This post is an abbreviated version of a recent presentation to the League of Women Voters of San Juan County, Washington. You will find a link to the slideshow version at the end of the post.
The question we most often hear about taxes is, are they too high, or too low? The answer to both questions is YES. How can that be?
Taxes are too high in the sense that they distort the decisions made by households and businesses. At the same time, they are too low in the sense that they do not bring in enough revenue to pay for government as we know it. We cannot continue to operate the government that way.
Economists measure the sustainability of the federal budget in terms of the cyclically adjusted primary balance (CAPB). That is the deficit or surplus averaged over the business cycle, without including interest payments. To be sustainable, the CAPB should be near zero, or slightly in surplus.
As of 2011 the United States has a CAPB of -6.8 percent, the largest deficit of any developed country. That means we need to cut nearly 7% from the deficit, through spending cuts or tax increases, to achieve sustainability. Failing to do so will cause the government debt to grow out of control. We will inevitably end up like Greece, or worse. Not tomorrow maybe, but not in the far distant future, either.
Where to start? The first choice we have to make is, how big a government do we want? Opinions differ. Some people are happy with the size of federal government we have now. At 23 percent of GDP (cyclically adjusted), it is about the same size relative to the economy as in the 1980s, although it is larger than it was in that lucky period between the end of the cold war and the start of the wars in Iraq and Afghanistan. Others would like to cap total federal spending at 18% of GDP, about where it was in the last year of the Eisenhower administration. Economists can't answer the question of how big the government should be; only voters can.
Once we decide how big a government we want, we need a tax system that can pay for it. Our current tax system cannot do the job. Its tax rates are too high. They distort the decisons of consumers, savers, employers, producers, everyone.
What we need is tax reform that lowers tax rates and broadens the tax base.
One approach to tax reform is to lower marginal tax rates for everyone while eliminating loopholes. There are lots and lots of loopholes.
Another approach to tax reform is to replace existing taxes like payroll taxes and the corporate income tax that distort incentives, while replacing the lost revenue with broad-based taxes like energy taxes or value added taxes.
The bottom line: Tax reform is a must. It is good for liberals, it is good for conservatives. It should not be hard to find a compromise. Remember, continuing business as usual is NOT a viable option.
Follow this link to view or download the slideshow version of this presentation.