Looming Budget Deficits: Can Tax Reform Help?

American Council for Capital Formation
June 1996
By Margo Thorning

BACKGROUND

Although the short-term outlook for the U.S. economy suggests continued moderate growth in the range of 2.0 percent, and employment data are encouraging (348,000 new jobs created in the month of May 1996), a new Congressional Budget Office (CBO) report concludes that this country's long-term strength and economic stability depend on making policy changes to ensure that the economy does not sink in a sea of red ink as the baby boomers begin to retire.¹

Remedying the fiscal dilemma described in the CBO report will require changes in the rate of growth of expenditures as well as measures to stimulate saving, investment, and economic growth. Tax reform and partial social security privatization could be important tools as we seek to ensure a strong economy in the twenty-first century.

THE CBO LONG-TERM BUDGET OUTLOOK

According to the CBO report, long-term U.S. prosperity is threatened by the prospect of looming budget deficits in the twenty-first century. These deficits, which become increasingly onerous after 2010, would challenge long-term U.S. political stability. CBO's gloomy assessment of the U.S. budget and deficit outlook stems from its analysis of trends in: (1) the aging of the U.S. population; (2) the slowing of labor force growth; and (3) rapid growth in federal health care expenditures and social security benefits.

Aging of the U.S. Population

Two factors help explain the predicted increase in the number of elderly: the huge baby boom generation is aging and people as a whole are living longer. Baby boomers will start to retire around 2010, when they will increasingly begin to draw benefits from the government's three biggest entitlement programs-Medicare, Medicaid, and Social Security. At the same time, the growth of government revenues will slow because the proportion of people working and paying taxes will shrink. As a result, budget deficits will start to mount rapidly.

Consequently, the CBO report notes, over the next several decades, each worker's taxes will have to support a growing number of retirees. Currently, five workers support each retiree; by 2030, less than three workers will support each retiree.

Slowing of Labor Force Growth

Labor force growth will slow significantly when the baby boomers retire because of the decline in the birth rate that began in the mid-1960s. In addition, women's labor force participation rates, which escalated sharply in the 1970s and 1980s, are likely to grow less rapidly in the future as the participation rate of women approaches that of men. The Social Security Administration projects that the average rate of growth of the labor force will slow from the 1.9 percent per year it achieved from 1960 to 1989 to 0.9 percent annually for the 1989-2010 period and 0.2 percent between 2010 and 2050.

Rapid Increase in Health Benefits

As the CBO report notes, rapidly rising expenditures per beneficiary in the Medicare and Medicaid programs will present a particularly serious challenge to the federal budget in coming years unless significant steps are taken to reduce their rate of growth. Federal spending for health care has been growing at a fast pace for many years. Over the past decade, expenditures for Medicare have increased at an annual rate of about 10 percent; Medicaid spending has risen at a rate of about 15 percent. Although some of that growth comes from an expansion in the number of beneficiaries, most of it is attributable to continuing increases in expenditures per beneficiary at rates well in excess of inflation.

Over the next decade, federal spending per enrollee in Medicare and Medicaid will increase at more than twice the rate of inflation, according to the CBO report. With such growth, Medicare and Medicaid spending absorb an increasing share of national income, from 1.3 percent of GDP in fiscal year 1975 to 3.7 percent in 1995, rising to 5.9 percent in 2006.

Rise in Social Security Benefits

Both the outlay and revenue sides of the federal ledger will be strained as the ratio of workers to retirees deteriorates. Outlays for Social Security benefits will rise substantially as the number of people eligible to receive those benefits surges. At the same time, revenues will be pinched because the number of people working and paying taxes will grow more slowly. Many scholars, including John Shoven, Dean of Stanford University's School of Humanities and Sciences and member of the ACCF Center for Policy Research Board of Scholars, have focused on the fact that our current unfunded system will run out of money to pay benefits to the then-retired baby boomers sometime around 2030 (see Figure 1). The looming bankruptcy of the Social Security system, absent sharp increases in payroll taxes or equally sharp cutbacks in benefits, is a serious challenge to U.S. political and economic stability.

Figure 1	Projected OASDI Trust Fund Accumulations (current dollars)
Source: Presentation by John Shoven, Dean, School of Humanities and Sciences, Stanford University, at the Investment Company Institute's Board of Governors Meeting, Palm Beach, January 31, 1996.

