employer-based health insurance.

Without a doubt, some aspects of tax law are difficult to justify with an economic rationale; the stepped-up basis on capital gains at the time of death comes to mind. That fact does not mean that most exclusions or deductions are poorly conceived “tax expenditures.” Consider, for example, the case of a person earning $30,000 a year who works for an employer who self-insures employee medical expenses. After she is injured in a fall at home, her employer pays $10,000 in medical bills. A tax reform purist may call it a “tax expenditure” because she does not owe income taxes on
the $10,000 in “noncash compensation” paid by her employer. Most voters, for good reason, would not view it in that way.

Many budget experts advocate the adoption of a new form of taxation. Often their attention turns to some type of consumption or sales tax, since most economists agree that taxes on consumption restrict economic growth less than do taxes on work and investment. Other nations typically rely more heavily than the United States does on consumption taxes, rebated for exports, to support government outlays.

It exceeds the scope of this book to weigh the merits or probablility of a new tax system. A new tax system can raise new revenues, but the United States has only replaced its tax regime in response to the fiscal exigency of war.

Expansive claims of benefits from a new consumption tax system warrant skepticism. The complexity of the current federal tax system results in part from the fact that it has already become a hybrid system of income and consumption taxation. A government can tax consumption by imposing taxes at a point of sale or by taxing income used for consumption. The current system has many features of the latter type of consumption taxation. Gains in the value of property or investments are not taxed as income until sale. Income earned on certain retirement savings and pension earnings is not taxed until distribution. Taxpayers can deduct some income not available for consumption, such as the amounts paid for state and local taxes or contributed to charity. The value of nontaxable employer-based medical insurance is unavailable for consumption except to respond to medical needs. No wonder that most advocates of a federal sales or value-added tax propose that these taxes replace a portion of the federal income tax. Substitution of one tax for another has never raised federal revenues.

Voters have complained to the people they elected to Congress about the federal income tax system. Congress frequently amends tax law. All tax law has been passed with a majority vote of the House and Senate and received a presidential signature. Anyone who believes lobbyists have coerced powerful members of Congress to relinquish large streams of federal revenue has little idea about how Congress actually works. Lobbyists are afraid of long-serving incumbents, not vice versa. Elected members of tax-writing committees, and their expert staffs, have considered every conceivable idea for tax reform. Every tax discourages something, and no one likes to pay. Federal tax law can and will be improved. But the vision
that much greater revenue will be gathered from picking the low-hanging fruit of “reform” rather than by “raising taxes” may be a mirage. The most pressing tax reform of all would be the reduction in the use of taxation hidden by deferral, in the form of debt, to fund routine spending.

The federal government has most effectively raised taxes to pay for its spending when federal leaders clearly tell voters what the nation can and cannot afford with additional revenues.

For example, the previous chapter described the merits of “pay as you go” Medicare. Merely dedicating existing income tax revenue to Medicare cannot fund the program without creating a hole of an equivalent size somewhere else in the budget. In light of the reasonable limits on corporate and personal income taxation, suppose the president and Congress considered adjusting Medicare benefits to a level fully funded with a higher payroll tax. The Medicare payroll tax is now the broadest form of federal taxation, covering 2.9 percent of income from salaries, wages, and investments, and 3.8 percent of all income above $250,000 for a couple filing jointly. Though some progressives criticize the Medicare tax for not applying even higher rates for high incomes, they should recognize that taxpayers cannot deduct payroll tax from the income subject to taxation, so Americans pay twice on income subject to the Medicare tax: first through payroll withholding and then by application of a progressive personal income tax.

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HE
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OLE OF THE
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EDERAL
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ESERVE

The Federal Reserve can play a constructive role in the future—as it has at times in the past—in restoring the American Fiscal Tradition. Though many people complain about the power of the Federal Reserve, it has earned credibility in financial markets. The independence of the Federal Reserve has evolved into a part of the nation’s unwritten constitution.

In 1977 Congress mandated that the Federal Reserve foster economic growth “so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”
¹²
Restoration of the American Fiscal Tradition will complement the Federal Reserve’s ability to discharge those responsibilities. Excessive debt can jeopardize long-term employment growth and moderate interest rates. Price stability could be threatened if a run on federal debt forced the Federal Reserve to monetize large amounts suddenly.

Rising levels of debt held by foreign creditors potentially weaken the effectiveness of the Federal Reserve’s open market transactions, an indispensable tool it uses to accomplish its mandated mission. Foreign creditors could, in essence, implement a competing monetary policy through market sales or purchases of large holdings of Treasury debt.

