The Price of Civilization: Reawakening American Virtue and Prosperity (31 page)

The real point for us is that despite America’s vast natural resource advantages, it has actually ended up with a
lower
average quality of life in many ways than in northern Europe. Yes, America’s GDP per capita is higher, but it is not bringing widespread benefits for the society. To ensure that the benefits reach more of society, the United States will have to invest more in public outlays for education, infrastructure, and the other priorities that I’ve identified.

Budget Choices in a Federal System

Americans will surely need to pay higher taxes to balance the budget and “pay for civilization.” Yet another thought arises: why not allow tax and spend decisions to be made at the state and local level? Areas that would like to provide more public goods could do so, and areas that are averse to public goods could organize their states and cities as they see fit. To some extent, of course, this already happens. The federal government accounts for about 65 percent of total revenues, while state and local governments account for 35 percent.
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There is a huge variation in taxes per citizen across the states. My own state of New York has an income tax that rises to a top rate of 9 percent, and New York City adds another 2.9 percent. The state sales tax rate is 4 percent, plus another 4.875 percent in the city. New Hampshire, by contrast, has neither an income tax nor a sales tax.
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Economists use the concept of “fiscal federalism” to denote the situation in the United States, Canada, China, India, and elsewhere, in which governments at the national, state (or provincial), and local level have their own tax collections and separate provision of public goods. The system may include collection of revenue at one level
of government and its transfer to another, such as when the federal government collects revenues and then returns them to the states as block grants to administer various programs. The question then arises as to the appropriate levels for collecting revenues and providing public goods and services. Why not, for example, simply leave the decisions to the most local level and thereby allow maximum freedom of choice? There are three reasons.

First, certain public goods are best provided at a higher level of government. National defense, clearly, should depend on the federal government, not the fifty states. Some are clearly the responsibility of governments at all levels, such as planning and implementing the national highway system or a national power grid. In these cases, indeed, the situation is even more complex because the goods and services involve the private sector alongside multiple levels of government.

Second, there is a collective action problem that makes tax collection more convenient at the higher level of government, that is, at the federal level rather than the state and local level. The fifty states are in competition with one another for businesses and wealthy citizens. By keeping its tax rates just a bit lower than the others’, each state can attract business and revenues. Yet the result is a race to the bottom, as described for the global economy in tax competition between nations. Each of the fifty states shaves the tax rate to entice business to come over the state border, until all of the states together are starved for cash. The race to the bottom among the states can be obviated in part by a unified federal tax collection that is then returned to the states so that they can implement programs that are tailored to each state’s needs.

Third, the differential provision of public goods in different jurisdictions leads to mobility of households as they sort themselves in response to the changing tax and spending conditions of the state and local governments. In part this is exactly what is desired. Economists have long studied a conceptual model in which sorting allows each household to choose just the spot where it would like to live: the place that delivers just the right combination of parks, good schools,
public concerts, and other amenities, balanced by high or low tax collections as needed to supply that level of public goods. The result is a “Tiebout equilibrium,” named after the economist Charles Tiebout, who first proposed it.
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In some cases this sorting can work well, but there are obvious reasons why it can create enormous trouble. If one jurisdiction decides to provide more generous help for the poor, it ends up being flooded by low-income residents in just the same way that businesses and wealthy individuals flee from high-tax jurisdictions. Once again, there is a race to the bottom when it comes to supporting the poor, which is a public function that should be shared across the society, not a small part of it. Similarly, the sorting will tend to lead to segregation by income, as rich households move to affluent jurisdictions in search of good schools and other public amenities. Land prices and property taxes increase, squeezing poorer families out of the more affluent communities. The society divides between rich communities and poor communities, with reduced spillovers and contacts between the various parts of society. This can leave the poor trapped in poverty, resulting in a massive loss of well-being not only for the poor but also for the rich, who end up absorbing the indirect costs of poverty (in terms of lower worker productivity, higher crime rates, larger transfer programs, more political instability, and so forth). The point is that when there are spillovers in human capital, the sorting of the population across local jurisdictions can be disadvantageous for the entire society, rich and poor alike. The solution is an adequate provision of public goods across the entire society by the federal government, as a backstop to local financing and local provision of services.

The upshot of these considerations is that local governments are often the most effective providers of public goods such as schooling, public health, and local infrastructure (roads, water and sewerage, and other systems), since these programs are best tailored to local needs. At the same time, the federal government should supplement local financing by collecting federal taxes and transferring them to
state and local governments for local implementation. The famous
subsidiarity principle
should in general determine the level of government best suited for implementation. The subsidiarity principle holds that the public good should be provided by the lowest level of government that is competent to provide it, for example, schools at the local level, major roads at the state level, national highways and national defense at the federal level. Americans, quite rightly, strongly endorse subsidiarity. A robust 70 percent of Americans endorse the view that “the federal government should run only those things that cannot be run at the local level.”
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Here’s the bottom line. Currently the United States collects around 18 percent of GDP in tax revenues at the federal level and another 12 percent of GDP at the state and local levels. Washington currently returns around 4 percent of GDP in tax revenues to the states to implement health, education, and infrastructure programs at the state and local levels.
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To close the budget deficit and implement needed new spending programs, the United States will have to raise overall tax revenues by several additional percentage points of GDP. I am suggesting that, to the maximum extent feasible, the new spending programs—for education, early childhood development, infrastructure, and so forth—should be implemented at the state and local levels using increased taxes collected by Washington but then returned to the individual states for program design and implementation.