LONG-TERM IMPACT OF AN AGING U.S. POPULATION

In its study, CBO analyzes the long-term impact of making no changes to current U.S. budget policy. To allow for different budget paths, CBO prepared two sets of projections. One assumes that discretionary programs after 2006 will grow at the rate of inflation, which holds their real value constant in today's dollars. The other assumes that discretionary programs will keep pace with the growth of the economy, which allows the amount spent on the discretionary accounts to rise with both inflation and real economic growth. Holding the growth of discretionary programs to the rate of inflation-rather than letting them grow with the economy-implies that spending for those programs as a share of GDP would decline over the projection period, the CBO report notes.

The CBO model also makes provision for the way the nation's debt (the total amount that the government explicitly owes) interacts with the economy. Federal deficits crowd out capital investment, which slows economic growth and raises interest rates. As a result, tax revenues decline, and the cost of servicing the debt goes up. Those economic feedbacks between the deficit and the economy can significantly increase the size of the deficit.

To identify the contribution of those feedback effects, CBO presents its long-term analysis in two parts. The first assumes that the deficit has no effect on the economy; the second includes the feedbacks between the two.

Results Without Feedback Effects

Even without the feedback effects, the outlook for the budget deficit is gloomy in the early decades of the twenty-first century, the CBO study concludes. Without changes in budget policy, the deficit would increase to relatively high levels by 2030. Under either assumption about discretionary spending (that it rises either with the rate of inflation or at the same rate as the economy), the deficit would climb from 2 percent of GDP in 1995 to between 12 percent and 15 percent in 2030 (see Table 1). Moreover, the deficit would continue to rise rapidly in the years thereafter, surging to between 19 and 24 percent of GDP in 2050.

In turn, the total amount that the government owed would soar to historic levels. Since 1790, the United States has let its federal debt exceed 100 percent of GDP only once for a brief period during World War II, and until the 1980s the ratio of debt to GDP has never risen significantly during a period of peace and prosperity. But under the base scenario, the national debt would surge from 51 percent of GDP in 1995 to 157 percent in 2030 and 311 percent by 2050 if discretionary spending grew with inflation. If it grew with the economy, the debt would burgeon to 180 percent of GDP by 2030 and 373 percent by 2050 (see Table 1). Because the debt would be growing faster than the economy, it would ultimately become unsustainable.

Although deficits need not reduce economic growth if the funds they provide have been used to finance productive government investment, little of the projected growth in federal debt would be used for that purpose. Instead, the growth in borrowing would go largely to increase consumption by elderly people and to pay interest on the debt.

Results With Economic Feedbacks

The long-term budget outlook becomes even bleaker according to the CBO study when the projections include the impact of the deficit itself on the economy. With discretionary outlays growing with inflation, the federal deficit would increase to 26 percent of GDP in 2030 (see again Table 1). And if discretionary spending grew with the economy, the federal deficit would climb to 37 percent of GDP by 2030.

Those increases would clearly push federal debt to unsustainable-indeed, unthinkable-levels. In the end, they would greatly weaken the economy and halt the long-term upward trend in real GNP per capita that the United States has enjoyed over its history.

If discretionary outlays grew with inflation, federal debt would rise to more than twice the size of GDP by 2030. If, on the other hand, discretionary outlays grew with the economy, federal debt would surge to almost three times GDP by 2030 (see Table 1 and Figure 2). With federal debt growing so rapidly, the economy would enter a period of accelerating decline.

Figure 2	Ratio of Debt to GDP With Economic Feedback Effect
Source: Congressional Budget Office, The Economic and Budget Outlook: Fiscal Years 1997-2006, May 1996. *Assumes that discretionary spending grows with the economy and that economic feedback from large deficits slows economic growth.

CBO projections show the economy responding smoothly to the rapidly rising debt; actually, those adjustments would probably be much more disorderly. Foreign investors might suddenly stop investing in U.S. securities, causing the exchange value of the dollar to plunge, interest rates to shoot up, and the economy to tumble into a severe recession. (Those developments have occurred in some countries with rapidly growing government debt.) Higher levels of debt might also ignite fears of inflation in the nation's financial markets, which would push interest rates up even further. Amid the anticipation of declining profits and rising rates, the stock market might collapse, and consumers, fearing economic catastrophe, might suddenly reduce their spending. Moreover, severe economic problems in this country could spill over to the rest of the world and might seriously affect the economies of U.S. trading partners, undermining international trade.