Members of Congress often complain about pressure from the Federal Reserve to balance budgets, but they do at times lean on external constraints when justifying hard decisions. Citizens concerned about the nation’s fiscal future should rally to defend the independence of the Federal Reserve when it is attacked for “meddling” in budget politics with actions that support fiscal discipline.

The monetization of some amount of debt by the Federal Reserve might play a role in creating a realistic and durable plan to balance the budget. Monetized debt reduces the net cost of debt service.

The dollar’s status as an international store of value and medium of exchange can at times give the Federal Reserve the ability to monetize some amount of debt without destabilizing consumer pricing. Conservatives who resist higher taxation should think carefully about their opposition to monetization in the form of “quantitative easing.” It may make more sense to retire a portion of the debt from the two recent wars and a severe downturn by monetization rather than raising a corresponding amount of tax revenue or watching the central banks of other nations monetize that debt. Obviously the extent of monetization must be tempered by careful analysis of the risks of inflation. Yet the options available with $17 trillion in federal debt are not optimal.

23

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EFORMING THE
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OLITICAL
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ARTIES

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EFORMING THE
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The political environment is right for Democratic and Republican voters, activists, and candidates who are willing to fight to restore their parties’ traditional fiscal discipline. Fear, as much as courage, gave generations of federal elected officials the will to balance budgets. “Pay as you go” has always been popular. The principle reflects the public’s desire to preserve opportunities for the future and maintain national independence.

Elected officials who were unable to balance peacetime budgets still labored to demonstrate their commitment to the American Fiscal Tradition. For example, the vast majority of Franklin Roosevelt’s record 635 vetoes were designed to restrain debt-financed spending. Public loathing of debt still compels many members of Congress to vote against increasing the debt ceiling even to pay for appropriations that they previously voted for.

Candidates who address debt forthrightly can command national attention. When sounding the alarm on the risks of debt in 1992, H. Ross Perot compared federal debt to “a crazy aunt” well known to neighbors but whom “nobody wants to talk about.”
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When Perot talked about debt and vowed to balance the budget, Americans listened to him.

Bipartisan support for balanced budgets need not diminish partisan competition on issues such as the level and nature of federal taxation, the strength of the social safety net, and the scope of American commitments abroad. For example, as leaders of both major parties embraced the
balanced budget in the years following World War II, they fought with bare fists concerning the federal regulation of labor–management relations.

Americans still believe in the values underlying their nation’s traditional fiscal constitution. In 2013 a phenomenal 74 percent of Americans were “very worried” about the impact of foreign holders of federal debt.
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Other polling showed that Americans opposed an increase in the debt ceiling based on concerns about the nation’s future.
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Large political changes can occur within the span of one or two election cycles. Because of the math of compound interest, the nation cannot wait for a decade before reformers in each party fight to restore fiscal discipline.

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IGHT FOR
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EMOCRATIC
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UDGET
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EFORMERS

All but one Democratic president who left office with a strong peacetime economy managed to balance the budget. Franklin Roosevelt believed in the progressive ideal of social insurance, but only if it could be paid for with broad-based taxation. Harry Truman, the last president to proudly identify himself as a “liberal,” insisted on submitting budgets with spending confined to estimated tax revenues. The Clinton administration balanced the budget and proposed a plan to earmark surpluses to fund social insurance for Baby Boomers. President Barack Obama reminded Democrats that “if we truly believe in a progressive vision of our society, we have an obligation to prove that we can afford our commitments.”
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Too often since 2001, however, many Democrats have been content to preserve federal programs they cared about rather than insisting that spending be limited to the available revenues. As a result, future funding for domestic priorities such as education will have to be cut to make room for higher interest payments. Democrats allowed Republicans to reduce taxes without forcing them to pay the electoral price of making corresponding cuts in national defense, Medicare, law enforcement, and many other federal programs with a broad base of public support. By failing to explicitly link tax cuts and spending cuts, Democratic leaders reinforced the stereotype that they somehow like taxes.

Democratic leaders strayed from their party’s heritage when they acquiesced to the use of debt to finance Medicare after 2000. The Medicare bill passed in 1965 was intended to be financed primarily with a sustainable combination of premiums and dedicated payroll taxes. Progressives
championed the idea of social insurance programs financed by broad-based taxation—proportionate to income—of the ultimate beneficiaries. The Democratic national platform adopted the year before Medicare passed expressed a traditional progressive goal: “a balanced budget within a balanced economy.”
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In 2000 President Clinton and presidential candidate Al Gore sought to assign more revenue from existing taxes to the trust funds to reduce the risk of future borrowing to sustain Medicare benefits. Democrats, including Barack Obama, repeatedly criticized the Bush administration’s use of debt to pay for Medicare Part D.