The Exploding Fiscal Gap

Clive Crook takes a hard look at the dark side of the U.S. budget in his FT.com column this week. What he sees is not exactly what the American middle class thinks is coming.

He starts out conventionally enough noting that the various administration budgets and fiscal stimulus plans have an embedded 3% gap between revenues and expenses, 4% if you want to use the Congressional Budget Office numbers. He notes that this is in addition to the 8% fiscal gap that most think exists once the baby boomers start collecting.

That’s a tough nut right there but he throws a ringer into the equation. It comes in the form of the cherished health care reform, half of which is supposed to be raised by cap-and-trade taxes. But this is where he sees things starting to go off track.

Also bear in mind that the budget’s signature spending initiative now looks more likely to pass, whereas its signature revenue-raising initiative looks doomed.

The House has written language into its budget that would allow health care reform to pass in both chambers with simple majorities, rather than with the super majority normally required in the Senate. The Senate bill does not include such language, but the version that emerges from the conference might. If so, this momentous reform could be enacted without a single Republican vote. At the same time, reflecting the reluctance of many Democrats, the Senate has as good as ruled out this same procedure for carbon cap and trade, the implicit energy tax that was projected to raise hundreds of billions.

In short, whether it intends to or not, Congress is leaning towards making the long-term deficit even bigger. It is preparing to underwrite a large and permanent expansion of the government’s spending obligations while failing to provide for a corresponding expansion of the tax base. A crucial question is therefore whether, and for how long, Mr Obama will continue to be bound by his pledge to raise income taxes “by not one cent” for almost all Americans.

Now, nowhere is it written in stone that the Congress of the United States won’t set aside their partisan bickering and agree to a responsible compromise. It’s just highly unlikely. Therefore, we can assume that something like this scenario is probably going to come to pass.

We can, for awhile, ignore the yawning fiscal hole that’s being created. After all, everyone knows that you don’t raise taxes in the middle of a recession. Right now we’re kind of like freshmen at college — for at least a little while there are no rules of good conduct. Like those same freshmen we will realize sooner than we like that living in that universe doesn’t square with the realities of life. They have to start studying and we will have to start taxing ourselves.

Here is where Mr. Crook’s column provides some very interesting data for the debate.

Mr Obama intends to squeeze the rich, but the scope for this may be more limited than US liberals would wish. Few Americans seem aware that the US income tax code, as a recent Organisation for Economic Co-operation and Development study showed, is already one of the most progressive.* Even before the rise in top marginal rates promised by Mr Obama, the US income tax collects 45 per cent of its revenues from the highest-income decile. Compare that with Britain at 39 per cent, Canada at 36 per cent, France at 28 per cent, Sweden at 27 per cent and an OECD average of 32 per cent.

This difference is only partly explained by the less-equal US income distribution. The fact that the US has no broadly based national sales tax – value added taxes make Europe’s overall tax codes less progressive still – only underlines the point. The US tax system raises comparatively little revenue; what little it raises already comes disproportionately, by international standards, from the rich.

Obama knows this, the Democrats know this and the Republicans know this. The only way that you can pay for the bills we’re running up is by broadening the tax base significantly and raising taxes on that base. Crook suggests that the solution is the European one — a VAT combined with the income tax.

I run hot and cold on the VAT. It has its advantages but it’s also so invisible as to be a politician’s dream. I could probably overcome my aversion if it were the only national tax but to retain an income tax and layer a VAT on top is a non-starter. That is simply capitulation to spending without restraint.

Don’t look for this to be a front burner sort of issue. The ruling class doesn’t want it there right now. Better to have the benefits in place when you spring the surprise that these things do have to be paid for. People tend to examine things a bit more closely if they are of the opinion it might actually cost them money.

When the can can’t be kicked any further you will see this issue emerge and once again the middle class is going to realize they have been had.

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