STIMULATING LONG-TERM U.S. ECONOMIC GROWTH

The gloomy long-run CBO scenarios of the future of the U.S. economy are not inevitable. Budget policies can be revised and entitlement programs modified. In addition, tax policies which promote long-term U.S. economic growth by reducing the bias against saving and investment in the current tax code can be put in place.

Role of Investment and Economic Growth

The United States' sluggish growth in recent years can be partly attributed to low levels of investment. An international comparison suggests that countries with high levels of investment experience faster growth than countries with relatively low levels of investment (see Figure 3). For example, U.S. gross domestic investment averaged 18.8 percent over the 1974-93 period compared to 32 percent for South Korea; the growth rates for the two countries averaged 2.3 percent and 11.4 percent respectively (see Table 2 and Figure 3).

Figure 3	Investment as a Percent of GNP and Real GNP Growth, 1974-1993
Source: The World Bank, World Tables 1995 (Baltimore:The Johns Hopkins University Press).

The overwhelming importance of investment in plant and equipment for economic growth is emphasized in Harvard University Professor Dale Jorgenson's recent book, Productivity: Postwar U.S. Economic Growth. This study analyzes economic growth between peaks in the business cycle over the 1948-79 period. Allocating increases in output to three sources-growth in the capital stock, labor supply, and multifactor productivity-Professor Jorgenson found that increases in the capital stock had the strongest impact on growth in output.

Studies by University of California Professor Bradford De Long and Harvard University Professor Lawrence H. Summers (now on leave at the U.S. Department of Treasury) concluded that investment in equipment is perhaps the single most important factor in economic growth and development. Their research provides strong evidence that for a broad cross section of nations, every one percent of GDP invested in equipment is associated with an increase in the GDP growth rate itself of one-third of one percent-a very substantial social rate of return.

Is U.S. Saving Adequate?

Recent reports that the low U.S. saving rate should not be cause for concern (for example, see the new study by the McKinsey Global Institute) seem to overlook several key factors. First, U.S. saving is low not only in comparison to our international competitors (see Table 2) but also in comparison to its own historical record. U.S. net domestic saving averaged 9.3 percent over the 1960-80 period compared to only 3.3 percent since 1991. Second, the argument that rates of return on investment are higher in the United States than abroad and therefore we need not save as much as our less productive competitors seems questionable. If returns on investment are significantly higher in the United States than abroad, why is so much U.S. capital flowing into foreign investments? (Over the past decade, the flow of U.S. investment abroad has risen by over 600 percent.) In fact, new data from the Union Bank of Switzerland show that the average yield on equities over the past ten years was 17.4 percent per year in the Netherlands, 14.5 percent in Switzerland, 13.6 percent in the United States, and 13.2 percent in the United Kingdom. Finally, if capital were truly much more productive in the United States than abroad, we would expect that inflows of foreign capital would drive down returns on U.S. investment so that rates of return around the world would tend to equalize.

In addition, scholarly studies by Stanford University Professor B. Douglas Bernheim and others conclude that U.S. households are saving at only one-third the rate needed to enjoy the same standard of living when retired as they now enjoy.

U.S. Tax Policy Impedes Growth

Several measures show that the United States taxes new investment more heavily than most of our competitors. For example, according to a study by the Progressive Foundation, the think tank affiliate of the Progressive Policy Institute, the marginal tax rate on domestic U.S. corporate investment is 37.5 percent, exceeding that of every country in the survey except Canada (see Figure 4). The tax rate calculations include the major features of each country's tax code, in particular individual and corporate income tax rates, depreciation allowances, and whether the corporate and individual tax systems are integrated.

Figure 4	Effective Tax Rates on Domestic Corporate Investment, 1991
Note: Tax rates include both the corporate and personal tax on investment. Source: Enterprise Economics and Tax Reform, Progressive Foundation, Progressive Policy Institute, Washington, D.C., October 1994.

In addition, research by Harvard University Professor Dale Jorgenson shows that the United States' marginal tax rates on investment in equipment exceed those of all other countries in the survey even without factoring in the alternative minimum tax (AMT). Inclusion of the AMT would raise the U.S. tax rate even higher under reasonable assumptions regarding debt finance and interest rates. Many analysts conclude that our relatively low rate of business investment is directly related to high U.S. taxes on new investment.