Time for the Rich to Pay Their Due

With a chronic budget deficit of around 6 percent of GDP, tax revenues will have to rise. It is high time that super-rich taxpayers picked up much of this cost. The top 1 percent of American households now collects around 21 percent of household income, which amounts to around 15 percent of GDP. These households pay roughly 31 percent of their income in federal taxes, so that their net-of-federal-tax income is around 10 percent of GDP. In 1970, the
top 1 percent collected around 9 percent of household income, or 6 percent of GDP, and paid roughly 47 percent of that in federal taxes, for a net-of-federal-tax income of around 3.3 percent of GDP. The post-tax income of the richest 1 percent of the population has therefore increased by more than 6 percentage points of GDP since 1970.
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Most of the population has been squeezed, while the rich have enjoyed a bonanza. It’s time once again for those at the top to contribute more to solving the nation’s problems.

The first step of the solution would be to end the Bush tax cuts for households above $250,000. The top tax rate would rise from 35 to 39.6 percent. This would collect an additional 0.5 percent of GDP. That’s a necessary start but by far not sufficient to close the budget deficit. To collect even more revenue, the top rate could be lifted above 39.6 percent, as it is in many European countries.

Even without raising the top rate above 39.6 percent, however, another 0.5 percent of GDP or so could be collected by closing a series of tax loopholes that now benefit the rich. For example, capital gains are currently taxed far below regular income, and the deficit commission called for capital gains taxes to be raised to the level of regular income (albeit with a drop in the tax rate of regular income). Mortgage interest is tax-deductible even for mansions and second homes. This deduction could be restricted to a single residence, with a cap on the size of the tax-deductible mortgage. Expensive health care insurance purchased by the rich is now fully tax-deductible and should be subject to a ceiling on the tax deductibility. Hedge fund managers, some of the world’s richest people, are actually taxed at only 15 percent of their income through a loophole that is least justified of all. Congress and the president should gather the courage to tell their billionaire contributors that they too will have to pay income taxes at normal rates.

Another part of the solution might be to tax some of the massive accumulated wealth of the rich. The top 1 percent of wealth holders owns around 35 percent of the nation’s total wealth, which is roughly equal to the wealth of the bottom 90 percent of the population.
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According to the latest wealth data of the Federal Reserve Board in the Flow of Funds, the total net worth of households is around $56.8 trillion.
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The wealth of the top 1 percent is therefore around $20.6 trillion. With roughly 113 million households, the average wealth of the richest 1 percent is roughly $18.2 million per household. Suppose that we levy a tax on the net worth
above
$5 million per household, so that the average tax base would be roughly $13.2 million per household ($18.2 million minus $5 million), for a total tax base of $14.9 trillion. A tax of merely 1 percent on net worth above $5 million per household would therefore collect around $150 billion, or 1 percent of GDP.

The combination of higher income taxation and wealth taxation would thereby raise at least 2 percentage points of GDP from the very top earners. But even if they had to pay another 2 percent of GDP, there would certainly be no need to shed tears for the rich. Their net-of-tax income would remain around 10 percent of GDP, a share of national income two-thirds higher than the 6 percent of GDP in 1980.

There are still other approaches to raising taxes on top earners and those engaged in tax evasion. The corporate income tax is now a sieve, with so many loopholes and ways to shelter income in foreign tax havens that the tax collection has declined from around 3.5 percent of GDP in the 1960s to around 1.5 percent of GDP now. By tightening the rules on foreign income and other loopholes, it should be possible to raise another 1 percentage point of GDP. Such a tax would be borne largely by the top wealth holders, who are the predominant shareholders. Of course, the current global political dynamic is to cut corporate taxes rather than to raise them, as part of a race to the bottom being played by the leading economies, even though virtually all economies would benefit by collecting higher corporate tax payments. International coordination in corporate tax policies among the major economies (such as the G20) could therefore be a boon for all countries by enabling each country to hold the line against tax cuts made in competition with other governments.

Curbing tax evasion is another route to added revenues. In a very detailed study of 2001 tax returns, the IRS concluded that there was a “tax gap” of roughly $345 billion (implying a noncompliance rate of 16 percent of taxes owed).
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Around $55 billion of that nonpayment was clawed back by the IRS through enforcement processes, leaving a net underpayment of taxes of roughly $290 billion, equal to almost 3 percent of GDP in taxes not paid. The single greatest cause is the underreporting of personal income from business activities, especially from nonfarm proprietorships and various kinds of partnership income. Tightening tax compliance through a variety of means could likely reduce the underreporting by perhaps 0.5 to 1 percent of GDP (a not inconsiderable $75 billion to $150 billion per year).

Yet another way to raise revenues would be higher taxes on oil, gas, and coal, both to collect more revenues and to help shift energy demand to low-carbon sources for both climate and national security reasons. A rough calculation shows that a price of about $25 per ton of CO
₂
emitted, equivalent to roughly 2.5 cents per kilowatt-hour of electricity and 25 cents per gallon of gasoline, would collect around 1 percent of GDP in revenues per year. As I explained earlier, the fossil fuel tax could be phased in over several years, even decades, in line with the gradual transition to a low-carbon economy.

The United States is absolutely ripe for a rise in gasoline taxes. The nominal gasoline excise tax rate has been fixed at 18.4 cents per gallon since 1994.
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Inflation alone has reduced the real value of that tax per gallon by around 30 percent. As with other federal tax rates, the U.S. excise tax rate on gasoline is extremely low by international comparison. We might conservatively assume that by 2015 an extra 0.5 percent of GDP could be collected by some combination of a higher gasoline excise tax and modest carbon levies on other fossil fuels (such as on coal at the utilities).