The budget deficit is deadly serious. Tax reform should be too.
Reforming the tax code is hard work, as President Bush might say. Thus, the President and his Advisory Panel on Federal Tax Reform are to be commended for issuing a sensible set of recommendations in November. But by declining to make deficit reduction the primary goal of tax reform, the administration did us all a serious disservice.
First, a rundown of what the Bush panel proposed: Following the formula that Ronald Reagan established with his tax cuts, the panel suggested that Congress reduce marginal income tax rates while creating a broader base of taxable income--in part by limiting the mortgage interest deduction and removing the deduction for state and local taxes.
The more ambitious of the two plans would reform corporate income taxes as well, by allowing companies to deduct all capital spending in the year the investment is made, though not interest on debt. This version would set the tax rate on capital gains and dividends at 15%--encouraging investment by companies and savings by individuals.
The consensus among economists is that either proposal would spur economic growth, though views differ on how significant the impact would be. Of course, politically speaking, neither of the recommendations is likely to be adopted in its present form, in large part because both target popular deductions for elimination.
The fact that the panel offered sensible but dead-on-arrival ideas isn't all that surprising, however. That's because, at the outset, the President forbade the reformers from looking at tax increases. This directive ignores the obvious: that, absent some revenue increases or drastic cutbacks in entitlement programs, the already uncomfortably large federal budget deficit will grow dramatically worse.
The projections, all from the nonpartisan Congressional Budget Office, are sobering. Today, federal revenue from all sources totals about 17.5% of gross domestic product, which is low by historical standards. Proponents of small government hail this as progress, but it's not really. That's because federal spending currently accounts for about 20% of GDP--hence the deficit. Twenty percent, by the way, is roughly the average of government spending over the past 40 years, and down a bit from the 1980s and early 1990s.
Look out several decades and the numbers get scarier. The CBO projects spending on Social Security, Medicare, and Medicaid benefits to rise from the current 8% of GDP to about 14% in 2030, 17% in 2050, and 21% by 2075. This assumes GDP grows at a rate of 3% per year, roughly the postwar average.
Add in record defense spending ($401.7 billion in fiscal 2005) and the cost of interest on mounting deficits, and if the budget remains the same--and if the tax cuts of recent years remain in effect--then the deficit will rise from 3% today to approximately 10% in 2030, 15% in 2050, and more than 20% in 2075. Argentina, here we come!
Yet despite the growing threat, too few policymakers discuss the problem in any meaningful and honest way. A good number of conservatives don't want to touch it because they can't tax-cut their way out of it, and they don't want to be accused of shredding antipoverty programs in the wake of Hurricane Katrina. Many liberals, meanwhile, refuse to entertain even modest cuts in entitlements and won't talk about new taxes for fear of being painted as unrepentant tax-and-spenders.
But eventually, as anyone who has had to meet a payroll realizes, the government must restore fiscal balance by cutting spending or raising revenue or some combination. Higher marginal income or corporate tax rates will discourage entrepreneurship, so we don't want that. The best solution, I think, is some sort of a consumption tax in the form of a direct sales tax or a value-added tax, on top of whatever progressive income tax we then have. This would promote more savings--and thus future investments--by small and big companies alike. As for entitlements, one clear sensible reform is a progressive deductible structure for Medicare benefits, something you are most likely already doing with your own company's medical benefits.
Given the likely failure of the Bush panel's reform proposals, the next President will probably convene a tax panel of his or her own. Here again, Reagan's example can be followed. Back in 1981, he tapped a savvy dealmaker to co-chair his tax reform panel: Alan Greenspan. By 2009, perhaps the outgoing Fed chief will be ready for a new challenge.
Robert E. Litan is a contributing editor, and a vice president at the Ewing Marion Kauffman Foundation in Kansas City.