How The Relationship Between Taxes And Expenditures Will Be Strained

Tax Code

Tax Code

President Obama is set to go before a joint session of Congress to talk about the economy tomorrow night. While not a State of the Union address (Presidents don’t give one their first year in office) it is taking on the importance of one. On Thursday he will present his fiscal 2010 budget.

The New York Times on Sunday carried some of the details;

The president inherited a deficit for 2009 of about $1.2 trillion, which will rise to more than $1.5 trillion, given initial spending from his recently enacted stimulus package. His budget blueprint for the 2010 fiscal year, which begins Oct. 1, will include a 10-year projection showing the annual deficit declining to $533 billion in the 2013 fiscal year, the last year of his term, officials said.

While that suggests a two-thirds reduction, exceeding Mr. Obama’s goal of at least half, advisers note that the current deficit as a starting point is inflated by one-time expenses to stimulate the economy.

Measured against the size of the economy, the projected $533 billion shortfall for 2013 would mean a reduction from a deficit equal to more than 10 percent of the gross domestic product — larger than any deficit since World War II — to 3 percent, which is the level that economists generally consider sustainable. Mr. Obama will project deficits at about that level through 2019, aides said.

According to the article, he intends to forgo many of the accounting gimmicks usually employed by Washington and will push ahead with tax increases mainly by allowing the Bush tax cuts to expire. I wish the tax cuts weren’t a part of the package but as we shall see in a moment there is no alternative to growing revenues. As for more honesty in the budgeting process, I can only congratulate him as well as wish good luck.

But there is more afoot than what the Times reports and the prospects for reducing the budget deficit are going to be much more difficult to achieve than advertised. In an article in the National Journal, Jonathan Rauch presents the sea change in government expenditures that we are about to witness and the natural implications to government revenues.

Mr. Rauch points out that for over 40 years, federal spending has remained remarkably constant at about 21% of GDP.  Here is a chart of the trend:

It’s a remarkable statistic when you consider the turbulence both political and economic that have occurred during that period.

At the same time revenues have tended to run right around 18% of GDP resulting in budget deficits of two to three percent per year. As the Times article notes, this is what most economists would consider manageable. Mr. Rauch contends that this was an uneasy truce that served the need of both liberals and conservatives. Liberals could live with that level of government expenditure though they might hanker for more and conservatives could live with taxes that took no more than 18% of GDP on average. He feels, however, that the economic crisis and the fiscal stimulus plan will permanently alter that historical 21/18 relationship.

The CBO had estimated in January that expenditures would rise to the 25% for 2009. That was before the stimulus bill was enacted. While they say that it will fall back to 21% by 2012 but Rauch contends that his unofficial contacts think that’s a pipe dream. If the economy continues to lag even a reduction in spending is still going to result in a higher percentage share and few doubt that many of the spending provisions of the stimulus bill will become a permanent part of the budget. Rauch postulates that the number is going to be around 25% for the foreseeable future.

If that’s the case then you shatter the case for taxes consuming no more than 18% of GDP. Two or three percent gaps are acceptable, deficits amounting to seven percent or more of GDP are unsustainable for more than a couple of years. The only way out is, of course, tax increases.

Here is where Rauch brings in Bruce Bartlett. Bartlett is a conservative who is highly respected by many and thoroughly damned by some on the right and left for positions he has taken over the years. He thinks that this budgetary gap is going to force the country towards a new tax system. The income tax in its current form is, in his opinion just too creaky and loaded with exemptions and carve-outs to be able to generate the required revenues in an acceptable manner. Bartlett’s suggestion is to replace it with a European style value added or consumption tax.

This post could get extremely long if we started going into the pluses and minuses of the VAT tax. In the interest of brevity, I’ll just say that conceptually I have no problem with that regime so long as the income tax is abolished. I would not want to see the real European solution which is a VAT tax and an income tax.

The point here is to keep these historical ratios in mind as you see the economic and political debate over all of this unfold. Sometimes the numbers can numb you but if you reduce it to the simple 21/18 ratio you can pretty easily see the implications of straying too far from the norm. In truth, taxes are going to have to go up and probably substantially up. The rich don’t have enough income to plug the gap if it develops as Rauch expects so the government will have to tap the middle class as it always eventually does. Whether or not that flies politically is an important question and could have profound implications.

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