By R. Glenn Hubbard
Tax increases cant plausibly address the coming entitlement crisis.
Moodys Investors Services warning last week that the AAA credit rating of the United States is in jeopardy raises fresh concern about the nations fiscal health. The question to ask about the presidents eye-popping budget also rolled out last week is whether it prepares the country for its futureor shackles it to past decisions that our leaders would rather not confront.
President Obamas blueprint gave us a federal budget deficit for fiscal year 2010 of $1.6 trillion about 10.6 of GDP. While one expects bigger budget deficits in a downturn the administration expects the deficit and debt buildup to persist. By 2013 it forecasts that deficits will bring about a debt-to-GDP ratio of 72 unprecedented in our experience except during a major war.
The problem is spending. Despite Mr. Obamas words about restraint the new budget proposes more spending1.8 of GDP for 2011 to be preciseand a higher level roughly one percentage point of GDP higher in subsequent years.
Debates about the budget traditionally revolve around these numbers. There is another way to look at the federal budget however and that is to focus on its effect on our economic health not just the governments fiscal health. Focusing on economic health means setting our sights on productivity growthour future living standards.
To understand what this means consider the famous kitchen debates between Soviet President Nikita Khruschev and Vice President Richard Nixon in 1959 about the merits of capitalism and socialism. Nixon famously pointed to color television as a milestone in American innovation. The Soviet leader replied by trumpeting his nations lead in rocket thrust. The issue resurfaced in the televised 1960 presidential debates when Sen. John F. Kennedy attacked Nixon for wanting to lead a nation No. 1 in color TV but not in rockets.
Nixons response was essentially nothing. But the correct response was obvious: The nation with the higher present and future productivity growththe U.S.could lead in both color TV and rockets.
Today our productivity growth is imperiled by the anti-investment tilt of the presidents budget plan for escalating federal debt. Even conservative estimates of effects of federal debt on interest rates (by Eric Engen of the Federal Reserve and me in the 2004 National Bureau of Economic Research Macroeconomics Annual) suggest that the last Obama budget blueprint would lead to a one-percentage-point rise in Treasury interest rates as the economic recovery takes hold. The consequencelower business investment and real GDP 4 lower than it would otherwise be by the next presidential electioncompromises our future.
But there is more bad news. The Congressional Budget Office (CBO) estimates that without policy changes by 2050 spending on Social Security Medicare and Medicaid alone would be 10 percentage points of GDP more than today. Total federal spending would exceed 30 of GDP. ObamaCare would only exacerbate the problem. This means government spending for national defense education research and other priorities would be dramatically constrained.
This brings us to the reason we need a real budget debate today: Tax increases cannot plausibly make these problems go away. If taxes were increased sufficiently to accommodate the CBOs projected increase in entitlement spending long-term U.S. GDP growth rates would be reduced between a half and a full percentage point (an estimate derived from widely cited research by Mr. Engen and Jonathan Skinner of Dartmouth) unacceptably lowering our future living standards. This would be equivalent to erasing all the growth dividend gains of the great productivity boom of the 1990s.
There is a better way forward. In the present economic situation attempting to reduce the deficit drastically could spell another economic contraction. One can even make cogent arguments for cutting taxes on business investment and corporate profits given the importance of an improved investment climate for the recovery.
Rather the president and the Congress need to present a credible path toward lower deficits and more effective government. Such a plan should have three elements.
First introduce specific targets for reducing discretionary spending. The administration has set too easy a goal for a putative Presidents Fiscal Commission likely requiring deficit reduction of only 1 of GDP by 2015 to stabilize the debt-to-GDP ratio at more than 70. But this level is even higher than in 1950 when we were paying off debt from World War II.
The discretionary spending binge in both the Bush and Obama years offer many opportunities for further cuts. Indeed holding growth in the nondefense discretionary spending to 2 per year well under present levels is achievable and would free up funds for our future priorities.
Second slow the growth of entitlement spending on Social Security and Medicare. A good way would be to shave 1 per year from projected entitlement growth.
It is possible to do so progressively lowering the growth in benefits for middle- and upper-income households while strengthening support for lower-income households. Expanded saving incentives and health saving accounts can be used to help more affluent households prepare for retirement. Taken together these changes offer the greatest chance for reducing long-term spending while holding fast to governments legitimate social insurance role.
Third if the administration wants to maintain the spending path on which its budget blueprint places us it must confront and propose significant broad-based tax increases. Lets be clear what this means.
Our present income tax already relies very heavily on revenue from high earners; the top 1 pay well over one-third of federal income taxes. Mr. Obamas budget increases the reliance. But we cannot count taxes on the rich for deficit reduction health-care expansion and funding entitlements while ignoring the effect of those tax increases on investment innovation and growth.
To raise the revenue for the presidents welfare-state ambitions the tax increases must necessarily be broad-based as for example with a broad-based consumption tax. A useful start would be to calculateand present to the public each yearthe broad-based consumption tax required to pay for higher spending.
In the end the reason to get the nations fiscal house in order is less about deficits or debt as percentage points of GDP than about our future. We need a healthy dynamic and innovative economy. We need a safety net for those buffeted by change. And we need the flexibility to increase support for national defense and other new domestic priorities.
Mr. Hubbard dean of Columbia Business School was chairman of the Council of Economic Advisers under President George W. Bush.