Consumption Taxes and Economic Growth

Most other industrialized countries depend on taxes on consumption to a larger extent than does the United States (see Figure 5). Many OECD countries derive an average of 25 percent of their tax revenues from consumption taxes, compared to 15.0 percent in the United States. Greater reliance on consumption taxes by many of our major competitors means that saving and investment in these countries can be taxed relatively lightly, thereby stimulating economic growth. Many of the countries listed in Figure 5 have experienced faster economic growth than has the United States over the past two decades (see Figure 3).

Figure 5	Consumption Taxes as a Share of Total Tax Revenue in 1993
Source: Organization for Economic Cooperation and Development, Revenue Statistics of OECD Member Countries 1965-1994, 1995.

Switching to a tax system based on consumption rather than on income would have a significant, positive impact on the U.S. growth rate, according to studies by many top-flight public finance scholars. For example, work by Professor Alan J. Auerbach of the University of California shows that replacing the income tax with a broad-based national sales tax or value-added tax (VAT) could raise output by about 6 percent within 10 years and by 9 percent in the long run. Similarly, Stanford University Professor John Taylor, an adviser to the Dole presidential campaign, concludes that fundamental tax reform which reduced taxes on saving would increase growth by 0.3 percentage points per year ($270 billion per year).

Similar conclusions about the beneficial impact of switching to a consumption-based tax system appear in studies by Harvard University Professor Dale Jorgenson, Stanford University Professor John Shoven, and Boston University Professor Lawrence J. Kotlikoff, among others.

Social Security Privatization

Social security privatization is another type of tax reform that could have a positive impact on U.S. economic growth rates and thus help prevent the economic "implosion" scenario predicted by the CBO. According to a new report by Harvard University Professor Martin Feldstein, switching to a privatized social security system would have a very favorable impact on growth.

Under privatization, each employee or his employer would be required to make regular contributions into the employee's own retirement account. This account would then be invested in stocks and bonds. In the first year after the privatization of a pay-as-you-go system, the capital stock does not increase because the government must borrow all of the mandatory saving to pay benefits to existing retirees. But as time passes, the amount of net capital investment grows (because the mandatory saving rises with the number of employees and their average incomes) while the net social security debt that is explicitly recognized at privatization remains constant. As a result, the capital stock grows causing income to rise. Professor Feldstein concludes that the present value gain from privatization ranges from $10 to $20 trillion, depending on whether full or partial social security privatization is implemented.

Modified Tax Reform

Restructuring the current U.S. federal tax system to reduce the multiple taxation of saving and investment in the income tax-and thus to promote productivity and higher living standards-could also be accomplished through an incremental process. For example, a low-rate, broad-based consumption tax could provide the wherewithal to improve saving and investment incentives, reduce capital gains tax rates, repeal the AMT, pay for the transition to a privatized social security system, and other pro-capital formation measures. For example, a broad-based 5 percent consumption tax yields close to $250 billion per year, an amount sufficient to make major improvements to the current income tax.

Conclusions

As the President and the 105th Congress set their priorities in 1997, the issue of tax restructuring to enhance investment and productivity growth should assume a prominent role in order to help prevent the dire economic consequences forecast by the new CBO report if current budget policies remain unchanged. The pendulum may be about to swing away from the economic policies of the last decade, especially the substantial increase in the tax burden on saving and investment, and back toward progrowth policies. The hard fact in the face of looming budget deficits is that we can no longer afford the luxury of government economic policies that reward consumption, discourage saving and investment, overregulate American business, and penalize economic growth.

Notes

1. Congressional Budget Office, The Economic and Budget Outlook: Fiscal Years 1997-2006, May 1996.

References

Alan J. Auerbach, "Replacing the Federal Income Tax: Economic Considerations," testimony before the Committee on Ways and Means, U.S. House of Representatives, March 27, 1996.

Congressional Budget Office, The Economic and Budget Outlook: Fiscal Years 1997-2006, May 1996.

Dale Jorgenson, Productivity: Postwar U.S. Economic Growth (Cambridge, Mass.: MIT Press, 1995).

Martin Feldstein, "The Missing Piece in Policy Analysis: Social Security Reform," in The American Economic Review, May 1996.

McKinsey Global Institute, "Capital Productivity," June 1996.
Organization for Economic Cooperation and Development, Revenue Statistics of OECD Member Countries 1965-1994, 1995.

Progressive Foundation, Enterprise Economics and Tax Reform, Progressive Policy Institute, Washington, D.C., October 1994.

Union Bank of Switzerland, UBS International Finance, Issue 27, Spring 1996.

The World Bank, World Tables 1995 (Baltimore: The Johns Hopkins University Press).