Don't let it get away!
Help yourself with the Fool's FREE and easy new watchlist service today.
Thomas F. Cooley is the Paganelli-Bull Professor of Economics at the Leonard N. Stern School of Business at New York University. He spearheaded a collaborative research and policy initiative, Restoring Financial Stability: How to Repair a Failed System. He also writes a weekly opinion column for Forbes.com and is a member of the Council on Foreign Relations.
President Barack Obama campaigned on the pledge that he would not raise taxes on the middle class. If you believed that, I have some bad news for you (if you haven't figured it out on your own). President Obama's promise is unsustainable. Virtually every individual and every investor will face higher taxes. There is an inevitability about this because his economic program is not fiscally sustainable. I can also tell you the form the taxes will take.
First, a few facts
Last fall, the U.S. Treasury closed the books on fiscal 2009, and the news was not good. The fiscal deficit for the year was $1.4 trillion dollars -- an increase of more than $960 billion over fiscal 2008. In a $14 trillion dollar economy that represents 10% of GDP. The Congressional Budget Office (CBO) -- the independent agency that provides non-partisan evaluation of the budgetary implications of various initiatives -- estimates that if current policies stay in place, the 2010 deficit will be slightly smaller at $1.3 trillion, but the total outstanding debt held by the public at the end of 2010 will be 60% of GDP -- the highest it has been since 1952.
The longer-term projection is equally grim. In the CBO's baseline projections, by 2020 the annual interest on the debt will be more than $700 billion. These facts should seriously temper any euphoria over the recent turnaround in GDP growth and the improvements in the U.S. economy because they will constitute an enormous drag on the economy. Simply stated, we are spending our way into a very big problem.
Consider the following picture of government revenues and outlays as a percentage of GDP (care of the CBO):
The dashed vertical line shows where we are right now (end of government fiscal year 2009). Everything beyond that is a projection (read: wishful thinking) based on these assumptions -- no new spending programs, expiration of the Bush tax cuts, no more adjustments to the Alternative Minimum Tax, and very optimistic assumptions about economic growth over the next decade. Even with these assumptions, it is not a sustainable path.
The administration has painted itself into a very difficult corner. It has dramatically increased spending and it has refused to acknowledge that its commitment to not raise taxes on taxpayers earning $250,000 or less is not sustainable. We are borrowing like crazy, just as we have been for the past decade -- the difference is that it is now the government that is levered to the hilt, not the private sector.
This is a bleak picture indeed, but there is some good news to go with it. As economic theory would lead us to expect, the savings rate in the U.S. has increased in response to the huge deficits. Private savings can offset the public dissaving up to a point.
The other good news is that the U.S. dollar is and will continue to be the world's reserve currency. Why is that good news? It means that the U.S. can run a persistent current account deficit because other countries need dollars for reserves. This is why we find it easy -- even now with staggering deficits -- to sell U.S. Treasuries at low interest rates. In response to the financial crisis last year there was a flight to the safety of U.S. Treasury obligations. That reaffirmed the world's belief in the long-term credibility of the U.S.
But, here is the rub: that credibility is not assured to last forever. In order to continue to do this and fund our deficit, we have to be perceived to be on a sustainable fiscal path. Exactly what constitutes a sustainable path can be hard to define. Market participants have to be confident that in the long run, revenues and outlays are moving closer to one another and will not be characterized by a gap that is increasing ad-infinitum. Stated simply, the government needs to spend less and collect more revenue.
What are the options?
As the economy improves, receipts will increase, but it will take a very robust recovery to make even a small dent in the gap. That leaves tax rates and spending cuts as the main levers to restore sustainability. And, how credible is it to assume that they will confront the problem by decreasing spending? The feeding frenzy of special political interests that erupted around the stimulus package ought to answer that question.
That leaves raising taxes. Rather than confront the problem directly as the Office of Management and Budget should do, the president has sought pseudo bi-partisan cover by creating a Commission on the deficit to study the problem. The commission will conclude that the best way to close the budget gap is with a value added tax (VAT) -- a tax levied at each stage of production on the value added at that stage. Think of it as a stealth sales tax.
Value added taxes can be a good fiscal tool. They are less distorting than other taxes, so if they substitute for other taxes that can be a good thing. But they have one huge drawback: Once they are in place they can be increased with a stroke of the budgetary pen. They become an ATM machine for spendthrift politicians. Europe has relied heavily on VAT for decades. Average rates in the E.U. are around 20%, but they can be much higher. In Germany, they started out at 4% but are now at 19%.
If we end up addressing our fiscal problems with a value added tax without cutting some other tax rates and spending, we will be on a very slippery fiscal slope. Credibility is something that is very easy to lose with irresponsible fiscal policy, and very, very hard to rebuild once it is lost. Right now it is leaking away.
Thomas F. Cooley thinks taxes are going up soon via a value added tax. What do you think? Share your thoughts in the comments box below.