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Flashpoint

August 15, 2011

FLASHPOINT: Time for adjustment to socio-economic compact

As the world economy trembles on news of brinksmanship in Washington on the debt ceiling, the subsequent Standard & Poor’s downgrade of U.S. debt, and the continuing Euro-zone crises which are moving from minor economies such as Greece to major ones such as Italy, it is time to re-consider our own socio-economic compact. That means that all tax structures and social safety nets have to be on the table for reform.

That would be a disproportionate response if the problem were temporary. It is not. Any examination of the Japanese economic situation beginning in 1990 or a look at where the U.S. economy would have been in the 1940s without a build-up to war, should scare you: two decades or more of no substantive economic growth on a per capita basis. 

At a time like this, it is easy to get caught up in details and focus on those that only support our underlying political beliefs. Republicans blame the entitlement state for rates of spending that are out of control and Democrats blame a refusal by Republicans to consider returning top marginal tax rates to their Clinton-era levels. Democrats simultaneously decry the “facts be damned” S&P downgrade while blaming Republicans for the S&P-cited political breakdown. Republicans assert it is that spending levels breaking out of their traditional 18 to 22 percent of Gross Domestic Product band and publicly-held-debt-to-GDP levels at 70 percent and rising fast. Who’s right? They all are.

Here are some basic facts:

• When a country’s debt rises beyond 90 percent of GDP there are serious economic-growth consequences. We are headed there.

• Other than during World War II, at no time has U.S. federal spending exceeded 23.5 percent of GDP with all but eight years being between 18 and 22 percent. In every year of the Obama administration it has been between 23 percent and 26 percent.

•The effective tax rate paid on the individual income tax has fallen in every income category. Those earning less than $50,000 have seen their effective income tax rate (actual income taxes paid/adjusted gross income) fall from nearly 15 percent at the end of the Clinton administration to 4.5 percent at the end of the Bush administration. The effective rate for those earning more than $200,000 also dropped from nearly 30 percent to 23 percent. That 7 percentage point drop constitutes much more money, by the way, than the 10.5 percent drop going to the lower end.

• Entitlement spending alone exceeds $2 trillion, will soon exceed $3 trillion, and will only grow from there.

We are here because we are spending more and because we are taxing less than we used to. The worst part about that is that we are doing both very badly. The spending is not on anything that will enhance future economic growth. It is largely just entitlement payments to people directly (Social Security, temporary assistance to needy families, earned income tax credit), for health care (Medicare and Medicaid), or other goods and services (food stamps, WIC, etc.) for those people. These transfer payments are part of our social safety net, but they do nothing to enhance economic growth.

Similarly, the tax structure has become as heavy with well-meaning deductions and credits as it was prior to  the 1986 tax reform. From “making work pay” to tax credits for energy efficient appliances and building materials, the unending desire to create a more perfect society by some has left us with a perfectly awful tax system. Our marginal tax rates have remained largely constant while effective tax rates have plummeted. In constructing a tax system you want the opposite to be true. You want the marginal rates to be as low as possible while raising the revenue you need to operate a modern government.

What all of this means is that the “grand bargain” discussed during the negotiations between Congress and the president was not nearly “grand” enough.

Here is my suggestion for a 21st century socio-economic compact to replace what we inherited but can no longer afford to maintain. In doing so, we need to recognize two realities and respond with policies that embrace them. The realities are that we are living longer and therefore need to work longer to stretch our old-age-based safety net, and that we need to know more than our parents did in order to be productive citizens. The policies that would enable us to manage our fiscal affairs in the face of this reality are these:

• We need to fold the entirety of federal payroll, corporate, estate, and personal income taxes into one individual income tax that is progressive. With no deductions or credits of any kind, no special treatment of income regardless of its source, and with the elimination of the double taxation on corporate profits, such a system would eliminate the perverse tax incentives, would eliminate the regressive nature of the payroll tax, would increase U.S. competitiveness, and with the correct rates, fund a revised social safety net.

• The social safety net needs to be revised by raising the eligibility age for Medicare (one month per year until it hits 67) and Social Security (two months per year until it hits 65 for early retirement and one month per year until it hits 70 for full benefits retirement.) We need to index the full-benefits ages for programs for life expectancy by adding a month per year as needed, and use the better chain-based price index to correct for inflation. Medicare Part B and Part D premiums also must be means-tested so that higher income individuals pay higher premiums.

• We need to provide the next generation the economic opportunity to prosper. We need a federal higher education voucher, in the amount of typical community college tuition costs, that would go to every high school graduate (allowing for military service and for a maximum of four years) to allow our children and future generations access to the lifestyle we hope for them.

Robert Guell is a professor of economics at Indiana State University. He is the author of “Issues in Economics Today,” McGraw-Hill’s leading economic issues textbook, and “Principles of Economics,” a McGraw-Hill electronic textbook. Send email to robert.guell@indstate.edu.

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